The COVID-19 emergency has triggered an increase in 10% depreciation reporting under Article 62 of the MiFID Org Regulation (Commission Delegated Regulation (EU) 2017/565). In this briefing we consider the FCA's relaxation of this requirement given the recent sharp declines in asset values, and how generally firms might approach the FCA when accommodations or waivers are required from regulatory requirements.
This briefing will mainly be relevant to firms that provide discretionary investment management services or hold retail client accounts in the context of providing an investment service. It will also be relevant to other entities within the investment distribution chain, such as advisors and platforms.
Article 62 of the MiFID Org Regulation requires firms providing portfolio management services or holding retail client accounts that include leveraged investments to inform investors where the value of their portfolio or leveraged position falls by 10% or more compared with its value in their last periodic statement. They must also report any subsequent 10% fall in value.
In response to concerns raised by firms about the impact of notifications on consumers and the operational burden of reporting in a highly uncertain market, the FCA has written to all firms in a Dear CEO Letter outlining a temporary period of supervisory flexibility for 6 months (to 1 October 2020) in relation to the 10% depreciation reporting rule. In particular, the FCA announced that it has “no intention of taking enforcement action” provided that the firm meets certain conditions which we discuss below.
The FCA's choice of words is deliberately limited. Its statement does not change the applicability of the rule to market participants because the FCA has no formal powers to disapply, or even defer, a directly applicable obligation under EU legal text. Consequently, a firm which is non-compliant with Article 62 would still be in breach of EU law, which can create a range of legal risks notwithstanding the welcome relief from an FCA enforcement investigation to which the firm may otherwise have been subject. Firms will commonly be under a contractual duty to comply with applicable regulatory requirements, and so a decision not to comply fully with Article 62 might leave a firm vulnerable to a breach of contract claim although, where information about the declining value of holdings is available to a customer through other means, that customer will likely struggle to show that the contractual breach has caused them a loss.
Against this backdrop firms should consider doing all they can to ensure their client reports remain fully effective. Where the usual reporting standards cannot be met in full, firms must at least take the necessary mitigating steps to meet the conditions for supervisory flexibility that the FCA has outlined. These are that the firm (1) has issued one or more 10% depreciation reports to its retail client within a current reporting period, and (2) subsequently provides general updates through its website, other public channels (such as social media) and/or generic, non-personalised client communications. These communications should update clients on market conditions, explain how clients can check their portfolio value and invite clients to contact the firm if they wish.
With this in mind, we have set out some key points related to client communications that you may wish to bear in mind over the next six months or so.
KEY POINTS TO CONSIDER
- The FCA’s supervisory flexibility applies to reports “within a current reporting period”. Once an obligation to report has arisen in relation to a 10% threshold, no new information would need to be disclosed if another threshold were exceeded during the same quarterly reporting period. However, supervisory flexibility is unlikely to extend to cover reports that are triggered during the next reporting period, and so more than one report to the same client might well be required between now and 1 October (and possibly beyond).
- The FCA has made clear that it expects firms to provide strong support and service to customers, and to enable them to make effective investment decisions. Amidst rising levels of consumer fraud and scams, firms are reminded of their ongoing responsibility to ensure that consumers are protected.
- Firms should not assume that all digital communication channels (e.g. through websites or social media) will always be appropriate to all customers. The FCA's Treating Customers Fairly principle (Principle 6) will still apply, and firms should consider carefully communications with vulnerable customers who may require extra support. Ultimately, when today’s decisions are scrutinised in the years ahead, it will likely be through a lens of presumed vulnerability in relation to retail customers.
- Another approach that firms might consider as a means of reducing the operational burden of making written notifications and the impact of repeated communications on consumers is to use email or phone calls to provide 10% depreciation notifications and updates to clients. That said, real time communications may raise real challenges in the current environment and those making calls will need a clear understanding of how to respond to customers' questions and concerns.
- Firms may wish to review and update their contingency measures for performing at least daily valuations during periods of market illiquidity and high intra-day volatility, for example, assessing what a fair value might be for financial instruments within the portfolio for which there is no secondary market or daily price reference.
- There are likely to be added challenges when carrying out depreciation reporting through retail investment platforms in circumstances where the discretionary portfolio manager does not have knowledge of the end investor or the transaction history to make the calculation. Firms are often reliant on the distribution chain to obtain underlying client data including daily calculations to detect when the proportions process should be initiated. Firms should consider reviewing those arrangements with third parties and making adjustments as needed as part of their contingency planning.
- The FCA also announced supervisory flexibility for firms that choose to stop making 10% depreciation reports for any professional clients (i.e. without necessarily being required to make subsequent updates). Again, while this may provide relief to firms struggling to meet their regulatory obligations, it does not shield firms from other legal risks that might arise as a result of breaching EU law.
- Firms should continue to check the FCA’s coronavirus response web page including any further amendments to guidance already provided. Firms and their associates are encouraged to sign up for the FCA’s alerts on scams and updates to the website and to subscribe to the new regulatory roundup.
The FCA is keen to work with firms and consumer organisations to understand how the impact of the pandemic is affecting the sector. On a number of issues we envisage that many firms will prefer to proceed indirectly, via their trade association. If individual waivers or accommodations are needed to help firms to adjust to the current crisis, the FCA has indicated in its Dear CEO letter that it will be unsympathetic to requests which seem opportunistic and may, if granted, undermine consumer interests. Some careful thought should therefore be given before making such a request, but it is important also not to be overly cautious, the FCA is proving itself to be flexible. Bear in mind that a key issue is often the time it takes for requests to be escalated to the appropriate level in the FCA so that decisions can be made. Where the request may receive a poor reception, we find that clients often ask their advisers to approach the FCA on a 'no-names' basis first. At least then it is possible to judge the risks and benefits in a firm approach.
However you determine your approach to 10% depreciation reporting, firms are operating in a period in which more UK customers are likely to be viewed as vulnerable. It is critically important that firms maintain a documented “audit trail” that will allow them to evidence the customer-focused outcomes that led to the decisions that were made. In particular, if you are operating in the retail investment sector then you should be prepared for increased scrutiny in light of the FCA’s 2020/21 Business Plan, which identifies enabling effective consumer investment decisions as one of 5 key priorities over the next 1 to 3 years.
If you have any questions or would like to know more, please get in contact.