Investment Management Regulatory Insights - June 2019

FCA warns investment managers over appointed representatives

On 20 May 2019, the Financial Conduct Authority (FCA) released its findings following a review of principal firms in the investment management sector, each with between one and 80 appointed representatives (ARs).(1) The FCA found significant weaknesses in the control and oversight of ARs, which required its direct intervention in several cases.(2) The FCA has issued a "Dear CEO" letter setting out its expectations of principal firms to ensure their arrangements with ARs are compliant.(3)

The FCA's review findings are relevant to firms with a range of business models, including asset management, promotion and management of alternative investment funds (AIFs), wealth management, provision of contracts for differences, and fund advisory and arranging activities. The FCA's findings give rise to a number of action points that must be addressed by firms in the sector – these are set out below.

Background: ARs in the UK investment management sector

ARs are exempt from the requirement to obtain FCA authorisation and can instead operate under the umbrella of the regulatory permissions of their principal, which makes entering into AR arrangements an attractive and relatively inexpensive way for AR firms to access the UK financial services sector.  This arrangement is available with respect to some, but not all, regulated activities.  ARs are permitted to provide investment advisory services if their principal is so authorised, however they are not permitted to provide portfolio management services even where their principal has this regulatory permission. The FCA has seen rapid growth in the numbers of ARs registered by some principals, without the necessary enhancements to principals' governance and risk frameworks to support this growth.  The FCA has, in particular, seen expansion in the "rent an alternative investment fund management" model (the Host AIFM model) in the past few years.

AR on-boarding

When on-boarding ARs, FCA rules require principals to conduct adequate due diligence, including gaining an understanding of the AR's business model, to ensure that the AR's activities are within the scope of the principal's regulatory authorisation. Principals must also ensure products offered by ARs are designed in the customer's best interests, to comply with product governance requirements. The FCA found significant shortcomings in the on-boarding process, stating that weak or underdeveloped risk control frameworks, internal controls and resources were prevalent among the principals surveyed.

Action points for firms:

• review AR on-boarding due diligence processes;
• review AR agreements to ensure they are tailored to the business model of the particular AR – generic agreements are not likely to be sufficiently tailored; and
• ensure product governance requirements extend to ARs.

Ongoing monitoring of ARs

The FCA found that inadequacies in risk frameworks meant that many principals failed to adequately challenge information supplied by ARs (which was often in the form of high-level attestations), to check whether ARs were acting within the scope of the principal's permissions on an ongoing basis, or to conduct reviews of ARs websites and promotional materials to ensure compliance with financial promotion rules and to check the veracity of regulatory status claims. Other principals failed to terminate inactive or dormant AR relationships, which resulted in unregulated firms remaining on the Financial Services Register.  

Action points for firms:

• ensure that ongoing monitoring of ARs includes client file reviews, testing and appropriate challenge and that ARs are conducting suitability or appropriateness tests where necessary;
• ensure that internal processes allow for review of ARs' websites and financial promotions; and
• ensure that conflicts of interest are identified and managed.

Capital and liquidity assessment

The FCA found that many principals may not be holding adequate financial resources (in breach of the FCA's Threshold Conditions) as firms were not adequately assessing the risks arising from the activities of their ARs.  

Action points for firms:

• senior management must be able to demonstrate adequate consideration of the risks to the firm in its role as a principal;
• the principal must ensure it includes ARs' revenues when submitting fee tariff data to the FCA, to ensure the firm pays the correct regulatory fees; and
• senior management should ensure they have taken into account the extent to which Professional Indemnity Insurance (PII) can mitigate risks arising from the firm's arrangements with ARs and that they acknowledge the circumstances in which PII cannot be a substitute for maintaining financial resources due to exclusions or limitations in the policy.  

AIF hosting services

Under the Host AIFM model, an unregulated firm is able to set up an AIF using the regulatory permissions of a principal which has been approved as an AIFM. ARs themselves are not permitted to conduct portfolio management activity but this distinction can be blurred where employees from the AR are seconded to the principal (the AIFM) and able to conduct portfolio management once approved to perform the customer-dealing function. The FCA found evidence that firms were not properly overseeing the AIFs and the portfolio management activities of seconded AR employees, and were also not proactively monitoring the trading activities of AIFs due to a lack of understanding of the principal's obligations to monitor and detect market abuse. The FCA will continue to monitor what it perceives as the significant risks of this model.  

Action points for firms:

• ensure the firm has adequate resources to oversee effectively the activities of AIFs and seconded portfolio managers;
• ensure the principal's market abuse surveillance and controls cover the activities of ARs; and
• ensure the FCA is notified where the principal ceases to act as the AIFM to a particular AIF.

ARs of contracts for differences providers

The FCA found that ARs registered by contracts for differences (CFD) providers were frequently owned by overseas shareholders. These firms were often inactive in the UK. However, firms with very similar names – and often linked by ownership to the UK AR – were being advertised abroad using the FCA registration number, which would give the impression that the foreign firm was in fact FCA-registered. The FCA is concerned that principals in the CFD sector lack adequate systems and controls to monitor their ARs and has intervened with some firms to require de-registration.

The FCA's next steps

In its Dear CEO letter, the FCA requires principals to assess how they are meeting their requirements and identify and address any shortcomings in their risk management frameworks, processes and practices. Firms should be ready to terminate arrangements with ARs in circumstances where the risks from the relationship cannot adequately be managed. The FCA expects Board engagement in this issue – the FCA may intervene further where firms fail to act.

1 - The FCA published its findings on a dedicated webpage on 20 May 2019.

2 - The FCA has intervened in relation to a number of principals in its sample, including by imposing requirements on principals' regulatory permissions, requiring principals to cease on-boarding of new ARs, requiring principals to de-register ARs and – in two cases – commissioning Section 166 Skilled Persons reports to examine the consumer harm arising from inadequate controls.

3 - The Dear CEO letter is available here.

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