The Financial Conduct Authority (FCA) has warned that there is "a significant risk of harm to consumers and to the market" arising from the activities of appointed representatives (ARs) operating in the investment management sector, in its multi-firm review into the supervision by principal firms of their ARs in the investment management sector. The review, published on 20 May 2019 and covering firms engaged in the promotion and management of alternative investment funds (AIFs), asset management, wealth management, contracts for difference (CFD) providers, fund advisory and arranging activities, has identified significant shortcomings in principal firms' understandings of their regulatory responsibilities. It should be of particular interest to any firm operating an AR model in the context of alternative investment fund manager (AIFM) hosting services and to any persons using or hoping to make use of such services; a practice perhaps most common among start up managers or overseas managers looking to establish a footprint in the UK, without committing all the resource necessary to establish an authorised firm in the UK. We would also note that some of the observations of the FCA and the lessons to be taken from the review could, in theory, apply equally to intra-group AR arrangements as they do when the principal is an external one. The FCA surveyed 338 principals (each with between one and 80 ARs) and selected 15 for a more detailed review. The FCA also reviewed the adequacy of financial resources of 33 principals. The review assessed principals' compliance with their regulatory responsibilities in relation to the management of business model risks associated with appointing ARs, oversight and ongoing monitoring of ARs, and adequacy of financial resources.
The FCA's findings
The FCA found that that most principal firms reviewed had weak or under-developed governance arrangements in place, including a lack of effective risk frameworks, internal controls and sufficient resources. The FCA is particularly concerned about the growth of "Regulatory Host" arrangements in the investment management sector. These arrangements allow small businesses to operate without their own authorisation under the regulatory umbrella of the principal, without necessarily selling the principal's products or services. The "Regulatory Host" principal may also permit AR staff to be seconded to the principal; those staff may then become approved persons undertaking regulated activities such as managing investments for which the AR cannot be exempt. Regulatory Host arrangements have led to the emergence of some ARs marketing themselves as "investment managers", which might be misleading. Appointment of ARs The FCA found that principals lack effective risk frameworks and adequate oversight when appointing ARs. Some of the FCA's particular concerns include:
- principals failing to take reasonable steps to assess their ability to oversee their ARs effectively when considering their appointment, allowing some ARs to conduct activities outside their principal’s core areas of expertise;
- insufficient numbers of appropriately skilled and experienced people to permit the principal to oversee the variety of business models being operated by their ARs;
- inadequate understanding of ARs' business models;
- improper use of generic contracts for ARs;
- lack of product governance arrangements.
Ongoing monitoring of ARs
Most principals reviewed by the FCA had not put in place appropriate control frameworks to monitor their ARs' activities on an ongoing basis; monitoring was often not bespoke to the AR's business model, and many principals were over-reliant on attestations from the AR. The FCA found little evidence of client file reviews, testing of ARs and challenge by principals. No principal reviewed by the FCA regularly reviewed their ARs' websites. The FCA found several examples of individuals performing relevant controlled functions within ARs without having approval to undertake those functions, and at one principal a number of ARs were acting outside the scope of their principal’s permission, in breach of the general prohibition. Perhaps in parallel with its concerns about Regulatory Host arrangements, the FCA was particularly concerned about a tendency at many principals to refer to their ARs as "clients" and to focus more on fees from ARs in management information than on their conduct. Adequacy of financial resources Most principals reviewed by the FCA were not assessing risks to their firms arising from the activities of ARs, including liabilities; where the FCA reviewed principals' assessments of the adequacy of their financial resources, more than 90% were not fit for purpose. While many principals rely on Professional Indemnity Insurance (PII) to mitigate the risks arising from their ARs, the FCA's findings make clear that PII is not a substitute for maintaining adequate financial resources. The FCA also found that some principals have failed to include their ARs' revenues when submitting fee tariff data, meaning that they have paid lower regulatory fees than they should have. Focus on AIFMs The FCA has seen a particular increase in the use of the Regulatory Host model in the AIF sector, leading to the growth of the "Host AIFM" model. Under this model, a principal is appointed as the AIFM to an AIF; the AR is usually appointed as an adviser to the AIF. Staff from the AR may be seconded to the principal, where they are approved as a CF30 to perform the customer function, and can undertake portfolio management activity. Under the Host AIFM arrangement, when marketing AIFs, the AR claims to be the fund manager when, legally, this role is taken by the principal as the AIFM. The FCA is concerned by a number of findings from the review relating to this model, including:
- insufficient identification and management of obvious conflicts of interest;
- inadequate control and risk management frameworks, including experienced people, to oversee AIFs and the activities of the seconded portfolio managers;
- ineffective systems and procedures to prevent and detect market abuse arising from a misunderstanding of the principals' obligations under the Market Abuse Regulation, for example a lack of proactive monitoring of trading activity to detect and report suspicious orders and transactions.
In a warning to firms operating under these arrangements, the FCA has noted that it has "significant concerns" about the AIFM Host model and will continue to assess associated risks.
The FCA's findings are the latest in a line of supervisory work focused on AR arrangements and the adequacy of principal oversight. It is clear that the FCA expects firms to take all of its concerns seriously, including those set out in its previous publications:
- a thematic review on this subject in the general insurance sector in 2016 and Dear CEO letter, identifying similar findings to the current review;
- an alert issued in 2016 highlighting some of the risks arising from authorised firms accepting business from unauthorised introducers/lead generators and/or other authorised firms;
- an alert issued in 2017 to all principals who have ARs or introducer ARs highlighting the risks of not having adequate oversight of ARs and reminding principals of their responsibility for the regulated activities of their ARs;
- a Dear CEO letter published on 9 January 2019 reminding all regulated firms of their responsibilities when communicating and approving financial promotions; and
- a Dear CEO letter published on 11 April 2019 reminding firms involved in the approval of financial promotions for unauthorised persons of their obligations when doing so.
The FCA has issued a Dear CEO letter alongside its review, setting out its expectations of principals in the investment management sector. Asset and investment management firms with AR arrangements in place should carefully review the FCA's findings and the Dear CEO letter. Those acting as principal should consider whether their risk control frameworks are fit for purpose. Such firms considering appointing ARs should ensure that their on-boarding processes take into account the FCA's concerns. Any shortcomings identified in risk-management frameworks, processes and practices should be addressed. The FCA expects to see that firms have acted on the expectations set out in the Dear CEO letter. In particular, asset and investment management firms operating as part of the AIFM Host model should heed the FCA's warning and ensure that their arrangements are compliant with the FCA's rules and take into account the conclusions from the FCA's prior work. These firms should be prepared for the FCA to undertake more supervisory work in this area. Equally, ARs benefitting from, or persons looking to benefit from, AR relationships with principals should consider the FCA findings and Dear CEO letter in determining whether the AR model, when run in line with FCA expectations, remains an appropriate model for them. The FCA's review led to a number of interventions, including agreeing the imposition of requirements on principals' regulatory permissions, asking principals to de-register ARs and commissioning Section 166 skilled persons reports. The FCA intends to do some additional with firms in the wider survey not included in the detailed review. While the FCA's review was limited to the investment management sector, all firms should take the FCA's findings, and the entirety of its supervisory work in this area, into consideration when considering whether their AR oversight controls are appropriate.