In Part 1 and Part 2 of our RDR series we looked at the consultation paper on Advisor Categorisation. We now turn, in Part 3 and Part 4, to the consultation paper on Investment-related matters which is a follow-up from the regulators after they considered the feedback received on the 2018 Investment Document. The latest paper provides the FSCA’s updated position on the activities of investment management, the relationship between various entities in that space and the implications for remuneration and charging structures.
RDR Proposals on Investment Related Matters
In this Part 3 on Investment-related matters we look at how investment management will be defined and categorised from a licencing perspective, and the impact that this may have on the fit and proper standards for investment managers. We will also consider how the Product Supplier Agent (PSA) and Registered Financial Advisor (RFA) categorisation will work in the investment sector.
Activities of Investment Management
Defining Investment Management
Currently the activities falling under the scope of a Category II FAIS licence are very broad and what one Cat II FSP does may differ significantly from what another Cat II FSP does. Because of the shift to activity based regulation – which has already been proposed in the RDR papers and has been included in the first draft of the COFI Bill, the FSCA is of the view that a “one-size-fits-all” approach is too wide. In the first investment paper there were 4 licencing categories proposed, but these were not completely in keeping with the activity-based principle and had aligned, to some extent, with product type. The FSCA took on board comments from the industry and is now proposing an overarching definition of “investment management” with various sub-activities falling under that.
What defines investment management?
The overarching definition will broadly define the activities common to all discretionary investment managers, such as:
- obtaining a mandate from a client,
- establishing and agreeing the client’s investment objectives and risk appetite,
- identifying, selecting, acquiring, or disposing of financial products/instruments, or other assets according to the agreed investment objectives and strategy and any parameters, limits, thresholds or other instructions which have been set out in the mandate, and
- handing any assets acquired to a custodian or nominee for safekeeping.
Although an investment advisor licenced under a Category I licence is able to perform very similar activities to that of an investment manager when it comes to constructing an investment portfolio for a client, the key difference is that an investment advisor must obtain written confirmation and consent from a client for every transaction. The FSCA’s view is that as long as the investment advisor meets the requirements for the provision of advice, then that is enough and there is no need to impose additional requirements or limits on investment advisors, at this point in any event.
What are the sub-activities performed by discretionary investment managers?
In identifying the sub-activities performed by investment managers, the FSCA recognises that these should not be so granular as to inhibit flexibility and business development. The proposed sub-activities are:
- Asset Management which involves the selection of assets and asset classes, as opposed to selecting a fund, for example. In the 2018 Investment Paper, the FSCA referred to this as “traditional investment management”.
- Multi-management refers to the selection of managers, including management style and asset class selection. This would be your fund-of-fund model where the investment manager selects funds or portfolios managed by other investment managers, rather than direct instruments.
- Alternative Investment Management includes all hedge fund managers, private equity management and other types of alternative investment strategies.
These proposals will have an impact on the licencing requirements of investment managers as they will have to apply for the overarching category of discretionary investment management and for authorisation to perform activities in one or more of the sub-categories.
Fit and Proper Standards
Setting different licencing requirements for the various activities falling into discretionary investment management will require a review of the fit and proper standards applicable to each sub-category. At this stage, the thinking is that a core set of standards will apply to all the sub-categories of investment management which will be complemented by additional requirements depending on the different activities performed.
Mandates for Convenience
In the 2018 Investment Paper, the FSCA identified certain activities performed by discretionary investment managers where there is very little or no actual portfolio construction taking place. While these “investment managers” are essentially performing advice functions very similar to Cat I investment advisors, in addition, they obtain mandates from their clients so that they do not have to go back to clients to obtain a written instruction from those clients each time switches are made. The question asked was whether activities relating to what the regulator calls ‘mandates for convenience’, fall into investment management in the true sense, or whether they should be excluded from the discretionary investment management category – in other words, should they be excluded from Cat II? The regulator’s updated position is that these activities should be shifted into the Category I space and should be viewed as ancillary to the provision of advice, but there would need to be clear definitions and controls in place. These ‘mandates for convenience’ would require an up-front authority from a client to rebalance the client’s portfolio back to the asset allocation percentages agreed in respect of the originally selected funds. The view is that this does not and should not involve discretion (i.e. no switching from one fund to another) and therefore, only an advice fee will be chargeable. No additional fit and proper standards are envisaged, and it is proposed that the existing requirements applicable to Category I FSPs would be sufficient. There would not be any additional licencing requirements for this particular type of activity under a Category I licence – instead, FSPs would have to inform the FSCA if they are making use of these types of mandates and will potentially have to make use of a template mandate prescribed by the FSCA. FSPs that only make use of these types of mandates may welcome this approach as they could continue to operate under a Category I licence only (no longer requiring a Cat II licence) and reduce the level of financial soundness requirements they are currently required to meet.
“Tied” Advice or Product Supplier Agents (PSAs) in the investment sector
By now the terms PSA and RFA are familiar – a Product Supplier Agent (PSA) (based on the existing RDR term) is an advisor appointed to the FSP licence of a product provider and is then limited to the products of that product provider or its group. A Registered Financial Advisor (RFA), on the other hand, is able to offer the products of various product providers where he or she has a broking agreement in place.
In the 2018 Investment Paper the FSCA proposed that the PSA model be introduced into the investment space. However, this presented certain challenges as investment managers provide a financial service (i.e. an investment management service) and are not typically product providers – so, how does the PSA model fit into this world? In response to this dilemma, it is proposed that the scope of the PSA model be adjusted and extended to allow tied advisors to be appointed by either product providers or services providers (specifically discretionary investment managers). If the regulators went this way it would require a change in the current term for PSA and the definition of “advice” in FAIS would need to be amended to also include advice on “financial services”.
If this thinking or proposal of the FSCA means that, where an FSP holds both a Cat I and Cat II licence in the same entity, the advisors appointed to that FSP will be designated PSA and therefore limited to providing advice on the financial services and financial products of the FSP (or its group), then this could be problematic for FSPs that want to operate as an RFA and that want to offer a range of financial products to their clients. If the FSP only offers discretionary investment services and is not a product provider then does this mean that those advisors be limited to advice on the discretionary investment services only and have no access to financial products? Given the wording used in the paper that the FSCA’s position is to “allow a discretionary investment manager… to appoint “tied”/PSA Advisors” we are inclined to think that their intention is to limit advisors on an investment manager’s licence (i.e. on a Cat II licence) to only provide advice on the investment management (financial) services of the Cat II (and products if the investment manager is also a product provider) and any in-group products and services.
The Investment Discussion Document, however, doesn’t provide a definition of this extended PSA model, making it difficult to fully understand the impact which this may have, particularly on FSPs that (a) operate a Cat I and Cat II licence within the same entity, (b) want to operate as an RFA and (c) don’t form part of a group of companies that has access to a broad range of financial products and financial services.
Group of Companies
Where a PSA forms part of a group of companies, the “tied” agent will be able to provide advice on the financial products and the financial services (through the extended PSA term) offered within the group. However, there are still a number of unresolved questions regarding the extent to which PSAs in a group are able to use LISPs that are not part of the group, mainly where the group does not have its own LISP. These questions require further input and deliberation and we will not deal with this any further in this article.
Third-party co-branded CIS Models
Who is ultimately accountable where investment management is outsourced to a Cat II FSP?
In the initial RDR paper (published in 2014), it was proposed that the outsourcing of investment management functions to financial Advisors be prohibited. This also meant that a CIS Management Company (Manco) would not be able to outsource the investment management of a portfolio to an FSP that also provided advice. As a result, some FSPs restructured their businesses by splitting the Cat I licence from the Cat II licence. While the FSCA has significantly relaxed this position, it remains strongly of the view that the Manco remains accountable for the outsourced investment activities.
Can a Cat II FSP that manages a CIS portfolio call itself “independent”?
Where the third-party investment manager also has an advice licence, the mere existence of a third-party investment management agreement will not preclude it from calling itself independent, unless it is designated as a PSA – then it cannot call itself independent. If it is not designated as a PSA then, providing it meets certain criteria, the RFA may be able to call itself independent, subject also to the recent amendments to the General Code of Conduct published at the end of June 2020. In terms of these amendments, one aspect to consider is that an FSP may not describe itself as independent if it is a significant owner in a product supplier or if a product supplier has significant ownership in the FSP, where the FSP renders financial services in respect of that product supplier’s products.
Is it likely that co-named broker funds will continue to be allowed?
The FSCA is concerned about “co-named broker funds” which are typically white labelled funds that are not operated through a formal third-party co-branding arrangement. The regulator has indicated that it will conduct further research to identify any conduct risks but they are considering prohibiting LISPs from permitting this type of branding by an entity that only holds a Category I licence, even if the Category I FSP uses mandates for convenience. Where a Category I FSP shares in the investment management fees relating to a co-named fund, there may be questions about the services performed for those fees and whether the client understands who is being paid for what.
In the 2018 Investment Paper, the regulator was firmly of the view that due diligence must be carried out by a financial institution before entering into any contractual arrangement with any party in the value chain. For example, financial advisors must conduct a due diligence on investment managers it uses or CIS management companies whose portfolios it recommends to clients. They should be able to demonstrate the due diligence process they followed, which goes beyond simply confirming the regulatory status of the relevant party, but must also consider things like treating customers fairly, the fit of the product provider or investment manager given the financial advisor’s business model, etc. In the updated Investment Discussion Document, the FSCA remains convinced of the need for due diligence to be conducted but agreed that due diligence requirements should be flexible and proportional. The FSCA has, therefore, committed to consult further with industry, and where necessary will provide guidelines about the level of due diligence expected.
Some of the investment related proposals are complex and, as we have already seen, the FSCA does take on board comments from industry. While it is very encouraging that the regulators are willing to adjust their positions or change in approach, it does make it difficult to plan too far ahead. The impact of these proposals will also differ depending on the FSP’s business model and the types of activities it performs. Although these proposals may change through the consultation process, FSPs that operate in the investment sector should consider how these proposals will affect their business.
This concludes Part 3 of our series on RDR Developments relating to Investment-related matters. Keep a look out for our last article in this series (Part 4) in our next issue of Mastering Compliance.