MontLake Commentary on Michael Hodson speech on 14 May 2019

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David Hammond, General Counsel at MontLake, summarises the key issues presented by Michael Hodson, Director of Asset Management and Investment Banking at the Central Bank of Ireland in his recent speech in London on the 14th May.

This speech covered a number of items of interest to fund managers with funds based in Ireland, and particularly for UK fund managers in the context of marketing and distribution in Europe by non-EU managers post-Brexit. This speech additionally covered substance requirements for funds and management companies.

Brexit – it hasn’t gone away

To begin with, Mr Hodson acknowledged the effects of Brexit fatigue, but cautioned against becoming complacent. He pointed out that the UK could leave the EU sooner than the 31 October date if an agreement is reached by the British Parliament and the EU, and suggested that it would be wise to continue planning for Brexit. He noted that lead times could be up to a year for establishing a regulated entity in the EU, so that even though a number of Brexit issues around the ability of UK firms to continue to manage EU assets post Brexit had now been settled in a way favourable to the industry, UK firms needing an EU regulated entity to service and market their products to their EU clients had a limited window in which to take action. The implication was that while the risk of these firms being excluded from the market had receded for now, it could reappear at any time.

Reverse solicitation in trouble?

More significantly perhaps, he made it clear that EU regulators were very much working together in a co-ordinated fashion to make sure that operations would only be authorised in the EU if they had sufficient substance, and that devices to circumvent or avoid EU regulatory requirements around marketing authorisations would not be tolerated.

He also warned against relying on the concept of ‘reverse solicitation’ to avoid the need for EU regulation, commenting that it was already limited in scope and that ESMA are already working on an initiative to restrict its use even further.

Regulators on the watch for artificial arrangements

Secondments of UK staff to Irish regulated firms (and presumably, by extension, to firms regulated in other EU locations) received special mention. Mr Hodson said that ‘genuine’ secondments, with the proper structures, can work, but that the Central Bank would be looking out for and had already turned down proposals which were “legalistic, technical or … artificial attempts” to get around EU rules.

EU regulation becomes more “joined up”

The most interesting aspect of Mr Hodson’s speech from a Montlake perspective was the emphasis on co-ordinated action by EU regulators around the regulation of distribution activity in the EU, as well as the explicit recognition that, if structured properly, there is a route for UK managers to continue to be able to access distribution channels in the EU post Brexit. The EU is often criticised for a piecemeal and fragmented approach to regulation across the different countries, but on this at least, if Mr Hodson’s remarks are a good indicator, the EU seems to be getting its act together. 

As a result, it appears that the Central Bank is clearly signalling that the current regime for marketing products across Europe, in particular fund products, is going to change, as the EU attempts to curtail some of the informal routes to market that managers use at present and to close the market to some extent to non-EU managers which have not established a regulated presence in the EU.

Not just a UK manager issue – this may affect all non-EU managers

Incidentally, while Brexit may be the trigger for these changes, logic suggests that changes in this area will affect all non-EU managers, and not just those from the UK, as rule changes will apply across the board. Managers from the US and elsewhere that have used reverse solicitation and other informal distribution methods may now find that, unless they take positive action, they may find themselves cut off from distribution to EU investors.  

Are there alternatives?

At the same time, it appears the Central Bank has also accepted that it is possible for non-EU managers to work in tandem or in partnership with properly structured and resourced EU entities, using non-EU staff on a part-time or secondment basis. The key, to paraphrase Mr Hodson, is to have sufficient management resource and organisational structure, while avoiding conflicts of interest and other risks, so that the control and risk management structure overall is satisfactory.

Implications for existing operations

Continuing the substance theme, the speech also discussed the Central Bank’s plans to follow up on its CP86 measures on fund and management company effectiveness with a themed review of how they have been implemented by firms. Brexit featured here too, as he indicated that the scope of the Central Bank’s review would be informed by input at EU level and experience with the recent flood of authorisation applications from UK firms looking to have an EU presence post Brexit. While he did not explicitly say this, our take on this is that he was hinting at an extension of the greatly increased substance requirements the Central Bank has been imposing on Brexit-driven authorisations to existing managers and self-managed investment companies.

This has been a concern of the industry for some time as, echoing the issue by the Luxembourg CSSF of its paper on management company requirements for Luxembourg companies at the end of last year, it appears that the Central Bank has been looking generally to increase substance requirements across the board for authorised entities.  While not targeted specifically at self-managed funds, the feeling amongst many industry participants is that these changes will make the position of many self-managed investment companies untenable, driving them to appoint a management company for the first time.

At the same time, increasing the substance required of management companies is likely to raise the bar for setting up new management companies, and prompt investment groups to reconsider whether it makes sense to persist with existing management company subsidiaries that might be perceived to be small or sub-scale, especially when third party solutions are available well-resourced and credible options, at reasonable cost.       

If you are interested in learning more about what was said by Michael Hodson and how MontLake is uniquely positioned to help, please get in touch.