The FSA extended the approved persons regime last year so that individuals at the parent or holding company level who exert significant influence over an FSA regulated firm require approval from the FSA. The FSA has recently published proposals in CP10/3 to amend and further extend the regime. This briefing focuses on the proposals in relation to parent or holding company level senior managers.

Impact for private equity groups:

  • Private equity groups with FSA authorised entities within their existing portfolio will hopefully already have analysed the impact of the current rules on the group. However, they will need to consider whether or not they are affected by the FSA's proposals in CP10/3.
  • Private equity groups which are considering acquiring FSA authorised firms for the first time should also consider how they may be affected by the proposals. Where the private equity fund wishes to play a role in how the FSA authorised firm is managed and there is a parent or holding company relationship with the authorised firm, this may mean that key individuals at the parent or holding company level will require approval from the FSA.

The approved persons regime

The approved persons regime allows the FSA to supervise and discipline individuals carrying out key roles within FSA authorised firms. All individuals carrying on key roles within such firms are required to obtain approval from the FSA before carrying on the roles (referred to as controlled functions). These individuals are known as approved persons and are required to comply with the Statements of Principle and the Code of Practice for Approved Persons (APER). Failure to comply with the approved persons regime could result in the FSA taking various measures, including fining the individual concerned or requiring that the relevant individual no longer perform a role with significant influence over the authorised firm.

The FSA extended the approved persons regime last year so that relevant individuals at the parent or holding company level who exercise significant influence over the UK authorised firm also require approval from the FSA for the executive director (CF1) or non-executive director (CF2) functions. Please click here to view a previous Herbert Smith briefing on the changes to the approved persons regime last year. The FSA has now published a consultation paper, CP10/3, which proposes further changes to the approved persons regime. The proposals have been summarised in a Herbert Smith briefing.

The potential for a general partner or fund manager to be in a parent/holding company relationship with the regulated entity may or may not be relevant for all funds but is certainly possible. This is discussed in detail below. If the relationship does arise, and if the decisions or actions of individuals at the parent or holding company level are regularly taken into account by the governing body of the FSA authorised firm, this could result in the need for those individuals to become approved by the FSA.

For private equity groups, two questions will need to be considered:  

  • Are there any entities within the group which could be a parent undertaking or holding company of the FSA authorised portfolio company?
  • If so, is there anyone within the parent undertaking or holding company whose decisions or actions are regularly taken into account by the governing body of the FSA authorised portfolio company?

The parent/holding company analysis for private equity structures

The position within private equity groups can be very complex. Section 420 of the Financial Services and Markets Act 2000 (FSMA) cross-refers to the definition of parent undertaking in the Companies Act 2006. In accordance with the relevant provisions of the Companies Act 2006, an undertaking is a parent undertaking in relation to another subsidiary undertaking if:

  • it holds (or controls alone or pursuant to an agreement with other members or shareholders) a majority of the voting rights in the subsidiary undertaking;
  • it is a member of the subsidiary undertaking and has the right to appoint or remove a majority of its directors;
  • it has the right to exercise (under provisions in the subsidiary undertaking's articles or a control contract) or actually exercises a dominant influence over the subsidiary undertaking; and/or
  • it and the subsidiary undertaking are managed on a unified basis.

The Companies Act 2006 definition of "holding company" essentially covers the first two bullet points above and will not be separately discussed in this briefing. It is worth noting that, for FSMA purposes, a parent undertaking could include an individual. It could also include a parent undertaking of a parent undertaking of the relevant entity.

Where a private equity fund takes a stake in a FSA authorised firm (also referred to below as the portfolio company), for example, in a retail bank, it may do so in various ways. Assuming a typical UK private equity fund structure, comprised of one or more limited partnerships, the shares in the authorised firm may be held by the general partner on behalf of the limited partnership or alternatively held by a holding company set up for this purpose. The holding company may be held by the general partner on behalf of the limited partnership. The general partner (or the fund manager if a separate entity has been set up to conduct investment management activities) will exercise voting rights, appoint or remove directors, and will be able to exercise other rights to which the limited partnership is entitled on its behalf in relation to the portfolio companies invested into by the limited partnership. Although this presents a risk that the general partner could be treated as a parent undertaking, the general partner (or any fund manager to whom rights have been delegated) may well benefit, at this level at least, from the Companies Act 2006 exemption that rights of control and influence held by a person in a fiduciary capacity shall not be treated as held by that person. All rights exercised by the general partner should not however be assumed to fall within this fiduciary exemption.

If the general partner has Companies Act controlling rights over the limited partnership, it will be the parent undertaking (or, depending on the facts, the holding company) of the limited partnership. Separate considerations will apply as to the fiduciary nature of this relationship if the general partner has delegated rights to manage the investment portfolio of the limited partnership to a fund manager, as to whether the fund manager is also a parent undertaking. This will include consideration as to whether its functions are exercised solely as agent for the general partner (as is commonly the case) or extend beyond that. Whether the general partner or fund manager in these circumstances is also then a parent undertaking of the portfolio companies will depend, in part, on the limited partnerships' relationships with the portfolio companies, as described above.

Potentially, other rights may also need to be considered:

  • Investors in a private equity fund would not usually be entitled to exercise sufficient control or influence over the limited partnerships or the portfolio companies so as to satisfy any of the Companies Act tests. The exception to this is a key investor in the fund who has agreed special rights to manage or control either the fund or portfolio companies (for example, it may, subject to certain partnership law considerations, have secured rights to appoint and remove portfolio company directors or to have a veto over investments/divestments).
  • With respect to any holdings by nominee companies, the Companies Act is clear that rights held by a person as nominee for another are treated as held by that other entity.

Where different funding structures to the types described above are used, or where there are changes made to an investment structure, these must also be considered against the tests set out in the Companies Act.

Special considerations

For a plain vanilla fund structure, the analysis may prove to be "relatively" straightforward. But some private equity sponsors will need to address additional complicating features such as:

  • substantial general partner commitment via the limited partnership or co-investment at the portfolio company level
  • significant co-investment arrangements with co-investment vehicles
  • funds that in reality are a series of parallel limited partnerships, each holding a small stake, but collectively a large majority stake in a portfolio company and which grant the general partner rights and influence (for example veto rights or rights over board appointments) over portfolio companies to such an extent that may be classified as controlling for Companies Act purposes
  • multiple fund entities used to invest funds from investors located in different jurisdictions or used to structure investments in a tax efficient manner

In such cases, the same Companies Act analysis will need to be performed.

Application of the approved persons regime to parents and holding companies

The current regime

Once it is established that there is a parent or holding company of the FSA authorised firm within the group, the next question to consider is whether there are any directors or senior managers at the parent or holding company level (except parent or holding companies which are FSA or EEA-authorised) who fall within the FSA's approved persons regime. If so, the FSA authorised subsidiary will need to submit approved person applications to the FSA in relation to those individuals.

The extension of the approved persons regime last year means that at present, relevant individuals (including directors, non-executive directors, partners, senior managers or employees) at the parent or holding company level whose decisions or actions are regularly taken into account by the FSA authorised firm must obtain approval for the executive director (CF1) or non-executive director (CF2) functions in relation to the FSA authorised subsidiary. Whether or not approval is required will depend on how an individual behaves in practice in relation to the FSA authorised subsidiary and will therefore require a case-by-case assessment. A summary of the current regime can be viewed here.

The FSA has set out some non-exhaustive examples of when an individual at the parent undertaking or holding company level is likely to be viewed as having significant influence over the UK FSA authorised entity and therefore require approval from the FSA:

  • a director of a parent or holding company who takes an active role in the running of the business of the UK firm, for example, as a member of a board or committee (on audit or remuneration) of that firm; or
  • a director of a parent or holding company having significant influence in setting and monitoring the business strategy of the UK firm; or
  • a non-executive director of a parent or holding company involved in carrying out responsibilities such as scrutinising the approach of executive management, performance, or standards of conduct of the UK firm; or
  • a director of a parent or holding company who is accustomed to influencing the operations of the UK firm, and acts in a way in which it can reasonably be expected that a director of the UK firm would act; or
  • a director of a parent or holding company exercising significant influence by way of his involvement in taking decisions for that UK firm, or who is accustomed to influencing the operations of that UK firm, and acts in a manner in which it can reasonably be expected that a director or senior manager of that UK firm would act; or
  • the chairman of an audit committee of a parent undertaking or holding company of a UK firm where that audit committee is working for that UK firm (that is, functioning as the audit committee for the group); or
  • an individual (such as a senior manager) of a parent or holding company who is responsible for and/or has significant influence in setting the objectives for and the remuneration of executive directors of that UK firm.

The current regime does not require individuals to become approved persons under the following circumstances:

  • where the FSA regulated entity is a limited liability partnership or a non-body corporate; and/or
  • where the parent entity or holding company is itself regulated by the FSA or in another EEA member state.

Proposals in CP10/3

The FSA is now proposing to extend the approved persons regime so that it applies irrespective of the corporate status of the UK subsidiary and regardless of whether or not the parent undertaking or holding company is authorised by the FSA. It remains the case that the extension to the approved persons regime will not apply to parent or holding companies regulated in other EEA member states. Private equity groups relying on these exclusions under the current regime will need to reconsider whether or not they are caught by the new proposals.

The proposals are linked to the proposed introduction of a new parent entity significant influence controlled function (CF00). This new controlled function separates out individuals who were brought within the scope of the CF1 (executive director) and CF2 (non-executive director) functions by the rule changes last year (see an HS briefing on the changes made last year). The same basic definition used to bring individuals at the parent company level into the approved persons regime through the CF 1 (director) and CF 2 (non-executive director) functions (see above) is used to define the new CF00 controlled function.

Transitional arrangements will be available to those firms which have already applied for approval for relevant individuals at the parent/holding company level. Funds which may be caught out by the current rules because of proposed acquisitions will need to apply under the existing rules and ensure that relevant individuals apply for the executive director (CF1) and non-executive director (CF2) functions. They will need to bear in mind however that the existing rules are likely to be amended before the year end and that, subject to transitional rules, they may need to notify the FSA again in due course. Transitional rules will involve notification rather than fresh approval applications under the new rules.

Consultation on CP 10/3 closes on 28 April 2010. It is expected that the FSA will publish final rules in the third quarter of 2010.

Liability of CF00 approved persons

The changes made last August have already caused practical difficulties as whether or not a parent level individual requires approval comes down to how each individual operates in practice (which will naturally vary from individual to individual). Affected groups may be tempted to review their reporting lines and management structures to remove the need for approval.

Unhelpfully, there is no guidance on the standards of conduct expected of CF00 approved persons. In practice, a CF00 approved person is likely to be relatively distanced from day-to-day decisions made at the level of an FSA-regulated subsidiary firm and ought, therefore, to be judged differently from a serving director of the firm. However, without a clearer steer from the FSA, this is far from clear.

Enforcement action against those performing significant influence function (SIF) roles (including the CF00 function) is likely to become more commonplace where problems occur. The fact that the FSA has not articulated the standards expected of CF00 approved persons and their potential liability is a matter of concern, especially for those being put forward for approval to perform these roles.

CP10/3 also sets out more detail on the approval process to help firms understand the FSA's expectations, reinforcing the message sent out in the Dear CEO letter in October 2009. Generally, SIF candidates will face a tougher application process, with a clear focus on their competence and capability to perform the role in question. It is expected that only those individuals applying for certain roles such as the chairman, CEO, finance or risk directors or non-executive directors at the larger, more complex or riskier firms will be interviewed by the FSA. However, the FSA has said that it may decide to interview any SIF candidate (which could include those applying for the CF00 function) at its discretion where it has concerns about the candidate's fitness or propriety or concerns about the FSA regulated firm.

It seems clear that the FSA will use the expanded scope of the approved persons regime and the more intrusive approach to the approval of candidates being put forward to perform SIF roles to articulate its expectations of FSA authorised firms' corporate governance arrangements and ensure that they are taken into account in practice. Private equity groups with existing FSA authorised firms within their portfolios or which are considering acquiring such firms should consider how the group might be affected by the current rules and the proposed rule changes.