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Outsourcing by asset managers - the FCA's "Dear CEO Letter"

By Alexander Brown, Partner

Simmons & Simmons

Q2 2013


On 11 December 2012, the UK Financial Services Authority (now the Financial Conduct Authority or FCA) sent a letter addressed to “the CEOs of asset managers” (the “Dear CEO Letter”).  In the Dear CEO Letter, the FCA expressed its concerns in relation to the risks associated with outsourcing by asset managers (“firms”) of operational activities to external service providers, a trend which it sees as on the increase, where the external service provider fails to provide service for any reason.

Recent engagement with the FCA has indicated that in addition to its concerns in relation to the risks associated with outsourcing, the FCA is more generally concerned at the inadequate nature of firms’ recovery and resolution plans.  It has therefore suggested that in order to address the concerns set out in the Dear CEO Letter and this more general point, firms should arrange for their Board of Directors to review relevant outsourcing agreements and their whole supply chain to their customers in order to satisfy themselves that there are adequate contingency plans in place for the firm as a whole.  Whilst no specific time limit has been set by the FCA, the FCA expects firms to engage rapidly to address its concerns.

The FCA has referred to “relevant” outsourcing agreements in the Dear CEO Letter.  The FCA is targeting a wide range of outsourcing agreements, but essentially the agreements covered are agreements which outsource regulated activities or activities “critical and important” to regulated activities.  In addition, the FCA refers to firms needing to ensure that their “recovery and resolution plans” are adequate.  Essentially, the FCA is referring to what can be variously described as exit, contingency, resilience or redundancy plans and it is seeking to ensure that measures are in place to address the failure of a service provider to continue providing relevant services as a result of financial distress, operational disruption or stressed market conditions, so in other words issues arising which relate specifically to the service provider, to the impact of a third party on the service provider or the impact of “force majeure” events on the service provider.  All three of these types of events need to be accounted for.

In addition to its general concern about ensuring arrangements with external service providers are in order, the FCA has drawn particular attention to the fact that a number of service providers are part of complex international banking groups and that the number of service providers able to provide these services is quite limited.  The FCA’s concern in respect of the former is that such banking groups may have balance sheet exposure at a group level to other activities which if they fail could have a knock-on effect on the services provided to firms.  The FCA has clearly stated that it does not view such banking groups as “too big to fail”, and so firms should not rely on this as an “adequate plan”.  In addition, on the second point, which the FCA describes as a “concentration risk”, if one service provider were to fail, it may be that there is no capacity to transfer to another provider, and so firms need to consider what to do in these circumstances.

Beyond the above two points, the FCA has expressed reservations about contractual provisions in outsourcing agreements which provide for:

  • the transfer of responsibility to another provider or to take it back in-house on the basis that this process could take too long (particularly where the firm does not have the requisite in-house expertise to take responsibility back in-house) and may not work where the service provider is in financial distress; or
  • step-in rights are being relied on as again the solution may not be sufficiently rapid and there may be difficulties in exercising those rights. 

The FCA is therefore seeking to ensure that firms have in place plans which are reliable, robust and realistic and which clearly define exit measures the firm will put in place.  The FCA considers that some firms have appropriate plans in place, but its own discussions and research have not seen great evidence on this. 

Firms should, therefore:

  • not assume that a banking group will not fail;
  • not assume that a service can be easily and rapidly brought in-house or transferred to another provider;
  • negotiate better contingency plans or move to another service provider; 
  • seek a “dual running” service from another service provider; and/or
  • encourage “ring fencing” of the service divisions of banking groups from other divisions in those groups which have balance sheet exposure to other activities which could impact upon the services provided to firms.

As mentioned above, the FCA has not set a specific time line for carrying out these activities, but it is clear that it expects rapid and effective action to address this concern.  Firms should be encouraged to seek advice on how best to proceed.  This can be obtained either from appropriately experienced legal advisers or from industry bodies such as the Investment Management Association which has set up a Working Group in response to the Dear CEO Letter itself.

alexander.brown@simmons-simmons.com
www.simmons-simmons.com

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