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By: Winston Penhall, Reed Smith LLP
This article addresses common questions and concerns regarding the marketing of alternative investment funds in the European Economic Area (EEA), should a “hard Brexit” occur. Hard Brexit is a scenario in which the United Kingdom (UK) fully exits the single market and leaves full access to the customs union along with its membership in the European Union (EU). In contrast, a “soft Brexit” would keep the UK’s access to the European single market (as part of the EEA) and remain within the EU customs union, meaning that there would be no border checks for UK exports, among other benefits.
THE ALTERNATIVE INVESTMENT FUND MANAGERS DIRECTIVE (Directive 2011/61/EU) of the European Parliament and of the Council of June 8, 2011, on Alternative Investment Fund Managers1 currently permits EEA-domiciled alternative investment funds (EEA AIFs) to be marketed throughout the EEA to EEA-domiciled or incorporated professional clients on a passported basis, but only if the alternative investment fund manager (AIFM) of the alternative investment fund (AIF) is fully regulated as an AIFM by an EU regulator. Note that the third-country passports under AIFMD for non-EEA AIFs and/or non-EEA AIFMs have not been activated yet.
A non-EEA fund manager (such as a U.S. manager) that is not regulated in the EEA as an AIFM typically actively promotes (as opposed to relying on reverse solicitation) its EEA-domiciled AIFs to EEA professional investors in one of three ways:
If Brexit were to occur without a formal withdrawal agreement or transitional arrangements being put into place by the remaining EEA states in respect of the UK, then UK AIFMS and UK AIFs will lose their passporting rights in respect of the EEA (and of course the reverse would apply). This will impact non-EEA managers using the AIFM Platform and Subsidiary Models where the AIFMs manage EU AIFs that are passported into or out of the UK.
The Treasury laid before Parliament, in July 2018, The EEA Passport Rights (Amendment, etc., and Transitional Provisions) (EU Exit) Regulations 2018 2 in draft form, which seeks to create a temporary permissions regime (TPR), among other things, for inbound passported AIFMs and AIFs.
The UK Financial Conduct Authority (the FCA) issued a consultation paper3 on October 10, 2018, which sought responses by December 7, 2018, to its TPR rules, which would apply on a hard Brexit (which would come into force if the UK does not negotiate a withdrawal agreement with the EU before 11:00 p.m. on March 29, 2019, called “exit day” in the draft regulations).
On the legislative front, the UK Treasury under the European Union (Withdrawal) Act 2018 published draft statutory instruments4 (The Alternative Investment Fund Management (Amendment) (EU Exit) Regulations 2018 (the Draft AIF Regulations) and The Collective Investment Schemes (Amendment etc.) (EU Exit) Regulations 2018 (which seek to amend the UK Alternative Investment Fund Managers Regulations 2013 and UCITS implementation laws respectively)) on October 8, 2018, which would come into force on exit day in a hard Brexit scenario and would repeal the existing EEA passporting regimes.
Without a form of TPR, EEA incoming managers would need to formally apply for and receive FCA authorization on or before exit day to continue conducting UK-regulated activities on and from exit day. The AIF marketing passport will likewise fall away on exit day (as would the national private placement regime requirements under AIFMD as they apply to the UK), so EEA-domiciled AIFs would need to be re-registered by their AIFMs with the FCA under the UK national private placement regime (or receive recognized fund status under Section 272 of the UK Financial Services and Markets Act 2000) prior to that date to enable seamless marketing from exit day.
Broadly, (1) EEA AIFMs may opt into the TPR if they qualify for authorization under the existing passporting regime and notify the FCA of that fact before exit day (more on the notification procedure below); and (2) EEA AIFMs may opt into their (i) EEA-domiciled AIFs and (ii) third-country AIFs into TPR, provided that EEA AIFs are eligible to be marketed via the existing AIFMD passport into the UK, or the third-country AIF is marketed under Article 36 of AIFMD (already registered under the UK national private placement regime) prior to exit day. By definition then, the TPR does not apply to UK-authorized funds (UK UCITS or UK non-UCITS retail schemes).
The effect from 11:00 p.m. on exit day on firms that opt into the TPR is that they will be treated as being authorized by the FCA and so (1) the FCA will supervise those TPR firms, and (2) UK laws and regulations will apply to those firms together with UK-implemented EU directives which are currently enforced by their home state regulator (including regulatory notifications and other obligations), which contrasts with the existing passporting regime where the compliance burden predominantly falls on the home state regulator of the incoming EEA AIFM. An EEA AIFM that opts into the TPR will be able to market its AIFs in the UK without having the financial promotion approved by an FCA-authorized firm.
Firms opting into the TPR should note that the FCA Principles for Business will apply to TPR firms in full (aside from Principle 4, financial prudence, which deals with capital adequacy) because from 11:00 p.m. on exit day, there will be no home/ host state regulatory split. Firms that have not previously been authorized by the FCA should note in particular that Principle 11 requires all firms to be open and cooperative with the FCA and are required to notify the FCA of any matter or issue of which the FCA would reasonably expect notice, regardless of whether there is a specific rule, for example, which requires notification to a home state regulator. TPR firms will need to adjust their compliance and reporting procedures accordingly.
The TPR is intended to run for three years (which may be extended by the Treasury); however, in practice, the actual period will vary. On acceptance of a TPR firm, the FCA will notify that firm of the three-month time period or landing slot by which time it expects to receive a formal FCA authorization application from the TPR firm. Given that the first landing slot period is envisaged to be September– December 2019, the actual transitional period will differ between firms depending on their landing slots.
Similarly, for AIFs the FCA will notify the AIF of its landing slot for submission of an application for recognized fund status under FSMA Section 272. The alternative for the AIF will be to register under the UK national private placement regime, which may not give it access to the same categories of investor. The FCA expects to enforce the landing slots, so it is likely that it will have the power to remove a firm or AIF from the TPR if that firm or AIF does not make its application during its allocated landing slot. If a firm is refused authorization by the FCA, then its TPR permissions will terminate.
When? The FCA will open the notification window in early 2019, which will terminate on exit day. If a firm or AIF does not make a notification on time, it will lose its right to opt into the TPR.
How? The FCA envisages that firms opting in will make the notification for a temporary permission by using the FCA Connect system and will in due course publish a guide to the notification process on its website.
No, the firm would have to apply for full authorization and include the varied permission as part of its application. Firms applying for the TPR will need to take care in determining which permissions they will notify the FCA of when opting into the TPR. Similarly, TPR firms will not be able to vary the categories of investor from those for which they had permission to market before exit day.
Only those umbrella funds and their specific sub-funds that received a passport before exit day and that opted into the TPR will be eligible to continue marketing after exit day. New sub-funds of an existing umbrella structure or new stand-alone funds will need to be registered under the UK national private placement regime or apply for recognized fund status.
Without a similar regime to the TPR or a general transition period granted by the EU, UK AIFMs will lose their right to passport UK AIFs and EEA AIFs into the EEA while UK AIFMs will also lose their AIFMD management passport.
Non-EEA managers using the AIFM Platform Model or Subsidiary Model should therefore consider what impact a hard Brexit would have on the marketing of their AIFs. For example, assuming no EEA transition period or TPR equivalent, a non-EEA manager using a UK AIFM Platform Model or a UK Subsidiary would not be able to market EEA AIFs managed by the UK Platform AIFM on a passported basis from exit day. It may also be the case that the UK AIFM Platform or Subsidiary AIFM would lose the right to manage EEA AIFs from exit day. UK AIFMs marketing EEA AIFs into the UK will be able to avail themselves of the TPR.
This article has focused on AIFs; however, it should be noted that a similar TPR regime applies to UCITS.
Assuming no transition period or EEA TPR equivalent, EEA UCITS will become AIFs, and, therefore, if they do not avail themselves of the TPR, they will be subject to NPPR/recognized fund applications to market into the UK (and will lose the automatic right to market to UK retail investors). The same mechanisms apply as for AIFs (so future sub-funds or funds/ sub-funds not eligible to passport prior to exit day will not be eligible under the TPR).
Assuming no EEA equivalent to the TPR, UK UCITS will become AIFs on exit day while UK UCITS managers will cease to have the right to perform the UCITS management function in relation to EEA UCITS.
UK UCITS, UK-authorized Non-UCITS Retail Schemes, and UK Qualified Investor Schemes do not need to opt into the TPR.
Given impending Brexit, it is unlikely that the EU will activate the third-country AIF/AIFM management passports anytime soon, so non-EEA fund sponsors will continue to consider forming EEA-regulated AIFM subsidiaries or using EEAregulated AIFM platforms to access the EU market.
Non-EEA managers who do not access the EEA market but do access the UK market may be less concerned as they will continue to market their AIFs to UK investors under the UK national private placement regime or, where appropriate, will apply for UK recognized fund status.
Winston Penhall is a partner in Reed Smith’s private funds group based in London. He advises clients on investment management law and regulation with an emphasis on alternative investment funds, their investment managers, and investors. He advises managers on their commercial arrangements and provides ongoing support to investment managers alongside the Reed Smith Regulatory Team. Winston also focuses on advising UK pension schemes and international institutional investors, including sovereign wealth funds, on their managed account and fund investments across the spectrum of investment categories, including insurance wrapped products. In addition, he is a contributing author to a hedge fund practitioner text.
To find this article in Lexis Practice Advisor, follow this research path: RESEARCH PATH: Private Equity & Investment Management > Trends and Insights > Practice Notes
For an overview of the Alternative Investment Fund Managers Directive (AIFMD), see
> AIFM DIRECTIVE
RESEARCH PATH: Private Equity & Investment Management > Fund and Manager Compliance > Practice Notes
For further information on the AIFMD private placement regime, see
> AIFMD PRIVATE PLACEMENT REGIME: PROMOTION OF NON-EU FUNDS IN THE EUROPEAN UNION
RESEARCH PATH: Private Equity & Investment Management > Fund Marketing > Practice Notes
For a discussion of issues faced by new funds in raising capital, see
> PRIVATE EQUITY FUND LAUNCH CONSIDERATIONS
RESEARCH PATH: Private Equity & Investment Management > Private Fund Formation > Private Equity Fund Formation > Practice Notes
1. https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A32011L0061. 2. https://www.legislation.gov.uk/ukdsi/2018/9780111172421/contents. 3. Consultation Paper CP18/29: Temporary permissions regime for inbound firms and funds, https://www.fca.org.uk/publications/ consultation-papers/cp18-29-temporary-permissions-regime-inbound-firms-and-funds. 4. https://www.gov.uk/government/publications/draft-eu-exit-sis-for-investment-funds-and-their-managers