“Whatever you budgeted, double it. It’s like building a house from scratch; you start off thinking it’s going to take you six months and cost half a million, and then you find it takes you twelve months and costs a million.”
This was the analogy provided by Matthew Hudson, chief executive officer of asset management consultancy MJ Hudson, on his company’s setting up an office in Luxembourg so that it could continue to access the EU fund management passport, and distribute funds across the EU, post-Brexit.
The second in this series of case studies examining compliance headaches for companies caused by Britain’s decision to exit the European Union looks at the example of a financial services company, not a behemoth like JPMorgan or HSBC, but a small firm of 125 professionals providing law, fund management, international fiduciary, investment advisory, and investor relations and marketing services from offices across Europe, including Jersey and Guernsey.
When asked if setting up an office in another EU country required him to comply with local regulations as well as EU-wide laws, Hudson replied, “You’re absolutely right that if you set up a company in Luxembourg, then that company is subject to the Luxembourg regulator plus the EU overlay, which is just the same as it is in London where you have the U.K. regulator, the FCA [Financial Conduct Authority], and the EU overlay as well.”
Since MJ Hudson already had offices across Europe and already has regulation with the FCA and Alternative Investment Fund Manager Directive (AIFMD) in London, I asked what was different about the current arrangements: “Historically, at least, there were two ways to set up in Luxembourg, or anywhere else for that matter in financial services. You can set up as a standalone company, which could be moderately staffed, and which would be regulated by the local regulator. Alternatively, you could set up a branch, which would be regulated in a lighter manner, if you remain regulated by your home regulator. But that all changed in May this year, when the ESMA [European Securities and Markets Authority] issued new guidance, or rather reiterated existing guidance, that made [the requirements] even clearer.”
Fundamentally, the ESMA guidance said that if U.K. companies that were aiming to relocate “entities, activities, and functions” thought they were going to have it easy, they aren’t. The ESMA reiterated that it would not accept what it called “letterbox” entities that employed few people after Brexit, there would be no short cuts even if a company was already regulated in the United Kingdom and by the EU AIFMD, and that national regulators should take a tougher line on policing the asset management sector.
“We were dealing with the Luxembourg regulator at that time on our own application,” commented Hudson “and we had to enhance the operation, basically increase the size of the office following this new guidance. With asset management, what ESMA is saying, as well as complying with all the local EU regulations, is that you need to have real substance on the ground, not only that, you need to employ locals who live in Luxembourg. They don’t have to be Luxembourgers, because, as you’re aware, half the people working there aren’t Luxembourgers; with many of them driving into town each morning.” However, one of the key points of the ESMA guidance is that locals needed to be employed in relocated offices, so it is not case of simply relocating staff from the U.K. but hiring local professionals.
But the ESMA guidelines were broader than just employment requirements. “Another key point with asset management,” continued Hudson, “is that you have to make key decisions in Luxembourg. That’s not that old practice where you send a fax somewhere and it comes back signed, or you fly in, sign something and then get back on the airplane before it flies off again. It is real decisions being made on the ground.”
While the exercise turned out to be more expensive than originally planned for, Hudson pointed to a number of commercial advantages that emerged from the expansion. “We’ve now built an office that’s cost us more than we thought, but, on the positive side, we’ve created two options for our fund clients. First, we can now essentially share with them our office and team, so we can share the cost of what we have with other asset managers by essentially forming a multi-manager hub. Second, is the ability to create Luxembourg funds. These funds can either be the main fund, i.e. the whole fund is a Luxembourg fund, or they can be parallel funds that we are working on at the moment for four different asset management groups. These can run in parallel to the sponsor’s own main fund, which could be in Delaware or London or anywhere else. So, it took a lot of money to set this up, but it’s a real, substantial office with high-quality professionals on the ground.”
There is real competition at the moment between EU27 countries to woo, especially financial services companies, to relocate their businesses there so they can maintain access to the single market after Brexit. There are huge efforts being made in Paris and Frankfurt and Dublin, which have all been relatively successful, to be the European city of choice for financial services, replacing London’s formerly preeminent position. Many companies in the sector, however, have been choosing Luxembourg, which, for such a small Duchy, has been attracting a number of large and small financial services companies.
Why Luxembourg, I asked Hudson? “Luxembourg has got good laws generally with very good fund laws. For example, it has this new RAIF [reserved alternative investment fund], which is very popular, which is a multifaceted fund structure. Luxembourg also has good professionals, plus an excellent regulator [the Commission de Surveillance du Secteur Financier (CSSF)]. It’s a big market, it’s very cosmopolitan, it’s fluent in many languages. It has laws and services which are very workable for closed-end funds and credit funds etc., Probably the only rival in asset management, outside the U.K.,” summed up Hudson “is Dublin; although Dublin’s background is more in hedge funds than other asset classes.”
I asked if one of the advantages of Dublin was that English was spoken there. Hudson replied that English was spoken in Luxembourg too. “If you are in a café, they will speak to you in French, but, if you go to the regulator, it’s all in English.” I suggested that the same might be true of Frankfurt, but Hudson countered that Luxembourg was still more cosmopolitan than most other countries he had worked in.
Since the ESMA release reiterated that EU offices must have “substance,” I asked how that impacted their plans. “If you are JPMorgan you are probably already in Luxembourg anyway, so all you need to do is get beefed up and get some decision-makers over there, because just having a back office somewhere in Luxembourg; that actually doesn’t work anymore. You need to have decision-makers in these countries now.”
Hudson is on the board of the Luxembourg office, and I asked if that was a result of the requirement to have decision-makers on the ground, rather than relying on faxes going back and forth, but he replied: “It’s because the regulator wants to know you are taking it seriously. In addition, historically, you used to be able to use the delegated investment model and stay in London, but that’s getting harder and harder and we took the view that we wouldn’t even get into that. So, our manager in Luxembourg, as well as being the compliance and regulatory manager, is also the portfolio manager. Some asset managers and insurance companies are setting up what they call the delegated model, but that is under some strain right now.” The delegated model refers to the practice that, while many asset management companies may be based in Paris, Dublin or Luxembourg, any real business is delegated to London. “We may be being overly cautious, but we think it’s better to do the portfolio management in the country where you are based and from where you are launching the fund.”
Following the requirement that local employees must be used, I asked if MJ Hudson transferred employees as well or did it do all its recruiting on the ground. “We have seconded one person over there,” said Hudson, “but, actually, our team of six on the ground are all from Luxembourg; and this is only our initial team, by the way, we will probably double the size of the office over the next couple of years. And, of the three board members, I’m the only one not in Luxembourg full time.”
Hudson, however, pointed to a potential problem with relocating to the duchy. “There is an issue with Luxembourg, which is that there’s not that many people to employ. Then again, you might have the same issue in Frankfurt, where there are ‘more’ people to employ, but how many compliance professionals, how many investment professionals are there? It’s hard to find good people, but we’ve been lucky in doing so.”
I asked if the regulations surrounding internal controls looked different in Luxembourg from the U.K., but Hudson said they were largely familiar, “because all the EU regulators like the FCA, the CSSF, are largely in step with each other. Luxembourg law,” he continued, “is based on the Napoleonic Code, so the law has a different derivation from English law, but in financial services it’s not too dissimilar. In fact, a lot of the Luxembourg fund structures have basically been copied from London or the Channel Islands, so it’s very, very familiar both in terms of fund management and regulation. At MJ Hudson, we embrace law and regulation, we love it, anything new and exciting is more fun anyway. But I would say it’s around 95% familiar.”
What were the processes used to assess the level of familiarity? “We compared the laws and regulations in Ireland, Malta, U.K. and Luxembourg,” replied Hudson. “Maltese law is very similar to English, for obvious historical reasons (with some Napoleonic code seasoning), and Luxembourg, as I said, is also very familiar. Oddly enough the most different was Irish law, which we were very surprised about. For example, the laws surrounding limited partnerships are not as robust as in the other three countries.”
Were there any other practices that needed to be adapted or changed as a result of the move, for example: risk management or managing a compliance violation, or employment law? Hudson noted that the main difference was employment law, an area with a wide degree of difference across all EU countries. “The differences in employment law in Luxembourg include, for example, statutory notice periods.” These differences resulted in the firm having to rewrite its standard employment contracts so that they could be used in Luxembourg.
“Things like risk management,” continued Hudson “are covered by regulations that are broadly similar across the main asset management fund regulators. It was easier for us, for example, because we’d already been running funds that were regulated by the FCA. It would be more difficult for somebody who was trying to set [a fund] up without that experience.” I asked how long it took to set up the office. “It took us a little over a year to get a licence; probably a little bit quicker for us than others because of that U.K. experience. But the office and funds still have to be totally standalone; you can’t ‘borrow’ bits from the U.K.”
Other areas of difference, I noted, might be laws surrounding data sharing, data privacy, know your customer, anti-money laundering or cybersecurity, though this last was such a recent phenomenon, it would seem unlikely that any EU27 country had any laws surrounding it pre-EU. Hudson replied: “Data services and data security are the same as financial services regulation; they’re largely covered by EU regulations and directives, and in 2018 we will see a big upgrade on that, across the EU. Cybersecurity is EU-wide again and rules around KYC [know your customer] and AML [anti-money laundering] are largely integrated across the EU. There are some states or countries that have taken KYC and AML to a higher level. We are based in Jersey and Guernsey as well, and those regulations are particularly high grade there. It’s all shades of difference, though, it’s not dramatic.”
Finally, I asked if MJ Hudson’s experience was just that of a financial services company or would the lessons it had learned have a broader application across industries. “I would say that there should be a lot of commonality among your interviewees, simply because whether you’re a bank or an asset manager or an airline, the same kinds of issues that we’re dealing with: differences in employment law, having real substance on the ground, difficulty recruiting sufficiently qualified staff, are all going to be experienced by everybody.”
In final comments, Hudson issued a series of warnings. “Post-Brexit vote, regulators have been overwhelmed with applications. The regulators are not trying to attract business to the country, maybe politicians are, but that just makes the regulators very busy. Furthermore, all the local regulators were slightly taken aback by the new ESMA rules; they had to go to all their applicants and tell them, essentially, to upgrade their application, more people, more this, more that. They were already stretched, and then they had go to a new level. So, in terms of picking where [in the EU] you want to go, you have to be conscious of whether you think the local regulator, and the local lawyers, accountants and risk consultants, are going to be able to pay attention to your application. Also, our first steps towards application were taken the week after the Brexit vote. But if you want to do it now, it may take two years. If there is a hard Brexit in early 2019, and if you haven’t put your application in already, you’re probably too late.”