On 28 June 2017, the FCA published its long anticipated Final Report (the “Final Report”) on the Asset Management Market Study (the “Market Study”). The Final Report follows on from the interim report published in November 2016 and sets out the FCA’s final set of findings taking some account of the feedback it has received on the interim report. Alongside the Final Report, the FCA also issued a consultation paper (“CP17/18”) setting out some of its proposed remedies to address certain of the issues identified.
This article comments on aspects of CP17/18 and the particular implications for investment trust companies (“ITCs”). For a full briefing on the Final Report and CP17/18, see our RegZone article.
What does CP17/18 say?
A key element of the FCA’s proposals in the Final Report and CP17/18 is governance of investment funds. Unlike ITCs, and unlike authorised funds in some other jurisdictions, authorised funds in the United Kingdom do not have their own separate boards. Instead, the board function is undertaken by a management company (“ManCo”) which is typically either a member of the same group as the portfolio manager or a host ManCo offering an authorised fund platform to third party portfolio managers. Independent directors may be appointed alongside the ManCo but this model is extremely rare. CP17/18 explains in some detail how, in the FCA’s view, this governance model gives rise to failings and conflicts. See the section "What are the (perceived) deficiencies of current authorised fund governance arrangements?"
The FCA’s proposals for remedying these deficiencies are set out in CP17/18. See the section "What are the FCA’s proposed remedies?" While they are not (quite) set in stone, it is in our view clear from the Final Report and CP17/18 that the FCA has broadly made up its mind regarding the obligations to which firms will ultimately be subject under those rules. As such, we do not expect the final rules to differ to any great extent from the proposed rules.
Of particular interest to ITCs is the fact that the FCA is considering whether to extend its governance proposals to ITCs and has asked for feedback on the following questions:
“What are your views on whether it would be appropriate and proportionate for the FCA to consider introducing similar rules to those proposed for authorised funds for investment companies?
Is there a risk of investor harm or disruption to the market if we do not extend our proposals for authorised funds to investment companies? If so, how would this risk affect investors?”
See the section "Extending governance recommendations to ITCs".
Noting the role of the board of the ManCo with respect to authorised funds, the FCA has found that those boards:
“generally do not robustly consider value for money on behalf of fund investors;
occasionally fail to take appropriate and timely steps to address underperformance; and
can lack the authority within the group structure to challenge the commercial strategy set by more senior boards and executive committees”.
The FCA notes that there is an inherent tension in the role of a ManCo board, which needs to balance the competing interests of investors and of the ManCo and its shareholders.
ManCos which delegate portfolio management to another company in their group are typically subsidiary companies within the wider investment management business of a group and the ManCo directors may be employees of the portfolio manager or directors of the parent company. The ManCo and its parent’s commercial object is to maximise revenues/profits from operating an asset management business, while fund investors’ interest is to get the maximum risk-adjusted return possible. The FCA’s findings show that the boards of ManCos in this business model may not always take action in the interests of investors, where to do so might go against the group’s wider commercial interests.
Where firms act as ManCo on a “host platform” basis, delegating portfolio management to a third party, the issue is that, in commercial terms, the portfolio manager may see itself as the principal and the ManCo as its agent, providing it with the service of operating funds. Although the portfolio manager is appointed as the delegate of the ManCo, in practice it is the portfolio manager that decides on the selection and ongoing relationship with the ManCo it wishes to use to run its fund. This may result in similar competing interests to the in-house ManCo model.
The FCA proposes to require ManCos to appoint independent directors to provide an independent view and challenge to the deliberations of the board. Under the proposed rules, 25% (and in any event at least two members) of a ManCo’s board must be made up of independent directors. The appointment of independent directors will be subject to certain term limits and candidates will need to meet certain eligibility requirements as to their independence from the ManCo in question.
Senior Managers & Certification Regime (“SMCR”)
The FCA will consult later this year on the extension of the SMCR to asset management firms. With this in mind it has proposed a new specific “Prescribed Responsibility” (“PR”) under the SMCR that will require a ManCo’s senior managers to ensure that the ManCo complies with the obligation to act in the best interests of investors (which is already an obligation for UCITS ManCos and AIFMs), including an assessment of value for money as set out below. Senior managers are personally responsible for PRs under the SMCR, and as such by taking this approach the FCA is seeking to apply pressure to ManCos’ senior management to ensure that the FCA’s objectives in this area are delivered.
Value for money
The FCA’s proposals include rules requiring ManCos to assess whether value for money has been provided to fund investors. A report will need to be published on the ManCos’ findings at least annually; and this report will need to include the actions they have taken or will take to discharge their obligations. The assessment must include whether economies of scale are being passed on to investors (with an explanation required where savings are not being passed on), whether charges are reasonable in comparison to the costs incurred and whether the share classes available to investors offer value for money. The FCA’s expectation is that “fees and charges will drop considerably” as a result of these value for money assessments, although it remains to be seen whether this will be borne out in practice.
Extending governance recommendations to ITCs
Our view is that, owing to the different legal and regulatory requirements that apply to ITCs compared to authorised funds and their ManCos, ITCs are ahead of authorised funds when it comes to governance. Their structure also means that they are generally not subject to some of the conflicts of interest identified by the FCA as being of concern in relation to directors of ManCos.
Premium listed companies are required to have a board of which the majority of members, including the Chairman, is independent of the investment manager. Where there is an AIFM and a separate portfolio manager, the term “investment manager” encompasses both. For AIM companies, the obligation is that a majority of the board, and the Nomad, is normally expected to be independent of the investment manager. Appropriate disclosures are required regarding the directors’ experience and independence.
In addition, the Listing Rules treat investment managers as related parties for the purposes of the rules on related party transactions (and the AIM Rules for Investing Companies have provisions with broadly the same effect). This means that, in particular, amendments to investment management fees have to be confirmed as “fair and reasonable” by the ITC’s sponsor or, if the financial impact of the changes are uncapped or exceed certain limits, have to be voted on by the ITC’s independent shareholders.
Finally, ITCs complying with the Association of Investment Companies’ Corporate Governance Code (“AIC Code”) should ensure that the existing directors take the lead in appointing new directors so that a directorship (and the accompanying fee) is not seen as being within the gift of the investment manager, which could compromise independence.
The typical ITC is not authorised by the FCA and therefore its directors are not approved persons subject to the controlled functions regime. Similarly, directors of ITCs would not be caught by the SMCR regime if it were extended to asset management firms. AIFMs and UK-authorised investment managers would be caught by an extension of the SMCR, which may give pause for thought to “host AIFMs”.
We do not think that the FCA is considering seeking to formally extend the SMCR to ITCs and their directors, nor indeed do we see a realistic legal basis for doing so. However, it is possible that the FCA might consult on ways to formalise or otherwise emphasise the duty of ITC directors to act in the interest of investors.
As directors of public companies under the Companies Act 2006, directors of ITCs are required to promote the success of the ITC. While they must take account of a variety of stakeholders, it is fair to say that the directors’ paramount duty is to represent shareholders, who are also the end investors. The inherent conflict identified by the FCA in relation to the boards of ManCos, between acting in the best interest of the ManCo’s shareholders and acting in the best interests of the fund’s investors, does not arise in relation to ITCs.
Directors of ITCs must also have regard to the Listing Rules, Listing Principles and to corporate governance requirements in the form of the UK Corporate Governance Code. These set out a number of obligations and recommendations, not least the requirement for directors to resign and seek reappointment by shareholders at least every three years (every year for non-independent directors).
These factors mean that if investors are not satisfied with the ITC’s performance and how the board is supervising the investment manager they can (and do) exercise their rights as shareholders to provide a catalyst for change. This may involve voting against the continuation of the ITC in a continuation vote, pressuring the board to return value to shareholders (eg by means of a tender offer) or voting against the reappointment of some or all of the board. Numerous investment company boards over the years can attest to the consequences of not keeping investors satisfied: recent notable examples being Electra Private Equity and Alliance Trust plc.
Value for money
Reviewing and benchmarking investment manager remuneration is built into the specific corporate governance requirements of ITCs. ITCs complying with the AIC Code (i.e. most of them) will have a Management Engagement Committee (“MEC”). The principal role of the MEC is to “regularly review both the performance of, and contractual arrangements with, the manager”. This review is carried out annually. The AIC Code sets out some issues for the MEC to consider, including:
monitoring and evaluating the investment manager’s investment performance;
considering whether to obtain an independent appraisal of the manager’s services;
requiring the investment manager to provide attribution and volatility analyses;
putting in place procedures by which the board regularly reviews the continued retention of the manager’s services;
reviewing the level and method of remuneration, the basis of performance fees and the notice period, giving due weight to the competitive position of the ITC against the peer group; and
considering whether the initial and annual fee should be based on gross assets, net assets or market capitalisation.
Additional considerations apply where the ITC’s fee arrangements include a performance element.
The decision of the MEC and its rationale are reported annually to shareholders. There is no prescribed course of action where are a board does not conclude that the continuing appointment of the investment manager is in the interests of shareholders as a whole; however, it is likely that a there would be a re-tender of the investment management agreement or a proposed corporate action, such as a winding-up or merger of the ITC.
The specific role of the MEC is typically taken to apply to the portfolio manager (rather than, say, a third-party AIFM) although the AIC Code also specifies that the board should regularly review all of its service providers for continued competitiveness and effectiveness.
It is difficult to read the governance recommendations of CP17/18 without concluding that ITCs are ahead of their authorised peers in this area and that to speak of “extending” these governance recommendations to ITCs is something of a mischaracterisation.
It would be shame if the FCA were to be the source of yet another piece of regulation that, failing to take account of the differences in structure and source of regulation that apply to ITCs, subjected ITCs to additional layers of regulation that put ITCs at a competitive disadvantage to their authorised counterparts.