On Wednesday 28 June, 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. CP17/18, which is open for responses until 28 September 2017, is expected to be the first of a number of such consultations to be published during the course of this year to address the FCA’s findings.
We have set out below our high-level thoughts on the FCA’s proposals within CP17/18 which are in our view of particular relevance to UK authorised fund managers of UCITS and authorised AIFs (“ManCos”).
A key element of the FCA’s proposals in the Final Report and CP17/18 is governance of investment funds. While the FCA’s proposed governance rules in CP17/18 are the subject of consultation and so 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, ManCos should not in our view expect the final rules to differ to any great extent from the proposed rules.
The FCA has proposed an amendment to COLL 6.6 to include requirements for independent director representation on ManCo boards 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. The FCA suggests that the final rules may include transitional provisions which ManCos may be able to rely on for twelve months from the date the rules enter into force.
The FCA’s proposed rules require among other things that a ManCo must take reasonable steps to ensure that independent directors have sufficient expertise and experience to assess “whether the [ManCo] is managing each scheme in the best interests of unitholders”. It is unclear from FCA’s proposals whether the role of the independent director will include oversight of only the management of investment funds by the ManCo or whether they will also oversee any additional MiFID activities carried on by ManCos under the UCITS Directive or AIFMD, such as management of segregated mandates. It will be interesting to see whether further detail in this regard will be forthcoming in the FCA’s final rules.
The FCA’s cost/benefit analysis assumes that the ongoing costs of independent directors will be passed on to fund investors, i.e. those costs will be met by the fund. It is not in our view clear that existing prospectus disclosures on ongoing costs will in all cases necessarily be broad enough to permit these costs to be met by the fund, in which case the consideration would need to be given under COLL 4.3 to expanding the prospectus wording. Alternatively, the costs of independent directors will need to be met from the ManCo’s annual management charge, which clearly would represent an additional squeeze on ManCos.
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.
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 leastannually; 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.
CP17/18 sets out proposed amendments to the FCA’s rules in COLL on the content of annual long reports to implement this proposal. Under the proposed rules, the disclosure may be made either in the annual report or in a standalone report, although it appears that a standalone report will only be permitted if it covers two or more schemes managed by the ManCo. As such it may be that smaller ManCos will by default need to include this information in the annual report.
There has to be a question around whether the proposals will result in meaningful disclosure to investors in practice on value for money. Following the abolition of the requirement for short reports, ManCos are only obliged under COLL to make half yearly and annual long reports available to investors on request. As such, the proportion of investors who will actually read the value for money disclosures in practice will most likely only comprise those (possibly only some of those) who request an annual report or download it from a ManCo’s website. It is therefore far from clear that these disclosures will factor in to the average investor’s decision-making process in terms of where they invest their money, and consequently that these requirements will result in the pricing and competitiveness outcomes the FCA is hoping for.
The FCA’s value for money proposals may present certain challenges for ManCos that act as host ACDs. The proposals potentially give rise to tensions between the ManCo’s commercial imperatives on the one hand, in the form of the relationship between the host ACD and the fund sponsor, and its regulatory imperatives on the other in the form of its regulatory obligations to ensure value for money, which will inevitably involve consideration as to fees. As such it may be that changes will be required to sponsorship agreements to allow ManCos to comply with their regulatory obligations.
One issue identified by the FCA in its interim report on the Market Study was circumstances where investors remained invested in more expensive share classes even though cheaper but otherwise identical share classes were available, including pre-RDR share classes that no longer pay trail commission. This was somewhat controversial given that many ManCos had wanted to move investors out of such share classes, however, the FCA’s Guidance had indicated that positive consent was required to do so. The FCA proposes in CP17/18 to amend its Guidance to make it easier for firms to mandatorily convert investors’ units/shares into alternative unit/share classes provided certain conditions are met, including that a power of mandatory conversion is set out in the prospectus in accordance with COLL 4.2.5R. This clarification is overdue but nonetheless welcome. ManCos should therefore consider whether any changes (which would require FCA approval) may be required to prospectuses to facilitate mandatory conversions in future.
A key part of the FCA’s focus in the Market Study has been transparency of fees, and as part of its interim report the FCA proposed the introduction of a single all-in fee as one measure to address its concerns in this regard. The FCA notes in the Final Report that under MiFID II firms will be required to provide aggregated and on-going information on all costs, which must be shown as a single disclosure, on both a pre-sale and ongoing basis. Additionally, the FCA states that it intends to carry out further work on the way in which this information is presented as it considers that this will impact the way in which the information is used. This will include consideration of the role of the prominence and formatting of charges information in encouraging investors to focus on the impact charges have on their investments and enabling effective price comparison.
Separately on fees, the FCA states in the Final Report that it is considering consulting on rules whereby performance fees would only be permitted above the fund's most ambitious target after ongoing fees, and will consider whether additional policy action is required to make UK funds’ performance fee structures more equitable, including “asymmetric fees” that do no align investor and manager incentives. ManCos that are remunerated by performance fee arrangements should therefore note the possibility of further consultation in this area, although our experience is that performance fees for pure retail funds are unusual.
The FCA’s spotlight also falls on box management revenues, which in the FCA’s view are not transparent to investors. As such, the FCA proposes to prohibit the retention of risk-free box management profits, that is to say profits arising from the difference between the bid and offer prices where the ManCo buys units at the offer price and sells them at the bid price at the same valuation point. The FCA takes the view that the benefit of these profits should accrue to the fund, and has proposed amendments in CP17/18 to its rules in COLL to effect this prohibition.
It is noteworthy that the FCA does not propose to prohibit the retention by ManCos of “at risk” box management profits, whereby a profit arises on units/shares held by a ManCo over a valuation point in the fund. However, the FCA states in CP17/18 that it wants ManCos to expressly state their policy on box management in the prospectus, including whether the ManCo retains any profits from it, and has proposed an amendment to COLL 4.2.5R to effect this. ManCos that use box management will therefore, assuming that this is carried forward to the final rules, need to update their prospectuses in due course to include a statement to this effect.
The FCA does not make any specific proposals in the Final Report or CP17/18 regarding investment fund objectives, but does say that it intends to carry out further work in this area, including chairing a working group on the issue, which could result in further rules or guidance in future.
The FCA also confirms its intent to undertake further work on investment platforms, including consideration of how direct-to-consumer and intermediated platforms compete to win business and whether platforms enable retail investors to access investment products that offer value for money. The Investment Platforms Market Study will therefore be of particular interest to ManCos which are in the same group as platform providers.
While the Market Study did not focus directly on unit-linked (“UL”) and with-profits (“WP”) funds and investment trusts, it appears from CP17/18 that the FCA is considering whether to extend its governance proposals to these funds, and in this regard it has asked for feedback on a number of specific points. The FCA also re-confirms that it has planned a thematic review which will examine the fair treatment of customers in WP funds. As such, insurance providers that offer UL and/or WP funds may wish to give preliminary consideration to their existing governance frameworks surrounding those funds in the context of the FCA’s proposals. The FCA does not expressly state that it will conduct a similar review in respect of investment trusts, but it does request stakeholders’ views in this regard in CP17/18 and so further consideration may be forthcoming in future.
Initial reaction to the Final Report
The initial public reaction to the FCA’s proposals described above has been broadly positive, although there has been some criticism that they do not go far enough to address the issues identified during the Market Study. The FCA’s hope is that its proposed measures will lead to increased competition, lower prices, greater price transparency and more effective governance across the asset management industry. Whether these hopes will be realised will only be seen in the fullness of time; as ever, the proof of the pudding will be in the eating.
It should of course be noted in closing that, in fulfilling its functions, the FCA always needs to strike a balance between appropriately regulating the financial services industry while still enabling it to flourish – to grasp the butterfly but not crush it, as it were. The FCA will no doubt have been mindful in finalising its proposals of the potential risks to the UK asset management industry if those proposals ultimately were perceived to impose too high a regulatory (and commercial) burden on UK firms, which could encourage rival jurisdictions to take advantage.