AIMA

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Alternative Investment Management Association Representing the global hedge fund industry

Skilled persons reports in the asset management sector

By Tim Boyce, Partner, Financial Markets Litigation; and Lisa Wilkinson, Associate, Financial Markets Litigation

Simmons & Simmons

Q4 2013

 

Skilled persons reports are independent reports by expert third parties to a firm which the Financial Conduct Authority (FCA) or the Prudential Regulation Authority (PRA) may require the firm to commission and pay for, on any matter in connection with the exercise by it of functions conferred on it by or under the FSMA 2000.

Criticised by some observers as “outsourced supervision and enforcement”, skilled persons reports are of increasing importance. The FSA commissioned twice as many in 2012/13 compared with 2008/9 and the FCA and PRA are already continuing that trend. Skilled persons reports are also very time consuming for firms and often very expensive. 

This article summarises the areas where asset management firms can expect to see their regulators deploying skilled persons in the next 12-18 months, explains the regime and then comments on how a firm which is required to appoint a skilled person should handle the process.

 

Regulatory agenda for asset management firms

All regulated firms are now familiar with the FCA’s current approach to monitoring firms – more intensive supervision, wider deployment of thematic reviews and earlier intervention are the key characteristics.

The FCA’s current list of priorities for the asset management sector includes:

  • Anti-money laundering - at the end of October 2013 the FCA launched a new thematic review into AML systems and controls within asset management and platform firms.
  • Conflicts of interest – the FCA recently also announced a thematic review in the sector, followed by a consultation paper in November 2013, focusing in particular on dealing commissions. This followed publication of a paper and “Dear CEO” letter in November 2012, which required firms to confirm that their boards had considered the paper and resolved that their arrangements complied with FCA rules.
  • Fund fee structures - the FCA has expressed concern over increasing use of “hidden” fees and complex charging structures, which are said to exploit consumer behaviours. It has announced that it will undertake a project to highlight those practices in 2013/14.
  • Outsourcing - a contributing factor in a number of enforcement notices, this is now a free standing area of concern for the FCA.  Following thematic visits to 17 asset management firms, the FSA sent a “Dear CEO” letter in December 2012 and this month published its findings in a report.  In the report the FCA said that it would consider further follow up supervisory work in the future.

So a discernible cycle has emerged, which asset managers can expect the FCA to follow as and when these issues crystallise. The cycle begins with a thematic review. It is often preceded or followed by a “Dear CEO or COO” letter, typically requiring some form of attestation as to compliance. Next comes another round of visits, often by specialist teams from the FCA. It is the firms which do not satisfy the FCA’s concerns at this stage which will be vulnerable to being required to appoint a skilled person under s166 FSMA.

This serves to illustrate the obvious point that for any thematic visit, suitably senior officers of a firm with responsibility for the issues in question must be able to convey coherently and convincingly what steps the firm has taken, or processes it has put in place, to address the regulatory concern. Firms will need to bear in mind that the FCA supervisors undertaking a thematic review will have limited time available to satisfy themselves that each firm has done what it needs to. If, in that time, they are not satisfied, then the risk of it sending a “Requirement Notice” under s.166, requiring the firm to appoint a skilled person, will be considerably increased.

Use of s166 has grown in parallel with the recent growth in the intensity of supervision and enforcement (although they are not typically used by the Enforcement Division). FSA statistics show that there are around 110 skilled persons appointments per year in each of the last two years. There was an exceptional increase in the use of s.166 in 2012/2013, for LIBOR.  This in itself indicates a willingness by the FCA to deploy s.166 thematically, as a tool to support consumer redress.  Both the PRA and FCA have said that they will continue to use skilled persons1 and the FCA now operates a centralised s.166 co-ordination team to drive efficiencies into the process.

 

The skilled persons regime

Under s166, the FCA or PRA may by notice in writing given to an authorised person, members of its group, or a partnership of which it is a member require that person to provide it with a report on any matter about which the Authority has required or could require the provision of information or production of documents under s.165 FSMA (s.166(1)).  S.165 is very broad in scope – it permits a request in relation to any matter in connection with the exercise by the FCA/PRA of functions conferred by the Act. The Financial Services Act 2012 has now extended the power to permit the FCA or the PRA to appoint skilled person directly (this is likely only to be used where a firm’s management is dysfunctional or lacking integrity)2.

The Supervision chapter of the FCA Handbook expands on when the FCA will deploy s.166. The FCA may use it for diagnostic or monitoring purposes, or as a preventative measure to limit or reduce identified risks, or for remedial action3. The FCA Handbook also states: “The decision to require a report by a skilled person will normally be prompted by a specific requirement for information, analysis of information, assessment of a situation, expert advice or recommendations or by a decision to seek assurance in relation to a regulatory return4.” Circumstances relating to the firm which the FCA/PRA will have regard to when making a decision whether to require the appointment of a skilled person will include (1) the firm’s attitude and levels of cooperation; (2) the quality of the firm’s records and the regulator’s confidence in them; (3) the firm’s ability to be objective, including the existence of conflicts of interest arising out of any allegations of misconduct; and (4) the firm’s own knowledge and expertise5.

 

The “Requirement Notice”

So if a firm receives a Requirement Notice under s.166, how will the process work? The Requirement Notice will usually be sent in draft at first, and will set out the scope of the report which the FCA requires the firm to provide and the timetable to be followed. The firm must then appoint one or more skilled persons, usually a firm of accountants, or a law firm and sometimes both. The skilled person must be nominated or approved by the FCA6. But, depending on the circumstances, the firm may have some element of choice as to who is appointed (the FCA now operates a panel of skilled persons, for example). 

A key initial phase is the clarification and negotiation of the precise words of the Requirement Notice itself. It may be necessary to explore with the FCA – and the skilled person - precisely what its areas of concern are, if that is not clear from the wording, to ensure that the specific issues under investigation are accurately described, by reference to, for example, specific products and time periods. This can avoid confusion, misunderstanding and expense later in the process. Equally, the FCA is likely to want to include in the Requirement Notice broader ranges of inquiry, for example into the effectiveness of relevant systems and controls operated by the firm.  It may also be necessary to discuss with the FCA staggering the skilled person’s work, where one phase of the inquiry is dependent on the outcome of another.

Skilled persons are sometimes required by the FCA to give a “reasonable assurance” opinion that a firm has complied with a particular rule or has remedied an existing breach. This is a standard to which accountants are used to operating, but such an opinion means that the skilled person is satisfied that it has reduced the risk of reaching a conclusion based on a material error to an acceptably low level. The skilled person is usually required, in its final report, to set out a program of remedial action which it considers the firm should take to address any shortcomings which the investigation identifies (including before it can give “reasonable assurance”.

On more practical points, the Requirement Notice will set out a timetable for the firm to make the appointment and for the skilled person to produce interim and final reports on the matters under investigation.  Again, this will be the subject of discussion, although the FCA is far tougher than it used to be on setting, or moving, deadlines. The FCA will also propose a structure for regular updating calls, often with just the skilled person and then, in a separate call, with the firm, or with both.  The Requirement Notice will provide that the skilled person gives an initial cost estimate, to be updated when exceeded7.

 

Handling a skilled persons appointment

What can a firm do to respond effectively to a skilled person’s appointment and to influence the skilled person’s view of the firm and of the issues? It is critical that the firm grapples with this issue early on, as when the skilled person produces a draft report there will be limited, if any, opportunity for the firm to comment on it, and then will probably be confined to commenting in issues of fact, rather than on conclusions. 

Steps which a firm should consider taking include:

  • Structuring a team, involving senior personnel, Compliance and Legal, to assist the skilled person.  The firm should set up regular briefing calls with the skilled person and ask for updates on the skilled person’s work and conclusions. This may bring key issues, misunderstandings and information gaps to light before the skilled person has reached any firm conclusions.
  • Providing the skilled person with briefing sessions on its business model and explanatory information, documents and flowcharts to illustrate the processes and systems relevant to the key issues under investigation. If well presented, this material is likely to influence the skilled person’s view of the organisation and to form part of its report.
  • Providing a clear briefing to all employees who will encounter the skilled person, so that they all understand the context of any discussions they may have and the importance of co-operation.
  • Appointing an external adviser to shadow the skilled person and, as necessary, to challenge their views. Another benefit of doing this is that the external adviser can provide the skilled person with its own analysis of matters which the skilled person needs to address. If the skilled person disagrees with the adviser’s analysis, the skilled person will need to explain the reasons for its differing view.  Again, this affords the firm another opportunity to test the skilled person’s conclusions.

There is no doubt that the frequency of skilled persons reports in the asset management sector is set to rise. This is an inevitable consequence of the regulatory agenda in the sector. However, by taking some of the steps referred to in this article, firms will be able to minimise the risk that they will receive a Requirement Notice and, if they do, should be able to handle the process as effectively as possible.

 


 

Footnotes

[1] For example - “The PRA continues to make increased use of section 166 reports as a supervisory tool.” (“PRA’s approach to banking supervision”, April 2013); and “We will put the responsibility on firms to do their own monitoring on some of the less important points and to self-attest that they have been addressed.  We will use a number of tools to ensure this happens, such as section 166 skilled person’s reports, internal audit review and non-executive director reports” (Journey to the FCA, October 2012).

[2] Schedule 12 to the Financial Services Act 2012.

[3] SUP 5.3.1G.

[4] SUP 5.3.2G.

[5] SUP 5.3.4G.

[6] S166(4) FSMA 2000.

[7] The total cost to the financial services industry of skilled persons reports annually (ignoring the exceptional costs associated with LIBOR) runs at around £35,000,000, with an average of around £350,000.

 

 

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