ESMA Takes Aim at U.S. Banks with New MiFID II Directive

The jurisdiction of U.S. economic sanctions is far greater than many financial institutions realize. After 2008 the Dodd-Frank Act gave the SEC broad authority to combat fraud and corruption in the financial markets. Over the next several years, the federal agency concluded dozens of investigations and levied billions in fines using that new power. Those inquiries and penalties weren’t limited to U.S. based firms – they extended to EU firms as well.

U.S. courts tempered the extraterritorial reach of U.S. securities law, but those efforts were undone by the adoption of the Dodd-Frank Act. With a stroke of the pen, the SEC attained jurisdiction over "conduct occurring outside the United States that has a foreseeable substantial effect within the United States." Since that time, the SEC has shown an ever-increasing willingness to pursue insider trading enforcement actions with substantial international dimensions. In the words of former SEC Enforcement Chief Robert Khuzami, "offshore trading is not off-limits to U.S. law enforcement."

U.S. Regulators’ Reach into EMEA Firm

It turns out these words weren’t "all bark and no bite." For example, SEC v. Tiger Asia Management et al., involved a firm which was trading Chinese bank stocks executed on the Hong Kong Stock Exchange (HKSE). Tiger Asia allegedly submitted losing trades in securities of Chinese bank stocks on the HKSE, in order to manipulate the price, which artificially inflated the management fees. The SEC claimed it had jurisdiction since the sole principal of the firm resided in New Jersey, and placed and received telephone calls (related to the charges) from his residence. The HK Firm ultimately agreed to pay a combined 60 million USD in disgorgement and penalties, including 44 million USD to settle the SEC’s civil action and 16 million USD forfeited in connection with the criminal action.

A few months later the SEC filed another case – SEC v. Certain Unknown Traders in the Securities of H.J. Heinz Company (yes, that is the ACTUAL name of the original complaint). Acting without knowledge of any material link to conduct within the United States, and without knowing the identities or nationalities of the traders involved, the SEC was able to affect an account freeze in Switzerland.

These may sound like extreme examples but they are by no means outliers, and more importantly are illustrative of a very disturbing trend. As the securities environment becomes increasingly intertwined, and cross border trading becomes far more common, the SEC, and by extension the United States, may have designed a playbook for foreign regulators of competent jurisdictions to impose their will within the U.S. markets.

MiFID II Turns the Table

In years past, the U.S. was shielded from such an unthinkable outcome. Matteo Winkler, professor of law at HEC Paris stated, "for companies to make money, they need to trade through the U.S. financial system. It is therefore a matter of global economic power. In addition, a key to understanding what makes the U.S. so influential is the use of dollars. The dollar is the main world currency and is dominant economically.” Having oversight for the security and stability of the largest financial system in the world, U.S. regulatory entities can certainly justify extreme measures. As a result some financial institutions in EMEA and APAC were forced to avoid trades and business decisions that ran afoul of DFA.
But now, the EU is borrowing a page from the U.S. playbook.

Today, MiFID II has everyone’s attention, in much the same way that Dodd-Frank did back in 2010. The EU regulation has been reported as "a bold new law that will reshape Europe’s capital markets," warning firms "the magnitude of this (sic) should not be underestimated." Although enforcement questions remain, a lot of guidance has been published and stern warnings issued for market participants not in compliance. Firms within the EU continue to prepare for the implementation date of 3 January 2018. Still, firms in the United States are by and large ignoring MiFID II altogether. If your firm is one of those taking a wait-and-see attitude, consider the following.

Come January, the EU will have a regulation that is as large, complex, and as far reaching as Dodd-Frank. ESMA, the independent EU authority, has the capacity to issue guidance that competent authorities of member states have the ability to conduct investigations outside the EU. Taking a page from the U.S. playbook, ESMA could conceivably require any firms with substantial ties to the EU markets to comply with MiFID II. Using the collective size of the EU markets, the European Commission has all the leverage needed to force compliance. The adjusted GDP of the 28 EU member nations is larger than both China and the US. In an interview, Joseph P. Quinlan, chief market strategist for US Trust stated "in nominal U.S. dollar terms, the European Union (plus Norway, Switzerland, Iceland) accounted for 25.4% of world output in 2014 according to data from the International Monetary Fund." Should the EU decide to pursue this course of action, how many firms would be willing to endanger access to the largest collective economy in the world? Furthermore, diplomatically the United States would find itself hard pressed to defend actions that they themselves developed.

Time for Action is Now

In sum, the issue of MiFID II’s applicability to U.S. firms is far from settled. Should the EU decide that MiFID II non-compliance by U.S. firms represents a systemic danger to EU markets, it’s not so farfetched to think they wouldn’t borrow a page from the very same extraterritorial playbook the U.S. created for Dodd-Frank. The expansion of the scope under MiFID II will make it far likelier for market participants to be caught within EU regulators’ crosshairs without even realizing it. Even if legal ramifications may seem defensible, the mere prospect of an ESMA investigation could cause internationally active firms to incur significant legal costs and corresponding reputational damage.

The key takeaway