On 30 June 2021, the Financial Conduct Authority (the “FCA”) published its findings following a multi-firm review on host authorised fund managers (“AFMs”) who outsource investment management to external third parties.
The FCA visited a selection of host AFMs between Q4 2019 to Q4 2020 with the aim to assess the effectiveness of the governance, controls, monitoring, and risks in their business models.
The FCA review focused on the following areas:
- the host AFMs’ understanding of their responsibilities for the operating funds;
- the adequacy of the AFMs’ governance, controls and resources;
- the effectiveness of the AFMs’ compliance with their regulatory responsibilities, especially under the Collective Investment Scheme Sourcebook (“COLL”);
- the AFMs’ oversight of delegated third-party investment managers with regards to the investors’ interest; and
- the appropriateness of resources adopted by the AFMs in relation to the nature and scale of their business.
MAIN AREAS OF THE REVIEW
The FCA grouped its observations into the following key areas:
Due diligence over delegated third-party investment managers and funds: Overview of requirements
The FCA set out a number of requirements with regard to due diligence for AFMs to adhere to. These include conducting businesses with due skill, care and diligence, organising and controlling affairs responsibly and effectively, as well as having adequate risk management systems in place. Firms that delegate investment management to third parties are also expected to adhere to specific requirements in relation to risk management, monitoring of delegation arrangements and ensuring unitholders (investors of the funds) are not subject to undue costs or charges. The review resulted in the following findings:
- Due diligence: from its review, the FCA found that overall, AFMs performed weakly in this area. In particular, the FCA found a lack of analysis of the actual distribution of funds versus the planned distribution done by the firms, little monitoring on the effectiveness of written policies and procedures put in place and a lack of adequate systems to operate funds prior to the firms’ submission of fund authorisation applications to the FCA.
- Fund authorisation applications: the FCA expect firms to have a complete understanding of their funds. However, the FCA had numerously asked firms to revise their fund applications and was referred to third-party investment managers in the process, evidencing the firms’ lack of knowledge.
Oversight of delegation: Overview of requirements
Despite the current FCA rules which permit AFMs to delegate investment management to third parties, these third parties are not deemed ‘clients’ of the AFMs, which the FCA regarded as an incorrect description of the relationship. Regardless of the outsourcing of investment management, the AFMs must still have an effective monitoring system in place and retain any necessary resources and expertise to give continuous instructions or withdraw delegation mandates when required. The review resulted in the following findings:
- Investment strategies
The FCA also observed that some firms have failed to put in place appropriate resources to oversee the investment strategies that were being adopted by the external third party manager. The FCA expects AFMs to, amongst other things, operate with reference to acceptable consumer outcomes and adopt clear lines of escalation where the performance of third parties falls outside of tolerance level, which must be measurable with clear tracking metrics.
As set out in COLL, AFM has a duty to assess its resilience in volatile market conditions and scenarios that would potentially affect the performance of funds. It is also their duty to ensure that third-party investment managers pass on information on any charges and costs to investors. These charges must be fair and clearly presented. The FCA recognised a lack of in-depth understanding of investment management activities and strategies by the AFM’s delegated overseer. The FCA has attributed this to the overseers’ lack of formal qualification or first-hand direct experience.
Governance and oversight: Overview of requirements
One of the rules set out by the FCA require AFMs to have robust governance arrangements in place, which specifically include:
- clear organisation structure with clear lines of responsibilities;
- effective process to control actual potential risks that AFMs are exposed to;
- internal control mechanisms; and
- orderly records of the business and internal organisation.
The assessment resulted in the following findings:
- Challenge from non-executive directors
The FCA discovered a wide difference in the quality of contribution from independent non-executive directors (“INEDs”). Some of these firms had no appropriate documentation of the INEDS or limited attendance by the INEDS in board meetings, unable to ensure a consistent level of the standard expected by the FCA.
- Conflicts of Interest
Where firms did put in place frameworks for managing conflicts of interests, the FCA was not satisfied with their efficacy. AFMs are encouraged to identify relevant conflicts of interest with sufficient evidence, which they currently appeared to be unable to do so.
- Assessment of value
Firms are reminded of their duty to assess the quality of advice with reference to the ‘quality of service’ consideration put forward by the FCA, especially where customers are charged for advice on pre-RDR share classes. At the moment, the FCA noted that many AFMs applied a broad-brush approach to their value assessment. The imprecision of such performance reviews and the misapplication of the 7 review considerations have led to inaccurate conclusions. Firms are reminded to check whether advice was provided and assess the quality of such advice going forward.
- Board effectiveness
The FCA recognised the lack of robust governance procedures by several AFMs. Some INEDs failed to effectively challenge board meetings minutes, others demonstrated potential conflicts in their management. Some firms held discussions outside of a formal meeting with little to no challenges by the directors, nor did the firms keep consistent records of follow-up actions.
Financial resource: Overview of requirements
Where an AFM is authorised under the Financial Services and Markets Act 2000 (“FSMA”), it is subjected to the Threshold Conditions set out within. These conditions include having appropriate resources and a suitable business model, which unfortunately is not met by all firms. Moreover, the effectiveness of the risk framework adopted by firms varies widely, some are even failing to demonstrate how capital risk assessments are used in their ongoing operations and decision-making process.
- Reliance on professional indemnity insurance and/or parent support
The FCA also identified a reliance on parent firms or professional indemnity insurance (“PII”) for risk management. While support from parent firm and PII are part of the appropriate risk mitigation approach, they should not be a complete substitution for having adequate risk assessment or maintaining adequate financial resources.
- Regulatory reporting
Firms’ failure to appropriately conduct regulatory reporting hindered the use of data and have led to materially distorted aggregated data for the purposes of analysis. The FCA also encouraged AFMs to refer to their Wind-down Planning Guide for ways to improve their existing plans with the hope to reduce the risk of harm to both consumers and the market in the event of such firms exiting the market.
- Business model
An observation by the FCA was that several firms operate at a relatively low operating margins, with systems, controls and human resources that lack appropriate investment. Some firms reasoned that such a problem was a result of fee pressure coming from their delegated third-party investment managers, which the FCA considered as an indication of the inadequate charging for their service by the host AFMs.
- Risk framework and assessment
Although all firms had some level of risk framework in place, the FCA identified a diversity in the effectiveness, maturity, coverage, governance and use within these businesses. Some firms, the FCA remarked, had no clear risk appetite statement, resulting in the management’s inability to articulate the ways in which they could identify whether the firm was operating outside of its risk tolerance or not. The lack of adequate assessment of risks by some firms also poses harm to the firm itself, the customers, as well as the market in general.
The FCA also noted that a couple of firms failed to update their capital risk assessment documentation to reflect the material changes in the firm’s financial adequacy over the years. A few, however, demonstrated reasonable consideration of a forward-looking approach to risk assessment, as well as the way the identified risks evolved throughout the economic cycle.
- Stress test and wind down planning
The FCA has consolidated a Wind-down Planning Guide, which encouraged firms to put in place a wind-down timeline, accompanied by detailed explanation. Most firms had only recently started to develop such a plan, and the FCA found them to be inadequate with no evidence of stress conditions.
The lack of credible wind down plans, as pointed out by the FCA, increases the risk of disorderly exit from the market.
The FCA is in the process of providing written feedback to the host AFMs that participated in the review and aims to review the progress of each firm in the following 12 to 18 months.
As result of the assessment, Host AFMs may be requested to hold additional capital to cover the risks posed by their business.
Host AFMs are expected to consider the findings published by the FCA and identify potential flaws in their own systems. Also, the FCA expects that any identified flaws are addressed by the Host AFMS.
Moreover, Host AFMs may expect intervention from the FCA where deficiencies in financial or non-financial resources are observed. This might include the FCA reviewing Host AFMs financial resources, such as capital and liquidity positions.
To review the second Consultation Paper, please click here.
To review the FCA’s publication of CP21/7 outlining the new UK prudential regime for MiFID investment firms, please click here.
For more information, and any guidance or advice on this FCA review and the respective FCA consultation papers, Cleveland & Co External in-house counsel™, your specialist outsourced legal team, are here to help.