A matter of equivalence: UK government proposes new overseas funds regime

The UK government has launched a consultation on how overseas retail and money market funds can be sold to UK investors following the end of the Brexit transition period.

Around a quarter of Investment Association members do not operate UK-authorised funds. Instead, over 8,000 funds, including undertakings for collective investment in transferable securities (UCITS) and money market funds (MMFs), domiciled in the EU are distributed to UK investors through the current 'passporting' system.

Absent similar arrangements being agreed between the UK and the EU, passporting will cease to be available after the end of the Brexit transition period (currently 31 December 2020). The UK government therefore intends to streamline the process of recognising EU and other overseas retail funds and MMFs for distribution into the UK.

Why is change needed?

The need to legislate became evident when in January 2020 more than half of the currently passporting funds had notified the Financial Conduct Authority (FCA) of their intention to enter the temporary marketing permissions regime (TMPR). TMPR aims to provide investor protection and continuity primarily for EU UCITS already exercising their passporting rights. However, as its name suggests, TMPR will only operate for a limited time following the end of the transition period.

The interest in TMPR indicates operational challenges for both the funds and the FCA where an in-depth assessment for individual recognition under section 272 of the Financial Services and Markets Act 2000 (FSMA) becomes the default. The consultation is therefore also an attempt to avoid administrative overload. The UK government has been clear that facilitating market access for an industry that makes an invaluable economic contribution remains a key part of its post-Brexit strategy. Hence the proposed overseas funds regime (OFR) which will replace TMPR in the long-run. The OFR also captures EU-domiciled MMFs.

Equal outcomes?

The OFR will allow HM Treasury to determine whether a foreign regulatory framework governing relevant funds is equivalent to that in the UK. If so, funds domiciled in a jurisdiction deemed equivalent can benefit from a streamlined process to be recognised and registered for UK retail marketing. Equivalence under the OFR will operate on an ‘outcomes-based’ assessment, with slightly different outcomes being required as between overseas retail funds and MMFs.

Equivalence for overseas retail funds will focus on equivalent levels of investor protection and determinations could be made in relation to all such funds domiciled in a particular jurisdiction, or only certain categories of funds. Similarly, MMFs, structured as UCITS or AIFs, can benefit from the OFR streamlining if relevant rules in their country of domicile produce at least equivalent outcomes to the UK MMF regime.

For distribution of MMFs to retail investors, the relevant MMF would need to benefit from both an MMF equivalence and a retail fund equivalence to be eligible for recognition under the OFR. Missing the latter means the process will default to the section 272 regime (which is generally regarded as being more onerous). MMFs marketed solely to professional investors are outside the scope of the OFR and remain subject to the UK’s existing national private placement regime.

Certainly flexible or flexibly certain?

There is currently a lack of certainty as to precisely how the OFR equivalence assessment will work or what outcomes-based equivalence will mean in practice.

Further uncertainty arises from HM Treasury’s power to impose additional requirements for specific retail funds to be recognised. These would ensure regulatory consistency and acceptable investment strategies, and could impose FCA rules on investment powers and limits, or specify a certain redemption frequency. In some instances, the OFR could therefore subject funds to a level of dual regulation.

In addition to the key focus on investor protection, equivalence assessments will also take into account the effects on UK financial stability, market integrity, competition and the prevention of financial crime. Following material regulatory changes overseas or in the UK, HM Treasury will also have the power to modify or withdraw an equivalence determination (the uncertainty of which has generally been a concern in equivalence determinations in other areas of financial services).

Multiple regulators?

Overseas retail funds (and MMFs marketed to retail investors) will need to register with the FCA if they fall within the scope of an equivalence determination. HM Treasury intends this process to be simple and straightforward.

Given the usual split between the regulation applicable to the fund when distributed to UK investors and the powers reserved to the relevant regulator of the fund in its domicile, the proposal stresses the importance of adequate cooperation arrangements between the FCA and an overseas fund’s regulator. But the FCA will retain exclusive powers to supervise and enforce any additional requirements that HM Treasury may have imposed in its equivalence determination.

Outside the scope?

The OFR will operate alongside (a modified) section 272 regime which will continue to apply to funds that do not fall within the scope of a relevant equivalence determination. To reduce procedural friction, the government proposes minor changes to this process in line with the generally more streamlined approach. These include limiting the FCA’s obligation to consider rules which do not yet exist and allowing funds more flexibility to change their operation or management without FCA approval.

The aims of the proposal, and in particular the objective of streamlining the ability for relevant overseas funds to be distributed into the UK, seem generally well received but as the old adage goes – the devil will be in the detail and there isn’t enough in the consultation to make a judgement on the extent to which the OFR will do so.

The consultation closes on 11 May 2020.