The delegation of investment management functions by UCITS management companies and alternative investment fund managers (collectively referred to as "mancos" in this blog) has attracted increased scrutiny by EU regulators in the context of Brexit. In July 2017, the European Securities and Markets Authority (ESMA) published an opinion which set out supervisory expectations for EU mancos delegating investment management functions, including to non-EU entities. EU regulators such as the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg and the Central Bank of Ireland (CBI) have responded by affirming local requirements. ESMA also set up a Supervisory Coordination Network to discuss concrete cases of relocation from the UK to the EU to foster a common supervisory approach on issues such as delegation.
In parallel, the UK Financial Conduct Authority (FCA) has set out concerns about UK mancos lacking independence from the fund manager they delegate to, and has published new requirements for independent directors on boards of UK mancos which manage authorised funds. Many of the FCA's concerns are similar to those highlighted by ESMA.
In the context of increased regulatory scrutiny on delegation, this blog discusses what regulators are concerned about and what firms can expect from supervisors.
What did ESMA's opinion tell us?
ESMA's opinion set out a number of areas where EU supervisors are likely to increase their scrutiny:
- Objective reasons for delegation: ESMA's opinion states that delegation to non-EU entities could make oversight and supervision of the delegated functions more difficult; consequently, national competent authorities (NCAs) should give special consideration to such arrangements to be satisfied that they are justified by objective reasons. In addition, where EU mancos delegate to a larger extent to non-EU delegates with respect to funds investing in EU assets, NCAs should require detailed information and evidence on why this is objectively justified even though the geographical spread of investments serves as an argument against such a delegation structure. Overall, while there is no prohibition on delegating to non-EU entities, the onus is on firms to demonstrate that their arrangements have objective reasons (rather than being intended to exploit any regulatory arbitrage) and there is a presumption that delegating outside the EU may create additional risks. Funds investing predominantly in EU assets can expect greater scrutiny, so firms managing funds that invest in a mixture of EU and non-EU European assets may need to consider the balance of their portfolios.
- Resources in the EU: ESMA states that:
- EU mancos should demonstrate that they dedicate sufficient human and technical resources to the selection and ongoing monitoring of delegates, which should include regular on-site visits;
- NCAs should apply additional scrutiny to situations where relocating entities do not dedicate at least three locally based full-time equivalent staff, including time commitments at both senior management and staff level, to portfolio management functions and/or monitoring of delegates; and that
- EU mancos should not delegate investment management functions for a particular fund to an extent that exceeds by a substantial margin those functions performed internally1.
Overall, there is a clear expectation that EU mancos must be able to demonstrate that they are resourced and equipped to oversee delegates effectively. We are likely to see increased supervisory pressure in this area, particularly when a firm is setting up a new EU manco or when a firm's business grows substantially.
- Independent oversight: ESMA states that firms should carry out due diligence on the delegate, including analysing potential conflicts of interest, and be able to justify why their delegate is the most suitable to perform the functions. In practice, mancos may have poor incentives to monitor their delegates effectively, either because the delegate is part of the same group as the manco or because the delegate is a client of the manco (see section on "What are the FCA's concerns" for more detail). Firms will need to ensure that they can demonstrate sufficient independent oversight and challenge of their delegates. In addition, ESMA states that mancos should have contingency plans in case of a change of delegates, including timely access to the required expertise, technology and data to replace delegates or insource functions at short notice. Credible contingency plans will give mancos more authority as it will make it easier for them to replace a poorly performing delegate. It will also enable them to continue operations or ensure an orderly wind-down in the event of a delegate's default or operational failure.
- UCITS protections aligned to those in AIFMD: ESMA states that the UCITS rules on delegation should be interpreted as consistent with the AIFMD rules, so that UCITS investors benefit from the same protections as AIF investors. A number of AIFMD provisions are significantly more detailed than those in UCITS and provide a higher level of protection. Nevertheless, it should not come as a surprise that EU regulators think that retail investors in authorised funds should have at least the same level of protection as investors in unauthorised funds. We may see this position being formalised in the upcoming review of the UCITS Directive.
What are national EU regulators saying?
A number of EU regulators have updated their local guidance for mancos following ESMA's advice. For example:
- In Luxembourg, the CSSF published a Circular in August 2018 detailing its expectations for mancos with a view to strengthen their long term resilience. This builds on the expectations set out in ESMA's opinion, and in some cases goes beyond them such as requiring all mancos to have at least three full-time equivalent staff, including two senior managers based in Luxembourg or a location that in principle allows them to travel to Luxembourg every day. The CSSF specifies that Board directors must not hold more than 20 fund mandates and must not have time commitments of more than 1,920 hours annually (around 40 hours a week), unless they justify how they can manage their responsibilities, including through technical and administrative support.
- In Ireland, the CBI has updated its authorisation process for UCITS and AIFMD firms to ensure that it has all the information needed to document the assessments described in ESMA's opinion. The new information requirements include the rationale for the geographical distribution of planned activities, the objective justification for delegation arrangements in relation to critical functions and details of the due diligence undertaken during the selection process.
Overall, while the areas covered by ESMA's opinion were already areas of focus for NCAs, we are now seeing a more formalised approach and greater pressure to meet higher standards in these areas, including documentation of actions and decisions.
What are the FCA's concerns?
In its asset management market study the FCA found that mancos often lack independence from the fund manager and do not exert effective challenge on issues such as value for money. This was the case across different types of delegation structure. For example:
- Delegating within the group: In this structure the manco is typically a subsidiary within the group that sponsors the fund range. The manco can lack the authority within the group to challenge the commercial strategy set by more senior boards and committees. Manco directors may face a significant conflict between their duties to the asset management group and their duties to the funds and their investors. The FCA has observed that this conflict tends to be resolved in favour of the asset management group.
- Delegating outside the group: In this structure, the group sponsoring the fund range approaches a third party – often known as a 'host Authorised Corporate Director (ACD)' to perform the functions of a manco. However, in commercial terms the asset management group is the host ACD's client and decides on its selection and ongoing appointment. This creates a similar conflict of interest to that where delegation is to another group entity, and the FCA's supervisory work indicates that the host ACD model is no more likely to provide effective challenge.
Alternatively, in some groups the manco performs portfolio and risk management in-house, with no delegation. However, this arrangement may not generate independent oversight of the fund manager either.
To address its concerns, the FCA is requiring UK mancos of authorised funds to appoint a minimum of two independent directors and for them to comprise at least 25% of the total board membership with effect from 30 September 2019. Firms will need to be able to demonstrate that their manco's board provides genuine independent challenge to the fund manager.
UCITS and AIFMD firms delegating investment management functions can expect to face increased scrutiny from regulators, both in the EU and the UK. Supervisors will expect firms to be able to justify their choice of delegate, demonstrate their capacity to oversee their delegate effectively, and demonstrate independent oversight and challenge.
1 A common approach is to delegate portfolio management and perform risk management internally.
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