The European Commission has published a draft regulatory technical standard (RTS) on own funds requirements for firms based on fixed overheads under Article 97 of Capital Requirements Regulation 575/2013 (CRR). The RTS amends the regulatory technical standard 757/2013 for own funds for institutions subject to the CRR.
How does the RTS apply to asset managers?
Article 97 applies to investment firms which fall into Article 4(1)(2)(c) of the CRR. This includes firms that are authorised under MiFID to perform portfolio management but not permitted to hold money or securities belonging to their clients which for that reason may not at any time place themselves in debt with those clients, e.g. some asset managers authorised under MiFID who offer segregated mandates. (See also Article 15 of Recast MiFID – MiFID 2. This links MiFID firms to the CRR and the Capital Requirements Directive 2013/36/EU.)
How is a MiFID linked requirement relevant to UCITS managers and alternative investment fund managers (AIFMs)?
Under Article 17(1)(a)(iii) of the UCITS Directive and Article 9(5) of the Alternative Investment Fund Managers Directive (AIFMD), the RTS is also relevant to UCITS managers and AIFMs, respectively. Both of these provisions cross-refer to Article 21 of the Capital Adequacy Directive (CAD), which Article 97 of the CRR has replaced.
Why is this important for managers?
The regulatory capital rules for asset managers are not as onerous or complex as those for banks. However, the fixed overheads concept is, in practice, central to those rules. The RTS provides an important clarification both with respect to the fixed overheads calculation and the powers of regulatory authorities. It also provides clarity for those asset managers who have become recently authorised.
Why might asset managers have overlooked the RTS?
As the European Banking Authority (EBA), rather than the European Securities and Markets Authority, was responsible for the RTS, it is a piece of regulation which many asset managers may have easily overlooked.
What is the basic rule under Article 97 of the CRR?
A firm must hold eligible capital of at least one quarter of the fixed overheads of the preceding year. This requirement must be read together with Article 95(2) of the CRR which requires a firm to hold own funds calculated in accordance with Articles 92(3) and (4).
How does this requirement apply to UCITS managers and AIFMs?
For UCITS managers and AIFMS, the requirement to hold eligible capital of at least one quarter of the fixed overheads of the preceding year applies irrespective of whether they hold the minimum amount of own funds prescribed in the UCITS Directive or AIFMD, respectively. (See Article 17(1)(a)(iii) of the UCITS Directive and Article 9(5) of the AIFMD and the Interim Prudential Sourcebook for Investment Business (IPRU(INV) 11.2.1.)
What is the rationale for using a fixed overheads methodology?
Recital 2 to the RTS encapsulates it as follows:
In order to ensure that firms are able to organise an orderly winding down or restructuring of their activities, they should hold sufficient financial resources to withstand operational expenses over an appropriate period of time. During the winding down or restructuring, a firm still needs to continue its business and be able to absorb losses which are not matched by a sufficient volume of profits, to protect investors.
What is the position under the regime which proceeded the CRR?
Article 21 of the CAD contained a requirement broadly similar to that under Article 97 of the CRR. However, the making of detailed rules and standards under Article 21 was left to the Member States. In the UK, this was implemented under the General Prudential Sourcebook (GENPRU) 2.1.53 to 9 and IPRU(INV) 11.3.4 to 11.3.10.
The GENPRU provisions will still apply to those firms that are BIPRU Firms but the FCA repealed IPRU(INV) 11.3.4 to 11.3.10 when it implemented the CRR on 1 January 2014. The basic methodology is the same as that under Article 97 as amplified under the RTS but the list of items which may be excluded under the RTS, discussed below, is arguably broader.
What is the basic calculation methodology under the RTS?
A firm must calculate its fixed overheads of the preceding year, using figures resulting from the applicable accounting framework, by subtracting certain allowable items (Allowable Items) from the total expenses after distribution of profits to shareholders in their most recent audited annual financial statements, or, where audited statements are not available, in annual financial statements validated by national supervisors. This can be described as follows
(Total Expenses – Distributed Profits) – Allowable Items = Fixed Overheads
What items are included as Allowable Items?
The RTS identifies the following:
- Fully discretionary staff bonuses
- Employees', directors' and partners’ shares in profits, to the extent that they are fully discretionary
- Other appropriations of profits and other variable remuneration, to the extent that they are fully discretionary
- Shared commission and fees payable which are directly related to commission and fees receivable, which are included within total revenue, and where the payment of the commission and fees payable is contingent upon the actual receipt of the commission and fees receivable
- Fees, brokerage and other charges paid to clearing houses, exchanges and intermediate brokers for the purposes of executing, registering or clearing transactions
- Fees to tied agents within the meaning of MiFID, where applicable
- Interest paid to customers on client money
- Non-recurring expenses from non-ordinary activities.
What about the exclusion of non-discretionary payments out of profits within the calculation?
The position is unclear. The list of Allowable Items indicates that these should not be included. However, using the overall calculation methodology, the total expenses figure is one that is determined after the distribution of profits.
On this basis, the inclusion of employees', directors' and partners’ shares in profits, to the extent that they are fully discretionary in item (b) in the Allowable Expenses is confusing although the overall effect is the same as excluding them at the point of determining total expenses.
What about fixed expenses incurred by third parties on behalf of the firm?
The firm may add those expenses to the amount for Allowable Items referred to above where the firm has a breakdown of those expenses. Where the breakdown is not available, the firm must determine those expenses in accordance with the firm’s business plan.
What provision does the RTS make for tied agents?
The firm may add an amount equal to 35% of all fees related to tied agents to the amount for Allowable Items referred to above.
How does the RTS deal with the powers of competent authorities to adjust the requirements in Article 97(1)?
Article 97(2) of the CRR gives a competent authority the power to adjust the fixed overheads requirement in Article 97(1) where it considers the change in the firm’s business to be material.
The RTS divides the conditions of materiality according to the current size of own funds.
For those with more than EUR 125,000 current fixed overheads, the materiality threshold is:
- a change of 20% or greater in the firm’s projected fixed overheads; or
- a change in the firm’s own funds requirements based on the firm’s projected fixed overheads being equal or greater to EUR 2 million.
For those with less than EUR 125,000 current fixed overheads, the materiality threshold is a 100% or greater change in the firm’s projected fixed overheads.
What about asset managers who have recently become authorised and have not completed business for one year?
Article 97(3) provides that where a firm has not completed business for one year, it must hold eligible capital of at least one quarter of the fixed overheads projected in its business plan. Unsurprisingly, the RTS requires firms to use the projected fixed overheads included in its budget for the first 12 month’s trading as submitted with its application for authorisation to determine the Allowable Items referred to above.
The European Commission adopted the RTS on 4 September 2014. If neither the European Parliament nor the Council object within three months, the RTS will enter into force twenty days after publication in the Official Journal – in time for Christmas.