Following a year occupied with Brexit confusion the FCA has commemorated the start of a new decade with a release of ‘Dear CEO’ letters, somewhat reminiscent of the US Securities and Exchange Commission’s ‘examinations priorities’, which set out key risks of harm that the regulator considers relevant to certain sectors, including asset management.
Many of the themes detailed in the letters are linked to perceived failings at asset managers of retail funds facing liquidity issues. These include Woodford Investment Management, which was forced to wind up its flagship fund, Woodford Equity Income Fund (worth £3.8 billion as of May 2019) and the £2.5 billion M&G property portfolio which was suspended in December 2019. The FCA has been subject to heavy criticism over its handling of these, including being accused by John McDonnell, the Shadow Chancellor, of being “asleep at the wheel” regarding Woodford.
The letters could therefore be seen as a ‘shot over the bow’ for other asset managers, in part to ensure the FCA mitigates any further reputational damage. From a less cynical viewpoint, there is however a contagion risk that the FCA may have considered important to stem, including where investors in peer funds that do not have a liquidity issue get spooked and it causes a run of redemptions on these funds. The FCA therefore has an important role to play in reassuring investors that it is, following on from McDonnell’s analogy, firmly in the driving seat in dealing with the factors underpinning these incidents.
‘Asset management’ and ‘alternatives’ portfolios
The FCA has separated asset managers into two ‘portfolios’ that share a common business model; each received its own letter. The ‘Asset Management Portfolio’ comprises firms that manage or advise ‘mainstream’ investment vehicles, such as authorised funds; the ‘Alternatives Portfolio’ comprises firms that manage or advise ‘alternative’ investment vehicles, including hedge funds and private equity firms.
Although a firm is assigned to one portfolio only, the FCA appreciates that many firms are conducting both mainstream and alternative investment activities. Therefore, both letters might be relevant to such firms. In addition, firms that have their foot firmly in one portfolio might also wish to review both letters in order to gauge the FCA’s respective priorities for each sector. Having digested these, our analysis of the letters is as follows below.
The themes detailed in the letter come as no surprise. The FCA has signalled its focus on these in a number of ways, including via recent publications and also the questions that we see posed frequently by FCA case officers vetting applications to become FCA authorised.
The alternatives letter has a strong emphasis on financial crime systems and controls as expected, given that this has always been a top regulatory priority. Crucially, however, the FCA indicates that firms’ financial crime systems and controls frameworks could be improved. Regarding market abuse, the FCA generally observes “that market abuse controls across the sector have significant scope for improvement.” This is with respect to both the firm’s obligations per the Market Abuse Regulation (“MAR”), and ensuring that these controls are ‘fit- for-purpose’ given the firm’s activities. Some further FCA observations on market abuse can be found in their ‘Market Watch’ newsletters. Recent publications have highlighted issues and concerns regarding personal account dealing and control of access to inside information, amongst other topics. This section of the letter contains a bulk of the ‘fighting talk’. The FCA states that they may conduct supervisory exercises (for example, firm visits) and this “may include your firm.” Furthermore, the FCA will consider the need for enforcement action where firms do not comply with MAR; around 20% of all open enforcement investigations relate to market abuse. Recent enforcement action on this topic has focussed on the sell side. For example, the fines imposed on Linear Investments Limited in 2019 and Interactive Brokers (UK) Limited in 2018. The letter might indicate a shift in focus to the buy side.
Separately in the letter, in addition to market abuse, systems and controls to mitigate the risk of money laundering terrorist financing, bribery and corruption are also noted, in particular due diligence on third parties, including Know Your Client (‘KYC’).
There is also a focus on ensuring that investment risk is appropriately managed, in particular ensuring that investments are suitable for the target investors. Whilst the language is somewhat toned down compared to the equivalent parts of the letter for the mainstream asset managers (as covered below), controls surrounding restrictions on marketing to retail investors and opting up investors to ‘elective professional investors’ are mentioned.
Operating robust risk management controls generally is also noted, including avoiding excessive risk taking and having in place high quality controls for high-risk investment strategies, including where significant leverage is employed.
Finally, the importance of robust systems and controls regarding client money and custody rules is emphasised. This relates in particular to firms that hold client money and/or client assets; however, firms which do not perform these functions should not be ambivalent. There remains the risk of a client money breach, for example where a firm holds client money in contravention of its regulatory licence, or where there are issues with respect to a firm in ‘control’ of client money (held by another) as part of its mandate with a client.
In contrast to the alternatives letter, the asset management letter focuses more on governance related themes; for example, the role of the board, the Senior Managers and Certification Regime (SMCR) and product governance.
Taking its cue from the well-publicised fund liquidity incidents (e.g. Woodford; M&G), the FCA states that it expects firms to take into account certain communications to appropriately manage the risk of a liquidity mis-match and to take prompt action to mitigate or resolve liquidity management issues.
Following on from other communications, governance continues to be a hot topic. SMCR, which took effect for asset managers in December 2019, is noted as being a particular area of focus. The FCA will carry out work in the first half of 2020 to evaluate the effectiveness of governance across the sector.
The requirements, inter alia, require firms to think differently about obligations to end investors by conducting value assessments on authorised funds and for governing bodies of authorised fund managers to have at least one-quarter of their members as independent. The FCA will perform work in the first half of 2020 to understand how effectively firms have undertaken value assessments.
Product governance was introduced by MiFID II in 2018. The FCA states in the letter that products should be designed with the best interests of a specific target market in mind. The FCA has started a review to assess how effectively product governance provisions have been implemented; they expect to complete their work in early 2020. The FCA also states that there are concerns regarding the ‘host’ Authorised Corporate Director (“ACD”) model, where the ACD – an independent third party – acts as ‘lead manager’ to a fund and delegates portfolio management to the ‘actual fund’ manager.
For example, Link Fund Solutions acted as ACD to the Woodford Equity Income
Fund, and has been accused of not holding Woodford Investment Management to account. The FCA asserts that ACDs are conflicted since they wish to avoid a loss of revenue should they be more ‘assertive’ in carrying out their duties with respect to the fund. The FCA is now conducting a study into this, so expect them to take a viewpoint on it soon.
Alternatives should note the similarities between this arrangement and arrangements where a third party – such as an ‘AIFM management company’ – acts as the ‘lead manager’ to a fund. The FCA has not indicated that the latter arrangement is an area of concern, however it would be prudent to watch for any developments in this space.
Although primarily an issue for dual-regulated firms, regarding the transition from LIBOR to other rates, such as SONIA (Sterling Over Night Index Average), the FCA advises that it is cur- rently gathering data from some asset management firms to enhance their understanding of business models, including exposure to LIBOR risk.
The letter states that the FCA expects asset managers to appropriately manage technology and cyber risk appropriately. In addition, asset managers with a greater risk of causing harm are subject to proactive technology reviews, as well as performing ad hoc reviews more generally. One benchmark for this is the £16.4 million FCA fine for Tesco Personal Finance plc in 2018. The personal finance division of the supermarket giant was found to have failed to exercise due skill, care and diligence in protecting its personal current account holders against a cyber- attack.
Finally, regarding both letters, the FCA implores firms to consider how the scheduled end of the Brexit implementation period on 31 December 2020, will affect the firm and its clients.
One key take-away for firms is that although the departure from the EU on 31 January has removed (or rendered statistically insignificant) the outcome of a revocation of Article 50, various uncertainties remain in terms of deal versus no-deal (and if the latter, what this will mean for asset managers) and, arguably, whether or not the implementation period shall be extended.
What to do next?
The FCA asks firms to present these letters to their senior management for review and consideration, and we urge firms to comply with this. (In fact, it could be argued that addressing the letters to the CEO, as opposed to senior managers, is somewhat anachronistic.) Going beyond this, it would be prudent for firms to review their current processes in regards to the areas identified by the FCA, as to whether they are appropriate for the current business or whether further controls should be implemented. It would be advisable for firms to provide a report to the senior management on their review, potentially as part of the Annual Compliance Officer’s report.
It has been two years since MiFID II, the most recent significant regulatory change affecting asset managers, took effect. 2020 poses to be no less dramatic given ongoing Brexit related uncertanties. However, a consistent regulatory theme remains: firms can always be doing more and the FCA would like to ensure that firms are not distracted from their core responsibilities.
To download a pdf. of this article please click on this link: FINAL Dear CEO letter Jan 2020.
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