Investment Management Regulatory Update
Developments this quarter
In the closing quarter of 2011, the flow of regulatory developments affecting UK investment management firms continued from international, European and UK regulators. Below we cover the key developments from the quarter:
- Dodd Frank Wall Street Reform
- Transparency Directive II
- FSA consultation on Transaction Reporting User Pack (TRUP) 3
- Alternative Investment Fund Managers Directive (AIFMD) Level 2 measures
- ESMA Opinion – practical arrangements for the late transposition of UCITS IV
- Short selling and Credit Default Swaps (CDS)
- European Market Infrastructure Regulation (EMIR) and Over the Counter (OTC) derivatives
- Markets in Financial Instruments Directive (MiFID)
- Market Abuse Directive (MAD II)
- Retail Distribution Review (RDR)
- Retail product development and governance - Structured products review
- Enforcement Action
In June 2011, the US Securities and Exchange Commission (SEC) finalised its rules which relate to the registration of investment advisers. The deadline for registration was extended to 30 March 2012. The exemptions from registration remain broadly as they were previously but specific definitions for terms within the exemptions have been provided. The exemption for Foreign Private Advisers is available to those non-US investment advisers which have fewer than 15 US clients and less than $25 million in assets under management attributable to those US clients.
In addition, certain asset managers entering into derivative trades for clients will be caught by Dodd-Frank rules on the following, broadly:
Clearing: The general requirement is that standardised swaps need to be cleared by a central counterparty.
Trading: Swaps that are required to be cleared will need to be executed on a designated contract market or swap execution facility.
Margining: The Act will bring in requirements on margining.
Reporting: The Act introduces extensive record keeping and reporting requirements.
These rules are intended to cover regulated swaps (including security based swaps) and trades that are substantively swaps. The timeline for implementation on security based swaps has not been confirmed. The rules regarding clearing and exchange trading of regulated swaps (not including security based swaps) are not likely to take effect before mid 2012.
In 2011 the European Commission (EC) issued a proposal amending the existing Transparency Directive on the harmonisation of transparency requirements affecting issuers of securities traded on regulated markets within the European Union. The EC identified two main areas for improvement required to modernise the Directive and put emphasis on these areas in the proposal: 1) the attractiveness of the regulated markets for small and medium-sized issuers (SMIs) of capital and 2) ways to improve the regime for major holdings of voting rights. The proposal was passed to the European Parliament and the EU’s Council of Ministers for adoption. The key issues affecting investment managers are:
- a broadened definition of financial instruments covered by the Directive;
- greater harmonisation for notification of major holdings - holdings of shares need to be aggregated with the holdings of financial instruments for the calculation of notification thresholds, and notification should include a breakdown of the type of financial instruments held to provide the market with detailed information on the nature of the holdings;
- Member States cannot require firms to produce Interim Management Statements, however, firms could still provide these if they want to and may be required to do so by Regulated Markets;
- the proposals would require the holdings of financial instruments with economic effects similar to holding shares, to be calculated by reference to the full notional amount of shares. This is different from the current UK regulation where the calculation takes into account delta-adjusted values; and
- the proposals would grant the relevant Member State authorities the power to suspend the voting rights of shareholders who breach their disclosure requirements.
The responses to the guidance consultation issued by the FSA on TRUP 3 in November 2011 are currently being reviewed targeting publication in Q1 2012. The following developments have also been noted:
- with the introduction of mandatory Alternative Instrument Identifier (Aii) transaction reporting on 13 November 2011, the FSA's new system (Zen) will reject transactions in non-reportable instruments executed on Aii exchanges;
- the FSA has informed users that the London Stock Exchange (LSE) has taken over the operation of the Transaction Reporting System (TRS) and the rights of TRS users under their contract with the FSA have been assigned to LSE. On 24 April 2012 contracts with the FSA for TRS transaction reporting will terminate. The FSA recommends TRS users to contact LSE to discuss transferring to its own reporting mechanism, UnaVista.
European Securities and Markets Authority (ESMA) advice to the European Commission (EC) on AIFMD Level 2 measures
The Alternative Investment Fund Managers Directive (AIFMD) came into force on 21 July 2011 and the transposition deadline for Member States is 22 July 2013. The EC expects to issue the final Level 2 rules by the middle of 2012. For a summary of the themes dealt with by the Directive, click here.
On 16 November 2011 ESMA published its 500+ page final advice to the EC on the proposed Level 2 implementing measures for the AIFMD.
The advice follows on from feedback received from stakeholders in response to two consultation papers published by ESMA in July and August 2011. ESMA’s advice to the EC covers four main areas and includes the following recommendations and points of clarification:
General operating provisions
- clarify the operation of the Regulatory Assets Under Management (RAUM) threshold for determining whether managers are subject to the Directive;
- propose the covering of risks from professional negligence through a combination of own funds and additional personal insurance; and
- reiterate that many of the organisational requirements are based on Markets in Financial Instruments Directive (MiFID) and Undertakings for Collective Investments in Transferable Securities (UCITS) frameworks.
- set out the framework governing depositories and includes criteria for assessing whether regulation and supervision applicable in a third country has the same effect as AIFMD provisions;
- clarify which circumstances constitute ‘loss’ for a financial instrument held in custody;
- the rules hold custodians liable for sub-custodians losses except those resulting from prescribed external events outside of their reasonable control; and
- aim to clarify which events would constitute ‘external events beyond the reasonable control of the depositary’.
Leverage and transparency
- clarify the definition of leverage and how it should be calculated;
- outline the circumstances in which regulators may impose limits on leverage;
- introduce a sliding scale to determine frequency and content of reporting to regulator; and
- set out the form and content of information to be reported to regulators and investors.
Third country provisions
- provide a framework for third country cooperation agreements – written agreements allowing for exchange of information for supervision and enforcement purposes.
For detailed notes on the key questions answered by the ESMA advice, see Deloitte’s AIFMD Alert. ESMA’s advice represents a significant step towards full implementation, however there are issues to be addressed (e.g. no guidance on remuneration policies applicable to AIFMD). These matters are likely to be next on the agenda for ESMA.
The UCITS IV Directive aims to create a single European marketplace for funds by increasing cross border distribution. The transposition deadline for UCITS IV was 1 July 2011 and rules implementing the Directive came into force in the UK on 1 July 2011. However, the majority of EU Member States have missed this deadline and have still not fully implemented the Directive.
In October 2011 ESMA responded to these delays by publishing an Opinion on practical arrangements for dealing with cross-border operations involving a Member State which has not transposed UCITS IV into national law. The key elements were as follows:
- a host regulator cannot refuse a valid notification under UCITS IV even if that host Member State has not transposed the Directive;
- a non-transposing Member State’s home regulator cannot automatically notify under UCITS IV but ESMA will develop a template to be used to certify to the host Competent Authority that it complies on a voluntary basis with the relevant articles of the Directive;
- UCITS management companies established in a transposing Member State should be able to create a fund via the management company passport in a Member State where the Directive has not been transposed;
- UCITS management companies established in a non-transposing Member State can make use of the management company passport only if the current national legislation materially complies with the relevant provisions of the Directive;
- due to the complexity of the operation, cross-border mergers involving a UCITS established in a Member State that has not transposed the Directive are not possible on the basis of the direct applicability of the Directive;
- mergers of UCITS located within the same non-transposing Member State where at least one of the two UCITS is marketed in another Member State may be possible if current national legislation materially complies with the Directive; and
- master-feeder structures should not be used where one of the Member States involved has not transposed the Directive.
These arrangements provide some useful clarification for fund managers dealing with cross-border provisions under UCITS IV. However, until all Member States have fully transposed the Directive there will still be elements of uncertainty.
In October, the European Council, Parliament and Commission reached a ‘trialogue’ agreement regarding the proposed regulation on short selling and CDS.
The new rules will:
- give ESMA the power to temporarily restrict short selling "in exceptional situations";
- require traders to disclose major short positions regarding equities to regulators; and
- prevent uncovered sales of Sovereign CDS - market participants will not be able to purchase CDS on Government bonds unless they already own the sovereign debt or linked assets. However, primary dealers and market makers will be exempt from this rule and national authorities will be allowed to temporarily lift this ban if sovereign debt markets are not functioning properly.
In November and December respectively, the European Parliament and Council officially endorsed the text agreed in the trialogue and the legislative Act is now expected to be published in the official journal of the EU in H1 2012. According to the text agreed in the trialogue the new rules are expected to come into effect from November 2012.
Additionally an ESMA Level 2 consultation paper on draft technical standards was published on 24 January 2012, with a deadline for comment of 13 February 2012.
The draft technical standards include:
- the details and format of the information to be provided to ESMA by the Competent Authorities;
- the details around information on net short positions to be reported to the Competent Authorities and disclosed to the public as well as the method of public disclosure; and
- the method of turnover calculation to determine the principal venue for the trading of a share.
ESMA is expected to publish a final report and submit the draft technical standards to the EC for endorsement by 31 March 2012.
It was expected that the European Commission, Council and Parliament would reach an agreement on EMIR, the proposed regulation for OTC derivatives, Central Counterparty Clearing Houses and trade repositories by the end of 2011.
After several unsuccessful trialogue negotiations in 2011, talks have now resumed under the Danish Presidency and there is renewed pressure to reach an agreement, which could happen by the end of the month.
The role of ESMA and third-country provisions are amongst the more contentious issues, which are perceived to be causing the delay in agreement.
ESMA was expected to begin consultation on the accompanying technical standards in Q1 2012, although this is also likely to be delayed. The delay is bad news for firms; EMIR is part of the G20 commitment to clear all standardised OTC derivatives by end-2012. This deadline was also reaffirmed at the Seoul G20 summit in November and there will be pressure on G20 countries to honour their commitment by the agreed date.
In October, the EC published its proposals to update MiFID. The proposals are set out in a Directive and a regulation, collectively known as ‘MiFID II’ and cover a broad range of areas, including:
Scope- The scope of MiFID could be extended to cover additional instruments, such as emissions allowances and structured deposits. More firms, such as data providers and certain commodities firms, could also be brought into scope, through the narrowing of existing exemptions and the introduction of new requirements.
Market structure- The proposals include significant changes to market structure, including the introduction of a new category of trading venue, Organised Trading Facilities (OTFs) and the requirement to trade specific derivatives on eligible trading platforms. Additional requirements could also be introduced in respect of algorithmic trading.
Transparency- More instruments could be brought into scope of transparency requirements. The current requirements in respect of equities may be extended to other equity like instruments.
Transaction reporting- Proposals include changes to the content of reports and the instruments covered. For example, instruments admitted to trading on venues, such as OTFs, will also need to be reported.
Investor protection- The proposals include a number of changes to enhance investor protection, including best execution, client assets and investment advice.
Supervision- This includes product intervention powers for regulators, as well as powers to impose position limits. The proposals also set out changes to the manner in which third country firms are supervised and provided access to EEA markets.
The full impact of the changes will not be clear until the legislation is passed, by which time some controversial points could be omitted, and there is sight of the Level 2 and Level 3 proposals. For more detailed information on the proposals, please refer to the Deloitte MiFID II Key Proposals and Impacts paper.
A consultation was launched in November by Markus Ferber, who is the European Parliament Rapporteur for MiFID II, which sought responses on a number of changes included in the MiFID II proposals. These cover areas such as investor protection, transparency and scope of the Directive. The consultation closed on 13 January and the feedback will be used to inform the work of the Economic and Monetary Affairs Committee (ECON). ECON also held an open hearing in December to discuss proposals on investor protection, position limits and OTFs in more detail.
ESMA continues to work on guidelines relating to existing MiFID requirements. In December, ESMA published guidelines for automated trading systems, as well as two consultations on additional guidelines on Compliance Function and Suitability requirements. The consultation on Compliance Function emphasises that firms should provide sufficient prominence to compliance risk management and allocate compliance resources using a risk based approach. The consultation on Suitability sets out additional guidance in a number of areas including information which firms should collect from clients in assessing suitability. The closing date for responses is 24 February 2012.
Slightly overshadowed by the MiFID II publication were two announcements on the new European Market Abuse Directive (MAD II). These were a proposal for a Directive on criminal sanctions for insider dealing and market manipulation and a proposal for a regulation of the European Parliament and European Council on insider dealing and market manipulation (market abuse). MAD II seeks to close gaps in the original Directive as a result of regulatory, market and technological developments, as well as to increase harmonisation with MiFID II. The new regulations also bring into scope the European commodity derivative requirements which have caused difficulties for some European regulators. The criminal sanctions are designed to harmonise the criminal market abuse regimes across Europe. The proposals for the Directive introduce two offences that of ‘Insider Dealing’ and of ‘Market Manipulation’, as well as the introduction of significant cross border information gathering powers.
Some of these new proposals are causing considerable debate and may be subject to a certain amount of change, with the new rules to be implemented by Member States in 2012.
The key areas of the proposals were as follows:
- clarification of which financial instruments are in scope- instruments only traded on a Multilateral Trading Facility (MTF) or any other Organised Trading Facility (OTF) would now be covered, as will the trading of emissions allowances;
- more defined requirements for the collation and maintenance of insider lists for issuers;
- Small and Medium Enterprises are, in some cases, not required to keep insider lists and there is clarification on the reporting obligations for investment manager transactions;
- the extension of information gathering requirements for regulators to include telephone data records and a provision for telecommunications operators to provide this information;
- attempted market manipulation will be prohibited- the new regulation would prohibit “trying to enter into a transaction, trying to place an order to trade or trying to engage in any other behaviour that constitutes market manipulation”;
- for sanctions, the updated Directive makes provision for minimum sanctions across European Member States. These include a minimum of a profit disgorgement and a fine of twice the profit made (or loss avoided) for an individual, or for a firm up to 10% of its total annual turnover in the preceding business year; and
- an amendment to include the requirement to report suspicious orders as well as transactions to the Competent Authority.
Also in the legislation are requirements to cooperate with ESMA and with other Competent Authorities and for ESMA to be informed where there is a cross boarder investigation.
The requirement is for the Directive to be adopted within 24 months of the entry of the regulation. The new proposed powers within the new Directive would be wide reaching.
FSA consultation on adviser charging at point of sale
Since the FSA first published finalised rules on adviser charging in PS10/06 (March 2010), the industry has been keen for further guidance and clarification from the FSA about numerous practical and operational consequences related to implementing and managing adviser charging.
In November 2011, the FSA issued a guidance consultation which includes clarification on adviser charging facilitation methods and whether refunds on cancellations have to be net or gross of adviser charges. The consultation also covers whether product providers that facilitate charges should report Product Sales Data (PSD) net or gross of adviser or consultancy charges. The FSA has proposed additional guidance to assist firms implementing the adviser charging rules including:
- Refunds on cancellations: Where the provider has facilitated an adviser charge, refunds on cancellations can be made either net or gross of the adviser charge. An amendment to the rules on disclosure is proposed to ensure that the effects of cancellation are clearly communicated so that the customer understands the firm’s approach; and
- Product Sales Data: The FSA proposes that an additional note be added to the PSD requirements to explain that the amount paid into the product should be disclosed to the FSA, irrespective of whether adviser or consultancy charges are deducted before or afterwards.
As such, this guidance is designed to give both product providers and distributors greater certainty and clarity on how to implement aspects of the adviser charging rules. It is designed to assist distributors when developing their charging structures and back office processes, and product providers when establishing the processes and controls if they are facilitating the collection of adviser charges.
RDR adviser charging - treatment of legacy assets
In November 2011, the FSA issued a consultation paper on treatment of legacy assets. Legacy assets refer to retail investment products purchased by a retail client before the RDR rules come into effect and which the client is still holding when the rules come into force. The FSA, in PS10/06, made new rules prohibiting the payment and receipt of commission for advised sales of retail investment products post-RDR. The treatment of legacy business however, has remained unclear and the FSA intends to introduce guidance on legacy business through this consultation. The FSA has published a table of scenarios to illustrate where a personal recommendation is likely to have been made. The guidance is intended to help firms understand when the ban on commission does and does not apply. Taking into account this guidance firms should ask themselves the following questions to determine whether adviser charging rules apply to a product:
- Has there been a personal recommendation to a retail client in relation to a retail investment product? If the answer is ‘No’ then adviser charging rules do not apply. If the answer is ‘Yes’, then firms should ask themselves the next question.
- Was the personal recommendation made before or after the RDR rules came into force? If the answer is ‘pre-RDR’ then the recommendation will not be caught by the rules and if the answer is ‘post-RDR’ then additional commission cannot be paid.
Final rules on FSA’s data collection post-RDR
In November 2011, the FSA issued a policy statement which confirmed the changes to its data collection requirements to enable it to appropriately monitor the industry post-RDR. The key changes confirmed in the paper were:
- new requirements for collection of data under the Retail Mediation Activities Return (RMAR), covering adviser charging revenue, payment and client numbers, and charging structure, from all firms that provide advice on retail investment products;
- requirements for firms that provide services on group personal pension schemes (GPPs) to provide data on consultancy charging and fees revenue, payment methods, employer client numbers and charging structures; and
- new complaints data at individual adviser level, for use in combination with other risk information as an indicator of behaviour that could imply potential consumer detriment.
In November 2011, the FSA issued a policy statement in response to the consultation paper issued in February 2011 which covered the product disclosure requirements for product providers in a post-RDR world. The key change confirmed in the paper was that where a product provider facilitates an adviser charge, it is required to include a description of the nature and amount of adviser charge being deducted from the product and the impact of that deduction should be reflected within the relevant projections. However, for an advised pension business the FSA has gone further and requires the provider to illustrate the separate effect of product charges and facilitated adviser charges.
Distributor-influenced funds factsheets
In December 2011, the FSA issued a guidance consultation setting out proposed changes to the Distributor-Influenced Funds (DIF) factsheet to take into account coming rule changes under the RDR.
The majority of the proposed changes aim to reinforce the RDR rules which state that a distributor cannot receive any benefit, financial or non-financial, from the underlying fund manager for making a personal recommendation to invest in a DIF. In the same way that, post implementation of the RDR, other retail investment products must be paid for by the customer via an agreed adviser charge, rather than through commission payments, split of annual management charges, profit share or other similar benefit from the product provider to the distributor, this guidance consultation confirms that this approach applies equally to DIFs.
In the guidance consultation the FSA proposes to insert additional wording covering firms who make personal recommendations in respect of a DIF. The proposed additional wording states:
“Given the inherent conflicts of interest involved, we would question whether an independent firm could meet its obligations to act in the best interests of its client and provide advice in an unbiased manner if it recommends a distributor-influenced fund.”
This sets out the FSA’s likely approach to independent firms who are recommending DIFs post the implementation of the RDR and represents an additional factor that firms will need to consider when deciding on their independent or restricted status post-RDR.
In November 2011 the FSA issued a guidance consultation, concerned that the growth of structured products and increasing product complexity is placing a strain on firms’ systems and controls, leading customers to buy, or be sold products which may cause them detriment. Between November 2010 and May 2011 the FSA assessed seven major providers of structured products, specifically looking at how firms were designing structured products, identifying target markets, and handling post-sales responsibilities. The FSA has proposed that firms should:
- identify the target audience and then design products to meet that audience’s needs;
- stress-test new products to ensure they are capable of delivering fair outcomes for the target audience;
- ensure a robust product approval process for new products; and
- monitor the progress of a product throughout its life cycle ensuring that it remains relevant to the target audience in prevailing market conditions.
The FSA’s enforcement team has issued 25 final notices during Q4 2011. Although not all cases were directly related to the investment management sector, many of those had underlying themes with wider messages applying across all industries and sectors. However, key areas of relevance this quarter included suitability failings, fitness and propriety issues and inadequate client money controls.
There were three high profile cases in relation to suitability issues, with the FSA imposing fines of £5.9 million, £6.3 million and £10.5 million. These cases draw attention to the need for firms to clearly understand the risk appetite, investment objectives and financial situation of their customers and to ensure that their assessments are carefully documented.
Case 1: Action was taken for unsuitable advice in relation to structured capital at risk products and inadequate systems and controls. In particular, the organisation did not adequately assess customers’ attitudes to risk, failed to retain evidence of suitability for its customers and did not effectively monitor its staff to ensure they were giving suitable advice.
Case 2: Action was taken for unsuitable sales and advice provided to elderly customers. The FSA found that the individual needs of its elderly customers had not been appropriately considered. For example, customers were advised to invest in products (typically investment bonds) that locked the customer in for at least 5 years. However, many of the customers had shorter life expectancies and so had to make withdrawals from the investments sooner than recommended. This, along with product charges led to a faster reduction of capital than if they had been given suitable advice.
Case 3: Action was taken for failings in the way that a fund was sold to customers. Specifically, it was found that customers were generally misinformed about the characteristics of the fund which may have led to a misunderstanding of the risks to their investments. In addition, the FSA also found that staff were inadequately trained about the features and risks of the fund, the firm failed to react to changes in market conditions, and failed to undertake an effective review of sales after the fund was suspended and customers had complained. The review showed the firm failed to adequately address suitability and disclosure issues.
Fitness & propriety
Of particular interest in the previous quarter was the FSA’s action on Dr Sandradee Joseph. Dr Joseph held the following controlled functions: Compliance Officer (CF10) and MLRO (CF11). She was fined £14,000 and banned from holding a significant influence function for failure of duty in those roles. In particular, Dr Joseph was found to have not investigated important matters relating to a fund that the firm managed despite concerns being raised by several investors and receiving a termination letter by the fund’s prime broker. She was also found to have placed over reliance on another employee’s knowledge and dealings of the fund. The employee in question had entered into a contract on behalf of the fund for the purchase and resale of a bond which was in breach of the investment mandate. This action had been taken to conceal losses and it was later established that the bond itself was a fraudulent instrument.
The action on Dr Joseph highlights a need for having effective and independent compliance oversight over fund activities which includes ensuring adherence to the fund’s stated objectives and strategy.
In Q4 2011 the FSA imposed a £3.5 million fine on Integrated Financial Arrangements PLC for “failings in relation to its protection of client money” over a period of more than eight years. Further exact details of the client money failings from the final notice are given below for your reference:
“(i) perform client money calculations to check whether its client money resource, being the aggregate balance on the Firm’s client bank accounts as at the close of business on the previous business day, was at least equal to its client money requirement as at the close of business on that day and, as a consequence, Integrated Financial failed to fund any shortfall in its client money bank accounts;
(ii) put in place adequate trust documentation in relation to three of its 28 client money bank accounts in accordance with the FSA's rules; and
(iii) take reasonable care to organise and control its affairs in relation to client money responsibly and effectively with adequate risk management systems in that it did not ensure that its procedures, systems and controls met all of the FSA’s client money requirements and did not identify the need to fund any shortfall (or remove any surplus) of client money in its client money bank accounts.”