Last year, the FCA registered some major limitations in the governance structures, conflicts of interest management and operational controls of UK AFMs (aka ACDs).
In July 2021, the UK Financial Conduct Authority (FCA) published the results of its latest multi-firm review of host authorised fund managers (AFMs), also known as authorised corporate directors (ACDs). The review followed the previous two assessments conducted in 2012 and 2014, and it was initiated after the Neil Woodford scandal and the role of his fund administrator Link Fund Solutions in the collapse of his investment empire.
According to the FCA’s official report, the assessment was conducted between Q4 2019 and Q4 2020 and focused on the effectiveness of AFMs’ governance, controls and monitoring practices in 5 key areas:
• Fully understanding of all their fund responsibilities
• Carrying out adequate internal oversight policies and processes to operate efficiently
• Complying with the Collective Investment Scheme Sourcebook (COLL)
• Managing conflicts of interest in their relationship with investment managers
• Maintaining appropriate resources for the nature and scale of their business
Although this review was dedicated to host AFMs managing UK UCITS funds, the findings are also relevant to in-house AFMs, firms managing non-UCITS funds, and investment managers with sub-delegation arrangements.
Similar to the findings of its previous two assessments, the regulator reported a series of significant failings in AFMs’ due diligence and oversight over 3rd party investment managers and funds, governance procedures, and financial resources and expertise.
AFMs due diligence and oversight over 3rd party investment managers and funds
The FCA’s Principles handbook requires AFMs to meet specific requirements when delegating investment management to a third party (e.g., requirements to have the necessary resource and expertise to monitor delegation arrangements, managing associated risks and ensuring that unitholders are not subject to undue costs and charges). However, most firms in the review had failed to establish and follow an effective due diligence procedure, with many relying on having informal conversations to assess and understand proposals.
In some firms, the regulator noticed an overreliance on delegates having written policies and procedures in place, with little practical observation or testing of how effectively these were implemented in practice and whether they produced good outcomes. Many firms also lacked adequate systems and controls in place to operate the funds before firms submitted applications to the FCA.
In addition, a number of firms showed poor oversight of delegated 3rd party investment managers and a lack of in-depth understanding of investment management activities and investment strategies by key stakeholders.
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AFMs governance and oversight procedures
According to the FCA’s review, a number of host AFMs failed to provide evidence of robust governance and oversight systems and procedures. Some examples included:
• Ineffective board communications – In some cases, minutes of board meetings and discussions did not show effective challenge by independent non-executive directors (INEDs) of, among other things, potential conflicts and their management. In others, it was revealed that decisions had been taken outside formal meetings with little or no discussion or challenge. Most communications also lacked adequate records keeping and consistency, whilst in some cases, risk and conflicts of interest registers were out-of-date static or standalone documents.
• Inadequate approach to managing conflict of interest – The majority of assessed firms have some sort of system for managing conflicts of interest, but they didn’t seem effective. Several host AFMs in the review were unable to demonstrate sufficient evidence that they had identified relevant conflicts of interest despite some appearing obvious.
• Assessment of value – The FCA identified that some firms had agreed with fund sponsors to cut their AFM charges as funds under management grew. While this reflected economies of scale from their AFM operations, it didn’t benefit the fund investors but solely the sponsors through a greater share of an unchanged Ongoing Charges Figure (OCF). This means that many firms are not acting in a way that prevents undue costs to funds and investors.
AFMs financial resources and expertise
The FCA review revealed that several firms operate at relatively low operating margins and did not have appropriate resources, including enough appropriately skilled and experienced people. A number of firms reported fee pressure from their delegates, which means that some host AFMs may not be adequately charging to execute their services effectively.
Also, while all firms had some level of risk management in place, the FCA spotted wide discrepancies in their effectiveness, maturity, coverage, governance and use within the business. Only a few of the assessed firms demonstrated reasonable consideration of a forward-looking approach to risk assessment and how risks may evolve throughout the economic cycle. Failure to adequately identify, assess and mitigate risks affects firms’ overall ability to calculate their financial adequacy.
Conclusion
To remain compliant and meet the FCA’s regulatory requirements, host AFMs should be constantly reviewing their conflicts of interest management, resources and expertise, oversight of funds and delegates, and board governance. Deloitte has summarised the FCA’s key requirements into a quick 7-step good practice checklist:
1) The company is well capitalised
2) The senior management can demonstrate good governance
3) The company is well resourced: systems, staff and expertise
4) Conflicts of interest are identified and controlled
5) Delegated Investment Managers (IMs) are held accountable
6) Decisions are made in the best interest of fund investors
7) The company has a credible wind-down plan
Having an effective internal risk and control management system can significantly facilitate this process. ControlNet is an end-to-end control and risk management software system that allows organisations to manage the controls and risks across all 3 lines of defence: Business line management, Risk management, and Audit.
By digitising the management of internal controls and risks, ControlNet eliminates the need to use inefficient, manual and paper-based systems and processes. Build a strong control and risk environment in a simple, cost-effective and secure way, with ControlNet.
If you want to learn more about how we can help you remain compliant with the FCA’s rising AFM regulation, click here to arrange a brief demo with one of our team.
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