New and proposed regulatory changes in the UK

UK fund managers will be well acquainted with the various changes to AIFMD and MiFID II over the past few years and it might, at first, come as a relief to hear about regulatory changes affecting fund managers that don't relate to either. However, there are a number of new or proposed regulatory changes in the UK that you might have missed over the summer that funds managers should consider carefully.

Consumer Duty

The Consumer Duty will apply to firms providing regulated activities to retail clients in the UK. It consists of three elements: a consumer principle; cross-cutting rules; and four customer outcomes. The Consumer Duty represents the biggest change to the retail market in a generation, probably not seen since the retail distribution review, and will lead to material changes in the way in which firms will have to think about conducting their business with retail customers.

If you are a retail fund manager reading this you should be well versed in these obligations already. However if you are an AIFM targeting professional investors you may find yourself inadvertently caught in the same way that you may have been caught by PRIIPS KID.

The Consumer Duty applies only to funds where you have investors who are not professional investors in the fund. However, as noted above, various sophisticated and high net worth individuals are still considered to be retail investors. If you target this semi-professional category you may be subject to the Consumer Duty.

It also is not clear how your obligation may apply where a fund has a mixture of retail and professional investors. It potentially cuts across other regulatory obligations in AIFMD to treat clients fairly and to disclose when an investor obtains preferential treatment.

One area of concern may be that your co-invest vehicles would be investments by relatively junior staff or middle and back office staff as well as friends and family. Technically all these investors are retail and the Consumer Duty applies to them.

Action points:

For retail fund managers you should be acting already. If you are not you need to move urgently. For wholesale fund managers you need to identify the circumstances where you have retail clients investing and start considering your approach.

Appointed Representative Regime

An appointed representative (AR) is an entity that effectively uses the regulatory permissions of a regulated entity, its principal, to provide arranging and advising services. The principal remains responsible for the activities of the appointed representative.

Many fund managers rely on the appointed representative regime. US-headquartered managers who are establishing a presence in the UK for the first time establish an AR in the UK, to 'test the waters', which in turn can become a fully authorised firm as who scale up. UK multi- strategy fund managers establish appointed representatives to manage their internal structures with a principal having different appointed representatives advising different strategies of the fund manager, thereby allowing for easy identification.

The FCA has concerns that the AR regime leads to poor outcomes for clients and is therefore implementing additional requirements for principals and ARs. The FCA's requirements fall into two categories. The first is an obligation on principals to provide additional and ongoing data to the FCA in respect of the activities of their ARs. The second substantially increases the obligations on principals prior to, but also during, the ongoing appointment of any AR.

These obligations impose an additional burden on the principals to oversee their ARs. Additional oversight will be required including board discussions about arrangements. It will also mean amending the contracts in place between the AR and the principal to ensure the principal has necessary oversight. The additional data from the FCA will also allow the FCA to undertake additional proactive and reactive surveillance and we expect additional scrutiny of this in the next 12 months.

If you are an AR you are not subject to these rules directly but it is likely that your principal will be imposing additional obligations and restrictions on your activities. Expect additional oversight especially where you rely on a third party principal rather than an intragroup arrangement. For intragroup arrangements, more documentation, at the very least, will be required.

In some ways fund managers are collateral damage in terms of the FCA's concerns with financial advisors to retail investors. The AR model is used by these businesses and leads to a disproportionate number of complaints to the FCA. However, limited distinction is made in the rules as to the commercial reasons behind the model.

Increasingly the obligations on an AR will start to align with those of fully regulated firms without the benefits of being authorised. The cost-benefit analysis may therefore change for some ARs.

The FCA has indicated it will work with the Treasury to make further amendments, so it may not be the end of the road.

Action points:

If you are a principal you need to ensure that you implement the new oversight obligations, amend contracts and ensure you are able to implement this.

Overseas Persons Exclusion

Many UK fund managers rely on third parties to provide advice or portfolio management in respect of their funds. The UK, unlike the EEA, has a liberal regime that has allowed these services to be provided on a cross-border basis into the UK without authorisation or registration. Therefore there is a relatively frictionless provision of services into the UK (unlike services being provided from the UK into other jurisdictions).

This is done through a combination of the characteristic performance test. Essentially where an activity like portfolio management is performed in, for instance, the US or EEA, even on behalf of a UK client, the regulated activity is not deemed to occur in the UK. Where the characteristic performance test isn’t available, the overseas persons exclusion states that where an activity, such as advising, is deemed to be carried out in the UK if it is not done from a place of permanent establishment it is excluded from the need to be authorised.

This is a well-trodden path in the provision of intragroup and third party services, not just for fund managers but for insurance and share trading, and is part of the financial ecosystem. The FCA however is concerned it is being used in a way that it was never designed for. It is therefore working with the Treasury to examine the extent of the OPE. The FCA has also indicated it may provide additional guidance on the use of the characteristic performance test, potentially expanding the activities that are occurring in the UK and are therefore subject to regulation.

A combination of the narrowing of the OPE and the expanding of activities deemed to occur in the UK would lead to a number of services being provided into the UK requiring an overseas affiliate to become authorised if they cannot rely on other exemptions.

Action points:

None at this stage. Keep watching the brief.

LTAF

The FCA has announced plans to relax financial promotion rules in relation to Long Term Asset Funds, with the result that these can now be marketed to a wider range of retail investors. Launched in 2021, the LTAF is a type of authorised open-ended fund designed to encourage investment in long-term assets such as private debt, private equity, infrastructure and property. Under current rules, the LTAF can be promoted only to professional clients, certified high net worth investors, certified sophisticated investors and self-certified sophisticated investors.

The FCA confirmed plans for broadening the retail distribution of the LTAF to more categories of retail investors. The move is in line with the FCA's broader strategy in relation to financial promotion rules for high-risk investments. LTAFs promoted to retail clients would need to comply with the following criteria: not contain any monetary or non-monetary incentive to invest; and include specified risk warning and risk summary. Further rules apply for nonadvised customers receiving direct offer financial promotions. The FCA is expecting to publish a final policy statement and final Handbook rules early in 2023.

Action points:

Some fund managers, who have seen a succession of vehicles designed to be marketed to 'semi-professional' investors – EuVECAs, EUSEFs, ELTIFs and FAIFs – all go largely unused might be sceptical about the benefits of the LTAF, but for managers of illiquid strategies LTAFs are worth considering.

Financial Promotions of High- Risk Investments

The FCA has published final rules on financial promotions of "high risk" investments. These rules are intended to increase protection for consumers by reducing the potential for harm from investing in "high-risk" assets, and therefore in practice are applicable to retail funds as opposed to funds typically targeted at large institutional investors.

The FCA has developed product categories for Restricted Mass Market Investments (RMMIs) and Non-Mass Market Investments (NMMIs). Mass marketing of RMMIs to retail clients is prohibited, while mass marketing of the NMMIs to retail clients is subject to increased requirements on promotions such as strengthened risk warnings and a ban on inducements to invest.

Units in a CIS, a QIS or an LTAF are currently considered NMMIs by the FCA. However, as detailed above, the FCA proposes to re-classify units in an LTAF as RMMIs, which would increase the ability for units in an LTAF to be promoted to retail clients (subject to relevant restrictions). Rules related to risk warnings will have effect from 1 December 2022, and all other rules from 1 February 2023.

Action points:

Retail fund managers, wholesale fund managers with retail clients investing, and other fund managers or firms who make or approve financial promotions of RMMIs or NMMIs should consider these incoming rules as a matter of urgency.

AIFMD 2

We can't write an article about regulation of funds without mentioning AIFMD! AIFMD 2 is currently being considered by the EU and we would anticipate this coming into force in 2024 or 2025. The final rules are not yet available but the drafts have been well received from industry on the basis that it is not as bad as it could be.

UK fund managers will not be directly affected by this as the UK is not implementing these rules, but some rules such as delegation may be imposed on UK fund managers and advisers/ arrangers. UK fund managers may find third party European AIFMs can perform a wider range of activities, including loan origination, the servicing of securitisation special purpose entities, benchmark administration and credit servicing, under the current proposals.

Action points:

If you are a principal you need to ensure that you implement the new oversight obligations, amend contracts and ensure you are able to implement this.

Authors:Jake Green, Partner; Greg Patton, Senior Associate