QuickTake: legal entity structuring for greater supervisory scrutiny
Supervisory authorities around the globe have continued to concentrate on how to increase the resilience of banking and financial services groups and notably for those with local operations in “their” respective jurisdictions but who have their headquarters in “foreign” jurisdictions. This applies while they are a going concern inasmuch as in the event of a recovery and/or resolution plan being triggered.
One of the key structural solutions that has been proposed to assist in simplifying resilience is to make greater use of holding companies in multijurisdictional corporate structures. This aims to ease on-going oversight and accountability as well as assist in permitting a “single point of entry” by authorities in respect of recovery and resolution operations in “their” jurisdiction.
In the United States, the rules of the Federal Reserve have introduced requirements for non-US firms to set-up intermediate holding companies (IHCs). The EU has used the finalization of the Capital Requirements Directive V (CRD V), as part of the agreement of the EU’s “Banking Package” reforms (see separate Eurozone Hub coverage on this) to introduce a requirement for those third country groups of financial institutions (TCE groups), with substantial presence in the EU, to establish an intermediate EU parent undertaking (IPU) that sits as a capstone to their EU operations.
While CRR II and CRD V, effectively amending texts to existing CRR and CRD IV, are still set for the final stages of legislative adoption and publication in the Official Journal of the EU, and there may be a further delay introduced to full entry into force, given the potential breadth of preparatory workstreams, both affected TCE groups as well as EU firms will want to prepare ahead of the entry into force of these new changes. This is particularly the case as even if the EU’s IPU requirement aims to mirror the US’ existing IHC requirements there are minor yet important differences. This Client Alert does not aim to consider how the United Kingdom may apply these rules or how it alters existing structural separation requirements.
What is an IPU and what are the likely impacts?
The relevant provisions of CRD V state that a TCE group exists where there is at least one subsidiary that is an EU bank or large EU investment firm within its group and where the parent entity is established in a non-EU country i.e. a third country. This will affect TCE groups with existing EU operations subject to transition periods inasmuch as it will affect TCE groups looking to set-up operations in the EU. These proposals apply across the entirety of the EU and pre-date discussions (and delays) on Brexit and will impact third country i.e. non-EEA jurisdictions as well as the UK when it becomes a third country. There is no clarity as whether any of the various temporary reliefs or transition periods connected to Brexit negotiations would extend to the IPU requirements.
The EU’s IPU requirements are likely to be supplemented within the Eurozone’s Banking Union by rules of the European Central Bank (ECB) acting in its Single Supervisory Mechanism (SSM) capacity. The requirement to maintain an IPU applies as per CRD V when:
Two or more institutions established in the EU (being credit institutions and investment firms), have the same ultimate parent undertaking in a third country; or
The group has been identified as a non-EU global systemically important institutions (G-SII) or has entities with total (balance sheet) assets of at least €40 billion.
The IPU itself can be set-up and authorized as a credit institution or investment firm or established as, what CRD V’s changes define as either a financial holding company (FHC) or a mixed financial holding company (MFHC). Changes introduced to the EU’s prudential regulatory regime by CRD V also require that FHCs and MFHCs are fully supervised entities with a greater degree of scrutiny than was previously the case. The new rules also permit TCE groups to establish two IPUs specifically where this is required to give effect to relevant requirements on structural separation i.e. ring-fencing, and this may also be a strategic decision for affected firms. EU entities that are part of a TCE group whose total value of assets in the EU are below €40 billion will not, as per the CRD V, require an EU IPU. The European Banking Authority is tasked with publishing a list of all TCE groups operating in the EU with their EU IPU(s) and equally all third country branches authorized to operate in the Member State. It is conceivable that the ECB-SSM may amend its list of directly and indirectly supervised institutions additionally to reflect that.
In the Banking Union, the location and make-up of the IPU likely will translate into closer supervisory scrutiny from the ECB-SSM as well as the Single Resolution Board. Operationally this may mean that affected TCE groups may need to consider the administrative timelines of supervisors, as well as in certain instances, the EU’s supervisory principles on relocations, as part of the process to obtain authorization of the legal entity that will be designated as IPU. This will also mean reviewing the adequacy of regulatory capital, liquidity, leverage and prudential standards as well as recovery and resolution plan at the IPU and group level, but equally fitness and proper status for key function holders as well as a range of documentation changes to policies, procedures and potentially counterparty facing documentation as well as tax, accounting and (regulatory) reporting as well as disclosure considerations.
While CRD V does not advocate conversion of branches into subsidiaries, it should be noted that the adequacy of how third country branches are supervised have been an issue that both the ECB-SSM as well as EBA and ESMA continue to look at as part of on-going supervisory improvements but also in relation to the SPoRs. Equally, those third country branches that qualify as “significant” are likely to be subject to even more intensified supervisory scrutiny certainly to 2021 and possibly beyond. CRD V in its own right requires that Member States oblige branches of credit institutions (but not investment firms – although this might change as developments elsewhere close this gap) that are TCE groups to report at least annually to the competent authorities:
Total assets corresponding to the activities of the branch authorized in that Member State;
Availability of liquid assets and those in EU currencies;
Own funds at disposal of branch;
Depositor protection arrangements available to depositors in branch;
The branch’s risk management, governance (incl. key function holders for the activities of the branch), as well a recovery plan arrangements for that branch; and
Any other information considered by the competent authority to be “…necessary to enable comprehensive monitoring of the activities of the branch.”
Bringing FHCs and MFHCs into the supervisory fold plus what does it mean for investment firms?
Changes introduced by CRD V and CRR II mean that FHCs and MFHCs are subject to further and now direct supervisory scrutiny to, as Recital 3 CRD V states, “…ensure compliance on a consolidated basis. Therefore, a specific approval procedure and direct supervisory powers over certain [FHC] and [MFHC] should be provided for in order to ensure that such holding companies can be held directly responsible for consolidated prudential requirements, without subjecting them to additional prudential requirements on a solo level.”
As a result, this includes an authorization requirement for FHCs and MFHCs and a requirement that compliance requirements extend upwards from the credit institution and/or investment firm “operating company level” to the holding company level on a consolidated basis. Approval authorizations are the responsibility of the “consolidating supervisor” or in the Banking Union, the ECB-SSM. Both authorizations of the holding companies and those “operational” EU entities i.e. credit institutions or investment firms are now required to contain greater detail as to how they relate to one another as well as their individual make-up.
In most instances this will translate into more granular descriptions in terms of the regulatory business plan i.e., “program of operations” setting out strategic steering but also details on capital and liquidity adequacy as well as the overall systems, policies, procedures as well as culture as it relates to an applicant’s governance, risk and other control functions as well as relevant fit and proper suitability assessments. CRD V also sets out specific rules of where the approval of the FHC or MFHC takes place concurrently with the operating units i.e. credit institutions and/or investment firms, in which case the latter coordinates with the consolidating supervisor.
Supervisors reviewing an application of a FHC or MFHC must be satisfied that:
The internal arrangements and distribution of tasks within the group are “adequate”, i.e. an undefined term, for compliance with the EU’s prudential regulatory regime on a consolidated and sub-consolidated basis—and we note that the ECB-SSM may likely apply certain criteria as to what it considers to be “adequate”—and, in particular are effective to:
Coordinate all the subsidiaries of the FHC or MFHC including through an adequate distribution of tasks amongst subsidiary “institutions” i.e. regulated firms—reference to distribution presumably also means outsourcing/delegation arrangements which themselves would require regulatory review for going concern and recover and resolution planning supervisory purposes;
Prevent or manage intra-group conflicts, and this will include careful consideration of what is set out, including by the ECB-SSM in terms of the supervisors’ presumption of actual or potential conflicts as part of the fit and proper review and suitability assessments; and
Enforce the group-wide policies set by the parent FHC or MFHC throughout the group; and
That the structural organization of the group of which the FHC or MFHC applicant is a part does not obstruct or prevent effective supervision of subsidiary, parent or other concerns on compliance with individual, consolidated and/or sub-consolidated obligations.
Despite the broadening of the scope to required FHCs and MFHCs to become authorized, CRD V does, under specific circumstances, permit that certain FHCs and MFHCs might be exempted from an approval requirement. This is available where these entities act simply as “acquisition vehicles,” and their principal activity does not undertake management, operational or financial decisions that affect the group or those group subsidiaries that are regulated institutions and that there is no impediment to effective supervision of the subsidiaries by exempting the FHCs or MFHCs.
That being said, CRD V makes clear that exercising power of on-going supervision by the ECB-SSM and/or national competent authorities outside the Banking Union (often in close-cooperation through supervisory colleges with the ECB-SSM) apply both at consolidated and sub-consolidated level. Supervisory tools that are introduced by the CRD V and which are directed at FHCs and/or MFHCs as opposed to their subsidiaries/branches aim, in the case of compliance breaches, to ensure or restore the “continuity and integrity of consolidated supervision and compliance with [CRR/CRD IV] on a consolidated basis.” This is without prejudice to tools and aims that the ECB-SSM is permitted to discharge within its mandate.
Some of these tools, which have not been (at time of writing) copied into the SSM Regulation or Framework Regulation (to the extent required) include the following measures, which in the event of disagreement between competent authorities may mean the European Banking Authority acts as adjudicator as to the nature of the following measures:
Suspension of exercise of voting rights of subsidiaries held by FHC/MFHCs;
Issuing injunctions or penalties against the FHC/MFHCs or members of management body and managers;
Giving instructions or direction to FHC/MFHC to transfer to its shareholders the participations in its subsidiaries that are credit institutions or investments firms;
Designating, on a temporary basis, another FHC or MFHC or institution within the group as responsible for compliance;
Restricting or prohibiting distributions or interest payments to shareholders—and this drafting is not clear as to shareholders of whom;
Requiring FHCs/MFHCs to divest from or reduce holdings in institutions but also those that are “financial sector entities” i.e., a much broader set;
Directing FHCs/MFHCs to present a plan on immediate return to compliance.
It should be noted that by bringing FHCs and MFHCs into closer direct scrutiny, the ECB-SSM is thus able to exercise greater degree of supervision over those MiFID investment firms that may, due to the EU’s Investment Firms Regulation and Directive, possibly come into closer SSM supervision. Other areas of “flexibility”, more so for supervisors rather than firms, also apply as to how CRD V extends the EU’s remuneration rules for certain key function holders and those that are “material risk takers”.
CRD V’s broadening of supervisory scrutiny up the corporate entity chain to cover FHCs and MFHCs and introducing the need for IPUs has been a long time coming even if the details of the requirements have only recently been finalized and even where these remain at risk of being further supplemented by ECB-SSM requirements or supervisory expectations. For many firms, part of the challenge will be in ensuring they are able to apply for and obtain authorization for new vehicles that are introduced into their legal entity structure in the appropriate supervisory, shareholder and corporate governance timeline while concurrently amending documentation and non-documentation workstreams that may already be in various stages of review and reform.
The changes coming here are not piecemeal and there is no panacea that can be applied as a quick fix, rather an on-going comprehensive approach to ensure these legal entity reforms fit in with “other” “change the business” or “change the compliance” measures is required. Early planning and involvement of specialist legal and regulatory counsel, in particular with a view to driving compliance with a very ECB-SSM feel to it, will be key for meeting these new requirements regardless of a firm’s business and operating model.
As most of the firms affected by these changes are likely to have a footprint in the Eurozone and thus be Banking Union Supervised Institutions (BUSIs), much of the supervisory ease and experience will depend on the operations of the ECB-SSM. The relevant supervisory teams, who besides looking to direct greater scrutiny towards “broker-dealer” investment firms, including as per the Investment Firms Regulation and Directive will now need to expand their remit to FHCs and MFHCs. While on the face of it this looks to be a “mere” resourcing question, BUSIs will want to note that the ECB-SSM’s increased shift away from how it assesses the operations of branches v subsidiaries leaning towards “onshore v offshore” capabilities may make for somewhat different supervisory conversations. It is also conceivable that the ECB-SSM’s anticipated efforts over the medium to longer term to streamline the prudential regulatory regime further, as modified by CRD V/CRR II, on a range of measures it has identified, such as the availability of applicability of waivers, will not only be aimed first at directly supervised BUSIs but then carry over in possible expectations directed towards competent authorities in non-Banking Union Member States.