Substance - ESMA Raises the Stakes

20 Jun 2017

As David Davis starts UK Brexit negotiations in Brussels this week with a "positive and constructive" state of mind, despite the General Election result, the European Securities and Markets Authority (ESMA) continues to push back, turning its attention to the topic of "Substance".

ESMA's latest opinion published at the end of May, has outlined nine principles for European Member States to take on board regarding the mind, management and control of investment structures. This opinion is off the back of increased requests from UK financial market participants to locate some operations in a Member State in order to ensure a pan-European distribution platform, but with sub-delegation back to its UK branch. Set within the context of AIFMD, the UCITS Directive, MiFID I and MiFID II; ESMA's proposition is seen as a practical tool to support supervisory convergence.

ESMA's Chair, Steven Maijoor has stated that the EU has a "shared interest in building a common approach to dealing with relocating firms that wish to continue to benefit from access to EU financial markets. Firms need to be subject to the same standards of authorisation and ongoing supervision across the EU27 in order to avoid competition on regulatory and supervisory practices between Member States. Effective and efficient supervision are essential to support the Capital Markets Union."[1]

ESMA has made it clear that, in the event of market participants sub-delegating activities or functions back to the UK, it will be necessary to ensure that the conditions for authorisation as well as for outsourcing and delegation do not generate supervisory arbitrage risks.

Any outsourcing or delegation activity from market participants within the EU back to the UK or to third countries will be "strictly framed and consistently supervised."[2] ESMA has made it clear that EU based entities should not simply become letter-box entities which could lead to barriers to effective supervision and enforcement. As a result, ESMA's latest opinion has set out the following nine principles:

1. No automatic recognition of existing authorisations - UK managers will need to seek a new authorisation from National Competent Authorities (NCAs) of Member State(s) from where they propose to establish. No automatic recognition of authorisation by the UK regulator will be granted in the EU.

2. Authorisations granted by EU27 NCAs should be rigorous and efficient - ESMA has stated that NCAs should focus particular attention in the areas regarding corporate governance, human and technical resources within the chosen domicile, marketing distribution activities, and also planned outsourcing and delegation arrangements.

3. NCAs should be able to verify the objective reasons for relocation - NCAs will need to have a clear understanding of the planned distribution arrangements of managers and therefore should receive information relating to marketing activities, products and services, and potential investors.

4. Special attention should be granted to avoid letter-box entities in the EU27 - ESMA has recommended to NCAs to reject any relocation request which creates letter-box entities.

5. Outsourcing and delegation to third countries is only possible under strict conditions - ESMA has once again highlighted that whilst firms can delegate specific functions and tasks, the responsibility for the fulfilment of compliance remains with the delegating/outsourcing entity.

6. NCAs should ensure that substance requirements are met - NCAs will need to be provided with the necessary information to ascertain if the applicant has the appropriate substance within the Member State and that decision-making must reflect this substance.

7. NCAs should ensure sound governance of EU entities - NCAs must ensure decision-making powers remain in the Member State and that board members have the appropriate technical expertise, understanding and resources to fulfil their fiduciary duties.

8. NCAs must be in a position to effectively supervise and enforce Union law - NCA will need to assess on a case-by-case basis whether the application put forward adversely impacts their ability to enforce relevant legislation.

9. Coordination to ensure effective monitoring by ESMA -ESMA is drawing up plans for a forum dubbed the 'Supervisory Coordination Network' which will enable NCAs to discuss specific cases.

As ESMA's latest report highlights, the topic of substance continues to be a key area within the funds industry, particularly driven by developments around BEPS, AIFMD and MiFD II. Clearly, managers must ensure that they maintain adequate resources with appropriate levels of technical knowledge, expertise and understanding, not only to ensure that decisions are being carefully considered, but that the decisions take place within the relevant jurisdiction.

As a leading third party administrator, having built a team of specialist Private Equity and Real Estate directors, Ocorian takes its fiduciary responsibilities regarding the running of client fund and investment structures very seriously. Fundamental to this responsibility is to ensure that the mind, management and control of these structures is undertaken in the appropriate jurisdiction with dedicated resources and expertise.




[2] ibid.

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Executive Director - Alternative Investments, Europe