It is increasingly difficult for firms easily to check which of the myriad rules on outsourcing in financial services apply to them. Rosali Pretorius, Emma Radmore and Kam Dhillon look at recent regulatory developments that apply to fund managers when outsourcing functions such as investment operations, fund administration, transfer agency or corporate actions.
A reminder – what is outsourcing?
There are many definitions of outsourcing, but for our purposes it is “an arrangement of any form between an investment firm and a service provider by which that service provider performs a process, a service or an activity which would otherwise be undertaken by the investment firm itself” (MiFID Implementing Directive article 2(6)).
What rules apply to fund managers when they outsource?
This is no longer a simple question. Managers of alternative investment funds must comply with the rules in the Alternative Investment Fund Managers Directive (AIFMD). Managers of undertakings for collective investment in transferable securities (UCITS) must comply with the UCITS Directives. Many fund managers also provide “investment services” and must therefore comply with the Markets in Financial Instruments Directive (MiFID). They must be aware of the EU measures and the UK rules implementing them.
Where are the FCA’s rules?
The starting point for UK firms is the Financial Conduct Authority Handbook of Rules and Guidance (in particular, the Senior Management, Systems and Controls rules (SYSC)). Chapter 8 of SYSC contains the key requirements governing outsourcing. Firms subject to SYSC may outsource regulated activities or functions that are “critical or important” for performing regulated activities, provided they:
- take reasonable steps to avoid undue additional operational risk;
- remain fully responsible for discharging all of their regulatory obligations;
- exercise due skill, care and diligence when entering into, managing or terminating any outsourcing arrangement;
- retain the necessary resources and expertise to monitor the outsourced activities effectively; and
- act in the best interests of their customers by ensuring the service they provide is not compromised by outsourcing critical activities.
The FCA’s view is that this includes having adequate contingency plans in place to deal with either an unexpected termination of an outsourcing contract or a service interruption affecting a service provider. The firm’s business model will determine if the SYSC requirements apply as rules or guidance. So if the fund manager is:
- a UCITS management company, the requirements in SYSC 8 apply either as a rule (if the firm is a UCITS investment firm) or are not applicable or are otherwise guidance. (See SYSC 1 Annex 1 Part 3);
- a full scope UK alternative investment fund manager (AIFM) of an authorised alternative investment fund (AIF), the requirements in SYSC 8 do not apply;
- a small authorised UK AIFM or a full scope UK AIFM of an unauthorised AIF, the requirements in SYSC 8 apply as guidance. So the extent to which the firm must comply will depend on the nature, scale and complexity of the firm’s business; or
- an investment firm that carries on some portfolio management activities and is a common platform firm, the requirements of SYSC 8 apply.
AIFMD outsourcing rules
Under the AIFMD and its supporting EU Regulation, AIFMs will be subject to the delegation rules in article 20 of AIFMD, addressed in Chapter 3 of the FCA’s FUND Sourcebook. In addition, the common platform requirements (including SYSC 8) continue to apply to an AIFM that is a full-scope UK AIFM of an unauthorised AIF and to the MiFID business of a UK AIFM. The delegation rules overlap with, and extend, the rules on outsourcing. The key provisions on delegation provide for the following:
- there must be objective reasons for the delegation;
- notification of the delegation must be submitted to the competent authorities in the home member state of the AIFM;
- where the delegation concerns portfolio management or risk management, AIFMs can appoint only authorised or registered asset managers or, where that condition cannot be met, can delegate only with the prior approval of the AIFM’s regulator;
- the AIFM must be able to show that the delegate is qualified and capable of undertaking the functions in question and that it was selected with all due care;
- the AIFM must review the services provided by each delegate on an ongoing basis;
- the AIFM’s liability towards the AIF and its investors must not be aff ected by the fact the AIFM has delegated functions to a third party, or by any further sub-delegation;
- the AIFM must effectively supervise the delegated functions and manage the risks associated with the delegation;
- the AIFM must take appropriate action if it appears the delegate cannot carry out the functions effectively or in compliance with applicable laws and regulatory requirements; and
- the AIFM must ensure the delegate establishes, implements and maintains a contingency plan for disaster recovery and periodic testing of backup facilities while taking into account the types of delegated functions.
AIFMs cannot delegate their functions to the extent that they would cease to be the manager of the AIF and become a letter-box entity. This means the delegation arrangements must not allow for the circumvention of the AIFM’s responsibilities, obligations or liability.
To avoid the risk of being categorised as a letter-box entity, an AIFM must perform a significant degree of day-to-day investment management itself. Proportionally, this should not be significantly outweighed by the amount of day-to-day investment management it has delegated.
An AIFM will be considered to be a letter-box entity and therefore no longer the manager of the relevant fund if it:
- no longer has the necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation;
- no longer has the power to take decisions in key areas that fall under the responsibility of the senior management or no longer has the power to perform senior management functions in particular in relation to the implementation of the general investment policy and investment strategies;
- loses its contractual rights to inquire, inspect, have access or give instructions to its delegates or the exercise of these rights becomes impossible in practice; and
- delegates performing investment management functions to an extent that exceeds by a substantial margin the investment management functions performed by the AIFM itself.
The European Commission will review these guidelines next year in light of market developments and may specify further conditions under which an AIFM will be deemed to be a letter-box entity.
Full scope UK AIFMs must establish, implement and maintain remuneration policies and practices that promote sound and effective risk management and do not encourage risk-taking that is inconsistent with the risk profiles of the AIFs they manage.
The remuneration requirements apply to staff whose activities have a material impact on the risk profiles of the AIFM and/or the AIFs it manages. This includes those working for firms to which the AIFM delegates portfolio or risk management. Delegates must be subject to requirements on remuneration that are “equally as effective”, or else the delegate and the AIFM must put in place contractual arrangements to ensure that the remuneration requirements are not circumvented.
Another contentious part of the AIFMD has been its rules imposing near strict liability on depositaries that lose assets. A depositary will have “lost” a financial instrument in its custody when:
- a right of ownership is invalid because it either ceased to exist or never existed;
- the fund has been definitively deprived of its right of ownership; or
- the AIF is definitively unable directly or indirectly to dispose of the instrument.
However, the depositary will not incur liability if the event that led to the loss is not the result of any act or omission of the depositary or a third party that it has delegated to, or the event could not have reasonably been prevented despite adopting all precautions incumbent on a diligent depositary as reflected in common industry practice.
Depositaries will also avoid liability if they could not have prevented the loss, and they have established, implemented and they apply, on an ongoing basis, certain structures and procedures set out in the EU’s AIFM Regulation.
UCITS V outsourcing changes
The key requirements of the UCITS Directive on outsourcing are set out in article 13 of the Level 1 Directive. The UCITS IV Directive has been amended by the UCITS V Directive and the changes will take effect in March 2016.
In summary, UCITS V upgrades the duties and liabilities of UCITS depositaries by clarifying the safeguarding, oversight and cash flow monitoring functions.
The ‘Dear CEO’ Letter (December 2012)
The then Financial Services Authority wrote an open letter to the CEOs of asset managers in 2012, highlighting its concerns regarding the risks associated with outsourcing by asset managers. Two areas of particular concern were resilience and oversight. The FSA asked asset managers to review their contingency plans to ensure compliance with regulated obligations.
FCA Thematic Review of Outsourcing in the Asset Management Industry (November 2013)
The FCA conducted a thematic review of outsourcing in the asset management industry and published its report in late 2013. It examined the outsourcing arrangements of 17 asset managers and concluded many were not compliant with existing regulations governing outsourcing. The FCA focused on two risks where outsourcing could have an adverse effect on customers: resilience risk and oversight risk.
Resilience risk. The FCA expects asset managers to consider how contingency plans would work under stressed market conditions. Contingency plans should be “viable, robust and realistic”. The FCA acknowledges there is no one-size-fits-all solution or ‘silver bullet’ that will mitigate the resilience risk. However, measures an asset manager could take include:
- forming a relationship with a ‘stand-by’ provider that could step in if the primary service provider fails;
- keeping a detailed understanding of its operational exposure to the service provider;
- improving surveillance of a service provider’s financial position to anticipate any potential failure; and
- knowledge of how, where and how often essential activities are performed.
Oversight risk. The FCA found asset managers were not maintaining adequate in-house expertise to supervise the outsourced activities effectively. This results in the asset manager placing undue reliance on the service provider’s own expertise and controls.
The FCA challenged asset managers to develop solutions to address its concerns.
An industry response to the FSA’s Dear CEO Letter on Outsourcing (December 2013)
In December 2013, the Investment Management Association published an industry response prepared by the Outsourcing Working Group (OWG) to address the concerns raised in the Dear CEO letter.
The OWG issued Guiding Principles and Considerations for asset managers. The principles cover oversight, exit planning as well as standardisation and focus on the outsourcing of fund accounting, transfer agency along with investment operations. The OWG expects firms to apply the Guiding Principles and Considerations in a way that is proportionate and most appropriate for their business. This will also depend on the nature, size and source of the outsourced arrangements.
Asset managers should document and review their assessment of each of the Guiding Principles and Considerations on a periodic basis and in response to significant events.
1. Key principles of an oversight model
There is no prescriptive approach to oversight. Oversight principles change during the lifecycle of the outsourced relationship. We set out below the key principles of an oversight model.
Principle 1: Know Your Outsourcing or ‘KYO’. Firms should have a full understanding of the scope, nature, locations and contractual terms of their outsourcing arrangements to enable them to manage and oversee the relationship with service providers.
Principle 2: Risk based assessment. Firms should conduct a risk-based assessment of outsourcing arrangements to understand the impact of those outsourced activities on the asset manager and the end client.
Principle 3: Ownership. Firms should establish an appropriate level of ownership at a senior level for outsourced activities.
Principle 4: Governance framework. Firms should set up an appropriate governance framework for oversight.
2. Key principles of exit planning
The overriding priority is to ensure continuity of service and no impact on end investors. We set out below the guiding principles on exit planning.
Principle 1: comprehensive exit plan. Firms should have a comprehensive exit plan to be able to transition from one outsourcing service provider to another. Firms should develop and maintain exit plans with the service providers.
Principle 2: governance framework. Th e existence and contents of exit plans should be overseen by the firm’s wider governance framework.
Principle 3: periodic review. Asset managers and service providers should review the exit plan at least annually and when there have been any material changes to the outsourcing profile of the firm.
Principle 4: single approach. The exit plan should include the arrangements in place for a controlled business-as-usual exit from an outsource relationship, as well as an exit in the event of a provider’s severe operational distress.
Principle 5: key documentation. The exit plan should detail the relevant outsourcing arrangements or refer to other documents that do (eg, service level agreements).
Principle 6: end to end transition. The exit plan should consider end to end transition from old to new provider.
Principle 7: transition governance. The exit plan should identify a governance framework to oversee a transition and a migration plan by which a transition would be effected.
Key considerations for effective exit planning:
- Detailed awareness of what is outsourced and to whom.
- Maintaining a transition project plan.
- Governance and maintenance of the exit plan.
3. Key principles of standardisation
The OWG recognises the transition process for outsourcing arrangements is time-consuming and complex. This is partly due to the degree of customisation, which varies from one asset manager to another. The Guiding Principles and Considerations focus on adopting standard terminology and documents, data interfaces as well as testing processes. This will help asset managers and service providers to manage more effectively the transition of outsourced services and reduce the time taken when transitioning to a new service provider.
International initiatives – IOSCO consults on principles for CIS asset custody
We are now seeing increased co-ordination among regulators at an international level. The International Organisation of Securities Commissions (IOSCO), the leading international policy forum for securities regulators, is now consulting on a set of principles for the custody of collective investment schemes’ (CIS) assets. Th e nine principles focus on:
- the need for the regulatory regime to cater for CIS asset custody;
- segregation of CIS assets from the assets of the responsible entity and related parties, all participants in the custody chain and the assets of other clients of the custodian;
- the need in principle for third-party custodians with additional safeguards where self-custody is allowed;
- that the custodian be functionally independent from the responsible entity;
- proper disclosure and transparency of the custody arrangements;
- that the responsible entity use appropriate care, skill and diligence when it appoints a custodian;
- that at a minimum the responsible entity should consider legal and regulatory status, financial resources and organisational capabilities when conducting due diligence on a potential custodian;
- the need for formal documentation of custody arrangements, which includes provisions on the custodian’s responsibility and liability; and
- ongoing monitoring of custody arrangements for compliance with the custody agreement.
Next steps for asset managers
The FCA, in its 2013 thematic review, recommends that asset managers review their outsourcing arrangements and if necessary:
- enhance their contingency plans to deal with the failure of a service provider providing critical activities; and
- assess the effectiveness of their oversight arrangements to oversee critical activities outsourced to a service provider, making sure the required expertise is in place.
As part of their review, firms should consider the OWG Guiding Principles and Considerations. To evidence compliance with applicable rules, firms should document their rationale and the procedures they adopt, for example, in an outsourcing manual and checklist.
The FCA has signalled that it may conduct follow-up work on the issues raised in its report and see if asset managers have started to implement its recommendations. If it considers there has not been enough progress, it will then consider further policy action.
It is therefore more important than ever that asset managers plan effectively and spend enough time and resources on managing their outsourcing agreements.
This article first appeared in the December 2014/January 2015 edition of Compliance Monitor. Written by Rosali Pretorius, Emma Radmore and Kam Dhillon in Dentons' London office.