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The FSA’s “Dear CEO” letter on outsourcing: what should asset managers be doing?

Tom Wheadon, Partner, and Lawrence Brown, Managing Associate

Simmons & Simmons

Q1 2014

Introduction

On 11 December 2012, the Financial Services Authority (FSA) (now the Financial Conduct Authority (FCA)) issued a “Dear CEO” letter in which it raised its concerns that many asset managers do not have in place adequate recovery and resolution plans in relation to the functions which they outsource to suppliers (the “Dear CEO Letter”).

Just over a year on from the Dear CEO Letter, it remains difficult to determine the precise level of engagement which has taken place by asset managers in relation to the concerns raised. While there has been significant visible industry-level engagement and some asset managers have sensibly drawn together cross-disciplinary teams to ensure that they would readily be in a position to satisfy the FCA should they be the subject of a further review, in our experience not all asset managers have engaged to the same extent. In our view, failing to respond substantively to the issues raised is the wrong approach.

The purpose of this article is to:

  • provide an overview of the FCA’s concerns;
  • summarise the activity which has taken place to date in the asset management industry in relation to the Dear CEO Letter;
  • comment on the current state of play, including the risk of further supervisory and enforcement action (based on lifecycles following other recent FCA review activity); and
  • make recommendations as to what asset managers should be doing now.

The FCA’s concerns – an overview

The Dear CEO Letter followed an FCA “resilience review” of 17 asset management firms, which started in April 2012. According to the FCA’s Thematic Review Report (TR13/10) “Outsourcing in the Asset Management Industry” which was published in November 2013 (the “FCA Report”), the firms reviewed represented a diverse range of asset managers of varying sizes, ownership structures and business models.

The Dear CEO Letter states that:

  • the FCA is concerned that, in relation to outsourcings that are “in scope” (i.e. supply arrangements relating to the outsourcing of regulated activities or activities which are “critical or important” to such activities), asset managers do not have adequate “recovery and resolution” plans in place. As a result, they would not be able to perform critical or important regulated activities if their suppliers face financial distress or severe operational disruption, thereby causing detriment to customers;
  • the FCA is concerned in particular that asset managers are often over-reliant on the fact that their suppliers form part of large financial institutions which asset managers regard as “too big to fail”; and
  • contractual remedies which are designed to protect asset managers where their suppliers face financial distress or severe operational disruption, such as “step-in” rights and exit and handover provisions (i.e. which relate to how a service may be taken back in-house or transferred to another supplier) may look good on paper but are not viable, robust or realistic. In other words, either they could not readily be implemented in the full range of scenarios that may occur or, if they could, they would not robustly address the risk to customers.

The Dear CEO Letter cites the FCA’s SYSC 8 rules on outsourcing. The SYSC 8 rules set out certain conditions that “common platform firms” must meet when outsourcing “critical or important” activities. These conditions relate both to provisions that relevant entities must include in their outsourcing agreements and to the steps that they must take internally in relation to outsourcings. It is worth noting that “common platform firms” are also subject to SYSC 4, which requires them to implement their own business continuity plans, which would need to take into account supply arrangements that are not subject to SYSC 8.

Asset managers which are subject to the Alternative Investment Fund Managers Directive (Directive 2011/61/EU) may not be subject to the SYSC rules (although, as the FCA notes in the FCA Report, “AIFM investment firms” which are “full-scope UK AIFMs” will continue to be subject to the rules in respect of their “MiFID business”), and will be subject to the FUND rules on delegation. Also, in some instances, the structuring of an asset management business will mean that suppliers are appointed by the funds which the asset manager manages (which are not subject to the SYSC 8 rules). Accordingly, it may be the case that, upon a strict interpretation of the law and regulation, some asset managers need take no action in relation to the Dear CEO Letter. However, taken in the broader context of the FCA’s customer protection agenda, and without losing sight of the fact that “well-run” outsourcing arrangements benefit asset managers and their customers, asset managers would be well-advised to consider carefully what steps they should be taking to address the FCA’s concerns in any event.

Industry activity

There has been an impressive level of visible activity within the asset management industry. Industry associations such as the Investment Management Association (the “IMA”) have brought together groups of asset managers and suppliers in workshops with a view to tackling the issues raised by the FCA. Perhaps the most prominent industry group was the Outsourcing Working Group (the “OWG”). The OWG comprised a mixture of suppliers, asset managers and the IMA (whose workstreams were facilitated by the “Big Four” consultancy firms, Deloitte, EY, KPMG and PWC) and has led the thinking on the issues raised, focusing on oversight of suppliers, exit planning and standardisation.

The OWG’s report (“An industry response to the FSA’s Dear CEO Letter on Outsourcing”), which was published on 9 December 2013 (the “OWG Report”) is a detailed and helpful document, which sets out a number of “guiding principles”. The FCA states in the FCA Report that these “guiding principles” should be taken into account by asset managers, where applicable.

However, the OWG Report is not, as the OWG Report acknowledges, a “checklist” for all asset managers as each has its own business model. Also, the OWG Report expressly does not address the scenario where an asset manager is required to quickly implement a migration from one supplier to another (or to the asset manager itself) over a weekend or similar period. The OWG Report acknowledges that this remains a core concern of the FCA. As such, the onus remains on asset managers to consider the risks associated with their own business models and put in place exit plans and other measures which are viable, robust and realistic to address the issues raised by the FCA, such that should a supplier fail an exit plan comes into effect, whether that leads to a replacement service being provided immediately or, where such would be a “reasonable” response to the FCA’s concern, a process beginning which will ultimately lead to moving to one or more new suppliers taking over from the failed supplier.

The FCA has indicated in the FCA Report that it has been “encouraged” by the level of visible industry activity but that it remains to be convinced that all asset managers have engaged sufficiently in relation to addressing the issues raised.

Current state of play

Based on enforcement lifecycles associated with other recent FCA reviews (and having regard to a recent Financial Times article, “Crackdown by UK watchdog raises alarm”, dated 07 October 2013, which reported how the FCA has set up its first asset management supervisory team, made up of more than 50 employees), asset managers can expect further FCA visits on, inter alia, the topic of outsourcing. From a timing perspective, these can be expected in the first half of 2014. In relation to client money, for example, the FCA followed up its “Dear CEO” letter of January 2010 with firm visits in early 2011.

If the FCA visits an asset manager and enquires about its response to this issue, the asset manager will have a limited window to assure the FCA that it is compliant with relevant rules and has addressed the FCA’s concerns (asset managers may see fit to distribute “red folders” on the topic to relevant members of senior management, and train them appropriately on their contents, so as to be better able to do so). Should an asset manager fail to do so, it could be subject to a range of sanctions, including the requirement to appoint a skilled person under section 166 of the Financial Services and Markets Act 2000. The cost of making this appointment alone is likely to run well into the hundreds of thousands of pounds. In addition, the requirement to co-operate with and field queries from the skilled person draws substantially upon senior legal and management resource.

Recommendations for action

To prepare for an FCA visit which raises this issue, asset managers should not delay in ensuring that they carry out the following (whether through internal or hired external resources):

  • Oversight: Asset managers should “know their outsourcings” (what is outsourced, to whom, for how long, the technology used and the locations from where services are provided, among other matters). The one-off step of compiling this information is not sufficient; asset managers should maintain a skilled and sufficient internal resource to regularly review supplier performance (ensuring that supplier inputs and outputs are actively interrogated, and not “taken as read”) and meet suppliers.
  • Review of agreements: In our experience a number of asset managers have entered into outsourcing agreements based on supplier templates. Understandably, these forms of agreement commonly give little consideration to the issues raised by the FCA. For instance, they may include limited governance, audit or exit plan provisions. Asset managers should take steps to identify any gaps. In our experience, many suppliers are ready to engage with their customers to help to address the FCA’s concerns and so it is worth contacting them with any concerns.
  • Amendments to asset manager’s own business continuity plans: The entire supply chain relating to the delivery of services to customers should be considered by asset managers, including the impact of supplier (and internal) failures on customers. Accordingly, asset managers should ensure that their business continuity plans are viable, robust and realistic and factor in linkages with suppliers appropriately.
  • Proportionality: As mentioned above, it is incumbent upon asset managers to consider the continuity issues arising from their own business models rather than assuming there are industry norms that will apply. As part of this, asset managers may wish to engage with industry groups to develop appropriate solutions.

Conclusion

Asset managers should act now to address the concerns raised by the FCA in the Dear CEO Letter, including by setting up a cross-disciplinary team including legal, compliance, risk and operations personnel. While the FCA has indicated in the FCA Report that it has been “encouraged” by the industry-led work which has been carried out, it remains to be satisfied that all asset managers are compliant with its requirements. FCA visits are likely to be imminent and asset managers should ensure that they are well-prepared – and have taken put in place robust, viable, realistic and proportionate measures in relation to the issues raised - to avoid expensive and time-consuming supervisory and enforcement action.

A microsite setting out the details of core materials relating to the Dear CEO Letter is available here.

 

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