Brexit update for financial services firms - week ending 10 August 2018

United Kingdom

The week in outline:

This has been another quiet week.

FCA published a “dear CEO” letter on business models and legal entity structures (see Document 1 below): “We [the FCA] are aware that some authorities elsewhere in Europe have set out specific requirements as regards business models. We are open to a broad range of legal entity structures or booking models. This includes those making use of back-to-back and remote booking, providing their associated conduct risks are effectively controlled and managed. Our starting point is therefore not to restrict business models but to understand the principles and practice involved and how the conduct risks that arise from them are managed.”

Policy statements from the ESAs on Brexit restructuring have adopted a more prescriptive approach (see for example the EBA opinion and the ESMA opinion).

The FCA’s statement and its more flexible approach coincides withrecent reports thatChancellor Philip Hammond was concerned about the danger of capital shifting from the UK to the EU as a result of Brexit -"preventing the wholesale movement of regulatory capital into Europe was key”.[1]Flexibility on business structures and back-to-back booking would help firms to maintain capital in the UK.

The Chancellor was also reported as encouraging the City to develop business outside the EU - “It is important that the UK is able to display in parallel, a strategy to grow non-European financial services business, such that the threat to pull out of EU arrangements is seen to be real”[2] (see our report on the Global Financial Partnership Strategy in our update of the week ending 22 June 2018).

FMLC published a Brexit report on legal uncertainty in financial contracts (see Document 2 below). This looks at the question of ‘contract continuity’ in some detail. It discusses the risks and mitigation steps that private parties can take (including ‘Brexit clauses’) but reinforces the message from market participants, who believe that legislative and regulatory action is required on both the UK side and the EU side (either at an EU or Member State level). This approach has support in the UK, where domestic legislation is proposed (see our update for the week ending 27 July 2018), but not on the side of the EU which has emphasised the need for firms to find their own solutions (see our update for the week ending 29 June 2018). Once again, the EU’s approach seems to be more about putting pressure on UK firms to relocate business to the EU-27 and less about legitimate regulatory objectives, such as financial stability.

HM Treasury introduced another draft SI for financial services under section 8 of the European Union (Withdrawal) Act 2018. This one makes changes to the onshored/ported version of the EU Short Selling Regulation (see Document 3 below).

1. FCA “Dear CEO” Letter: Cross-Border Booking Arrangements

“In the light of Brexit, this "Dear CEO" letter sets out a number of principles for firms to comply with and notes that FCA expects UK boards and senior managers to ensure that effective governance is in place to identify and mitigate the potential harm which could arise from modified booking arrangements. Firms should also be able to demonstrate how the principles have been observed and implemented. The letter can be accessed here.

“If you are expanding your presence elsewhere in Europe, the structures you put in place must enable us to supervise the conduct of your UK business effectively and ensure that you continue to meet our threshold conditions. When designing the structures you should assess whether the proposed changes are in the best interests of your clients.

We are aware that some authorities elsewhere in Europe have set out specific requirements as regards business models. We are open to a broad range of legal entity structures or booking models. This includes those making use of back-to-back and remote booking, providing their associated conduct risks are effectively controlled and managed. Our starting point is therefore not to restrict business models but to understand the principles and practice involved and how the conduct risks that arise from them are managed. As such, booking models should comply with the following principles:

  • Firms should set out a clear rationale for their booking arrangements, document them and have them approved by the Board.
  • Risk management should be appropriate for the firm’s booking activities including hedging arrangements.
  • There is a broad alignment of risk and returns at the entity level.
  • Firms should have adequate systems and controls in place to ensure that booking arrangements are followed.
  • Firms should consider whether responsibility for oversight of booking arrangements should be explicit in statements of responsibilities.
  • Booking arrangements should not be an impediment to the firm’s recovery and resolution.

We expect UK Boards and Senior Managers to ensure that effective governance is in place to identify and mitigate the potential harm which could arise from modified booking arrangements. Firms should also be able to demonstrate how the principles above have been observed and implemented. For dual-regulated firms, this approach, including the principles above, is consistent with the PRA’s established approach to booking practices and we will continue to liaise closely with PRA colleagues on their implementation in the context of EU withdrawal.”

2. FMLC: UK Withdrawal from the EU: Issues of Legal Uncertainty Arising in the Context of the Robustness of Financial Contracts

FMLC's report considers the continuity of legacy contracts and highlights the legal uncertainty which will arise if there is no clarity as to the future of the UK/EU post-Brexit relationship. It also looks at ways in which these issues might be mitigated by firms and through legislative action. The report can be accessed here.

“The possible consequences of a “hard” Brexit, involving a wholesale loss of authorisations, may be divided into three broad categories: (1) consequences under the general law in those cases where the contract may be affected by illegality or frustration; (2) any consequences according to the terms of the contract itself, as, for example, in those cases where loss of authorisation may breach a representation and trigger a termination event; and (3) consequences under criminal law or similar sanctioning regimes which might come into play were the firm considered to be carrying on a regulated activity without authorisation.”

[…]

“As noted above there are risks for parties to contracts concluded by U.K. firms with E.U. clients or counterparties before the U.K.’s departure from the E.U., where these contracts remain to be performed or otherwise operated after the U.K. departs. There are significant legal uncertainties in respect of whether U.K. firms may require E.U. or local (Member State) regulatory authorisations for the performance or operation of those contracts after the U.K.’s exit, authorisations which cannot practically be obtained and the absence of which might mean that a U.K. firm is exposed to criminal or administrative sanctions or other adverse regulatory consequences and/or that the contracts may be found to be illegal or unenforceable.”

[…]

“One possibility which market participants have been exploring is the insertion of a “Brexit clause” into contracts entered into after the referendum. A “Brexit clause” is a contractual provision which triggers some change in rights/obligations as a result of a defined Brexit-related event. The clause therefore sets out two basic things: (a) the specific Brexit related event triggering the clause; and (b) the contractual consequences of that event. These clauses have been compared to Material Adverse Change clauses.”

[…]

“In acknowledgment of the limitations of the private sector solutions, market participants have suggested that legal and regulatory action by authorities in the U.K. and E.U. might better mitigate these risks. Such action, whether included in the Withdrawal Agreement, undertaken by the E.U. or initiated by individual Member States, would apply similarly to business conducted in the E.U. as that proposed by U.K. authorities in relation to business conducted in the U.K., and would involve legislative provisions continuing, after the U.K.’s exit from the E.U. (likely to be at the end of the transition period), the E.U. regulatory authorisations of U.K. firms which formerly benefitted from the “passport”, to the limited extent necessary to enable an orderly wind down of their business with E.U. clients and counterparties.”

[…]

“The E.U. could adopt an E.U. regulation to address the continuity issues for existing contracts, again in a similar way to that proposed by U.K. authorities.”

“In this paper, the FMLC has highlighted the questions which will be faced by market participants in relation to the continuity of contracts following a hard Brexit. The FMLC has found that, for the most part, it is in agreement with the European Commission’s Communication of July 2018 (mentioned in paragraph 1.12 above) and considers it unlikely that Brexit will give rise to issues of contractual continuity in a general sense and so far as it is a matter of English law and jurisdiction. Nevertheless, the FMLC has explored the potential consequences to all concerned, including clients and markets, where authorisations are lost without adequate alternatives. Finally, the FMLC has examined some of the ways by which these issues might be mitigated, both by firms themselves and through legislative action, including within an agreement between the U.K. and E.U.”

3. HMT: Draft Short Selling (Amendment) (EU Exit) Regulations 2018

HMT has published a draft SI and explanatory note that makes amendments to retained EU law related to short selling to ensure that it continues to operate effectively in a UK context once the UK leaves the EU, in any scenario. HMT intends to lay this SI before Parliament in the autumn. The draft SI can be accessed here. The accompanying explanatory notes can be accessed here.

According to the explanatory notes:

“The EU SSR [short selling regulation] applies to financial instruments admitted to trading or traded on an EEA trading venue (unless they are primarily traded on a third country venue). The regulation also applies to debt instruments issued by EU sovereign issuers and related credit default swaps. The SSR requires holders of significant net short positions in shares or sovereign debt to make notifications of their positions to their national competent authority (NCA) once certain thresholds have been breached. It outlines restrictions on investors entering into uncovered short positions in shares or sovereign debt and contains buy-in procedures and late settlement requirements to ensure settlement discipline. The SSR also enables NCAs to tackle the downward spiral in the prices of shares, notably financial institutions, which could otherwise threaten their viability and create systemic risks during times of market stress.”

The legislation corrects deficiencies in the domesticated/ported/onshord version of the SSR and Commission Delegated Regulation No. 918/2012 (which are both pieces of ‘retained EU law’) including the removal of single market DRC/scope -

  • It amends the scope of the regulation to relate to instruments admitted to trading on UK venues and UK sovereign debt only
  • It deletes provisions to facilitate cooperation and coordination across the EU
  • It adapts certain exemptions where the principal trading venue is in a third country and provides for FCA powers and the potential for transitional measures relating to lists maintained by ESMA
  • It adapts certain exemptions for market markers and authorised primary dealers and puts EU-27 firms on a similar basis to third country firms
  • It gives the UK greater powers to impose restrictions to address threats to financial stability or market confidence

FCA will consult separately on relevant changes to its rulebook and onshored binding technical standards at a later stage.

Other publications from the RegZone Brexit news feed

HoC: Brexit – implications for private pensions

This HoC library briefing considers the potential impact of Brexit on private personal and occupational pensions. The paper can be accessed here.

FCA: Board minutes

FCA has now published Board minutes for its 23/24 May 2018 meeting. Topics discussed include: annual reports from FCA, PRA and monthly reports from the independent panels; Brexit and the Handbook; BSPS; sovereign-controlled companies and the high-cost credit review. The minutes can be accessed here.

CMS RegZone publishes weekly updates (available via email, on-line and via Twitter) on Brexit developments for financial services firms. These provide analysis and commentary on significant developments during the week in question. A daily digest of Brexit news (without analysis or commentary) is also available by email here and online via the RZ news wizard here (both of these can be filtered using the Brexit topic). Links to publications are contained in each update; publications released before the updates commenced in April 2018 can be found in a bibliography here. CMS RegZone publication ‘Where we stand’ provides an overview of the current position in a single report; this is updated regularly to take account of the key developments from the weekly updates.

 


[1] See Financial Times, “Hammond sees dangers of bank capital shift after Brexit” (6 August 2018).

[2] See Financial Times, “Philip Hammond warns over French effort to stifle City with red tape” (August 5 2018).

[3] See Financial Times, “Hammond sees dangers of bank capital shift after Brexit” (6 August 2018).

[4] See Financial Times, “Philip Hammond warns over French effort to stifle City with red tape” (August 5 2018).