The Financial Conduct Authority (FCA) has published its findings from its multi-firm review into the supervision by principal firms of their appointed representatives (ARs) in the investment management sector.
The findings are detailed and do not make for pleasant reading for principals in the investment management market. The FCA has identified "significant shortcomings" in principal firms' understanding of their regulatory obligations and their oversight of their ARs. Alongside the review findings, the FCA has also published a "Dear CEO" letter directed at CEOs of principal firms. The letter reminds principal firms of the regulatory standards and obligations they are required to meet with respect to their ARs.
An AR is a firm that carries on regulated financial services activities but is not directly authorised by the FCA to do so. Instead another firm (known as the AR's "principal") agrees to take on regulatory responsibility for the regulated activities carried on by the AR. The principal takes on full responsibility for ensuring that the AR complies with the FCA's rules and will be held responsible for any regulatory failings of its AR. The principal firm must also ensure it is itself complying with its own regulatory obligations before and while acting as a principal firm.
The FCA notes that in the investment management sector authorised firms have appointed and accepted responsibility for over 1,000 ARs. ARs in the sector service all client types, including retail clients.
As part of the review, the FCA surveyed over 330 principal firms, each with between one and 80 ARs. The FCA also conducted site visits with 15 firms and undertook more detailed reviews in those cases.
The FCA found that the principals they surveyed had "weak or under-developed" governance arrangements in place, including a lack of effective risk management, internal controls and resources.
In particular, in reviewing the conduct and practices of principal firms, the FCA raised concerns regarding:
- poor AR on-boarding processes and a failure to fully assess the principal firm's ability to oversee the prospective AR effectively;
- a failure to have in place product governance arrangements and oversee product design by ARs;
- a lack of ongoing monitoring of ARs and failure to take adequate steps to ensure ARs are complying with relevant regulatory obligations;
- a failure to identify, record or manage conflicts of interests arising from AR arrangements (despite the existence of obvious conflicts);
- a failure by many principal firms to assess the risk to their firms (including liquidity risk and compliance with liquidity adequacy rules) arising from the activities of their ARs and to hold adequate financial resources;
- the growth of the "Host AIFM" model, whereby a principal firm is appointed as the AIFM to an AIF for a fee with the AR usually appointed as the adviser to the AIF. In particular, the FCA is concerned about inherent conflicts of interest, particularly where employees of the AR are seconded to the Host AIFM so that they may carry on regulated activities that are not covered by the AR model (e.g. portfolio management);
- Host AIFMs failing to put in place appropriate control and risk management frameworks, including experienced people to oversee the AIFs and activities of the seconded portfolio managers. The FCA also found that many principals failed to maintain effective systems and arrangements to prevent and detect market abuse because they misunderstood their regulatory obligations under the Market Abuse Regulation; and
- insufficient systems and controls to monitor ARs in the contracts for difference sector. Specifically, the FCA is concerned about ARs who are owned by overseas shareholders and do not have a proper presence in the UK and that third-country investors are sometimes given the impression that they are contracting with an FCA-registered entity when this may not be the case.
While the FCA's findings cover the investment management sector (including firms engaging in asset management, management of alternative investment funds, wealth management activity, contracts for difference activity, fund advisory and arranging activities), the FCA says the findings may also be applicable to principals and ARs operating in other sectors of the UK financial services industry. Accordingly, all firms should take heed of the FCA's recent findings and expectations when it comes to entering and overseeing AR arrangements.
As a result of its review, the FCA has intervened in relation to a number of firms in its sample. In some cases interventions included the imposition of requirements for the principal firm to either remove or stop on-boarding ARs and asking principal firms to de-register their ARs. The FCA's work in this area is set to continue and will include ongoing work with firms included in the survey and additional work with firms that were not previously included. Additionally, the FCA has "significant concerns" regarding the Host AIFM model and says it will continue to assess the associated risks.
As principal firms are "on the hook" for each AR they contract with they should take particular note of the FCA's renewed interest in this area. Firms should review their AR arrangements to ensure they are compliant with FCA rules and expectations and are appropriate in the circumstances. The FCA expects principals to assess how they are meeting the FCA's requirements in relation to ARs and expects principal firms to identify and address any shortcomings - and really it is in the best interests of firms to do so if they want to be able to demonstrate a compliant culture to the FCA.