ECJ rules against the UK in landmark short-selling case

The ECJ this morning rejected all the UK’s claims against the EU's short selling regulation. The result was surprising given that the Court's Advocate General Niilo Jääskinen issued an opinion supporting the UK’s position last September – court rulings often, but not always, follow these opinions.

The nub of the UK's complaint was that the new regulation transferred too much discretionary power to ESMA (the European Securities and Markets Authority) to ban short-selling over the heads of national regulators. And that the legal base for doing so in the EU treaties was unsatisfactory. The case could therefore set an important precedent.

The UK’s complaint as described by the court:

The United Kingdom contends, inter alia, that ESMA has been given a very large measure of discretion of a political nature which is at odds with EU principles relating to the delegation of powers. The United Kingdom also submits that Article 114 TFEU is not the correct legal basis for the adoption of the rules laid down in Article 28 of the regulation.

The full regulation and article 28 can be found here.

Here is what Jääskinen had to say about the complaint in September:

"The outcome is not harmonisation but the replacement of national decision-making with EU level decision-making. This goes beyond the limits of Article 114."

While he didn’t side with the UK on all issues, he did recommend changing the legal base of the regulation to Article 352, which would have given the UK a veto.

However, the ECJ took a very different line arguing that the regulation is in line with the treaties since ESMA already has a role to play in this area and because the powers are limited to times when financial market stability is in question - of course when this is, remains to be defined by ESMA itself. The court also suggests that, contrary to the Advocate General's view, the new rules do provide for harmonisation.

As we noted before, this ruling has the potential to be very important for the UK and could set the tone/precedent for future rulings. The court’s decision to reject the UK’s claim could have some important implications:

• Firstly, it potentially sets a precedent for the transfer of powers to an EU agency under the single market article (114). This is decided under qualified majority vote (QMV) meaning the UK does not have a veto. Not only that, but the scope of the powers remains vague and widespread, allowing ESMA quite a significant amount of leeway in deciding where to act in what the UK Government would argue are political decisions.

• More generally, there will be a concern that it could allow the use of Article 114 to be stretched – a question which is raised in some of the UK’s other on-going court challenges against EU financial regulation.

• This will raise concerns in the UK over two issues – financial services regulation and the split between euro and non-euro countries. The first is obvious given that the UK may feel its ability to legally protect itself against burdensome regulation is now diminished. The second stems from the potential abuse of the single market article to further the needs of the eurozone - the short-selling ban was largely conceived following the eurozone/financial crisis to combat 'speculators'.

• One saving grace may be that the ruling is quite specific in terms of financial market oversight, a role which the agency in question (ESMA) already has a part in. However, only time and future legal challenges will tell far-reching the implications of this ruling will be.

What happens now?

Given that the ECJ rejected all aspects of the UK's claim, it is dismissed entirely. There is little more the UK can do from a legal aspect, unless it decides to challenge other parts of the regulation but that seems unlikely.

The UK can continue to work behind the scenes to limit the practical power of ESMA and define strict criteria for when it can act on this issue. Of course, if any decision to limit short-selling by ESMA does happen, it could always challenge that specific move.

Nevertheless, this is clearly a political blow to the UK.  

The AIFM Directive: It's back!

Some of you may recall the AIFM Directive, tabled by the European Commission in 2009. The proposal was aimed at striking down on hedge fund managers, private equity firms, investment trusts and other so-called “alternative investment” funds (i.e. those that do not invest in stock, bonds or cash), in the wake of the financial crisis. That there was absolutely no evidence that these funds had much to do with the crash in the first place seems to have been a secondary concern. That Commission President Jose Manuel Barroso was seeking support from socialist MEPs for his re-appointment was likewise just a coincidence...

Now, as we argued in the first comprehensive impact assessment of the proposal, the industry does need more transparency and accountability, so in that sense, the Commission was correct in looking at new regulation for this sector. But the Commission’s original proposal was fundamentally flawed. Leaving aside the huge number of technical details involved (for a wider discussion see here and here), the original proposal would have paved the way for a world in which investors in these funds, the managers of them, their custodians (that hold the assets of the funds) and the funds themselves were all confined to a life either within the EU’s borders, or a life outside them. This was clearly contrary to best industry practice (for example by increasing concentration risk), the nature of modern finance (which is inherently mobile, global and cross-border) and would have also contradicted the 2009 April G-20 summit conclusions, which instructed world leaders to

“promote global trade and investment and reject protectionism, to underpin prosperity.”

To their credit, MEPs and national ministers, following 18-20 months of negotiations, adopted a far more sensible version of the proposal which kept many of the Directive’s transparency provisions while aligning most of the other rules with global economic realities and the need for inward investment into Europe.

But, as we also argued in 2009,

“The Commission is the dark horse in all of this. The way the Directive is written leaves the EU executive unusually large room for manoeuvre in deciding key aspects of the legislation – including leverage levels, valuation standards and restrictions on short-selling – either in the implementation phase or further down the road.”

This is because, in the so-called Comitology stage, the Commission has the power to lay down ‘technical’ or ‘supplementary’ standards when these are specified in the proposal, with limited involvement from MEPs and member states (for a background see here).

As reported by the FT this morning, this is precisely what the Commission is now seeking to do, in several ways, including

• Tougher liability rules for custodians (which would be liable for the safekeeping of assets, even if the custodian decided to delegate the responsibility to a third party). This could make EU-based banks far more hesitant to operate with partners in emerging economies, in turn undermining investment in those parts of the world.

• Stricter rules on leverage, i.e. how much money a fund manager is allowed to borrow. Interestingly, a recommendation for a more discretionary model of calculating leverage, put forth by ESMA – the EU’s markets supervisor – was rejected by the Commission.

• Fund managers based outside the EU, would face more obstacles before they could market their products to investors based in the EU. As Andrew Baker of AIMA put it,

  “This would be extremely problematic if not impossible to conclude if the regulation prescribes that the co-operation agreements ensure that third-country regulators enforce EU law in their territories.”

Now beyond the boring technical details, this is politically interesting for at least two reasons:

• The Commission is ignoring ESMA, begging the question, what exactly is Commission's relationship with ESMA and the other EU financial supervisors (ESAs), set up in 2010, meant to be. Specifically, whether “technical details” will be allowed to remain technical or become politicised with the ESAs being colonised by the Commission’s agenda.

• Via the Lisbon Treaty, the Commission has increased its powers in the so-called comitology procedure (for the full story, see here). This is an interesting test case for how far the Commission dares to push its luck.

This will go on for some time and we should not jump to conclusions – and clearly, the industry has its own agenda as well. But, the episode is a reminder of one thing: in EU politics, proposals and laws have a curious habit of always coming back.