A new dawn for EU "substance" requirements?

29 November 2022

At the Irish Funds’ UK symposium on 24 November, the Central Bank of Ireland’s (CBI's) Derville Rowland made an ominous remark in her address: the AIFMD reforms "mark the start of a longer-term process that will take a deeper and more comprehensive look into delegation in Europe."

Since the Brexit vote in 2016, EU policymakers have considered tighter controls on the ability of firms to market their products and services in the EU, while undertaking much of their activity in so-called "third countries", and very often, the UK. Part of the rationale is undoubtedly economic and political, but there is also a regulatory concern about "brass-plating": firms nominally domiciled in the EU to take advantage of those benefits, but in practice running a lean local operation with few resources, controls or oversight.

Much focus has been on the delegation of portfolio management activity from EU firms to investment managers in the UK. EU policymakers had appeared to row back from tougher ideas, especially emanating from France in the more febrile days before the EU/UK Trade and Cooperation Agreement was agreed. The AIFMD II appears to have settled on more transparency, rather than hard limits to the amount of activity that can be delegated outside of the EU: firms will be required to report to regulators on the nature and scale of their delegation arrangements. The immediate priority is to ensure that firms comply with ESMA’s tougher guidance, and local rules in Ireland and Luxembourg that more closely prescribe the need for firms to have "substance" in the EU.

However, the CBI’s comments suggest that “there will be a period of evaluation and reflection” after the AIFMD reforms are completed. “Further work in this area may be proposed”, Rowland added. As the CBI official in charge of Ireland’s conduct policy and the chair of ESMA’s Investment Management Standing Committee, her remarks are a good indicator of what will happen next.

Delegation is not the only area in the EU’s firing line. Firms’ methods of marketing services under MiFID II have also come under scrutiny – particularly more fluid arrangements such as chaperoning, secondments and tied agency. (For background, read our briefing for Private Debt Investor that explains the post-Brexit problem, the solutions in the market and ESMA’s response.) ESMA is currently consulting on reforms to the tied agency passport. Firms that wish to use a tied agent across Member State borders or tied agents that wish to offer their services across the EU, will be subject to additional reporting requirements. Like the AIFMD’s delegation reforms, the outcome is enhanced transparency.

The sense of these reforms must be that EU regulators are collating more information about cross-border arrangements with a view to further regulatory rules or supervisory action. The drift to divergence between the EU and the UK is set to gain momentum as the EU pursues its own legislative reviews and the UK seeks a "Big Bang 2.0". In turn, this could result in more explicit barriers to trade with the EU – and by implication, these protections will impact the rest of the world and not only the UK. Firms that had hoped for protectionism to recede from 2020 are likely to be disappointed.

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