Author: Hermann Beythan, Partner, Head of the Investment Management Group, Linklaters Luxembourg
The vote by the United Kingdom in favor of leaving the European Union on June 23 represents a step into the unknown not only for the UK but the remaining members of the EU. Almost every aspect of the ‘Brexit’ process remains shrouded in uncertainty, from the political and legal complexities of withdrawal to the impact on British and European economies – not least the financial industry.
How these play out over the coming months and year will be of critical importance to Luxembourg, which maintains particularly strong ties with the UK and the City of London, and for which Britain’s exit from the EU entails threats, but opportunities too.
The withdrawal process would be triggered by notice served under the Article 50 of the Lisbon Treaty – which could take place at any time over the coming months, or could be delayed even longer. This would start the clock on a two-year period by which time arrangements for withdrawal would have to be completed. Article 50 deals only with matters such as budget issues and the position of UK staff in EU institutions, not with new trading arrangements.
Before the vote, the Leave camp did not specify what kind of trade agreement it would prefer, and subsequent official comment has not offered any clear indication. In calling the referendum, the government put forward various models including that of Norway, as a member of the European Economic Area. A Norway-style arrangement would involve very little change except that the UK would no longer be involved in decisions on legislation but would still have to contribute to the EU budget.
Switzerland, which voted against joining the EEA two decades ago, has a bilateral free trade model for trade relations with the EU. It requires the free movement of people and involves more than 120 separate agreements designed to secure access to Europe’s single market for most Swiss industries. However, its financial sector and other services do not have full access to EU markets, and the bilateral arrangements are at risk after a referendum two years ago favored restrictions on people from the EU working in Switzerland.
Turkey has a customs union with the EU under which its industrial exports to EU countries are not subject to tariffs or quotas. However, this does not apply to agricultural goods, nor to services, and Turkey is required to impose the EU’s external tariff on goods imported from outside the union but does not get any say in determining it.
The UK could negotiate its own customized arrangement, which would take some time – otherwise it would face the alarming prospect of having to follow the ponderous and complicated World Trade Organisation rules. This uncertainty prompted global organisations and world leaders to warn Britain not to take any risk with economic stability, seemingly without much effect on the final result.
Complications for the fund industry
Whatever the ultimate impact of Brexit on Luxembourg as a financial centre, it will certainly make things more complicated. For example, it would mean that UCITS funds domiciled in Luxembourg (or any other EU country) could no longer be easily distributed in the UK, although any new rules in Britain could probably be accommodated. By contrast, UK-domiciled former UCITS will technically become AIFs (Alternative Investment Funds) for the purposes of EU legislation and could potentially be distributed to professional investors through a future AIFMD (Alternative Investment Fund Managers Directive) third-country passport.
Many Luxembourg management companies have branches in other EU countries, notably in the UK, used for the distribution of both UCITS and AIFMD funds ranges. If the passport disappears, ManCos would have to be licensed under whatever new rules applied in Britain and would be completely dependent on the UK regulator, which might be good or otherwise, but would almost certainly add to the complexity of the process.
Since a Luxembourg or any other EU fund alternative investment fund can already have a third-country AIFM, the latter could continue to be based in the UK, although they would lose the distribution passport. Whether or not Luxembourg ManCos could continue to manage UK investment funds would depend on the British authorities. UK management companies could continue to manage Luxembourg and EU UCITS and AIFs by way of delegation, currently a popular model. Distribution activities through branches of Luxembourg ManCos in the UK may remain possible, but it would in all likelihood become more costly.
For credit institutions, UK banks would no longer be able to use a Luxembourg branch as a depository for UCITS or AIFMs, obliging them to set up a standalone Luxembourg institution, or use another depository. Cross-border mergers involving a UK fund would become impossible under current UCITS rules; other methods exist, but they are much more costly and complicated.
Luxembourg and other EU funds of funds could continue invest in UK-domiciled former UCITS funds, but subject to the 30% ceiling for non-UCITS funds in their portfolios. This would mean that in the event of Brexit, asset managers, depositaries and administrators have to review the portfolios of investment funds to see if they exceeded the ceiling. The same applies to master-feeder structures; a Luxembourg UCITS could no longer feed into a UK ex-UCITS master fund.
UCITS is a preferred status for many institutional investors, such as for insurance policy wrappers, and a non-UCITS fund would need to meet Luxembourg’s five tests to demonstrate its equivalence. Pension funds, insurance companies and other institutional investors might have to divest from UK ex-UCITS. There are no rules currently in place regarding grandfathering of fund distribution rights, although this could be adopted through negotiations or on a unilateral basis.
Other areas in which Luxembourg could step in to financial services fields currently dominated by London include the listing of bonds and other financial instruments on a regulated market, where a prospectus approved by the regulator in one member state can be used for marketing throughout the EU; the Luxembourg Stock Exchange is already the leading international bond listing venue.
There are also opportunities including the central clearing of certain derivatives, where the default rule is that market infrastructure providers such as central counterparties or trade repositories should be EU institutions and non-EU competitors may face obstacles obtaining recognition as subject to equivalent regulation.
Two other non-financial aspects are important, starting with the free movement of individuals. Without successful post-Brexit negotiations, not only might UK citizens employed in the Grand Duchy see their situation change, but EU citizens resident in the UK under EU freedom of movement rules might have to consider leaving London, either because they were obliged to or because their employment prospects might become less favorable. –
Meanwhile, the EU data collection and management framework sets out standards for the reception, hosting, processing and transfer of data. If British rules are no longer identical with those in the EU, especially as these evolve in recognition of the increasing importance and sensitivity of protecting private and commercial data, Luxemburg, with its strong existing network of data centres, might be an option for offering services that otherwise might have been provided in the UK.
End of regulatory convergence
Following the Brexit decision, one may expect the UK and EU regulatory frameworks to cease converging and start drifting apart, raising the prospect of Luxembourg institutions having to comply with an increasingly different regulatory and legal regime in the UK in areas that up to now have been governed by a common framework. Of course, the same applies to British companies that will have to adapt to different rules in Europe.
However, given the longstanding financial and business ties between the two countries, and the complementary nature of their financial industries, Luxembourg is well placed to act as a bridge between the UK and the rest of the EU. For example, the London-based global asset management sector is already a major user of the Grand Duchy’s administration and distribution expertise in the sector.
This relationship could well develop and grow, as long as asset managers meet requirements for substance within their EU management companies, including people on the ground, to enable them to benefit from passporting rules. The benefits of bringing together portfolio management expertise from the UK with administrative and operational capabilities from Luxembourg will remain relevant in a post-Brexit future.
Luxembourg and London benefit from rapid and efficient communications, including many direct flights every day. At least during a transitional period, UK-based investment managers could spend part of their working week in Luxembourg, perhaps under contracts that split their duties between the two jurisdictions. This would be mutually beneficial for all parties, and one that would reinforce the long-term ties of professionalism and friendship binding together the two countries, their economies and their people – and a development falling squarely in the tradition of Luxembourg’s philosophy of flexibility and inclusivity.