Asset Managers: What is on the exposure horizon?
Although not due to come into effect until 1st January 2022, in this article we discuss the Investment Firm Prudential Regime (‘IFPR’) proposed by the Financial Conduct Authority (‘FCA’) and the emerging exposures faced by asset managers in the UK.
IFPR
Although the UK has now left the European Union, IFPR is broadly based on the EU’s Investment Firms Regulation and Investment Firms Directive. The regime will provide a comprehensive prudential framework for investment firms authorised under rules implementing the Markets in Financial Instruments Directive and governed by the FCA’s Prudential sourcebook for Banks, Building Societies and Investment Firms and Prudential sourcebook for Investment Firms.
The key prudential changes likely to emerge from IFPR include an increase in capital requirements, changes to rules concerning liquidity requirements (with the FCA being able to impose additional capital requirements on individual firms), and potential new environmental, social, and governance (‘ESG’) requirements; all of which could add to the regulatory burden faced by investment firms as well as potentially giving rise to exposures in the future.
Potential exposures faced by investment managers when IFPR comes into effect
Environmental, Social, and Governance (ESG)
There has been a lot of recent commentary on ESG. However, the implications of failing to implement and follow through on a robust ESG strategy should not be underestimated by asset managers.
ESG Representations must be acted on to prevent future claims by both investors and regulators. A term we may see more of in the future is ‘greenwashing’. This is where investment managers are alleged to have mis-sold or ‘greenwashed’ their ESG credentials.
Greenwashing is the process of conveying a false impression or providing misleading information about how a company's products are more environmentally sound.
Claims could stem from ‘greenwashing’ of certain investments/products, or in situations where asset managers fail to ensure that funds which are supposed to follow ESG investment mandates are not in fact environmentally sound, ethical, and socially responsible.
We do not anticipate seeing claims arising from ESG in the near term, but if investment obligations are not met or representations made that are not fulfilled, future claims may arise. These could involve complex litigation (possibly cross-border) and regulatory investigations. Any fallout will no doubt impact the reputation of asset managers. Reputation is key. Asset managers should therefore take careful note of the expectations of UK investors, including but not limited to environmental obligations. In addition, they should note the recommendations made by the Asset Management Taskforce, led by HM Treasury, which include an increased focus on sustainability.
Already cases of investor activism are starting to arise. Last year saw the matter of McVeigh v Retail Employee Superannuation Trust (‘REST’), an Australian case involving a 25-year-old investor who raised the fiduciary duties of the fund’s trustees in relation to climate change. REST agreed as part of a settlement that its trustees had a duty to manage the risks of climate change. The case of McVeigh shows that ESG issues are starting to evolve and, in our view, will come to greater prominence in the future.
Investors now have clear expectations of what action must be taken by asset managers to uphold their stated commitment to diversity and inclusion. Indeed, we have started seeing matters where investors are bringing actions against company directors for failing to meet commitments in relation to race, gender, or sexual orientation. Cases may currently be concentrated against directors; however, similar litigation against trustees who fail to address issues of diversity—not only within their own organisation but in respect of the investment decisions taken—may well follow in due course.
Remuneration
Under IFPR, investment firms will be required to have proper remuneration governance in place, and the FCA expects them to have a policy that complies with the minimum requirements of the remuneration code. Firms will need to develop a remuneration policy that is commensurate with the size, scope, and nature of its activities. This basic remuneration requirement is intended to apply to all employees.
Small and non-interconnected FCA investment firms (‘SNI’) will have to adhere to basic remuneration requirements, whereas additional remuneration requirements will apply to large non-SNI firms.
There has been considerable commentary on the subject of both gender and ethnicity pay gaps in recent years. Whilst the FCA is not proposing that firms will be required to report on such gaps, it is considering the use of reporting on diversity-related data as part of its continuing work in relation to diversity and inclusion. Therefore, although it may not be an immediate requirement in 2022, we foresee this potentially changing in the near future. We also anticipate that investors will expect to see the remuneration policies of asset managers, thereby bringing greater pressure on them not only to ensure they employ from a diverse cross-section of society but that people doing the same job receive equal pay.
Basic liquid assets requirement
Following the unfortunate demise of Neil Woodford’s investment funds, and in particular the alleged mismanagement of the Woodford Equity Income Fund, which collapsed leaving many retail investors incurring substantial losses, there has been an increased focus on liquidity risk and how this is managed by investment firms. The FCA intends to announce new rules for open-ended property funds to deal with the issue of ‘liquidity mismatch’ later this year, but in order to strengthen the protection afforded to investors, it is additionally proposing to include basic liquid asset rules as part of IFPR that will require investment firms to hold liquid assets that are at least equal to the sum of:
- one third of the amount of a firm’s fixed overheads requirement (this is subject to separate IFPR rules); and
- 1.6% of the total amount of any guarantees given to clients by the firm.
It is of significance that this will be first time the FCA has imposed a quantified liquid assets requirement on investment firms, with the stated intention of ensuring they always hold a minimum stock of liquid assets to fund the initial stages of a winding-down process in the event that one is triggered and have adequate financial resources to meet liabilities as they fall due.
Asset managers should be aware that the new rules will specify a list of core liquid assets firms can use to meet the basic liquidity requirements. These are intended to be straightforward liquid assets that an investment firm is likely to hold and do not require any reduction (or ‘haircut’) given the certainty of their value. Examples include physical cash, short-term bank deposits, UK gilts and Treasury bonds, and units or shares in a short-term regulated money market fund. SNI and non-SNI firms that do not have permission to deal on their own account will also be allowed to include trade receivables (including fees and commissions) as core liquid assets. However, it is proposed that trade receivables can only be used to meet up to one third of the liquid asset requirements under IFPR based on fixed overheads (note they cannot be used to meet the guarantee requirement).
Internal Capital Adequacy and Risk Assessment
The basic liquid assets requirement is said to form part of the overall FCA framework that investment firms will need to adopt in order to assess their liquidity needs in future, known as the Internal Capital Adequacy and Risk Assessment (ICARA) process. While a detailed discussion of ICARA is beyond the scope of this article, asset managers must be alert to what the FCA is hoping to achieve by introducing new requirements around capital adequacy and liquidity. Fear among investors of another Woodford scandal, together with the ongoing effect of the COVID pandemic into 2022 and beyond, may well lead to increased redemptions and the winding down of funds, which in turn could potentially expose breaches of liquidity requirements and leave directors facing regulatory action as a result, particularly in the light of risk management responsibilities for IFPR under the Senior Manager and Certification Regime. Firms will be expected to notify the FCA when their level of own funds and/or liquid assets fall below specified intervention points.
ICARA is intended to be the centrepiece of an investment firm’s risk management and will be a continuous process to: identify and mitigate harms; undertake business model assessment, planning, forecasting (including stress-testing); recovery and wind-down planning; and assess the adequacy of own funds and liquidity requirements. The proposals are expected to provide greater transparency around the actions the FCA expects investment firms to take in certain situations.
Liquidity risk has always been an important consideration for asset managers and is likely to be of even greater significance following the implementation of the basic liquid assets requirement and ICARA next year, with increased regulatory scrutiny of what core liquid assets are being held by investment firms to satisfy the new regime.
Conclusion
It is clear that whilst the new capital requirements will be at the forefront of the minds of asset managers in 2022, ESG and remuneration policies are but two of a number of additional key issues that will need to be considered and acted upon going forward. Accordingly, asset managers, brokers and carriers need to be mindful of these sources of potential claims and would be wise to examine the extent to which any claims might emanate.
Asset managers will be well served to consider an overarching objective to reduce such liabilities before they arise, with due diligence and effective implementation of bespoke approaches and procedures around ensuring compliance with the new rules, IFPR framework and possible future regulation on ESG issues.
