Funds First – key regulatory issues affecting funds, including the FCA Asset Management Market Study


By Chris Ormond, Matthew Baker and Nileena Premchand

Summary: At our recent Funds First seminar we shared some key regulatory issues affecting funds over the next year. We were delighted to see so many of you there. This briefing sets out some of the highlights of the topics discussed, which we hope will also be of interest to those who could not attend the seminar itself.

On 28 June 2017 the FCA announced its Final Report from its Asset Management Market Study, together with a new Consultation Paper looking at how it will seek to implement some of those findings. We have included a section of the highlights at the end of this briefing.

Regulatory developments in funds – MiFID II

MiFID II, a vast series of complex legislative measures, has been described by ESMA, the regulator of regulators for the European securities market, as “by far the most significant piece of regulation that ESMA has ever undertaken” and also that “the magnitude of MiFID II should not be underestimated”. To understand MiFID II’s application to investment managers, you first need to consider what type of firm yours is, and how that maps to the MiFID II regime:

  • For firms that are simply MiFID investment firms, for example only doing discretionary management or acting as portfolio managers to other alternative investment fund managers (AIFMs) (whether in the same group or not), they will be fully caught and subject to the whole directly.
  • For firms that are full-scope AIFMs but which also provide other services under article 6(4) of AIFMD, for example running some discretionary portfolios or giving investment advice to other clients, MiFID II will generally not apply to their activities as AIFM, but it does apply to those additional activities.
  • For firms that are AIFMs and perform no MiFID standalone activities, the FCA has chosen to apply some rules to them, but not others. For example, the FCA has expressly stated that it will extend the MiFID II rules on telephone recording to AIFMs. Similarly, rules on product governance are likely to extend to many AIFMs, albeit by the back door (as summarised in the highlights section below).

A few other highlights from the issues raised in our seminar are set out below.

  • Unlike AIFMD and MiFID I, with a very small number of exceptions, MiFID II doesn’t have any transitional period or grandfathering provisions. As a result, you will need to be absolutely ready by 3 January 2018, with no exceptions.
  • Under MiFID II, there is a much greater emphasis on the need for a strong compliance function, including a need to have annual reports and for compliance to have direct access to senior management. There are also restrictions on the numbers of directorships that senior managers of MiFID firms must hold, being that considered appropriate for their size and complexity. However, this is only being applied to “significant firms,” so won’t apply across the board.
  • MiFID II brings in new rules on product governance: for instance, investment firms that create, develop, issue or design products, must consider the target market, stress test products before launch, and revisit the target market analysis if there is a new issuance, or otherwise “periodically”. Although AIFMs launching and designing new alternative investment funds (AIFs) (as set out in the third category of firm type above) do not have a direct obligation to apply these rules, it may be that MiFID firms seek to require AIFMs (both in the EU and outside) to perform a similar exercise as if they were directly caught by the legislation before the distributors take on their products. We therefore need to be alert to how market practice develops in this area.

Regulatory developments in funds – PRIPPs

The regulations on Packaged Retail and Insurance-based Investment Products (PRIIPs) are due to come into force on 1 January 2018. This section of the seminar aimed to provide a high-level introduction to the regulations and why PRIIPs may be relevant for UK fund managers, investment advisors and discretionary investment management firms, amongst others. Key points to note:

  • The aim of the PRIIPs regulations is to help retail investors compare PRIIPs and make informed decisions by better understanding the key features of such products.
  • The main requirement under the PRIIPs regulations is that a Key Information Document (KID) has to be provided to retail investors when a PRIIP is made available to them.
  • The PRIIPs regulations have a much wider scope than may be expected, this is due to the broad range of products that may be classified as a PRIIP and also the wide definition of ‘retail investor’, which derives from the MiFID II definition of ‘retail client’ and covers any investor that is not classified as a ‘professional client’. Due to changes resulting from MiFID II, local authorities are no longer automatically classified as professional clients, and therefore, unless they can ‘opt up’ as an ‘elective professional client’ under the strict criteria set out in MiFID II, any local authority investors are likely to constitute retail investors.
  • Examples of PRIIPs include both regulated collective investment schemes (for example NURSs and QISs) and unregulated collective investment schemes (such as unauthorised unit trust schemes and private equity funds). AIFs are also likely to fall within the definition of a PRIIP, even if they are not collective investment schemes. Examples of types of products that are unlikely to constitute PRIIPs include shares or bonds that are directly held by the retail investor.
  • There is no transitional period and so it is important for firms to start considering whether the PRIIPs regulations are applicable to them and if so, to start preparing now.

Key requirements under the PRIIPs regulations include:

  • ‘PRIIPs manufacturers’ must prepare and publish a KID for each PRIIP on their website. They are also required to ensure that the KID is reviewed at least every 12 months and is kept up to date.
  • ‘PRIIPs distributors’ must ensure that the KID is provided to the retail investor in good time before the investor is bound by any contract or offer relating to the PRIIP.

The PRIIPs regulations and regulatory technical standards (RTSs) set out the prescribed rules in relation to the content and format of the KID. Key points to note are:

  • The KID must be a standalone document and no more than 3 sides of A4.
  • The KID must contain certain information, which should be presented in a pre-determined sequence of sections using prescribed headings.
  • Preparation of the KID should not be underestimated, the RTSs’ contain some particularly complicated requirements around risk indicators and performance and stress scenarios.
  • PRIIPs manufacturers and PRIIPs distributors will also need to ensure that information set out in the KID is clear, fair and not misleading.

The FCA has acknowledged that the PRIIPs regulations are unclear in places and is working with the European Commission and the European Supervisory Authorities to provide further clarity. We are expecting further commentary or guidance to be published on these areas later this year. Key areas on which further guidance is required include:

  • Whether or not a KID is required in relation to secondary trades or in relation to top-ups and closed book products. This stems from a lack of clarity around what is meant by “made available” in the context of PRIIPs being ‘open’ to retail investors.
  • Whether or not the regulations apply to third country PRIIPs manufacturers marketing to retail investors in the UK. The FCA’s view is that the regulations will apply if a PRIIP is being marketing to retail investors in the UK.

Marketing options for UK fund managers post-Brexit

The focus of this part of the seminar was on examining four possible marketing options or solutions for UK fund managers to consider post-Brexit: the delegation model; the MiFID II third country passport; using the concept of equivalence, and reverse solicitation. These were then applied in a handful of case studies. The working scenario for this discussion was the absence of a positive legislative framework in place when the UK leaves the EU – the UK therefore becoming a third country, with no regulatory equivalence decision from the European Commission across the core single market directives, no enhanced equivalence status granted and no new access arrangements agreed, either universally or by individual member states. Our headline observations on each possible marketing solution are set out below.

Delegation under the Alternative Investment Fund Managers Directive (AIFMD)

  • This model involves relocation of a UK AIFM to an EU AIFM (either by way of an outsourced platform or a new fully-authorised manager) who then delegates portfolio and/or risk management roles to the UK manager.
  • Already being used in current structuring, this translates well into a post-Brexit world: the AIFMD marketing passport is not lost (assuming the fund being sold is an EU AIF), and the expertise and brand of the UK portfolio manager are maintained.
  • This structuring is premised on compliance with the delegation provisions in AIFMD, including FCA approval of the UK manager, as a third country delegate, and that the EU AIFM does not become a ‘letter box’ entity.
  • There are two wider issues of potential concern around this structure, and which we continue to monitor. First, that EU legislators move to tighten the rules around delegation and outsourcing, and even seek to prevent third country firms being delegates of EU principals. ESMA’s 31 May 2017 opinion on supervisory convergence in the context of Brexit reminds the remaining 27 member states of the strict legislative conditions around delegation and outsourcing, the need for consistent supervision, and raises the issue of substance. The second point to be alert to is the November 2016 ESMA Q&A on AIFMs being responsible for all AIFMD functions (including the permissive activities ancillary to the AIFM’s portfolio and risk management role, such as administration, marketing, asset-related, regulatory compliance, legal and accounting functions). The consequence of this ESMA guidance (contrary to industry interpretation and practice) is that any third party service provider of these ancillary tasks would be treated as a delegate under AIFMD. Various industry groups have urged the FCA to disregard ESMA’s guidance on this point, and to stick to the approach set out in the FCA handbook.

MiFID II third country passport

  • MiFID II/MiFIR, which will apply from 3 January 2018, allows third country firms registered with ESMA to provide cross-border services into the EU, without needing to establish a branch.
  • This may be relevant where a UK manager falls within the scope of MiFID II, where it is providing MiFID II investment services or activities.
  • However, the key requirement to access this passport is that the UK firm, as a third country firm, is assessed by the European Commission to be ‘equivalent’. We have set out some of the issues around equivalence decisions in general below. Also, this MiFID II passport relates to professional investors only. Cross-border distribution to retail or ‘elective professional’ investors under MiFID II/ MiFIR would involve establishing a branch in a member state that has opted in, and complying with various other conditions.


  • Although a central concept in AIFMD, in being part of the framework to allow replication of passporting rights that would otherwise be lost by UK AIFMs on Brexit, equivalence has limited application only elsewhere (eg MiFID II) and does not feature in most of the other single market directives.
  • We do not think that equivalence is a reliable solution in the third country scenario outlined: it is granted at entirely at the European Commission’s discretion and can be withdrawn at any time. It therefore is subject to political will, lacks permanence and presents an ongoing legal risk to business continuity.

Reverse solicitation

  • The approach to reverse solicitation (where a fund manager receives an approach from a potential investor, at that investor’s own initiative) and whether or not it comprises ‘marketing’ under AIFMD varies between member states, both in terms of it being recognised as a concept as well as how it is interpreted.
  • Whilst the FCA’s approach is robust and pragmatic and in some cases provides a workable solution: providing that ‘passive marketing’ on a reverse solicitation basis does not constitute ‘marketing’ under AIFMD, and it should be sufficient to rely on an investor confirmation given in advance that it made the approach to the AIFM, provided it is not being used to circumvent AIFMD’s requirements. However, our view is that reverse solicitation is unlikely to be a reliable and practical solution to providing services into the EEA post-Brexit. This is particularly the case given ESMA’s recent messaging around regulatory harmonisation and the EU regulators taking a rigorous and emboldened supervisory approach.

STOP PRESS: FCA issues Final Report from its Asset Management Market Study

On 28 June, the FCA issued the Final Report from its Asset Management Market Study, the culmination of nearly 2 years’ work. The Final Report makes a number of findings and recommendations, many broadly in line with the findings of its Interim Report from November 2016. The findings include the following:

  • The FCA is concerned that there is insufficient competition on price for actively managed retail funds and that an increase in passive funds has not done enough to change this;
  • The FCA is also concerned that some retail funds described as being actively managed are in fact operating more like passive or tracker funds;
  • There needs to be stronger governance within fund managers;
  • Funds should be clearer about their investment objectives, especially when targeting retail investors; and
  • There are concerns about the operation of the investment consulting market, particularly around conflicts of interest and the operation of, and fees for, fiduciary management arrangements.

Managers responding to the Interim Report had asked the FCA to take into account the huge amount of changes that they are already seeking to assimilate into their businesses – including MiFID II, PRIIPs and the anticipated extension of the senior managers and certification regime (SMCR) to investment managers. As an aside, the FCA also confirmed that its consultation on the extension of SMCR will be published “later this year”. Whilst the FCA acknowledged that these measures “will at least partially address” its concerns, a Consultation Paper (CP17/18) was also issued seeking to consult on changes in a number of areas and discussing potential changes in others. Key changes being consulted on include:

  • Seeking to require authorised fund managers to appoint independent directors to make up at least 25% of their board (and being at least two individuals where there are fewer than eight directors);
  • Requiring authorised fund managers to prepare and provide information on how they sought to achieve value for money for investors within the long annual report of their funds; and
  • Preventing authorised fund managers from retaining profits derived from operating a manager’s box.

The deadline for responding to the Consultation Paper is 28 September 2017. The draft rules only apply to managers of authorised funds (such as UCITS, NURSs and QISs) but also contemplate expanding similar requirements to other retail products such as long-term insurance products, pensions products and closed-ended investment companies.

Finally, the FCA also announced that it was rejecting ‘undertakings in lieu’ which had been provided by the three largest investment consultants. Instead, the FCA is still considering the issue of investment consultants and expects to decide on whether it will ask the Competition and Markets Authority to conduct a market investigation in September 2017.

As such, whilst described as the Final Report, it is looking like this is just a fork in the road with further actions, reviews and reports to be expected in due course.

Our Investment Management and Antitrust & Competition teams would be delighted to discuss any aspect of the Asset Management Market Study with you. We hope to see you again in the autumn for the next in our series of Funds First seminars.