Regulators’ far-reaching assessment of the UK’s asset management industry has raised potential conflict of interest issues by leaving oversight to the firms themselves.
In its comprehensive review, the Financial Conduct Authority (FCA) envisages a broad array of new rules for fund managers in the future. As well as proposing new governance structures in a bid to improve investor protection, the regulator wants to promote competition in the market and boost the effectiveness of intermediaries like investment consultants and platforms.
Overall, the industry welcomed the report and acknowledged many of its claims. But its plan to require firms to appoint a minimum of two independent directors to their board has raised questions.
“There’s a big possibility for conflicts of interest here, which the FCA does acknowledge,” said James Dorr, general counsel at Orbis Investments in London. “It seems the regulator is leaving a lot of the oversight work to both executive and non-executive directors, and I’m not sure they thought that through.”
The regulator’s reasoning is that fund governance bodies ‘tend to lack independence from the fund manager and do not appear to exert effective challenge on value for money’.
The newly appointed independent directors will be tasked with assessing the fund’s value for money on behalf of the end user on an annual basis.
But Dorr argues that this creates a fairly major conflict between the directors’ duty to promote the success of the firm for the benefit of its shareholders and employees as per the companies’ act, and their obligation to act in the best interests of investors.
- The FCA’s comprehensive review of the UK asset management industry has raised potential conflict of interest issues with its proposal for two independent directors to be appointed to investment firm boards;
- Internal struggles can also come into play at bigger, centrally managed groups with more than one firm within;
- It’s not clear if there are enough qualified individuals in the country to fill the positions;
- According to Fitch the UK will still be lagging behind the US if it implements the changes;
- But others have questioned if now is the right time to crack down on one of the UK’s biggest industries in light of Brexit uncertainty and other incoming regulations.
“My hope is that conflict is addressed when the FCA has had time to consider the industry’s response to the consultation paper,” he said.
But Jan Putnis, head of Slaughter and May’s financial regulation group in London, thinks the potential conflict should be manageable in most cases. “That is, unless the rules develop in an unexpected way,” he said.
Can’t get the staff
The FCA notes that some respondents to the initial consultations voiced concerns over the number of qualified people required to fulfil these roles.
This was also raised when the requirement was introduced for banks. Although there are far fewer banks in the country than investment firms, the rule was more onerous, requiring a majority of board directors to be independent.
It’s not clear at this point how much asset management experience the right candidate would need, though the accompanying consultation paper is specific about requirements. In the regulator’s view, an independent director should serve a term no longer than five years and a cumulative term no longer than 10.
In fact the new governance requirement is broadly similar to the Securities and Exchange Commission (SEC) independence and value for money requirements for US mutual fund boards, with a few differences. “Also of note is that the cost of complying with those requirements is much higher than the FCA has estimated in its cost/benefit analysis,” said Dorr.
One of those differences between the two is that independent directors are paid substantially more for the role in the US.
A Fitch note released on June 30 acknowledges that following the FCA’s consultation, fund boards will in future play an increasingly important role in the outcome for investors – but that the UK continues to lag behind the US in terms of board independence.
"My hope is that conflict is addressed when the FCA has had time to consider the industry’s response"
According to Fitch, European Ucits [Undertakings for collective investments in transferable securities] have an average of 1.9 independent directors on each board – but almost a quarter have none. In the US, there’s a clear requirement for a minimum of 40% of those directors to be independent.
In both Ireland and Luxembourg, certain types of funds are required to have at least one independent director, although the FCA goes one step further by suggesting two.
It’s not just the potential for conflicts of interest concerning market participants. According to Putnis, the requirement can cause chaos in major groups made up of more than one fund management company.
“It can make a group difficult to manage, at best resulting in delays and at worst deadlock and chaos within groups when people can’t agree,” he said. “The boards that oversee centrally-managed groups might not expect to be second-guessed by the board of a subsidiary on a well-thought through strategic plan.”
As the regulator proposes the new framework apply to UK firms both in and outside of the UK, but not to foreign firms that operate in the UK, there is a possibility for a competitive disadvantage. While continental European markets are on the whole much smaller fund management hubs than London, there’s no guaranteeing that this will remain the case in a post-Brexit world.If things were different it might have resulted in regulatory arbitrage, with firms shifting their head offices to the continent while passporting into the UK. But of course Brexit throws all of that up in the air.
The paper acknowledges the potential unintended consequences of this selective scope, but notes that the improvements to investor treatment will actually make the UK an even more attractive destination for asset managers, and will therefore improve the competitiveness of the UK market. “That seems to be a little bit optimistic,” said Dorr.
Meanwhile Kirkland & Ellis partner Lisa Cawley thinks the FCA should have considered this more before releasing the proposal.
“The industry is facing so much right now with Brexit on top of various pieces of regulation from Europe. If there is not an immediate and clear need then really, they should be holding fire for now,” she said. “The regulator needs to be very careful.”
UK regulator plans asset management overhaul