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Published 27 enero 2022
Heightened regulatory scrutiny upon the asset management sector is expected to continue throughout 2022, not least because the FCA itself remains under intense pressure from the Treasury Select Committee to complete its action concerning the suspension and closure of the LF Woodford Equity Income Fund.
December 2021 saw the FCA publish the conclusions of long-running enforcement action against GAM International Management Limited (“GIML”) and former fund manager, Tim Haywood, and against BlueCrest Capital Management (UK) LLP (“BlueCrest”).
The underlying issues in all of these cases have long been played out in the press. The FCA will be sensitive to the possible emergence of comparable cases involving other industry players.
We highlight the top ten areas of conduct risk for asset managers in 2022, where if a serious issue crystallises for an asset manager then FCA intervention or enforcement action may well follow. We recommend that firms keep all of these areas under active review.
The dangers of conflicts of interest are an evergreen issue for asset managers. Principle 8 of the FCA’s Principles for Businesses requires that a firm must manage conflicts of interest fairly, both between itself and its customers and between customers. Failure to do so by asset managers has led to enforcement action in the past, notably on conflicts arising from “side by side” management of different funds and mandates.
The front office and senior management are best placed to identify potential conflicts of interest and the FCA will be looking for them to have been fully involved in keeping a firm’s conflicts policy and procedures up to date, rather than leaving this to compliance teams.
In December 2021 the FCA published a Decision Notice setting out its findings that BlueCrest had breached Principle 8 and imposing a fine of £40,806,700. BlueCrest has stated that it intends to challenge the FCA’s decision. From 1 October 2011 BlueCrest had managed an internal fund in which senior partners and other key members of staff had an interest and which was not open to BlueCrest’s external clients, alongside acting as sub-manager to the BlueCrest group’s flagship external client fund.
According to the Decision Notice, without adequate disclosure to investors, individual fund managers were reassigned from managing capital on behalf of the external client fund to focus on the internal fund, with a portion of external fund capital instead being allocated to a Semi-Systematic Capital Unit that managed using a combination of algorithmic processes and manual review and intervention. The Semi-Systematic Capital Unit is said to have performed poorly compared with the fund managers and this was a known issue for BlueCrest staff.
Based on similar facts, in December 2020 the US SEC ordered Jersey company BlueCrest Capital Management Limited to pay $170,000,000 to be used to compensate harmed US investors.
Also in December 2021 the FCA published warning notice statements disclosing an intention to impose a fine of £9.1 million on GIML and £230,037 on Timothy Haywood in agreed settlements. The FCA considers that GIML failed to ensure that its systems and controls for the identification, management and prevention of conflicts of interest operated effectively between 2014 and 2017 and that it actually failed to manage conflicts of interest with customers fairly in respect of certain investments made by its Absolute Return and Long Only team. The FCA noted the significant time and resources GIML had devoted to cooperating with the FCA’s investigation and taking remedial action.
Culture remains a high priority with the financial services regulators, who see poor culture as being at the root of many major compliance failings. The FCA expects firms to have completed their initial work on improving internal culture and will soon be moving to a phase of conducting culture audits on regulated firms, a programme that has been slowed down because of resourcing issues caused by the corona virus pandemic. We expect FCA culture audits may begin in the largest firms during 2022. More recently there has been a specific focus by the financial services regulators on improving diversity and inclusion, to avoid group think and to encourage constructive speaking up. When a serious compliance incident happens in an asset manager the culture within that firm will also be under the FCA’s spotlight.
Introduction of the Senior Manager and Certification Regime has resulted in a very significant increase in the number of internal whistleblows in FCA solo regulated firms and in the number of direct whistleblows to the regulators. This is happening largely because of the heightened awareness amongst Conduct Rules staff of their own personal responsibility to call out wrong-doing. Whistleblows have covered a range of suspected compliance shortcomings and poor conduct, with a sharp increase over the past two years in the number of whistleblows concerning non-financial misconduct. We expect this trend to continue through 2022. It is not just the subject matter of the protected disclosure, whether it be compliance breach or bullying or whatever, that is of concern to the regulator if a whistleblow happens. The FCA is also scrutinising firms’ procedures for handling a whistleblow fairly with appropriate protection to the whistleblower.
The FCA’s 2021/22 business plan highlights market abuse as an area of major focus, with the FCA continuing to allocate significant resource to proactive monitoring of transactions and equity order book data, assessment of Suspicious Transaction and Order Reports (“STORs”) and following up on intelligence from whistleblowers. The FCA has developed a suite of proprietary algorithms to detect manipulative trading strategies. Market manipulation detected in this way has already resulted in FCA enforcement action against the CIO of a hedge fund manager.
The FCA is concerned not just with incidents of suspected market abuse but also with the adequacy of asset managers’ systems and controls to detect and report suspected market abuse. The FCA has already imposed financial penalties on firms on a number of occasions where it found that controls were inadequate, even where no actual market abuse had occurred. Firms are expected to be self-policing and proactively take remedial actions where issues are identified. A failure to do so that comes to the attention of the FCA will make it more likely that a firm is selected for enforcement action. In November 2021 the FCA expressed its concern that firms are still not meeting the requirements for market abuse surveillance, 5 years after the introduction of the EU Market Abuse Regulation (now onshored). In particular, the FCA highlighted trading via web-based interface (UI) portals, matching sessions and ‘pop-ups’ supplementing traditional platforms for rates and fixed income products, where users are not systematically recording order messages preceding execution and orders that do not result in a trade, so that these are not monitored. This means firms may fail to identify manipulative trading behaviours like layer and spoofing. The FCA is also still looking to understand better the mismatch in coverage of STORs submitted by asset managers and the brokers serving them, where it is a not infrequent occurrence for a broker to submit a STOR about an asset managers’ trading when the asset manager itself does not do so.
One of the FCA’s most significant interventions arising from the Asset Management Market study has been the obligation put upon Authorised Fund Managers (“AFMs”), applying since 30 September 2019, to conduct an assessment of whether fees charged by a fund are justified by the value provided to fund investors (Assessment of Value - “AoV”). Minimum considerations to be taken into account in these assessments are set out in FCA rules. Details of the assessments must be reported to investors together with a clear explanation of what action has been or will be taken if firms find that the charges paid by investors are not justified.
In July 2021 the FCA published the outcome of a multi-firm review of how AFMs have carried out the first round of AoVs. The FCA concluded that “Most of the AFMs we reviewed had not implemented AoV arrangements we expect to be necessary to comply with our rules.” Even when firms had good AoV frameworks, the FCA often saw a gap, which firms were unable to explain, between the data being provided by the frameworks and the value conclusions reached by AFM Boards.
The FCA committed to review firms again within 12-18 months of the report, meaning Q2 2022. It said “We will consider other regulatory tools should we find firms are not meeting the standards….”. Those other regulatory tools could include imposing an independent skilled person review under Section 166 Financial Services and Markets Act 2000 or even possible enforcement action. The FCA will expect to see evidence that all AFMs have made efforts to review AoV processes in light of the FCA’s criticisms.
Front office trading controls are another evergreen area of conduct risk, not least because staff turnover means that corporate memory can be short. Breach of trade allocation and best execution rules, trading outside investment guidelines, whether innocent or deliberate, and poor responses when trading errors are discovered present ongoing sources of conduct risk that still crystallise relatively frequently. Now that the Senior Manager and Certification regime applies to asset managers, firms should ensure that their responses to such breaches and remediation work include an appropriate assessment of whether involved individuals have breached the FCA’s Conduct Rules.
The launch of new ESG and sustainable investment funds and strategies is expected to continue apace during 2022. As far as regulated funds are concerned, the FCA has been able to act as gatekeeper on applications for authorisation of new funds in the UK. The FCA is concerned to ensure that funds marketed with a sustainability or ESG focus describe their investment strategies clearly and that any assertions made about their goals are reasonable and substantiated. In a “warning shot” letter to Authorised Fund Manager chairs in July 2021 the FCA expressed the view of fund documents filed with authorisation applications “A number of these have been poorly drafted and have fallen below expectations. They often contain claims that do not bear scrutiny.” The FCA said that it would have expected these deficiencies to have been addressed at the product design stage. “We also expect clear and accurate ongoing disclosures to consumers where funds make ESG-related claims, and we want to see funds deliver on their stated objectives and/or strategy”. With this letter the FCA launched a set of Guiding Principles. Of course, the FCA does not have a gatekeeper role in respect of AIFs and investment strategies with ESG and sustainability objectives offered to professional and institutional investors. Nevertheless it would be wise for their managers and sponsors to bear in mind the Guiding Principles.
From 1 January 2022 the FCA’s rules implementing the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) came into force for the largest asset managers with the requirement to publish annually a TCFD entity level report (setting out how the entity takes climate-related matters into account in managing or administering investments on behalf of clients and consumers) and TCFD product/portfolio reports. For clients being provided with discretionary investment management services and for investors in unauthorised AIFs, there is an obligation to provide “on-demand” reports, the first of which can be requested no earlier than 1 July 2023. The first public disclosures must be made by 30 June 2023 and firms will be working out during 2022 how to meet these requirements in a compliant way. The aim of these disclosures is to reduce the risk of clients engaging firms that do not adequately manage climate-related risk and of consumers buying unsuitable products.
Experimentation in this asset class by institutional investors and their asset managers can be expected to gather pace in 2022, bringing with it not just investment risk around the volatility of these assets but also significant conduct risk which needs to be assessed before such investments are made and appropriately mitigated.
Obviously these are risks that all businesses face. Our experience of working with firms that have faced data theft or operational outages has shown that there are very few cases where firms are let down by technology alone. Most successful cyberattacks, data loss incidents and operational outages have as a root cause an error by a human being, whether it be a failure of governance with poor judgment allowing short cuts in planning and implementing technology change projects, overstretched IT staff failing to patch known vulnerabilities in software in a timely way, through to an individual clicking the link in a phishing email that lets malware into a firm’s systems. This means that this area not just one of operational risk but also of conduct risk.
As at January 2022 we still await the outcome of the FCA’s investigation into the circumstances leading to the suspension and closure of the LF Woodford Equity Income Fund, which allegedly breached or may have wrongly circumvented the limits on exposure to unlisted securities prescribed by the EU UCITS Directive. As long as this issue is open, the FCA will remain highly sensitive to the possibility of comparable cases emerging and so will continue to look closely at this area in supervisory interactions with managers and depositaries of UCITS funds.
In a new development, on 20 January 2022 the European Securities and Markets Authority announced a “common supervisory action” with EU national regulators to assess the compliance of UCITS funds and open-ended alternative investment funds with the valuation requirements of the UCITS and Alternative Investment Fund Managers Directive frameworks, focusing upon the valuation of less liquid assets to ensure that they are valued fairly both during normal and stressed market conditions. UK based managers of EU based UCITS and Alternative Investment Funds can be expect to be called upon to participate in this exercise, whether directly or via lead managers, during 2022 and this may uncover valuation practices to which the regulators object. It would be wise, therefore, to review valuation practices now, ahead of being called upon to provide information.
Over the past several years the FCA has highlighted the conduct risks inherent in the transition away from the use of LIBOR as a benchmark rate. For asset managers, if the transition has not been handled well this can manifest in value lost for underlying portfolios. The three main areas of exposure for asset managers are LIBOR based products in portfolios, use of LIBOR as a performance target for funds or mandates and critical models underpinning operations and administration using LIBOR as an input, such as pricing, valuation and risk models. The FCA will react to emerging issues and at some point can be expected to conduct a multi-firm review of the transition process. Firms should ensure that their LIBOR exposures have been fully assessed and appropriate steps to transition away taken.
Our financial services regulatory team, working with our other legal experts as appropriate, can provide firms with rapid diagnostic assessments where a conduct risk issue arises and ongoing legal support. We can also provide external review and assurance whether the FCA’s requirements have been met.
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