The FCA’s recent refusal to grant permission to a firm seeking to offer regulatory hosting services through a number of appointed representatives (AR) may serve as a reminder of the regulator’s toughening approach to the AR regime following its consultation paper (CP 21/34) at the end of last year and could be a sign of things to come.
With the consultation now closed and the FCA’s policy statement and final rules planned for publication in H1 2022 there are a number of steps firms could be taking now to prepare for the anticipated changes in the FCA’s final policy, which we expect will be broadly as set out in the consultation paper. We set out below a recap on what these changes may entail and how those potentially impacted can best position themselves to adapt as required.
2 What is the main driver behind the FCA’s desire to improve the AR regime?
Whilst the FCA acknowledged in its consultation paper that the AR regime has benefits, it considered there was significant evidence of harm to consumers and markets as a result of the way the regime was being used. The FCA’s data analysis identified that on average principals generate 50% to 400% more complaints and supervisory cases than other directly authorised firms.
There has been some clear evidence of fundamental misconceptions, within the market, as to the meaning of an AR structure and expectations of governance standards and quality of advice and/or services they provide. This has also extended to consumers, who may be either confused or wary of the implications of working with an AR.
The FCA therefore decided to take action to mitigate the risk of harm by consulting on two key areas of proposed change: (a) requiring principals to obtain from their ARs and share with the FCA additional information; and (b) oversight of ARs by principals.
Although the FCA has yet to publish its policy statement confirming the changes to the regime (and consequential amendments to the FCA Handbook) it is unlikely that the final published policy of the FCA will differ radically from the proposals on which it consulted. The newly formed Appointed Representatives Department within the Supervision, Policy and Competition Division of the FCA, is also an indicator of how seriously the regulator intends to take its role in regulating the enhanced regime.
3 Who will be affected by the proposed changes?
The proposed changes will have an impact across a wide range of AR business models, including:
(a) Introducer Appointed Representatives (IARs): ARs which can only undertake the limited activities of effecting introductions and distributing financial promotions on behalf of the principal.
(b) Network models: where a principal has a group of ARs sharing the same commercial objective and operating in the same market.
However the regulator recognises that some models pose greater harm than others and therefore the degree of regulatory intervention will vary depending on the level of risk. For example, the scope of activities which IARs are permitted to carry out is limited and therefore the potential harm arising from an IAR arrangement is usually relatively low.
Accordingly the FCA is intending to ask for less information from principals about their IAR arrangements than from those with other AR models.
The third AR model which received particular focus in the consultation paper was the ‘regulatory hosting’ model where the principal does not carry on any substantive regulated activity itself but oversees the use of its permissions by its ARs; typically the ARs are independent, unconnected businesses operating in different markets from each other and the principal. Whilst the consultation did not include potential rule changes in relation to regulatory hosts, the “for discussion” part of the consultation paper invited views and input on potential policy change which could improve the effectiveness of the AR regime and reduce the potential harm arising from these business models.
4 What are the key areas of change?
The FCA consulted on two main areas of change:
(a) additional information regarding ARs; and
(b) oversight of ARs by principals.
Additional information requirements and changes to the register
Currently the FCA requires principal firms to provide high-level information on the market in which the AR operates, this might include basic information on the structure of the business and the nature of services provided. However if the proposed changes come into force following the publication of the policy statement this year, the regulator will ask principals for new additional details in relation to four key areas:
(a) the AR’s business;
(b) the AR’s revenue;
(c) complaints against the AR; and
(d) the split between the AR’s regulated and non-regulated activities.
The consultation paper included a detailed list of items in respect of each of these four categories, providing an insight into where the FCA sees potential or actual harm arising as a result of the AR regime. By way of example, the regulator intends to request information from principals on the scope of the AR appointment as well the nature and size of its non-regulated business; whether it will provide services to retail clients; and whether it had previously been an AR of a different principal and if so why the AR is now intending to operate under a new principal. It is clear throughout the consultation paper that the FCA has particular concerns about the size of an AR relative to its principal, the risk of an AR acting outside the scope of its appointment, and in particular the potential and actual risk of harm to retail consumers.
The primary focus is on the retail sector. Whilst the wholesale sector will also be impacted as a result of the proposed enhancements to the regime, the consultation served as a pertinent reminder that the highest numbers of ARs operate within the retail lending and general insurance and protection sectors, and that more effective oversight of ARs is critical to ensuring that consumers are able to access better quality information on the products and services offered by principals and their ARs in order to make more informed choices.
Principals will have to comply with the additional information requirements in relation to both existing and new ARs (within 60 calendar days of the new rules coming into force). They will also be expected to notify the regulator of ad hoc changes such as changes in relation to the nature of the AR’s regulated and non-regulated activities and any significant changes made to the financial relationship between the principal and the AR. The principal will also be expected to carry out annual reviews on their ARs and comply with ongoing reporting obligations in relation to complaints data and data on revenue streams from regulated and non-regulated activities. The FCA believes this greater visibility of revenue data will provide it with an indication of the size of the AR by comparison to its principal, making it easier for the regulator to assess the potential impact of the AR’s business on consumers or the principal’s ability to pay any redress for harm caused by the AR.
Firms should also be aware that the FCA’s proposals included making the additional information requested from principal firms publicly available on the FS Register, on the basis that enabling consumers to check the type of activity an AR is permitted to undertake would help them to avoid contracting with an AR for a product or service falling outside the scope of the agreement with its principal.
Oversight of ARs by principals
The FCA also proposed further rules and guidance to clarify the standards expected of principals to ensure effective oversight of their ARs. The key aims of the FCA’s proposals in this area were to:
(a) clarify expectations and responsibilities of principals for their ARs;
(b) strengthen existing requirements for principals’ oversight of ARs;
(c) give more guidance on when and how a principal should terminate an AR relationship;
(d) require principals (under a new rule in SUP 12 of the FCA Handbook) to conduct an annual review of each AR, to assess:
- the fitness and propriety of senior management at the AR;
- the AR’s financial position;
- the ability of relevant persons at the AR to carry out regulated activities for which the principal has accepted responsibility; and
- the adequacy of the firm’s controls and resources.
Principals would also be expected to annually prepare a self-assessment document demonstrating their compliance with aspects of the policy for the enhanced AR regime. Principals should be ready to submit the self-assessment document to their FCA supervisor if requested.
5 What will enhanced “effective oversight” of ARs look like on a practical level?
The skills, experience and expertise of senior management at both the principal and AR is a significant concern for the FCA. The proposed annual assessment by a principal of its ARs would include ensuring that the senior management of each AR remains fit and proper. The FCA’s expectation is that principals should actively be assessing and recording whether and how individuals at ARs meet fit and proper expectations on a continuing basis.
To assist with this it is likely that the FCA’s policy statement will confirm new guidance on how to assess the competence and capability of senior management at the AR on an annual basis, including whether:
(a) they are appropriately experienced and trained for the activities they carry out on behalf of the principal;
(b) they have the necessary time to perform such activities; and
(c) they have the requisite knowledge and skills to undertake such activities.
The FCA will expect senior management at the principal to have a “clear picture” of their relationship with their ARs and specifically how they meet the fit and proper requirements. In the FCA’s view this will limit the risk of harm from more inexperienced staff carrying out assessments of ARs’ fitness and propriety.
Sufficient Resources, Monitoring and Threshold Conditions
As well as enhanced scrutiny of senior management, we also anticipate the forthcoming policy statement will confirm additional guidance in respect of the following areas:
(a) the requirement on principals to have sufficient resources in place to oversee and monitor their ARs including clarification of the meaning of “adequate” resources and controls;
(b) monitoring AR activities outside the scope of appointment;
(c) monitoring AR growth; and
(d) threshold conditions and effective oversight.
The FCA has expressed significant concern about some ARs conducting regulated activities outside the scope of their appointment and the harm this can cause to markets and consumers. This is because the principal may not be obliged to accept responsibility for misconduct by an AR that does not relate to the scope of activities for which it is responsible under the AR agreement. The FCA proposed to clarify its expectations regarding the “reasonable steps” that principals must take to ensure that ARs act within the scope of their appointment. Firms should be warned that this is likely to include an expectation on principals to ensure a “high standard of oversight” of their ARs.
Another key concern of the FCA is related to ARs growing very quickly over a relatively short period of time. This can have a detrimental impact on consumers and markets because the principal may not be able to “keep up” with such rapid growth in terms of its oversight responsibilities. Under the new proposed guidance firms would be expected to conduct an “oversight appropriateness” review in the event of certain trigger factors, to then consider what action to take to either remedy the issue or terminate the AR’s contract.
Perhaps even more burdensome is the FCA’s expectation that principals have systems and controls in place to enable them to effectively oversee financial services staff at ARs to a “comparable standard as if they were individuals directly employed by the principal and the AR’s activities were in-house at the principal”. This would be a significant development compared to current guidance and reflective of the high standard of oversight and responsibility the regulator will likely expect of principals going forward.
Combined with the other elements of the enhanced regime outlined in this briefing paper, this is indicative of the expectation on senior managers at principals to scrutinise at both a business and individual level the principal’s own capacity and capability to oversee the relevant elements of the AR’s business for which it is responsible, as well as to ensure it maintains a deep understanding of the AR’s business model and markets within which it operates.
6 What potential changes are in the pipeline for principal firms operating a “regulatory hosting” model?
A potential area for further change is in relation to regulatory hosting business models and arrangements where the business of the AR may not align with that of the principal.
Whilst this business model was not subject to proposed rule changes in the FCA’s consultation paper the regulator invited views and input on potential policy changes in “the discussion” part of the paper. This appeared to be at least in part driven by the disproportionate amount of FCA resource and time being spent on regulating regulatory hosts relative to the size and level of their activity.
The FCA cited the following concerns against the backdrop of significant growth in the number of firms providing regulatory hosting services in recent years:
(a) FCA supervision work has identified that most issues arising from regulatory hosting arrangements are because the principal lacked sufficient resources to effectively oversee ARs and lacked the skills and experience in the different markets in which the ARs operated;
(b) many regulatory hosts have a large number of ARs with wide-ranging business models which makes it inherently difficult for principals to have the requisite knowledge and expertise and systems and controls to effectively oversee their ARs;
(c) over-reliance on income from ARs to sustain the principal’s business model can create a conflict of interest where the principal may be reluctant to enforce strict regulatory compliance;
(d) regulatory hosts have on average more FCA and Financial Ombudsman Service complaints against them, and create on average more FCA supervisory cases than other principals; and
(e) specific concerns within the context of the investment management sector where a principal is appointed as the alternative investment fund manager (AIFM) to an alternative investment fund (AIF) and the AR is usually appointed as an adviser to the AIF. Under this model, individuals from the AR may be seconded to and perform the client-dealing function on behalf of the principal. In this scenario the AR typically claims to be the “fund manager” when marketing AIFs, when legally this role is being performed by the principal as the AIFM.
One of the key concerns is conflicts within this model. For example, where the AR is large enough to be a major source of revenue for its principal, the principal will likely be less motivated to ensure compliance with appropriate standards or take action to address detriment. Hence the FCA’s proposal, as alluded to above, that principals submit revenue data on their ARs in a new AR reporting form. A ban on regulatory hosting has also been mentioned in the discussion portion of the consultation paper, which illustrates the level of the FCA’s concern about regulatory hosting activities.
7 What are the possible consequences of the enhanced regime on principals and ARs?
At the more extreme end of potential consequences of enhancement to the AR regime, is that ARs may leave the market. The FCA estimates that not more than 10% of ARs will exit the market but if the AR model becomes regulated to the extent that it can no longer be distinguished from direct authorisation, this figure may be higher with potential consequences in terms of competition and costs.
We anticipate more FCA intervention and enforcement action against principal firms, both in terms of (i) their own systems and controls in relation to the management of risks presented by ARs in the broadest sense; and (ii) holding principal firms to account for the activities of their ARs.
There may also be increased compliance costs for firms (which could in turn result in additional costs for retail and wholesale consumers where these costs are passed on, for example through increased prices for products and services provided to customers by principals and their ARs).
On the basis of the proposed revenue reporting requirements, it seems likely that FCA scrutiny of large ARs with principals operating this model will be high. One possible adaptation would be principals seeking to limit the size of their ARs and there may be less appetite to maintain large-scale AR operations.
8 What should principal firms be thinking about now?
The additional information and notification requirements and increased scrutiny of ARs required under the new proposals will impact on both time and resources of principal firms. As such principals should ensure their ARs are contractually obliged to provide the relevant information both at the time of appointment and throughout the relationship, so that principals do not fall foul of the regulator’s enhanced expectations.
In light of the FCA’s focus on organisational process change and increased senior management responsibility, in particular principals should:
(a) ensure all responsible individuals at the principal firm are sufficiently experienced with the right level of seniority to supervise the AR and execute decisions; review its governance framework including systems and controls for overseeing and monitoring its AR relationships to ensure there is adequate board oversight; escalation procedures; engagement with the AR and management information;
(b) review the contractual arrangements with each of its ARs to ensure the AR is required to provide the additional information and cooperation to ensure the principal can meet regulatory expectations;
(c) ensure that all reasonable steps are being taken to mitigate against harm or potential harm to both consumers and markets and ensure alignment with its approach for preparing for the new Consumer Duty; and
(d) ensure oversight is built in to the relationship with the AR. With oversight being a key driver, it is vital that both principals and AR’s are adequately resourced.
The FCA has made clear it is seeking more robust and effective oversight of the AR regime and as such principal firms are under increased scrutiny.
A recently published final notice related to the FCA’s refusal to grant permission to a principal to enable it to offer regulatory hosting services through various different appointed representatives due to:
(a) insufficient non-financial resources, specifically, a lack of appropriate personnel with knowledge and frontline experience, and a lack of previous SMF experience amongst the senior management team required to conduct the “extensive oversight” required to carry on a regulatory hosting service for investment products;
(b) inconsistencies in policies and procedures and inappropriate reliance on the AR’s systems and controls, suggesting a lack of understanding of regulatory requirements and a flawed business model; and
(c) a subsequent failure to update key policies and procedures to reflect its business model.
Firms should expect the regulator to continue to toughen its stance, both via more direct supervision and enforcement action, towards the AR regime following publication of the policy statement which was expected in H1 2022. Firms should review the final policy statement to see whether it remains consistent with the policy approach set out in the consultation paper, as expected.