The approved persons regime (the regime) enables the FSA to hold individuals accountable for carrying out their responsibilities in relation to the regulated firm for which they have been approved to perform controlled functions. The regime provides incentives for honest, prudent and sensible management. The significance of adherence to the regime is the protection of the interests of both the firm and its customers.
The FSA review which led to the recent CP proposals focuses on individuals who have significant influence over a firm, in particular those who are responsible for corporate governance. The CP proposals underline the growing policy emphasis on senior management responsibility and involvement to a far greater degree than before.
Background to the review
The FSA conducted an internal audit of the lessons learned from the high profile collapse of Northern Rock. Recommendations from the audit report led the FSA to establish the Supervisory Enhancement Programme (SEP) to implement the recommendations.
One of the key recommendations was that the FSA should increase the rigour of its day to day supervision, in particular focusing on increasing the thoroughness of its supervision where issues concerning the competence of firms’ management were identified. This led the FSA to review its approach to the significant influence controlled functions.
The following is a list of some of the more common significant influence functions:
Please click here to view table.
The FSA has already made a number of changes to the regime which have not required Handbook amendments. These include:
- Significant function candidate interviews: From 1 October 2008, the FSA started interviewing more of those candidates applying for approval to perform significant influence functions at larger firms.
- A change to the approved persons approval application: Changes have already been made to the application form for approval to perform controlled functions (the Form A). The change requires candidates to provide supplementary information about their competence and capability in relation to these roles, as well as requiring the firm to provide details as to why the appointment complements the firm’s business strategy, activity and market in which it operates, and how the appointment was agreed.
- Shift in enforcement emphasis: The FSA has stated that it will seek to hold individuals performing significant influence functions accountable for poor conduct at those firms. Where the FSA previously focused on cases of dishonesty and lack of integrity where prohibition or withdrawal of approval was the most appropriate outcome, it will also now consider the competence of significant influence function holders and will not shy away from pursuing cases against individuals who breach the Principles or Code of Practice in APER. The Abbey Mortgages Limited case which culminated in a Final Notice being issued by the FSA on 14 October 2008 is a good example of this approach.
The CP consults on five further proposals, the detail of which is set out below. The consultation period ends on 31 March 2009.
Extending the definitions of CF1 and CF2
Currently, the provisions which deal with how the approved persons regime should be applied to individuals who exercise significant influence on a UK regulated firm from a parent undertaking or holding company within its group which is not regulated by the FSA or any other EEA financial services regulator, do not require these types of establishment to have individuals approved in CF1 or CF2.
The FSA proposes to extend the definitions of CF1 and CF2 to include those individuals who exercise significant influence in this way. The proposal will apply to individuals exercising significant influence in this way from the following types of company:
- regulated and unregulated UK parent undertakings and holding companies
- regulated and unregulated third country parent undertakings and holding companies
- EEA unregulated parent undertakings and holding companies.
A significant number of FSA regulated firms will be affected by the proposal. These firms will need to complete a comprehensive analysis of the roles of parent companies’ directors and senior managers and to identify those individuals whose decisions, opinions or actions might be captured under the proposal. If a firm identifies individuals who meet this test it will need to submit Form As in relation to those individuals. Firms will be able to submit Form As from the date of publication of the proposed Policy Statement (PS) in Q2 containing the final rules. There will be a transitional period of six months, but firms should start thinking about this now.
The rationale for this proposal is that the current regime “does not necessarily reflect the increasing significant influence exerted on an authorised firm by individuals based in parent undertakings or holding companies to which the authorised firm is accountable”. The extended functions will capture those directors (executive and non-executive) and senior managers employed by a parent or holding company whose “decisions, opinions or actions are regularly taken into account by the governing body of the authorised firm and therefore likely to have significant influence on the conduct of an authorised firm’s affairs”.
- Systems integration – Firms may need to redevelop HR/compliance communications procedures to ensure the flow of information at both authorised firm and group levels.
- Ongoing monitoring – Firms will need to monitor approved persons arrangements closely at both authorised firm and group levels. Larger firms may require additional compliance resources to comply with the new obligations.
- Training – Firms may need to train personnel employed at group level to ensure that all relevant individuals are identified and appropriate approvals obtained before controlled functions are performed.
- Information flow – UK entities may face resistance in obtaining application information from relevant individuals at overseas parents/holding companies.
- Consistency – Although the FSA has provided examples of circumstances in which it would expect relevant individuals to be registered, facts will need to be considered on a case by case basis. This may lead to inconsistent views being taken within firms, with some individuals remaining unregistered.
Clarifying the role of CF2
CF2 was originally created to recognise the importance of the non-executive role within the governing body of a firm, as well as to separate their duties from those of the executive members.
In the CP, the FSA states that it considers the duties of a non-executive director to cover three key areas of responsibility:
- assisting executive colleagues within the firm’s governing body in setting and monitoring the firm’s strategy
- providing an independent perspective to the overall running of the business, scrutinising the approach of executive management, and the firm’s performance and standards of conduct
- carrying out other responsibilities as assigned by the board, for example as a member of a board committee, such as an audit or remuneration committee.
It is clear from recent communications from the FSA (such as the speech given by Sheila Nicoll (Director, Retail Firms Division) on 17 September 2008, entitled Non-Executive Directors: Survival in a Volatile Market) that the FSA is placing more importance on good governance, with an emphasis on the role of the non-executive director within governance structures. The FSA’s proposal to clarify the role that it expects non-executives to play should therefore not come as a surprise.
The FSA’s proposal will not involve it imposing any new requirements. Instead, the FSA proposes to consolidate the expectations which it has expressed in various speeches and documents and incorporate these expectations into the Code of Practice for Approved Persons to make the Handbook clearer about the non-executive role.
The FSA makes it clear that it will actively pursue a non-executive where it thinks the individual should have intervened in the affairs of the business, i.e. where they think the individual has acted with incompetence. As one view, this is a departure from the current policy whereby the FSA generally only pursues non-executives in cases where it identifies dishonesty or a lack of integrity in the individual’s actions.
Having reviewed the Statements of Principle and the Code of Practice, the FSA’s view is that whilst sufficient guidance is available on its expectations of executive responsibilities, the Statements of Principle and Code of Practice need to include its expectations of non-executives.
Against this background, the FSA’s shift in its enforcement policy will act as an incentive for non-executives to become more deeply involved in the way in which the business is run, and provide a real challenge to executive members of the board where this is needed.
Industry codes – In the CP, the FSA states that the aim of this proposal is to “clarify rather than impose any new requirements on non-executives that don’t already exist in the various industry codes”, including the Higgs Report and the Combined Code on Corporate Governance. This statement seems to indicate that the FSA already expects non-executive directors to consider industry codes. There are also indications that the FSA expects even private companies to have regard to them.
Increased risk of personal liability – The proposal will result in increased personal responsibility of the non-executive role whereby non-executives may be held personally liable for the actions of the executive members of the board. A consequence of this is that there may be fewer individuals willing to take up the role of non-executive director in the medium to long term.
Market demand – Increased demand for suitably experienced non-executives, coupled with the increased risk of personal liability potentially leading to a reduced number of individuals willing to act as non-executives, may make it difficult to identify suitable candidates.
Evidence of intervention – There will also be practical issues for non-executives in terms of how they ensure an audit trail to evidence how they have intervened in situations where executives have made poor decisions over a period of time and whether they might need independent legal advice on occasion.
Extending the definition of CF29
Under the current regime, proprietary traders are caught in two ways: CF29 (significant management function) captures those senior proprietary traders who exert significant influence over a firm’s affairs (for example, in their role as head of the trading department), or who have risk-bearing trading limits, and CF30 (customer function) which captures proprietary traders that do not hold senior managerial roles.
The FSA has proposed to extend the definition of CF29 to include proprietary traders who are not senior managers, but who are likely to be able to exert significant influence over the firm’s business through their trading activities. It is clear from the CP that the FSA’s expectation is that the extended CF29 will capture all proprietary traders.
Timing – Relevant firms will need to undertake a full review of the controlled functions which their proprietary traders are approved to perform, to determine whether any individuals need to be approved to undertake CF29. It is likely that there will be a significant number of CF30-approved individuals who also need to be approved as CF29. Firms will be able to submit Form As from the date of publication of the PS containing the final rules. There will be a transitional period of 6 months, but firms should not leave this too late.
Approval for individuals performing the customer function for eligible counterparties only – Pre-MiFID, the SUP rules did not require individuals performing customer functions for market counterparties only to be approved in any of the customer functions. Following changes to the approved persons regime implemented in November 2007, it has been commonly accepted that individuals performing the customer function for eligible counterparties only are required to be approved in CF30. The FSA’s reference in the CP to CF30 applying “where the proprietary trader may deal with customers who are not market counterparties” throws doubt on this understanding. It will be interesting to see whether there are any further developments on this point in the proposed PS.
UK branches of third country firms
Currently only controlled functions 3 (chief executive function), 8 (apportionment and oversight function), 10 (compliance oversight function), 11 (money laundering reporting function) and 30 (customer function) apply to third country branches, whereas all controlled functions apply to UK subsidiaries of third country firms. Controlled functions 1 and 2 do not apply.
In the CP, the FSA proposes to extend the regime so that all controlled functions will apply to UK branches of third country firms. The aim is to achieve some regulatory consistency between third country firms with UK subsidiaries and third country firms with UK branches.
Firms will be able to submit Form As from the date of publication of the PS in Q2 containing the final rules. There will be a transitional period of 6 months, but firms should start thinking about this now.
In making this proposal, the FSA anticipates that the regime will “better reflect current corporate governance arrangements” and aims to “ensure regulatory consistency” between third country firms which incorporate subsidiaries in the UK and third country firms that establish branches in the UK.
In a similar vein to Proposal 1 above, the FSA expects that this proposal will also affect individuals whose senior management roles on governing bodies of third country firms that have a branch in the UK, cause them to have significant influence in relation to the UK branch.
Although the proposal aims to ensure regulatory consistency between third country subsidiaries and branches, there may be confusion as to how controlled functions 1 and 2 will apply owing to structural differences, in particular the fact that it is common for the directors of a UK branch to be domiciled abroad. The FSA has stated that it will continue to be non-prescriptive and flexible in terms of how controlled functions are applied in the context of a UK branch, but expects that the extension will catch a number of individuals that are domiciled overseas.
Currently, regulated firms that employ an individual who has previously been an approved person at another firm, with the intention of them performing CF30, can request certain information from the individual’s previous employer. Once the request has been made, the previous employer is under an obligation to supply the new employer with a factually-based reference.
The FSA’s proposal is to extend the rule concerning CF30 references to cover references relating to all controlled functions.
The CP’s key message is that the FSA is keen to see that approved persons have experience which is relevant to the roles which they propose to undertake. Proposal 5 is one of the ways in which the FSA is approaching the fundamental issues which it identified in its review of Northern Rock’s collapse.
Principal members of the senior management of small start-up entities may lack employment experience which is directly relevant to the significant influence functions they wish to undertake. The proposal may therefore make it harder for new start-ups to obtain authorisation without some significant financial outlay to bring people with suitable UK regulatory experience on board.