Today, a couple of months away from the official departure of the UK from the EU, it is worth assessing the impact of Brexit on the financial service industry, from a legal and regulatory perspective. Two factors seem to have been underscored so far and happen to converge towards dismissing the massive “cliff-edge” gap feared by many: the depth of the financial service industry does not stop at its most visible, EU regulated part; and the unrivalled ability of English law (as opposed to civil law jurisdictions in the EU) to promote the sovereignty of parties to commercial contracts over their own affairs.
Depth of the financial service industry
The five main types of licensable financial services (deposit-taking, lending¹, asset management, investment and payment services) are only the tip of the iceberg making up the financial service industry.
Lurking below the surface is a wider range of activities including sub-contracting, back-office, market infrastructure, clearing and settlement activities. Clearing and settlement services cover payment transactions but also financial instruments. The so-called European Fintech challengers, many of whom have chosen London as their home base, have mainly been active in the payments space.
Tip of the iceberg significantly impacted in the short term
From a legal perspective, the most visible impact expected of Brexit at the end of the transitional period² will be the loss of EU passporting rights for financial service firms authorised in the UK. Setting up a branch in the European Economic Area (EEA) will no longer be enough for a UK firm to provide its licensable services throughout the EEA³, let alone to provide services on a pure cross-border basis. A locally licensed company will be required. Large groups have already taken steps to deal with this major change, the main question left for them being the full extent of the reallocation of resources from the UK to the EEA. Smaller players, however, make up a category where many have remained passive or have struggled to maintain a viable business model doomed to lose a cheap tool to sell into the EEA (the freedom to provide services out of the UK without even setting up branches). Firms making up this latter category must come to terms with reality sooner rather than later, by abandoning any false hopes that “regulatory equivalence”⁴ will make up for the loss of EU passporting rights and “empty shells”⁵ can be set up in the EEA.
Submerged part of the iceberg subject to complex and uncertain changes
The loss of EU passporting rights will not affect the ability of service providers based in the UK to continue providing services to the EEA financial industry that do not fall within the scope of EU licensing requirements.
Because of the inherently slow major change in decision-making process at EU level, it would take years for the European Commission – assuming there is a political will for doing so – to extend licensing requirements to the submerged part of the financial service industry. As conflicting views have arisen between the European Commission and the European Central Bank (ECB), the relocation of euro clearing to the EU is not expected in the short term despite having been the subject matter of a fierce location battle (that went up to the European Union Court of Justice (EUCJ) between the UK and the EU before Brexit.⁶
In the meantime, the battleground for the relevant UK authorities⁷, the ESA⁸, the NCA⁹, financial service providers and Fintech companies will mainly be how far “delegation” and “outsourcing”¹⁰ as defined by EU legislation can stretch without compromising the proper supervision and accountability¹¹ of the client-facing entities licensed in the EEA.
Predominant use and influence of English law
English law and courts have long been the predominant law and jurisdictions in Europe as far as financial services are concerned, due to the predominant number of service providers incorporated in the UK and as it is standard practice (as much as common sense) that the party who provides the services defines the terms and conditions applicable to them including the governing law. For instance, although they have opened themselves to decentralisation, both International Swaps and Derivatives Association (ISDA) and Loan Market Association (LMA) remain firmly rooted in English law and most lending and derivative transactions in Europe are documented under ISDA and LMA agreements governed (or at least significantly shaped) by English law.
Contractual tensions on the rise
Due to Brexit, tensions have arisen from commercial contracts involving UK regulated entities and their EEA clients, or EEA regulated entities and their UK clients, reminding each side of the still significant gap between English law and civil law jurisdictions.
Indeed, despite the wide use and influence of English law in the financial service industry for decades, a deep cultural gap remains with civil law jurisdictions making up most of the EU, so much so that parties from most of those jurisdictions, who instinctively rely on “contract categorisation”¹² and overriding principles such as the obligation to enter into and perform a contract in good faith¹³ or the unenforceability of exclusion or limitation liability clauses in case of gross negligence¹⁴, realise that the approach taken by English courts is different, as being viscerally attached to the sovereignty of the will of the parties over their own affairs. Conversely, UK parties to contracts governed by civil law and facing civil court proceedings may be pleasantly surprised by the generally much lower costs associated with litigating in the EEA, but should also be aware that the level of “contractual sovereignty” which the English judicial system provides is not matched in civil law judicial systems.
Widening of legal gap
The shift from using English law to using civil law is taking place and will increase, as far as the tip of the financial service iceberg is concerned, but not significantly in respect of its submerged part, at least not in the short or medium term. This has nothing to do with the merits of one system over the other but is a mechanical consequence of the relocation of licensable services from the UK to the EEA.
As over 40 years of EU membership have not eroded the ability of English law to serve the parties’ sovereignty over their own affairs, our assumption is that life outside the EEA will not do so either, even under an EU/UK regulatory alignment scenario. And if the EU takes the pragmatic approach of consenting to the UK adhering to the Lugano Convention 2007¹⁵, the convenient way of enforcing judgements on both sides under the Re-Cast Brussels Regulation¹⁶ will be broadly maintained, though outside the jurisdiction of the EUCJ.¹⁷
In these turbulent times, vigilance should increase when navigating cross-border contracts between the UK and the EEA. A thorough assessment of both the validity and enforceability of any such contracts is needed now more than ever. In this respect, experience tells us that marketplace legal opinions cannot replace legal advice given on a case-per-case basis, independently. When not attended to and properly dealt with at the outset, the gap between expectation and reality will invariably lead to challenging consequences for one party or the other – or perhaps even both.
¹ The general rule in the EU is that the extension of credit for consideration is a regulated activity subject to local exceptions or exemptions. In the UK, consumer lending is regulated whilst business lending is not.
² Unless the UK re-joins the EEA via EFTA, which would be a political U-turn and is therefore extremely unlikely.
³ Depending on the legislation available in each EEA country, a third-country branch fully authorised locally can be set up, but such branch will not be able to enjoy any passporting rights into the other EEA countries.
⁴ As described in its Commission Staff Working Document issued on 27/02/2017 (“EU equivalence decisions in financial services policy: an assessment”), (i) only a few pieces of EU legislation contain “third-country provisions” empowering the EU Commission to decide on the equivalence of foreign rules and supervision for EU regulatory purposes, (ii) among those few pieces, only two sets of “third-country provisions” provide a door for third-country passporting to the EEA (AIFMD and MIFID/MIFIR), and (iii) the door has not been opened to any country yet.
⁵ EBA Opinion 2017/12; ESMA Opinions 42-110-433/70-154-270/34-45-344/35-43-762.
⁶ “The EU’s post-Brexit policy on euro clearing explained”, by Scott James and Lucia Quaglia, 17 February 2020, London Public School of Economics and Political Science.
⁷ Mainly the Prudential Regulatory Authority and the Financial Conduct Authority.
⁸ The European Supervisory Authorities such as the EBA and ESMA.
⁹ The National Competent Authorities in the EEA.
¹⁰ “Brexit and the Provision of Financial Services into the EU and into the UK”, by Eddy Wymeersch, European Company and Financial Law Review, 2018, pages 732 to 771, University of Gent, European Banking Institute.
¹¹ Broadly based on the requirement that key people, assets and data be directly available for scrutiny and enforcement in the EEA country where the licence is held.
¹² Under the “contract categorisation” approach, parties entered into contracts that should fall into categories. If they do not, various issues arise including the risk of a court squeezing a contract into a category against the will of the parties or leaving them uncategorised and potentially unenforceable either wholly or partially. If they do fall into a category, parties face the risk of courts supplementing the contract against their will or even denying their will, based on the statutory regime governing the category.
¹³ “English law has, characteristically, committed itself to no such overriding principle” (Bingham LJ in Interfoto Picture Ltd v Stilleto Visual Programmes Ltd  1 QB 433).
¹⁴ Armitage v Nurse  EWCA civ 1279.
¹⁵ Convention on Jurisdiction and the Recognition and Enforcement of Judgments in Civil and Commercial Matters, done at Lugano on 30 October 2007.
¹⁶ Regulation (EU) no. 125/2012 of the European Parliament and of the Council of 12 December 2012 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters.
¹⁷ “UK Accession to the Lugano Convention 2007 – an oven ready” option?”, by Ben Rayment, 30 January 2020, Monkton Chambers.
If you have any questions on the issues raised in this article, please contact Bruno Fatier.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.