The Regulatory Spotlight is shining bright and not just on AFMs
On 20 June 2021, the FCA published its findings from the review it carried out on host Authorised Fund Management firms during 2019-2020. The purpose of the review was "to test the viability of the host Authorised Fund Manager (AFM) business models and assess whether conflicts of interests were being effectively managed."
The results of the review are highly important not only for host AFMs, but also for all Fund Managers and FI Insurers that underwrite fund managers.
UK regulated funds must have a managing entity that is authorised by the regulator. These are commonly known as Authorised Fund Managers (AFMs) and are responsible for ensuring that the fund complies with the rules laid down by the FCA.
A 'host' AFM, is one that operates a fund but delegates the management of the investments to a third party.
The FCA initially identified areas of potential regulatory failures by AFMs as early as 2012. These failures appeared particularly in the areas of oversight, due diligence of delegated third party investment managers, lack of resources and lack of understanding of some of the strategies used by delegate third-party investment managers. These areas were therefore the focus areas for the most recent review.
Overall, the review found that many firms did not: (i) carry out the requisite due diligence; (ii) have adequate risk management systems in place; (ii) have an appropriate governance structure to manage the funds; or (iv) have appropriate resources and suitable business model.
The FCA has confirmed that it expects fund managers to have already considered the ways in which it is going to comply with the requisite regulation, prior to applying for the fund to be authorised. One of the key points made by the FCA was that many firms did not fully understand the funds. Without that knowledge, firms cannot effectively manage the performance of the funds or challenge any decisions made by the fund manager.
The outcome of the review showed a lack of focus on controlling risks of harm, with some firms failing to identify conflicts of interests, even where the FCA confirm they were obvious. The example given by the FCA in this context is where a conflict arises between an investor's funds and a sponsor whose fees are paid by the fund.
What happens next?
The FCA has confirmed it will be providing feedback to all the firms that have been involved in the review and has indicated it will be employing the use of all the measures available to ensure there is compliance in this sector. This can include section 166 Skilled Person Reports which the FCA confirms "will primarily consider the adequacy of firms’ governance, systems, controls and delegated third-party manager oversight". The expected time frame given by the FCA for progress is 12 – 18 months.
The FCA has indicated that the results of the review have been so substantial that it is considering whether it needs to make changes to the regulatory framework currently in place. It is clear some big changes are anticipated over the next year or so. We will provide a further update in due course.
The FCA published guidance for firms in June 2020. This guidance explains the FCA's expectations for assessments into adequate finance resources.
A key part to compliance with the requisite obligations is knowledge. Firms must have a clear understanding of the relevant regulation and how to adhere to it, as well as in respect of the funds themselves. If there is a lack of understanding of the funds, it is impossible to effectively oversee their management and ensure adequate risk management systems are in place to govern them.
The FCA clearly wants AFMs to take their responsibilities seriously. AFMs must act in the best interests of the funds they manage, as well as the interests of the investors in that fund. Firms are expected to pay more attention to their own systems and identify where there are potential weaknesses.
The FCA is taking a proactive approach and where it finds firms are underperforming from a regulatory perspective, they must be prepared to receive a section 166 notice.
It is clear from the review that firms must be prepared to identify and act on any conflicts of interests, and make any decisions required in the interests of investors, even if those decisions impact their business. Firms should be proactive in ensuring decisions are challenged where needed, and that the model portfolio is analysed with the actual portfolio to ensure the fund is appropriately monitored.
This is just the beginning from the FCA who are keen to ensure standards are being met and risks are managed effectively. We can therefore expect more developments, either by way of the FCA seeking rectification of any failing, low standards or non-compliance or by new or amended regulations.
FI insurers and fund managers should be vigilant of the FCA's findings given the heightened risk of scrutiny, whether by way of section 166 reviews or formal investigations, giving rise to significant costs exposure and potential for sanctions. In addition, such firms should also be mindful that claims often follow regulatory sanctions/reviews that highlight failings, especially in respect of a lack of due diligence and conflicts of interests.