On 19 April 2021, the UK Financial Conduct Authority (FCA) published its second consultation paper (CP21/7) on the new prudential regime for FCA investment firms (IFPR), which includes UK Markets in Financial Instruments Directive (MiFID) firms and UK collective portfolio management investment firms (CPMIs — that is, alternative investment fund managers (AIFMs) with MiFID “top-up” permissions). This follows the FCA’s first consultation paper on the IFPR that was published in December 2020 (CP20/24). A third consultation paper will be published later in 2021.
The IFPR is based largely on the new prudential regime for EU investment firms as contained in the EU Investment Firm Regulation and Directive (IFR/IFD — see our previous Update), but the IFPR proposals deviate from the IFR/IFD in a number of ways.
CP21/7 and CP20/24 contain proposals that would be of particular significance to in-scope UK investment managers. In particular, while CP20/24 dealt with matters such as the categorisation of firms and what constitutes own funds for capital purposes, CP21/7 is likely to be more interesting to investment managers, as it covers, among other things, the methods of calculating a firm’s likely capital requirement as well as rules on remuneration.
Once finalised, the IFPR is expected to come into effect on 1 January 2022.
References in this Update to “investment firms” means UK FCA-authorised investment firms.
Core features of the IFPR proposals — capital and remuneration
The IFPR proposals aim to create a common prudential framework more sensitive to the particular risks faced by investment firms than the current UK prudential rules (such as can be found in the BIPRU, IFPRU, and IPRU-INV sourcebooks of the FCA Handbook).
Under the proposals, UK investment firms would be subject to tailored capital requirements that scale with the size and complexity of the firm. The rules would also apply on a consolidated basis where there is a consolidation group.
CP20/24 consulted on placing all investment firms into one of two categories.
- Small and non-interconnected (SNI) firms — being firms that fall below all of the following thresholds
- assets under management (AUM) < £1.2 billion;
- client orders handled (COH) — cash trades < £100 million per day;
- COH — derivative trades < £1 billion per day;
- assets safeguarded and administered zero;
- client money held zero;
- on- and off-balance sheet total < £100 million;
- total annual gross revenue from investment services and activities < £30 million; or
- Non-SNI firms — being investment firms that exceed any of the SNI thresholds.
It is generally expected that for UK investment managers, the thresholds pertaining to AUM, on- and off-balance sheet total, and total annual gross revenue from investment services and activities would be of greatest relevance. Based on initial feedback, we expect that many of our investment manager clients will be non-SNI firms.
FCA-authorised firms that are currently only authorised to provide investment advice and/or arrange deals in investments (exempt CAD firms) would likely be SNI firms; that is, the existing exempt CAD category of firm will disappear. Nonetheless, exempt CAD firms would likely become subject to significantly higher minimum regulatory capital requirements where their FOR (defined below) is substantially higher than their current minimum capital requirement of €50,000.
SNI firms — minimum regulatory capital requirements
Under the proposals, SNI firms would be required to maintain an amount of “own funds” that is the higher of its:
- permanent minimum capital requirement (PMR), which for UK investment managers should generally be £75,000; and
- fixed overhead requirement (FOR), an amount equal to three months of the firm’s “relevant expenditure” (being, broadly, a firm’s total expenditure for the period but with certain deductions, e.g., profit distribution, staff bonuses, nonrecurring expenses from non-ordinary activities, amongst others).
The K-factor capital requirement (as discussed further below) will not be relevant to SNI firms.
Non-SNI firms — minimum regulatory capital requirements
Non-SNI firms would be required to maintain an amount of “own funds” that is the higher of its:
- FOR; and
- total “K-factor” requirement.
The “K-factors” are a new concept to the UK prudential regime. The total K-factor requirement would be the sum of individual K-factor requirements, with different K-factors applying to a firm depending on its MiFID investment services and activities.
The IFPR contemplates a range of K-factors, each with a coefficient to be applied:
Requirement based on the value of
client assets safeguarded and administered
client money held
0.4% (segregated accounts)
0.5% (non-segregated accounts)
0.1% (cash trades)
0.01% (derivatives trades)
For most UK investment managers, we expect that only the K-AUM and K-COH K-factors would be of relevance.
We discuss further each of these individual K-factors below.
The K-AUM capital requirement would be a firm’s AUM multiplied by the coefficient of 0.02%. This would have to be calculated at the start of each month.
AUM is proposed to include each of the following:
- “assets managed on a discretionary portfolio management basis”; and
- “assets managed under nondiscretionary advisory arrangements of an ongoing nature” which is defined in the CP20/2 proposals as:
“the recurring provision of investment advice as well as the continuous or periodic assessment and monitoring or review of a client portfolio of financial instruments, including of the investments undertaken by the client on the basis of a contractual arrangement”
CP21/7 proposes to allow an investment firm to exclude from its AUM the value of any assets that have been formally delegated to it (to manage) by a “financial entity.” However, “financial entity” has been defined to include only the following:
- an investment firm, including a MiFID firm as well as a CPMI firm;
- a collective portfolio management (CPM) firm (that is, an AIFM or UCITS management company without MiFID “top-up” permissions); or
- a third-country entity subject to an AUM-based financial resources requirement that is similar to the K-AUM requirement.
Given the definition of “financial entity,” we expect, for example, an investment firm that has been delegated investment management responsibilities by a U.S. investment manager would have a K-AUM requirement under the IFPR proposals. This is because, in general, U.S. investment managers are not subject to an AUM-based financial resources requirement under their home/U.S. rules and thus are not “financial entities” for the purposes of these IFPR proposals.
When calculating the K-AUM requirement, the FCA proposes to require the firm to:
- measure the amount of AUM it had on the last business day of each of the previous 15 months;
- exclude the three most recent monthly values; and
- calculate the arithmetic mean of the remaining 12 monthly values.
When measuring its AUM, firms would have to:
- use the market value of the relevant assets, where available; and
- use an alternative measure of the fair value of an asset, where a market value is not available, which may include an estimated value calculated on a “best efforts” basis.
When measuring AUM, it is proposed that a firm may offset any negative value or liabilities attributable to positions within the relevant portfolios. Therefore, helpfully, AUM is equal to the net total value of the relevant assets.
CP21/7 contains further details on the methodology to calculate K-AUM.
Questions remain as to how AUM based on “assets managed under nondiscretionary advisory arrangements of an ongoing nature” should be calculated in certain situations, such as for firms providing investment advice in relation to private-equity fund structures.
The K-COH requirement capital would be a firm’s average daily COH multiplied by 0.1% for cash trades and 0.01% for derivatives trade and would have to be calculated on the first business day of each month.
COH is proposed to include the execution of orders on behalf of the client and the reception and transmission of client orders.
When calculating K-COH, the FCA proposes to require the firm to use the total of the absolute value of each buy and sell order, measured throughout each business day over the previous six months (but excluding the three most recent months) and then using the arithmetic (daily) mean of the remaining three months.
An investment firms may exclude from its K-COH calculation any unexecuted orders and, to avoid double counting for regulatory capital purposes, any orders that the firm generates in the course of providing portfolio (or investment advice of an ongoing nature) where the relevant portfolio is already included in the firm’s K-AUM calculation.
This would mean that, for example, a UK investment firm that has been delegated investment management authority by a U.S. investment manager (and, thus, would have a K-AUM requirement, as discussed above) would not have a K-COH requirement unless the firm executes trades separately from those delegated portfolio management activities (e.g., execution-only services). Any trades executed separately from the firm’s delegated portfolio management activities would result in a K-COH capital requirement for the firm.
CP21/7 contains further details on the methodology to calculate K-COH.
CP21/7 proposes to replace the remuneration rules to which investment firms are currently subject.
Different rules will apply depending on the type of investment firm.
Under the proposals, investment firms would have to implement the new remuneration rules from the start of their next performance year beginning on or after 1 January 2022.
Basic remuneration requirements
All investment firms would be subject to the “basic remuneration requirements.” This would require an investment firm to develop a remuneration policy proportionate to the size, internal organisation, and nature as well as to the scope and complexity of its activities. Amongst other requirements, the remuneration policy should ensure that the fixed and variable components of the total remuneration be appropriately balanced and that variable remuneration must not affect the firm’s ability to ensure a sound capital base.
Investment firms would have to apply the basic remuneration requirements to all staff.
Whilst SNI firms would have to adhere to the basic remuneration requirements only, additional remuneration requirements would apply to non-SNI firms.
Standard remuneration requirements
Non-SNI firms would be subject to the “standard remuneration requirements” in addition to the basic requirements.
Non-SNI firms would have to apply the standard remuneration requirements to their “material risk takers” (MRTs) and would not be compelled to apply them to any members of staff, but the firm may nonetheless choose to do so.
Among other requirements, the standard remuneration requirements would require:
- non-SNI firms to set a maximum ratio between variable and fixed remuneration;
- performance-related variable remuneration of MRTs to be based on a combination of the performance of the individual, the relevant business unit, and the firm overall;
- performance assessment to be based on a multiyear period, taking into account the business cycle of the firm and its business risks;
- firms to take into account all types of current and future risks when measuring performance to calculate bonus pools, when and awarding and allocating bonuses; and
- firms to have in-year adjustments, malus, and clawback arrangements in place.
In addition, certain restrictions as to guaranteed variable remuneration, retention awards, buyout bonuses, and severance pay would be applicable to non-SNI firms.
Extended remuneration requirements
Non-SNI firms with total on- and off-balance sheet assets of more than £300 million over the preceding four-year period would be subject to the “extended remuneration requirements.” There are other thresholds for firms with trading books, but those are not relevant for investment managers, as investment managers typically do not have trading books.
The extended remuneration requirements would be applicable in addition to the basic and standard requirements for these firms.
In particular, these large non-SNI firms would have to:
- establish a remuneration committee (as well as, as a general governance requirement, risk and nomination committees);
- pay 50% of variable remuneration out in shares, instruments, or via “alternative arrangements” approved by the FCA (the FCA recognises that alternative arrangements may be necessary for certain firms, such as partnerships and limited liability partnerships (LLPs); this would likely be the approach that in-scope UK investment managers would need to take); and
- defer at least 40% of variable remuneration (or 60% where the variable remuneration is £500,000 or more) for at least three years.
Given the high balance sheet threshold, we would expect many in-scope UK investment managers to be out of scope of the extended remuneration requirements.
Basic liquid assets requirement
Under the proposals, both SNI and non-SNI firms would be required to maintain liquid assets (including, but not limited to, cash, short-term deposits and units or shares in short-term regulated money market funds) that is at least equal to the sum of:
- one-third of the amount of its FOR; and
- 1.6% of the total amount of any guarantees provided to clients (though we do not expect this item to be of relevance to UK investment managers).
ICARA and SREP
The FCA proposes to introduce the Internal Capital Adequacy and Risk Assessment (ICARA) process to replace the current FCA Internal Capital Adequacy Assessment Process (ICAAP).
Under the proposals, all investment firms would be required to undertake an ICARA in order to:
- identify and monitor harms: operate systems and controls to identify and monitor all material potential harm;
- undertake harm mitigation: consider and put in place appropriate financial and nonfinancial mitigants to minimise the likelihood of crystallisation and/or impact of the material harm;
- undertake business model assessment, planning, and forecasting: forecast capital and liquidity needs, both on an ongoing basis and were they to have to winddown; this must include expected and stressed scenarios;
- undertake recovery action planning: determine appropriate and credible recovery actions to restore own funds or liquid resources where there is a risk of breaching threshold requirements tied to specific intervention points;
- undertake wind-down planning: set out at entity-level credible wind-down plans, including timelines for when and how to execute these plans; and
- assess the adequacy of own funds and liquidity requirements: where, in the absence of adequately mitigating risks through systems and controls, the firm assesses that additional own funds and liquid assets are required to cover the risk.
To reflect the FCA threshold condition for a firm to maintain adequate financial resources, the FCA proposes to introduce the Overall Financial Adequacy Rules (OFAR). The OFAR will require a firm, at all times, to hold adequate all funds and liquid assets to:
- ensure it can remain viable throughout the economic cycle, with the ability to address any potential harm from its ongoing activities; and
- allow its business to wind down in an orderly way.
Should a firm determine that additional own funds and/or liquid assets are required as a result of the ICARA process, the higher amounts would together constitute the firm’s “threshold requirement” and, in turn, represent the firm’s view of what is required to meet the OFAR unless the FCA advises otherwise. The FCA has stated that not meeting these requirements would show that the firm had breached the adequate financial resources threshold condition.
The FCA will separately assess a firm’s financial standing through a new Supervisory Review and Evaluation Process (SREP). As a result of a SREP conducted on a firm, the FCA may impose a higher threshold requirement as well as take other action (such as directing the firm to implement new risk management or governance arrangements).
The consultation period for CP21/7 will close on 28 May 2021.
Once finalised, the IFPR is expected to come into effect on 1 January 2022.
In the meantime, investment firms should continue to monitor the progression of IFPR and also respond to the FCA consultation should they have any comments on the proposals.
Sidley Austin LLP provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship.
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