The late summer saw the U.K. Financial Conduct Authority issue a “Dear CEO Letter” (the Letter) setting out its Alternatives Supervisory Strategy FCA Portfolio Letter: Our Alternatives Supervision Strategy 2022. With their summer holidays complete, the Letter will be important reading for private fund managers in confirming or setting their regulatory priorities for 2022-23.
The Letter outlines the FCA’s updated supervisory strategy and priorities for alternative investment managers and addresses six areas, discussed below, under three “FCA Commitments” that follow the FCA’s 2022-23 business plan:
- Consumer needs;
- The integrity of the markets and market abuse; and
- ESG (Environmental, Social and Governance).
All managers should also note anti-money laundering and the combatting of financial crime highlighted in the Business Plan but not addressed in the Letter, as an area of perennial focus for the FCA. For some managers, other compliance points of relevance in the Business Plan, not covered in the Letter, include operational resilience and the revised appointed representative regime. The more product specific areas of concern in the Business Plan, not covered in the Letter, include the Long Term Asset Fund, on which the FCA is consulting, and crypto-assets.
SIX AREAS OF CONCERN: WHAT THE FCA EXPECTS MANAGERS TO DO
In identifying the areas where the FCA believes managers can improve, the Letter makes it clear that the FCA will expect:
- Manager CEO’s to discuss the Letter with their board/executive committee; and
- Managers to consider (i) which of the risks identified in the Letter apply to them, (ii) whether they have the appropriate strategies in place to address those risks, and (iii) what actions are necessary to mitigate those risks to ensure that the managers meet the FCA’s requirements.
The FCA acknowledges that the Letter is addressed to a large and diverse group of managers and that not all issues raised will be relevant. In considering the extent to which a manager is expected to comply, the nature, scale and complexity of the manager’s business is also relevant.
Irrespective of the extent to which managers has addressed the points in the Letter, it will need to include the Letter as an agenda item at the next board or relevant committee meeting at which compliance issues are scheduled for discussion.
1. CONSUMER NEEDS
The FCA refers here to investors’ exposure to inappropriate products or levels of investment risk with “inappropriate distribution and marketing practices by managers targeting mainstream investors [remaining] a concern.”
The FCA’s focus, as it was in its last alternatives Dear CEO Letter in 2020 Portfolio Letter: Our Alternatives Supervision Strategy is investments offered to or targeted at investors who are retail or elective professionals. However, even if a manager does not target such investors, the Letter is relevant as the FCA indicates that it will expect:
- A due diligence process connected with client categorisation that prevents investors with a lower risk appetite from gaining access to (high risk) investments that do not match their objectives.
- Managers that onboard retail or elective professional to review their processes to ensure they are effective, including the procedures for checking that elective professional investors meet the quantitative and qualitative tests in the COBS 3.5 section of the FCA rules.
The FCA will be issuing a questionnaire in the coming months asking all managers for information about their business model, products, investor categorisations, and associated control framework.
More specifically, for managers that offer investments to retail investors, the FCA will expect:
- A governance process that considers the application of relevant marketing restrictions to retail investors when communicating or approving financial promotions, especially to ensure compliance with COBS 4.12;
- A governance process that ensures that target markets are clearly outlined for distribution channels to ensure a clear understanding of in scope investors;
- Managers to review new rules contained in PS22/10: Strengthening our financial promotion rules for high-risk investments and firms approving financial promotions, including changes to COBS 4.12 (The main risk warning rules come into force on 1st December 2022, with the remainder landing on 1st February 2023); and
- Managers to consider whether they have any new obligations under the Consumer Duty rules contained in PS22/9: A new Consumer Duty which come into force for new and existing investments open for sale on 31 July 2023 and on 31 July 2024 for closed investments. In this respect, the FCA’s final position on the application of the consumer duty to firms that can “determine or materially influence retail customer outcomes” is helpful for alternative investment managers. The FCA states that it would not expect the consumer duty to apply to a to a firm whose role is limited to operating within a mandate determined by another firm in a distribution chain. This could include a portfolio manager whose role is limited to managing assets under a mandate determined by a professional client, such as a pension fund manager, where that client is entirely independent of the manager. Where a manager offers and/or manages funds and investments to/for retail investors directly, the consumer duty will be relevant although there is time to consider its impact.
2. CONFLICTS OF INTEREST
The FCA’s comments are a reminder of the centrality for investment managers of the requirement to manage conflicts of interest fairly, highlighting market manipulation or improper fund performance reporting where managers fail to manage conflicts fairly.
The FCA highlights the bypassing of internal processes, internal firm conflicts, and situations where dominant shareholders make material decisions independent of a managers' governance structure as particular areas of concern. It also points to recent enforcement actions, FCA fines GAM International Management and former Investment Director Timothy Haywood, a particular focus (which I commented on in an earlier e-mail to many of you) being the failures (a) to convene meetings of the conflicts committee, (b)promote the identity of the conflicts officer, (c) of the board to discuss conflicts and (d) of the internal audit function and FCA publishes Decision Notice against hedge fund for conflicts of interest failings.
The FCA will expect manager boards to carefully review their conflicts procedures and also consider the impact of their shareholder structure and the potential implications this has on the effective governance of their organisation.
3. MARKET INTEGRITY
The FCA highlights the need for managers, especially the managers of large hedge funds that employ high-leverage to ensure their risk management systems, controls and resources are fit for purpose, noting the nature, scale and complexity of the risks inherent in the business model. It point to managers that overestimate liquidity in the context of stressed or fast-moving markets.
The FCA will expect managers to have robust risk and liquidity management processes and manager boards to, therefore, ensure that risk functions are appropriately resourced, contemporaneous, and commensurate with the levels of portfolio and business risk being taken. Any MIFIDPRU manager will need to ensure that its Individual Capital Assessment Risk Assessment (ICARA) picks up liquidity risks and deals, for example, with the servicing of debt in the face of rising interest rates a concern that we have seen the FCA raise in the context of its approval of a private equity acquisition.
4. MARKET ABUSE
As is the case with conflicts of interest, the FCA’s comments on market abuse are a reminder of the importance the FCA attaches to “established, robust systems and controls” for mitigating the risk of market abuse and ensure compliance with the UK Market Abuse Regulation (UK MAR).
The FCA will expect managers to ensure UK MAR controls are tailored to their individual business models. For managers with representatives on the board of a company that is subject to UK MAR, a recent case to note is that in Final Notice 2022: Sir Christopher Grant in which the FCA fined a company chair for negligently disclosing inside information.
The FCA has reiterates its view that understanding the culture of the managers that it regulates is central to the FCA’s supervisory approach. The Letter focusses on (a) remuneration and incentivisation of staff and their contribution to organisational culture and notes the arrival of the MIFIDPRU Remuneration Code for the performance period on or after 1 January 2022 and (b) diversity and inclusion, noting DP 21/2: Diversity and inclusion in the financial sector – working together to drive change (D&E DP).
During the forthcoming supervisory cycle, the FCA will look at how senior managers and manager policies influence an organisation’s culture, noting, in particular, concerns about evidence of staff being unable to speak up and how healthy cultures are embedded in managers where founders or other senior individuals occupy a dominant role.
The FCA will also expect managers to “consider the steps they can take to provide an environment where diverse talent can flourish, and diversity of thought is encouraged”. The specific output for managers remains difficult to specify, the FCA recognising in the D&E DP that it cannot take a “one-size-fits-all approach” to D&E compliance for firms. That said, a D&E policy would be a minimum requirement.
The FCA highlights the fact that ESG remains a priority area in the Asset Management department. The FCA refers to PS21/24: Enhancing climate-related disclosures by asset managers, life insurers and FCA-regulated pension providers and the FCA ESG Rules requiring asset managers, including authorised alternative investment fund managers, to make disclosures in line with those recommended by the Taskforce on Climate-related Financial Disclosures (TCFD). These include disclosures include both qualitative and quantitative elements at both entity and product level. The FCA also refer to the ESG themes in the Authorised ESG & Sustainable Investment Funds: improving quality and clarity letter also noting the increases in the number of Alternative Investment Funds with a stated focus on these themes.
The FCA will expect:
- Managers offering ESG funds and investments to be subject to review to ensure marketing materials accurately describe the funds and investments, with clear and consistent disclosure; and
- Managers with assets under management of over £5bn (currently exempt from the FCA ESG Rules) to be in a position to comply with the FCA ESG Rules from 1 January 2023.
To discuss the contents of this alert, please contact the authors or your usual Goodwin contact.