Welcome to the third installment of Ropes & Gray's European regulatory podcast for asset managers. These fortnightly podcasts and accompanying speaker notes are intended to provide an overview of updates relevant to GCs, CCOs and other compliance professionals to help you navigate both COVID-19 and other developments relevant to your business. The speakers on today's podcast are Eve Ellis, a partner in Ropes & Gary's asset management group specialising in fund regulation, Rosemarie Paul, a partner in our litigation & enforcement group specialising in regulatory enforcement matters, and Jason Brown, a partner in our asset management group specialising in investment adviser regulation.

This update covers topics relating to market abuse, a recent SEC enforcement action relating to insider trading procedures, financial resilience, the Financial Conduct Authority's ("FCA") expectations of firms as we move towards a "new normal," as well as AI, big data and a European Securities and Markets Association ("ESMA") supervisory briefing on UCITS and AIF costs.



FCA warning about market conduct and handling inside information in the context of COVID-19

The FCA's latest edition of Market Watch (#63) sets out its expectations of market conduct in the context of increased capital raising events and alternative working arrangements resulting from the COVID-19 crisis.

The FCA accepts the uncertainty and current operational challenges caused by the COVID-19 crisis, but warns that all market participants must act in a manner that supports the integrity and orderly functioning of the financial markets, and ensure that they comply with the Market Abuse Regulation.

Firms must have effective controls in place to address market abuse, conduct and managing conflicts of interest. The FCA encourages firms to particularly focus on:

  • ensuring inside information continues to be identified and handled by all persons involved in the information chain so that it cannot be misused (e.g. for insider dealing);
  • ensuring inside information is appropriately disclosed by issuers so that investors are not misled;
  • maintaining robust market surveillance and STOR reporting by relevant market participants in the context of changing market conditions and alternative working arrangements;
  • meeting the transparency and short position covering requirements under the Short Selling Regulation for market participants to support the effective functioning of the market; and
  • identifying and managing conflicts of interest by market participants that may arise around capital raising events.

The FCA reminds market participants that they must assess market abuse risks in the context of the crisis and new working conditions. Firms need to consider whether their systems and controls continue to mitigate identified risks and may need to consider reviewing the availability or application of controls for restricting access to inside information and how access to inside information can be remotely supervised. Common industry controls such as a mandatory two week holiday for staff may be appropriate and/or updating and or repeating training to on managing inside information may also be helpful.

The regulator makes it clear that it will continue to monitor and investigate issues of market conduct and will take enforcement action where it considers firms have fallen short.

Market abuse compliance is clearly a key focus for European regulators. Whilst relief has been provided in a number of areas, market abuse is not one of them. It is also a focus for the SEC where some recent enforcement action highlights this.

On 26 May, the SEC released a settlement order with a private equity firm regarding their material non-public information ("MNPI") procedures.

In short, the firm had a loan and equity investment in a publicly traded portfolio company. The firm received "potential MNPI" through its board designee and pursuant to its information rights as a lender, subject in each case to accompanying confidentiality obligations. The order described the "potential MNPI" as potential changes to senior management, along with plans related to certain financial and transactional matters. The SEC did not affirmatively conclude that any of the information received by the firm actually constituted MNPI – it instead referred to the information as "potential MNPI" throughout the order. Following receipt of this information, the firm purchased approximately 17% of the publicly traded shares of the portfolio company on the open market.

The firm's written procedures required trades in the stock to be pre-approved by the compliance staff, and compliance was required to confirm that the trading window was open and to check with the firm's director designee that he did not have MNPI. The policies and procedures did not provide any guidance concerning the identification of relevant parties with whom to inquire regarding possession of potential MNPI and the manner and degree to which the compliance staff should explore MNPI issues with these parties. For example, the procedures did not expressly require an assessment of whether the director shared information with others or confirmation of the full spectrum of employees who could have acquired the potential MNPI (even though such information was regularly shared by the director with other firm personnel). In addition, the procedures did not specifically contemplate the steps to be taken to address the "special circumstances" created by the director's dual role (where the employee was also involved in trading decisions regarding the stock).

In addition, their compliance staff failed to document sufficiently that they had made such inquiries or to apply a consistent practice to the inquiries made. The compliance staff simply asked if the director had MNPI, which required "these employees to self-evaluate whether particular information could be deemed 'material' for purposes of" the firm's compliance policies and federal securities laws.

The firm was found to have violated Section 204A (which requires advisers to have MNPI procedures) and Rule 206(4)-7 (which requires compliance procedures more generally) and had to pay a penalty of $1 million.

A few observations follow:

  • There is no suggestion that the firm actually engaged in insider trading, or that the information in question was actually material. In fact, the trading took place during an open trading window. This confirms that while obviously helpful, the SEC will not view trading in an open window as independently inoculating with respect to establishing a system sufficient to prevent the misuse of MNPI. By analogy, public companies generally require certain groups of officers and directors who want to trade in an open window also to certify that they are not in possession of MNPI, and the Order appears to extend that concept to the employees of private equity firms with a board designee who might have been exposed to MNPI.
  • The requirements of the SEC for MNPI procedures in this case go beyond market practice in our experience. That said, firms now proceed at their own peril if they ignore this enforcement action. We will be working with our government enforcement litigators to modify our model MNPI procedures, and would be happy to answer any questions that you might have regarding your procedures. In the meantime, it makes sense going forward to consider developing a list of those persons at the firm who might have MNPI for each name and develop a checklist to check-in with each such person ahead of any public market security transactions to confirm the lack of MNPI (even if in an open window).

Financial resilience

The FCA is undertaking a survey of 13,000 firms to obtain an accurate view of firms' financial resilience as a result of the COVID-19 pandemic. The survey is being sent out between 4 and 8 June 2020. This forms part of the FCA's wider efforts to evaluate how firms are being affected during the current crisis and shows the focus the FCA has in this area.

FCA's expectations of firms as they move from crisis response to the "new normal"

In a recent speech, the FCA's Executive Director of Supervision – Investment, Wholesale and Specialists, Megan Butler, set out some helpful guidance as to the FCA's expectations of the wealth management and advice industry, as firms transition from immediate crisis response to adapting to meet the long-term impacts of COVID-19.

Ms. Butler focused on two FCA priority areas: (i) operational; and (ii) financial resilience.

Operational resilience

The FCA expects all firms to have contingency plans to deal with major events and that these plans have been properly tested. Firms should review the FCA's operational resilience consultation paper, which sets out the FCA's proposals for firms to strengthen their resilience.

Firms need to keep their focus on operational resilience as circumstances change, government guidance is updated and, as things return to some form of "new normal," how those changes will affect their resilience and their services.

Financial resilience (including preservation of client assets and money)

The FCA is beginning to see the impact of the crisis in its significant downward pressure on many firms' revenues. Ms. Butler noted that financial pressure could lead to harm to customers if firms "cut corners" on governance or systems and controls (e.g. leading to an increased likelihood of financial crime, poor record keeping, market abuse, unsuitable advice and investment decisions).

The regulator acknowledged that some firms holding client money and custody assets may need to exit the market. In these cases it is crucial that they minimise delay in the return of client money and custody assets and take action ahead of time to prevent shortfalls in what should be held on behalf of clients.

Ms. Butler also reminded firms of the outcomes that the regulator continues to pursue in the wealth management sector:

  • firms must maintain adequate arrangements to protect client money and custody assets in accordance with the FCA requirements;
  • firms must provide suitable advice and discretionary investment decisions;
  • firms must act with integrity (which includes charging appropriate fees for services delivered and prevention of fraud); and
  • firms must prevent financial crime and market abuse through adequate controls and governance.


AI and big data

Use of big data and AI has been on the regulatory agenda for some time. Recent reports around the launch of new index products powered by artificial intelligence and big data to make investment decisions are likely to increase scrutiny of this area.

In its February 2020 Sector Views report, the FCA identified big data, AI and new technologies as having the greatest impact on the financial sectors within its jurisdiction. The FCA has also issued a Call for Input to explore the changing use and value of data in wholesale financial markets and how this could change business models and how the markets function. The FCA has made it clear it does not want to impede beneficial innovation but wants to understand the potential impact on issues such as market stability and competition, as well as consider what harms could arise, for example, market manipulation and price discrimination. The deadline for response to the Call for Input has been extended to 1 October 2020 and roundtables to discuss these issues will be scheduled later this year.

ESMA issues supervisory briefing on UCITS and AIF costs

On 4 June, ESMA issued a supervisory briefing setting out a common framework for regulators in relation to costs charged by UCITS and AIF managers. The briefing is designed to ensure consistency on how these issues are supervised and that investors are not charged undue costs (as is required under AIFMD and the UCITS Directive).

The briefing focuses on what undue costs are and that this notion should be assessed primarily against the best interests of the fund and its investors. To that end, it should be ensured that:

  • costs should be consistent with the fund's investment objectives, in particular when payments are made to third parties; and
  • managers should be able to identify and quantify all costs charged to the fund, whether they are paid to the manager or a third party.

To assist with this, managers should prepare and review a structured pricing process addressing various factors including whether:

  • the costs are necessary to allow the fund to perform its investment objective;
  • the costs are proportionate to the market standard and the services provided – this requires an assessment of competitor fees and conflicts (particularly payments to third parties and intragroup payments);
  • the fees are consistent with the characteristics of the fund;
  • the costs ensure equal treatment for investors;
  • there is any duplication of fees;
  • a cap is applied and if so is it clearly disclosed to investors;
  • the performance fees are consistent with ESMA Guidelines (which apply to UCITS and certain AIFs); and
  • all costs clearly disclosed in line with relevant rules.

In order to supervise undue costs, regulators should review the processes leading to costs being charged to investors on a case-by-case at various stages, including on authorisation, approval of marketing documents, thematic reviews and during one-on-one inspections.

Whilst there are no specific rule changes, the briefing emphasises the importance of acting in the best interests of investors, transparency and disclosure. This will likely become an area of greater focus for regulators, particularly during initial authorisation and subsequent fund approvals. Managers should review their costs against the framework and be prepared for regulatory scrutiny in this area going forward.

Contact us

For more information on the topics we have discussed or other topics of interest, please visit our website at www.ropesgray.com. Also, if Eve, Rosemarie or Jason can help you navigate any of these areas, please do not hesitate to contact any of us. You can also subscribe to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.