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Funds interview on important investor protection issues

Shay Lydon, Funds Partner in Matheson and Laura Wadding, Regulatory Advisory Partner in Deloitte, spoke to Conor Molloy, Director of Funds at IOB, about fund governance and investor protection related issues.

Why is investor protection so important for the funds industry?

Shay: It is key. When you think about asset management regulation it has always pursued a number of objectives. First it is financial stability, second is development of capital markets but third and perhaps most important of those pillars is investor protection. And that goes right back to one of the most fundamental pieces of legislation in the Irish regulatory rulebook – the UCITS Directive. The European Commission report from the 1980s commenting on the provisions of the UCITS Directive (sometimes referred to as the van Damme Report), spoke about giving the small savers both the protection needed and the best opportunities for saving. Then going onwards, we saw the impact of the global financial crisis was an increased emphasis on protecting the investor. The legislation that was introduced – for example, AIFMD and depositary rules - were designed to restore investor confidence and create re-assurance about investor protection and did through such investor focussed steps as disclosure and reporting.

There are a number of ways in which investor protection is achieved – diversification rules to ensure that “not all eggs are in the one basket”, liquidity management rules to ensure investments can be realised, rules in relation to transparency and disclosure so that an investor can see what a fund has invested in and can understand the investment they are making.

More fundamentally investor protection can also be secured by rules in relation to the conduct of the various parties – the manager, the administrator, the depositary and of their delegates as well to ensure they are also acting in a manner consistent with investor protection. For example, every Irish regulated fund must have certain service providers in place, all regulated, starting with the manager itself, the investment manager which might be a separate entity, the fund administrator responsible for books and records, transfer agency, the depositary with responsibility for ensuring assets are held safely, right through to distributors, who must ensure that marketing of the product complies with relevant Irish rules and those of the state in which marketing is conducted. All are subject directly to their own regulation and indirectly to rules applicable by virtue of regulation of the fund. The focus on the position of the investor is also seen in the PRIIPs legislation, which applies to packaged retail investor products. One of the main initiatives it introduced is the provision of tailored key investor information for investors. Like a similar UCITS requirement, it effectively distils down the large prospectus or offering document into 2-5 pages of key information for investors to receive before making the investment.

Laura Wadding 2

Laura: For a long time there was this concept that as long as a firm was making money everyone was happy but unfortunately, we have found that if something goes wrong the money made in the past gets eaten into by the cost of fixing the issue and compensating investors.

Investors want to make a return but they also want to ensure they can get their original investment back. Of course different investors have different risk appetites -ranging from those which are very risk averse to those who are risk aware and can tolerate higher levels of risk. The challenge is, when it comes to institutional money, to consider (and I would expect a board to consider this) is it really institutional or, perhaps because of the distribution model, is it retail money behind the scenes. MiFID speaks to this in the context of suitability requirements and rules in relation to target market – in fact all of the regulatory framework is designed to bring about fair treatment of investors and the management of risk that is suitable for that investor’s tolerance of risk.

What are your thoughts on governance including both good and bad governance?

Laura: Governance is the way in which a firm organises itself to achieve its objectives and those objectives will include things like its financial performance, its ability to comply with legal and regulatory requirements, the way it organises its people, the control framework it has in place, the way in which it manages risk and also the way it makes decisions. In financial services, governance would include the structures that are in place within the entity and the way in which they operate. We have become practiced in using terms like three lines of defence – having a board, board sub-committees, executive teams, business line management teams – we consider all of that as part of the governance. Governance should be something that goes right through the organisation and right down to where controls are performed. All regulated financial service entities are expected to have appropriate governance arrangements in place. The ultimate goal of good governance is to ensure fair outcomes for investors and to reduce the risk of bad practices such as miss-selling or taking excessive risk exposures.

The ultimate goal of good governance is to ensure fair outcomes for investors and to reduce the risk of bad practices such as miss-selling or taking excessive risk exposures.

Bad governance is usually something that is outcome driven – something goes wrong and the outcome is usually detrimental to investors such as a loss of money, or unfair treatment or loss of opportunity. Detriment can take a number of forms and we have seen this in other sectors where individuals suffered for lots of reasons. But ultimately there are signs and symptoms and things that we can identify that indicate bad governance along the way and the key is to address them before investors suffer. Those types of things are usually a lack of controls or a weak control environment (no escalation process or policies and procedures in place, nothing is well documented), rogue decision making, particularly within investment management, someone having unfettered powers of decision making so there is no opportunity for those decisions to be challenged by the board, excessive risk taking otherwise known as irresponsible behaviour, lack of oversight, no lines of defence. Poor performance can sometimes be indicative of bad governance particularly where the product as designed should have performed well. Increased regulatory scrutiny is usually an indicator of bad governance.

There could be a combination of some of these (rogue decision making, irresponsible behaviour and excessive risk taking) where it is almost intentional. It could also be inadvertent where the firm does not have the right structures in place – for example that the standards expected today of risk management are not something the firm is familiar with. It might be an educational opportunity for the board to recognise that the way in which they used to do things might not be right for today or in the future. Nevertheless, even if inadvertent or even accidental, these issues can be just as detrimental to the firm or investors but to some extent easier to address.

Shay Lydon 2

Shay: A board will be concerned with suitability of products for target investors. This may include: checking if investment objectives and policies are appropriately disclosed; are they suitable for the type of investor; and questioning the liquidity of the assets the fund will invest in to ensure redemptions can be met.

Where a management company is part of a group it could be that there are times where the interests of the group, including any entities which act as service provider to a fund may be in conflict with the interests of investors. Central Bank guidance and recent speeches addresses this, referring to the culture within firms and the need to always put the investor first. Products are complex, there are multiple parties involved and it is not easy for investors to get their heads around the quantity of information in a prospectus including the parties involved and what they do. There is also a huge imbalance between the information available to the product producer or seller and the investor making the investment decision. As a result it is really important that the rules designed to protect their interests are applied effectively. One word of caution - all of the rules themselves introduce complexity and there is a need for balance between protecting the investor and ensuring that rules are not too restrictive so that an investor is prevented from accessing certain products.

Have you some thoughts on the role of the regulatory authorities?

Laura: The Central Bank of Ireland operates a supervisory framework called PRISM within which it assesses the risk impact of the entities it is responsible for and categorises them as low, medium or high impact (and within those categories medium low and medium high.) It looks at the nature of the business of the firm, its size, its complexity. The PRISM rating applied to the firm will directly reflect the amount of scrutiny that firm will get and the amount of Central Bank supervisory resources which will be allocated to it. The Central Bank plans its supervisory process on a yearly basis – testing can take different forms including the issuance of questionnaires to different sectors, desk top reviews and onsite inspections. Onsite inspections could take different forms including a targeted risk assessment, specific to the firm or a full risk assessment of that firm. Themed reviews are also carried out – this is currently being carried out in the funds sector – a themed review related to CP86. The Central Bank issued a questionnaire to every authorised management company last summer and then distilled the responses down to select a number for firms for a desk-based review and they further distilled the numbers down to select a number of firms for onsite inspection. That’s thematic – the results will apply to the whole sector. Dear CEO letters with the result of a thematic review are normally issued – every CEO in the sector gets one. It covers off the themes identified during the review. They are usually light on the positives and heavy on the areas where the Central Bank would expect to see improvement. The Central Bank will also take action to address weaknesses or failings identified within an individual firm – that is a different process and usually results in a findings report or a remediation plan. It can also result in direct action taken by the Central Bank including enforcement action – usually in the form of a fine.

Shay: It is interesting and informative to look at the Central Bank’s mission statement, which is published prominently on their website and sets out the Central Bank’s own view of its role as regulator. It is around serving in the public interest while safe-guarding monetary and financial stability and by working to ensure that the financial system operates in the best interests of consumers and the wider economy. There are different ways that it does all of this. It sets appropriate rules, has regard to cost and impact, (i.e. that rules are appropriate and consistent with EU standards), it monitors implementation of the rules and ensures that those who fail to meet the required standards remedy the situation.

Laura: Approaches across Europe are converging intentionally and we hear about supervisory convergence quite a bit. It is interesting to see how the ESMA role is evolving as they are tasked with ensuring that there is no country in the EU taking a lighter approach to supervision in order to avoid the perception or ability of firms to use a regulatory arbitrage strategy. Domestic regulators in Member States are buying into that. It is advantageous for one regulator to be applying the same standard as another. So culturally there is acceptance I think that supervisory convergence is positive. What that means going forward is that there will be more policy and guidance coming from ESMA in order to bring about consistent standards. There is always the potential for local regulators to go further, to gold-plate the standard, perhaps because of local conditions and that is their prerogative. But in the future ESMA are likely to play an even more important role as we have seen in the banking sector. The EU framework is very important for this sector and it is very important that it works because of the nature of funds.

Shay: One aim of financial services legislation in a European Union context is to ensure harmonisation where necessary. Maybe 15-20 years ago we would have seen different rules in Member States but this is being steadily replaced with a single European rule book and we see this happening more and more. The regulators will tell you they still see differences and divergent interpretation of EU rules across Member States so this makes the meeting of securities regulators at ESMA, the European Securities and Markets Authority, all the more important. This forum consists of delegates from each Member States working together to debate and formulate common sets of guidance and rules, consider various legislative initiatives and make recommendations. It has been the source of a lot of work completed to ensure convergence across the Union.

For example, we saw that ESMA was very active recently in the context of Brexit where lots of fund managers were looking at alternative locations where they might set up their business and regulators discussed a co-ordinated European response at ESMA level. This included in particular consideration as to how national regulators should approach questions related to substance and we then saw a uniform position coming out of that process. Regulators are keen to ensure that when they regulate these entities, they are taking a similar approach in terms of the rules they apply to their funds and their service providers. The results of this process included significantly increased requirements in relation to substance and staffing requirements in management companies across the EU. At ESMA regulators are sharing their experience and their views seeking to implement EU rules effectively, consistently and without giving rise to arbitrage. ESMA has its own mission statement where investor protection is a core objective. In the last year it has produced requirements in relation to liquidity and fees, each such initiative focussing on the impact of current industry practice on investors.

And finally, what are your views on the Central Bank's approach to the regulation of fund management companies as set out CP86?

Shay: The Irish guidance for fund management company effectiveness (CP86) sets out what is good practice for fund boards. It was developed over a number of years concluding in December 2016 with an implementation deadline in June 2018 and the Central Bank is currently reviewing implementation. The CP 86 guidance refers to matters for a board to take into account at the launch of a fund and ongoing obligations and sets out quite prescriptive rules which are to be followed by a management company in the course of its establishment and in its ongoing operations.

My view is that it sets an excellent framework for entities who wish to demonstrate that they have implemented an appropriate structure to discharge the key functions of a fund management company.

My view is that it sets an excellent framework for entities who wish to demonstrate that they have implemented an appropriate structure to discharge the key functions of a fund management company. My concern is that some aspects of CP86 are reflective of the time at which they were formulated and may in some respects be too prescriptive in terms of how a management company should operate. It preceded some of the developments we mentioned earlier regarding increased substance requirements and may result in some circumstances in management companies and their broader groups which now have a significant footprint on the ground here having to shoe-horn their structures into the framework mandated by CP 86. However, I am conscious that the current review of implementation should see further evolution of the CP 86 framework and its application to the broader range of management companies now to be found in Ireland. Laura: The fund management company guidance is designed by the Central Bank to enable better governance within fund management companies in order to facilitate greater levels of compliance with regulatory requirements and standards. I always differentiate between requirements and standards because you can do things by the book, but you might not necessarily meet the standard that is expected for a firm of your nature, scale and complexity. The Central Bank set about developing the guidance a number of years ago and they would have seen themselves as a leader in the European regulatory field in doing so. I think other regulators are following and will continue to follow. But then Brexit came about and dozens of firms sought authorisation here in Ireland in order to keep the passport and that has had a consequence of opening the Central Bank’s eyes to the types of firms that might exist here, types of firms and types of risks that we did not have here before. I expect as a consequence that the fund management company guidance will continue to evolve. The current guidance talks about the concept of supervisability – being capable of being supervised. There are some rules relating to directors and designated persons but it is still a principles-based guidance and that is why the concept of organisational effectiveness is also being included. That organisational effectiveness piece is the piece that expects firms to take a step back from time to time and assess if they are organised for effectiveness governance and to look forward to take into account what is coming down the tracks.

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