By Michelle Moran and John Young

The Financial Conduct Authority (“FCA”) has published its final policy statement on implementation of the revised EU Markets in Financial Instruments Directive (“MiFID II”), which takes effect in the EU in January 2018.

The statement includes some significant policy decisions by the FCA, affecting the impact of MiFID II on UK asset managers. The key decisions are as follows.

Inducements in relation to research

MiFID II introduces a requirement for full “unbundling” of investment research received from brokers from dealing commission, requiring separate payment for investment research. As expected, the FCA will apply these rules more widely to collective portfolio managers that are not subject to MiFID II, and not only to investment firms that are subject to MiFID II by virtue of conducting activities such as segregated account management. The FCA has also clarified that the requirement on brokers to price research and other services separately will apply to all services performed by MiFID investment firms. It also gives limited guidance on other aspects of this part of MiFID II, such that the transfer of research charges into a “research payment account” should take place within 30 calendar days, and that a limited trial period for a research service could constitute an acceptable minor non-monetary benefit. The FCA also gives its view that a MiFID firm could accept transaction reporting offered by a broker as part of the execution service provided to its clients, provided it does not influence best execution and is offered as a standard term of business by the broker. In response to industry lobbying on the impact of the MiFID II reforms on firms that receive research from US broker-dealers (in particular, as to whether US broker dealers are willing to receive separate payments for research due to restrictions under the Investment Advisors Act), the FCA makes a limited comment – that it understands that US brokers are in discussions with the SEC in the US to explore the potential for arrangements that would allow US broker-dealers to accept research payments by EU firms, that it is not yet clear whether this will provide a solution, and that the FCA will continue to monitor the situation and provide an update in due course. This should allow the industry to collectively gather thoughts on best practices to comply these provisions.

Client categorisation

One key change under MiFID II is the regulatory treatment of local authorities as clients. MiFID II classifies local authorities as retail clients, meaning that they will need to opt up if they want to be treated as professional clients. The FCA recognises that, in practice, most larger local authorities (in respect of their both treasury management and pension funds) wish to be opted-up. As the opt-up has been mainly performed on individuals to date, many firms asked the FCA to clarify how various aspects of the test (such as an assessment of the client’s expertise and experience) would apply to a local authority. The FCA provides some indication of how firms perform this test, such as by taking “a collective view of the expertise, experience and knowledge of committee members”, and, in relation to the criterion that the client has worked in the financial sector for at least one year in a professional position, the FCA clarifies that this should be applied to “the person authorised to carry out transactions on behalf of the client works or has worked in the financial sector for at least one year in a professional position”. For local government pension schemes, the FCA adds a new criterion as part of the test, which is that the client is subject to the Local Government Pension Scheme Regulation for their pension business. In relation to the portfolio size threshold criterion for the opt-up, the FCA has set this at £10 million (and confirms that firms cannot combine the local authority’s own assets with its pension scheme assets for this purpose).

Best execution

Contrary to its earlier proposal, the FCA will not apply the new best execution rules in MiFID II to asset managers authorised under the Alternative Investment Fund Managers Directive (AIFMs), citing the “diversity in nature and scale of this set of firms” and respondents’ concerns about applying these obligations to certain types of business models. The FCA is also mindful of the planned review of the AIFMD over the next two years, which may well incorporate aspects of the MiFID II regime into a revised version of AIFMD. In an interesting policy distinction, the FCA has decided to apply the changes to best execution rules to UCITS managers, in view of the investor protection and market integrity benefits.

Telephone taping

MiFID II revises the requirement on firms to record internal and external telephone conversations. In its earlier consultation, the FCA signalled its intent to apply this requirement to firms carrying out corporate finance business (that are generally exempt from MiFID) and to portfolio managers widely. In response to concerns raised on the very broad scope of the proposal, the FCA announced that it will only apply the obligation to communications during corporate finance business that would be in scope of the MiFID requirement – in other words, only insofar as they result in (or that are intended to result in) transactions concluded when dealing on own account and the provision of client order services that relate to the reception, transmission and execution of client orders. The FCA gives examples of relevant conversations. In relation to portfolio managers, the FCA confirmed that it will remove the current exemption for portfolio managers (given the FCA’s difficulty to date in market abuse investigations in relying on sell-side records) and gives its views on the scope of the obligation, stating that the focus of the regime is on the transactional side of portfolio management, where conversations that relate to transactions undertaken are required to be recorded. In both cases, considerable work will be required by firms to ensure that in-scope conversations are recorded and retained. For private equity managers, the FCA helpfully clarifies that telephone taping only applies to MiFID financial instruments – unlisted equity and loans will generally be outside the scope of MiFID.

By Michelle Moran and John Young

The Financial Conduct Authority (“FCA”) published today its final report on its asset management market study.

The report is the culmination of almost two years’ work on the UK asset management sector by the FCA, focussing on matters such as weak price competition amongst asset managers (particularly in the active retail sector), perceived high profitability, price clustering for asset management fees and a lack of customer focus on fund charges.

The Final Report sets out the FCA’s conclusions on its work, and the FCA will now focus on specific remedies. Because remedies will be the subject of various future consultations, there are no immediate rule changes, although the FCA includes a Consultation Paper (CP 17/18) to set out its proposed specific new rules on a number of areas covered in the final report.

The FCA’s work mainly impacts retail fund managers that are established in the UK. Alternative investment fund managers are not directly impacted. Retail fund managers that are established in EEA jurisdictions outside the UK (such as Luxembourg and Ireland) are also not directly impacted, including those that operate in the UK by exercising passport rights.

The FCA’s proposals are as follows.

Fund governance and asset manager duties

To address its criticism that fund governance bodies are not independent from the fund manager and do not appear to challenge “value for money” on behalf of investors, the FCA will consult on new rules for authorised fund managers (“AFMs”) of UK authorised funds. The FCA proposes to require AFMs to appoint a minimum of two individuals, and at least 25% of the total board, as independent directors on the board. An independent chair will not be required this is a matter for the AFM to decide. In its accompanying Consultation Paper, the FCA sets out its requirements for directors to be sufficiently independent to serve on the board, such as that a board member cannot be an employee of the AFM, or a recent employee, or remunerated by the AFM for any other role. The FCA also sets out the factors that the AFM board should consider as to whether value for money has been provided to fund investors, taking into account matters such as whether economies of scale are shared with retail investors, the criteria to assess the manager’s performance, and whether the fund management fee and other charges are reasonable (compared to other similar products, or comparable institutional client accounts). AFMs will be required to publish an annual report on this assessment and the actions they have taken to discharge this responsibility. This is a significant development in fund governance.

There are interesting parallels here with the requirement under the US Investment Company Act of 1940 that at least 40% of a US mutual fund’s board of directors not be “interested persons” of the fund. That Act sets out strict conditions for assessing a director’s independence, and, in practice, independent directors represent a majority, and frequently more than 75%, of many board of US investment companies. There are also similarities between the factors that the FCA sets out for the board’s consideration and the factors that must be addressed in shareholder reports for US mutual funds regarding the board’s considerations in performing its annual review of the fund’s investment advisory contract, including approval of the advisory fee, the extent to which economies of scale are realized as the fund grows and comparisons of the advisory fee with that paid under other advisory contracts.”

Separately, the FCA will apply its Senior Managers Regime to all authorised firms in 2018. This regime is to ensure better accountability of senior individuals in firms for their decisions and conduct. Under the regime, firms must allocate applicable responsibilities to relevant senior managers to ensure that there is an individual accountable for all aspects of regulated activity in the firm and, therefore, liable, if the regulator can show that the individual did not take “reasonable steps” to prevent misconduct. To increase the effectiveness of fund boards, the FCA proposes to introduce a new “Prescribed Responsibility” under the regime to ensure that asset managers act in the best interests of investors, including assessing value for money, and to allocate this responsibility to the chair of the AFM board.

These rule changes will also apply to UK UCITS managers, but not EEA UCITS managers that are accessing the UK market through the passport. The FCA points out that the main UCITS jurisdictions of Luxembourg and Ireland have introduced “comparable fund governance proposals over recent years, including independence requirements”, but these arguably do not go as far as the FCA’s requirement for two independent directors at the manager level and for the board to challenge the value for money provided by the fund’s service providers.

Fund objectives, benchmarks and performance

The FCA has earlier expressed concerns on whether investors understand the investment objectives that the fund indicates it will meet, and whether investors can in practice assess that the fund is performing against its objectives. The FCA has also raised concerns on possible investor confusion as to whether a benchmark is being used for comparison or management purposes, and the degree to which a fund’s strategy is linked to a benchmark. In its 2016 interim report, the FCA considered requiring a benchmark for all funds, allowing investors to track performance against the benchmark over time.

At this stage, the FCA does not propose any specific rules changes in this area, but will carry out further work to require managers to be more specific when describing the fund’s objective (focussing on the language used) and to ensure that managers track performance of the objective over time, including against any benchmark. The FCA will chair a working group on this subject before considering any rule changes.

The FCA does not “currently” think that all funds should have a benchmark, but will consult on rules and guidance that will require managers to be clear about why a benchmark has been used, and require that the use of benchmarks is consistent across marketing materials. Where a fund does not set a benchmark, the FCA will consult on introducing a new requirement that the fund explains the reasons for this to investors.

The presentation of past performance information is already governed by rules in the UCITS Directive and the Markets in Financial Instruments Directive (“MiFID”). As an overlay to these rules, the FCA will consult on new requirements to clarify that, when AFMs present past performance, they must do so against the “most ambitious target” communicated to investors. For example, where an absolute return fund’s most ambitious target is LIBOR +4%, the effect of the proposed new rule will be to make clear that, where the AFM displays the fund’s past performance, it must show the past performance against LIBOR +4%, and not against LIBOR alone.

The FCA has separately raised concerns that investors do not switch away from funds with long-term under-performance. The FCA found that “self-correction” by the industry, such as the closure or merging of under-performing funds, is effective to a degree. However, in light of its proposals for funds to better clarify their objectives and their use of benchmarks, the FCA will not take any further actions to “shine a light” on persistently poorly performing funds.

Transparency of fees and charges and treatment of fund performance fees

The FCA reiterated its concerns in the report that investors do not pay sufficient attention to fund charges or understand what they represent. The FCA acknowledges that the new disclosure requirements under MiFID II and the forthcoming PRIIPs Regulation (as from January 2018) will require firms to provide aggregated and on-going information on all costs associated with a fund (including underlying transaction costs), in particular requiring firms to show all costs as a single figure in monetary and percentage terms. The FCA considers that these EU-wide requirements will substantially address its concerns on greater clarity on charges. In light of this, the FCA will concentrate on improving the effectiveness of disclosure, focussing on matters such as formatting and prominence. It is helpful that the FCA acknowledges that the industry is doing much to bolster its efforts to increase transparency, whilst also allowing the time required to see how MiFID II will affect such measures.

The FCA makes some significant comments on funds’ use of performance fees. Under current rules, funds may charge a performance fee, but there are no particular rules on how it is operated, other than that the fee must not be unfair to unitholders. The FCA is considering consulting on new rules to permit performance fees to be charged only above the “most ambitious target” that the fund holds out to investors, and only above the “most ambitious target” after deduction of ongoing fees. There is some lack of clarity on what is meant by the “most ambitious target”, and there is the possibility that firms will stop publishing any such target in response to the new rule. The FCA also refers to consulting on a possible requirement that losses should be offset before further performance fees are charged (a high water mark, which is currently the norm), and will consider more generally whether additional policy action is required to make UK funds’ performance fees more equitable, considering “asymmetric fees” that do not align investor and manager incentives.

In relation to disclosure to institutional investors, the FCA acknowledges that MiFID II requirements mean that firms should provide accurate information on costs and charges. The FCA wants to encourage a standardised template for this disclosure, and will convene a group of stakeholders to take this forward.

Box management practices

Currently, fund managers may operate a “manager’s box”, which is a mechanism for the manager (as principal) to deal with investors in units in a fund and to match transactions between buying and redeeming investors, with the opportunity to make a profit when buying and selling units. There is currently no rule that explicitly prohibits managers from retaining profits from box management, and the FCA’s concern is that some managers may profit unfairly, this practice, although acknowledges that this is not a widespread norm.

The FCA proposes new rules to require AFMs to pass “risk-free” box profits to the fund and to disclose their policy on operating a manager’s box, and how any profits will be treated. The FCA notes that firms have already appeared to be changing their practice in this area, following publication of its interim report in 2016.

Retail investors switching share classes

The FCA has raised the concern that some retail investors continue to hold more expensive share classes, where, post-FCA 2012 Retail Distribution Review (“RDR”), cheaper “clean” share classes (which do not attract trail commission) are available. Some of these share classes continue to pay trail commission to financial advisers who acted as intermediaries for sales, which is permitted for products sold prior to RDR coming into effect. The FCA points out that in practice investors may not know that they are still paying trail commission, and that some managers are unwilling to stop the payment of trail commission. However, in the report, the FCA does not propose any immediate restriction on the continued payment of trail commission to financial advisers (and is mindful of the impact if it did on small and retired advisors). As an interim measure, the FCA is asking for evidence of scale and investor harm and refers to “future policy work in this area”.

The FCA has also stated that, where firms create new share classes, they find it difficult to switch investors to the cheaper share class – primarily because investor consent is required. The FCA has already published guidance (FG 14/4) on changing customers to post-RDR unit classes. As a further step, the FCA will clarify that an AFM can undertake a mandatory conversion of share classes for unitholders, subject to the conditions outlined in its earlier guidance (such as prior notification to the investor).

Further FCA work on competition in retail distribution

Fund distribution “platforms” are responsible for a significant part of retail fund distribution in the UK. In its report, the FCA considers the impact of platforms on fund charges and the total cost of investment, and the barriers that platforms may create to managers gaining routes to market. The FCA states that, since the RDR, distribution costs and intermediary fees have increased, and are often in excess of fund manager fees. In light of the dominance of a small number of such platforms, and a perceived lack of competition in the market, the FCA has announced that it will undertake a market study on investment platforms, to consider how “direct to consumer” and intermediated investment platforms compete to win new and retain existing customers, and to explore whether platforms enable investors to access products that offer the best value for money. This will be a significant new piece of work for the FCA.

Institutional investors and investment consultants

The FCA is mindful that smaller pension schemes have fewer resources to monitor performance of their asset managers, and wants to encourage economies of scale through pooling of their assets. The FCA will not make asset pooling mandatory for defined contribution or defined benefit pension schemes, but recommends that the relevant government department continues to explore how to remove barriers to pension scheme consolidation and pooling.

The FCA has paid particular focus on the competition aspects of the investment consulting market, defined as firms that provide investment advisory services (such as strategic asset allocation and manager selection) to institutional investors and advice to employers on pension schemes. In its 2016 interim report, the FCA made a provisional decision to make a market investigation reference of investment consultants to the Competition and Markets Authority (“CMA”). This was prompted by the FCA’s findings of “high levels of concentration and stable market share amongst investment consultants”, and perceived conflicts of interest in some of their activities.

In response, the three largest investment consultants provided undertakings in lieu of the reference – a mechanism to resolve the FCA’s concerns as an alternative to a reference to the CMA. In its final report, the FCA states that it is proposing to reject these undertakings, is seeking views from other interested parties on this proposal and expects to make a final decision on whether to make a market investigation reference to the CMA in September 2017. The FCA also recommends that the Treasury brings advice given by investment consultants on strategic asset allocation, and advice given by employee benefit consultants to employers on establishment of pension schemes, into the regulatory perimeter, allowing the FCA to supervise the quality and independence of advice given.

Extending the proposals to other retail investment products

The FCA’s study focussed on the market for retail investors that invest through funds and segregated mandates. It did not cover economically similar products such as unit-linked insurance products and investment trusts, which are not FCA-authorised in their own right. In the FCA’s view, and mindful of possible regulatory arbitrage, customers that invest through unit-linked or with-profits life assurance products would also benefit from the protections proposed for authorised funds, and the FCA invites views on extending the new governance rules to these types of products. The FCA also asks for views on introducing similar rules to investment trusts.

By Nigel Farr, Tim West and Nish Dissanayake

On 28 June 2017, the FCA published its highly anticipated final findings of its Asset Management Market Study (“Final Report“), which can be accessed here. This follows the release of its interim report in November 2016 and the subsequent intensive consultation process with industry which involved 153 submissions.

Key Findings of the Final Report

The Final Report broadly confirms the key findings set out in the interim report, outlining:

• Lack of Price Competition:The FCA considers that price competition remains weak in a number of areas of the asset management industry. In its additional work following the interim report, the FCA found that the pricing of segregated mandates typically offered to larger institutional investors tended to fall as the size of the mandate increases, but that such lower prices were not available for equivalently sized retail funds.
• Variable Performance:The FCA found substantial variation in performance and that, on average, both actively managed and passively managed funds did not outperform their own benchmarks after fees. While the FCA recognised that some investors may choose to invest in funds with higher charges in the expectation of achieving higher future returns, in its further analysis, the FCA found that there is no clear relationship between such charges and the gross performance of retail active funds in the UK.
• Clarity of objectives and charges:The FCA remains concerned about how asset managers communicate their objectives to clients and that investors’ awareness and focus on charges is mixed and often poor.
• Investment Consulting and other intermediaries:The FCA remains concerned about the investment consulting market with there being relatively high and stable market shares for the three largest providers, a weak demand side, relatively low switching levels and conflicts of interest. The FCA found that retail investors do not benefit from economies of scale when pooling their money together through direct-to-consumer platforms and noted that it has concerns about the value retail intermediaries provide.

FCA’s Proposed Remedies

The FCA has put forward a series of proposed remedies that it intends to dovetail with other forthcoming legislative change (such as MiFID II, PRIIPs and the Senior Managers and Certification Regime). In summary, the FCA’s proposed remedies can be categorised as follows:

1. Increase investor protection

• Strengthen the duty on fund managers to act in the best interests of investors and use the Senior Managers and Certification Regime to bring individual focus and accountability, in particular by introducing a new Prescribed Responsibility to act in the best interests of investors including a consideration of value for money
• Consult on proposals to introduce a minimum level of independence in governance structures
• Consult on requiring fund managers to return any risk-free box profits to the fund and disclose box management practices to investors
• Introduce technical changes to improve fairness around the management of share classes and the way in which fund managers profit from investors buying and selling their funds

2. Drive competitive pressure on asset managers

• Support the disclosure of a single, all-in-fee to investors
• Support consistent and standardised disclosure of costs and charges to institutional investors
• Recommend that the Department for Work and Pensions remove barriers to pension scheme consolidation and pooling
• Chair a working group to focus on improving the usefulness of fund objectives and consult on how benchmarks are used and performance is presented

3. Improve the effectiveness of intermediaries

• Commence a market study into investment platforms
• Seek viewsfrom interested parties on the FCA’s proposal to reject the undertakings provided by the three largest investment consultants (which were provided in lieu of a market investigation reference to the Competition and Markets Authority regarding the institutional advice market)
• Recommend that HM Treasury considers bringing investment consultants into the FCA’s regulatory perimeter

Next Steps

The FCA has indicated that implementation of the remedies will take place in a number of stages, with some proposed remedies requiring more consultation than others. These matters are central to the UK asset management industry and will be of keen interest to all in the industry. We would encourage readers to actively participate in the consultation process; responses to the first consultation relating to governance, box management and share class switching are due by 28 September 2017. The FCA also expects to make a final decision on whether to make a market investigation reference regarding investment consultancy services in September 2017.

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.

Equivalence

• 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.