Supervisors are once again reinforcing the need for good governance of firms, including board composition and engagement, clear responsibilities and individual accountability. Extended remote working is challenging existing systems and controls. Product governance is under the spotlight, together with firms' behavior in the capital markets and stewardship of client assets.
The trends towards sustainable investment strategies, alternative asset classes and digitalization bring with them added complexity to business models and challenges to existing operational processes. Firms will find that regulators require them to do more in terms of governance structures, procedures, and onboarding of highly-skilled professionals in core functions and among board directors.
See below for more detail on:
Key considerations for firms
Have we reviewed and updated the composition of our board? Is there strong board engagement and challenge?
Are the design and operation of our corporate governance arrangements still appropriate, given our business strategy and culture? Are we able to make well-informed and well-evidenced decisions?
Are we able readily to identify individual responsibility and accountability, without overlaps or gaps? Have any senior responsibilities changed in response to the pandemic, or should they?
Are our risk management framework and controls fit-for-purpose given continued and large-scale remote working? Have we documented any changes, and can we evidence that our governance, risk management and controls work well in practice?
Are our product governance arrangements fit-for purpose, aligned to regulatory expectations, subject to robust and objective challenge, and delivering good customer outcomes?
Are we following best and evolving practice in relation to stewardship of client assets, including proxy voting and engagement with investee companies?
In the detail:
Governance arrangements and accountability
The composition of boards of directors is under the spotlight, and whether fund management companies (FMCs) appropriately challenge asset managers to which they have delegated portfolio management of their funds. For example, according to the findings of the Central Bank of Ireland (CBI) issued in October 2020, some Irish FMCs lacked sufficient substance and were not challenging investment managers effectively.
The CBI reviewed compliance with its framework on FMC governance and oversight. Newer FMCs were generally in compliance, but FMCs that have been active in Ireland for some time were found not to have sufficient substance to deal with their regulatory requirements and had not fully implemented the rules. This included having an insufficient number of full-time employees and a lack of staff of sufficient seniority and experience, relying instead on group resources. The CBI requires FMCs to have at least the EU minimum of three full-time employees for the smallest and simplest of entities, with the number rising in proportion to the complexity of the operation.
The CBI also found that nearly 30 percent of FMCs had an independent director who had been on the board for more than 10 years, which called into question their independence and that fund boards are not sufficiently challenging the appointed investment manager, including not conducting appropriate due diligence or receiving delegate reports of insufficient quality to allow for meaningful review. There were instances of poor documentation and recordkeeping.
All FMCs received a letter from the CBI requiring them to undertake a review of compliance by end-March 2021, and some were subjected to special supervisory measures by the regulator. The review was not a one-off - assessment of FMCs' compliance will form part of the CBI's ongoing supervisory engagement. The regulator has also found weaknesses in regulated financial service providers' compliance with fitness and probity rules. Inspections found that awareness of the obligations among boards was poor, due diligence for board and senior management appointments was weak, and there were not processes in place for robust testing of fitness and probity to identify and escalate concerns.
The UK Financial Conduct Authority (FCA) is concerned about overlapping directorships between an FMC and its delegated asset manager, especially among smaller and medium-sized companies, which it regards as an inherent conflict of interest. In September 2020, Marc Teasdale, FCA Director of Wholesale Supervision said the regulator often saw insufficient consideration being given to the conflicts of interest caused by heavily overlapping boards. Among other things, in its value assessment for each fund, an FMC's board needs to avoid the risk of bias in favor of the company's overarching commercial interests. Directors can continue to hold multiple directorships but must be able to demonstrate to the FCA that they have identified and declared, and are managing or preventing, any conflicts of interest.
In the same month, the Monetary Authority of Singapore (MAS) published guidelines and good practices, to strengthen the accountability of senior managers in key functions in financial institutions and to promote ethical behavior. The MAS set out five high-level outcomes it expects of firms (see box).
In November 2020, the US Securities and Exchanges Commission (SEC) warned (PDF 275 KB) registered investment advisers of compliance shortcomings with securities regulations and for not empowering chief compliance officers (CCOs). The Division of Examinations found deficiencies related to the compliance rule, which requires firms to develop policies and procedures that ensure they meet their fiduciary and regulatory obligations. Notable issues included inadequacies in compliance resources and training, authority of the CCO within the firm, annual reviews, written policies and procedures, and implementing actions required by policies and procedures.
Good governance outcomes
Senior managers responsible for managing and conducting the firm's core functions are clearly identified
Senior managers are fit and proper for their roles, and held responsible for the actions of their employees and the conduct of the business under their purview
The firm's governance framework supports senior managers' performance of their roles and responsibilities, with a clear and transparent management structure and reporting relationships
Material risk personnel are fit and proper for their roles, and are subject to effective risk governance, and appropriate incentive structures and standards of conduct
The firm has a framework that promotes and sustains among all employees the desired conduct
Accommodating remote working
There is recognition that, overall, firms' existing governance arrangements and controls have fared reasonably well during extended lockdown periods. However, the pandemic has given firms and regulators an insight into how things could be done differently in a future where hybrid models of remote and office working are likely to be a permanent feature. Traditional risk management, oversight and controls are challenged by large-scale remote working. Firms will need to recalibrate their risk frameworks and rethink associated controls.
Regulators are thinking through what this means as regards their expectations of firms and their own supervisory practices. For example, the Luxembourg Commission de Surveillance du Secteur Financier (CSSF) has set out governance and security requirements for supervised entities to perform tasks or activities through "telework", which will come into force at end-September 2021 if the threat of the pandemic has receded. Many Luxembourg fund management personnel live in a neighboring member state, so working from home raises question about "substance" of the FMC.
The CSSF says that while all staff members of a Luxembourg entity can in principle work remotely, it will impose certain baseline requirements to ensure that key functions are still being performed in a physical office in the jurisdiction. Firms must ensure that staff working remotely are able to return to the office at short notice and that the amount of an employee's normal working time spent working remotely should be limited. Also, firms will need to carry out detailed risk assessments of their remote working arrangements and ensure that their IT and cyber-security arrangements are proportionate to the risks.
New fund manager regulations
Some jurisdictions are introducing new or amended regulations for FMCs. In Saudi Arabia, for instance, responsibility for fund authorization has been transferred from the central bank to the Capital Markets Authority. In Cyprus, the "Mini Manager Law" was enacted in July 2020, creating a regime for the regulation and licensing of sub-threshold alternative investment fund managers. Prior to the enactment, such firms were not subject to licensing in Cyprus. A draft law on the regulation of fund administrators is in progress.
The China Securities Regulatory Commission (CSRC) has consulted on new measures and implementation provisions for the supervision and administration of public-offered securities investment fund managers. The aim is to revise and improve the 2012 measures for FMCs, by improving the approval process, strengthening on-going supervision, optimizing the public fund management license mechanism and enhancing the governance structure of FMCs.
Product governance expectations increase
Regulators are re-asserting the importance of robust product governance arrangements, in the interests of market stability and investor protection. Market stresses and volatility have impacted underlying assets and the management of clients' and funds' portfolios, which have led to a renewed emphasis on liquidity management and stress testing (see chapter 4). Regulators are also concerned that product development and distribution methods should genuinely be aligned to investors' best interests, and they are having regard to moves to sustainable investing.
The Australian Securities and Investments Commission (ASIC) published in December 2020 a new regulatory guide on product design and distribution obligations. Firms are required to design financial products to meet the needs of consumers, and to distribute their products in a more targeted manner. The obligations will take effect in October 2021, having been deferred by six months due to the pandemic. ASIC Acting Chair, Karen Chester said "The design and distribution obligations are a game changer. They are designed to embed a consumer-centric approach and assist industry to deliver better outcomes for consumers while managing non-financial risks and avoiding costly remediation".
The European Securities and Markets Authority (ESMA) clarified (PDF 395 KB) the compliance function's role in product governance in June 2020. It said the compliance function should be formally involved in the development and maintenance of a firm's product governance framework, policies and processes. Further, ESMA expects the compliance function to play a part in each fund or service approval, whether relating to manufacturing or distribution. In practice, this means that the compliance function should have an effective and objective impact on the firm's process, and that the product governance framework must genuinely shape and challenge fund/service design, distribution proposition and value for the client/fund investor.
ESMA subsequently launched in February 2021 a common supervisory action with national regulators on the application across the EU of the product governance rules in the Markets in Financial Instrument Directive (MiFID II). The aim is to ensure consistent implementation and application of the rules and to enhance the protection of investors. It will assess:
- How managers ensure that the costs and charges within funds are compatible with the needs, objectives and characteristics of their target market and do not undermine the fund's return expectations
- How managers and distributors identify and periodically review the target market and distribution strategy
- What information is exchanged, and how frequently, between manufacturers and distributors
Meanwhile, in the same month, the UK Financial Conduct Authority (FCA) published findings of its review into the product governance arrangements of eight asset managers. The FCA believes there is significant scope for firms to improve their product governance arrangements and to align them to the rules. The key failings identified were:
- Product design: not appropriately considering the product's "negative" target market and not assessing conflicts of interest at a sufficiently granular level of detail
- Product testing: stress and scenario testing were either too backward-looking or too generic (not addressing product-specific characteristics)
- Distribution: insufficient due diligence conducted on distributors at outset and insufficient procedures for monitoring management information
- Governance and oversight: ineffective oversight by second line, poor record-keeping and inadequate training
There is more to come for EU asset and fund managers. Amendments to rules under the UCITS1 Directive, the Alternative Investment Fund Managers Directive (AIFMD) and MiFID II require firms to consider clients' sustainability preferences in suitability assessments and to embed consideration of sustainability risks into their product governance and risk management processes. In its advice to the Commission on the amendments, ESMA noted that asset managers will have to set up new controls and potentially hire more staff, so that firms have “sufficient human and technical resources for the assessment of sustainability risks”
Capital markets activity
Regulators are keen to ensure that the activities of investment managers in the capital markets are always in the best interest of, and support good outcomes for, their clients and fund investors. They are also concerned that smaller companies should be able to raise capital, to support economic recovery, and that investment managers should have access to market data.
In September 2020, the MAS published a notice and related guidelines on execution of customers' orders in connection with dealing in capital markets products, fund management or real estate investment trust management. The notice sets out requirements for financial institutions in Singapore to have policies and procedures to place and execute customers' orders on the best available terms, so as to support fair outcomes for customers.
The first stage of the EU's review of MiFID II has introduced an exemption from the investment research rules in relation to small- and medium-sized enterprises (SMEs) and fixed income. Payment for research on such companies will no longer need to be unbundled from the cost of execution of transactions. The next stages of the review will cover many of the wholesale market rules, including pre-and post-trade transparency. The UK FCA is mirroring the EU's review, but with some differences in detail. For example, on the rules on payment for research, the FCA is proposing to exempt SMEs with market capitalization of below GBP 200 million, as opposed to the EU threshold of EUR 1 billion.
Good stewardship of investments
Rules have changed for both investment manager and investee companies. For instance, revisions to the Japanese Corporate Governance Code regarding the exercise of the functions of the board of directors require at least one third of independent outside directors for listing on the prime market, diversity in the core human resources of a company, sound group governance (including issues related to the listing of subsidiaries) and the reliability of audits.
In July 2020, the US SEC adopted amendments to rules governing proxy voting advice. The aim is to ensure that clients of proxy voting advice businesses have reasonable and timely access to more transparent, accurate and complete information on which to make voting decisions. The SEC issued supplemental guidance to assist investment advisers in assessing how to consider additional information from issuers that may become more readily available due to the rule amendments. The guidance also addresses circumstances where the investment adviser utilizes a proxy advisory firm's electronic vote management system, and disclosure and client consent obligations.
SEC Acting Chair, Allison Herren Lee said in March 2021 that she wants to see clearer disclosures on how asset managers cast shareholder votes. Voting information is "unwieldy, difficult to understand, and difficult to compare across fund complexes", she said. She envisions a new rule that could mandate more standardized and timely disclosures, and potentially make clear the number of shares where fund managers decline to exercise their vote. Also, there may be a disconnect between passive index funds' proxy voting and their investors' sustainability inclinations.