Eyes on the ball
13 Dec 2023
The efficacy of fund oversight operations has implications that spread far and wide. Lucy Carter discusses the current landscape, the changes that have been made and what needs to be done next
Image: michael_flippo/stock.adobe.com
The consequences of inadequate oversight of fund managers can be fatal, going far beyond the loss of money or a sullied reputation. Following the Madoff investment scandal in 2008, six suicides are noted as a direct consequence of the fund’s collapse.
Similarly devastating, the 2008 Financial Crisis, attributed in part to regulatory and oversight failure, was the catalyst for Europe’s Alternative Investment Fund Managers Directive (AIFMD) and drew attention to the importance of sound oversight practices.
But regardless of the changes that the crisis ushered in, the effects on lives and livelihoods were incalculable and are still being felt today.
Changes to regulations and compliance rules may be onerous and exhausting, but their importance cannot be overstated. Even if the industry complains about the layers of oversight they must maintain, and the endless paperwork that regulators demand, not keeping up with obligations can have dire results.
State of affairs
In 2018, the Financial Conduct Authority (FCA) introduced the requirement for at least a quarter of authorised investment funds’ boards to consist of independent directors. Following the US approach, this strategy aims to embed an investor watchdog into funds’ practices, with the primary goal of championing the end investor’s interests.
However, a 2021 review of this business model — assessing whether conflicts of interest were being effectively raised — brought a number of concerns to light. Alternative investment fund managers (AIFMs) could not provide sufficient evidence of their governance procedures, and the contributions of independent non-executive directors (iNEDs) were of varying qualities. The review further identified a failure to challenge senior management decisions, whether due to independent non-executive directors’ unwillingness to voice issues or a lack of awareness of their duties or insufficient expertise.
A more recent FCA report, released earlier this year, stated that although the value assessments generated by fund managers had improved “significantly”, there is still work to be done. The lack of challenge from iNEDs has persisted, with information accepted at face value, and a large disparity noted between good and poor fund performance assessments.
To improve this persistent issue, Stephen Johnson, managing director of client delivery operations at Broadridge Fund Communications Solutions, advocates for “more specific expertise at board level.” He suggests that rather than relying solely on broad government experience, iNEDs should bring specialised expertise to their roles. “That’s not to say that other board members can relinquish responsibility,” he clarifies, “but oversight will be enhanced if there are diverse skills and experiences represented at a board level.”
“Independent directors at asset management firms have an inherent conflict of interest”, explains Paul Spendiff, head of business development for fund services at Ocorian. “They serve two masters: the shareholders of the asset management firm and the investors in the funds.”
FCA 2023
In its 2023 report, ‘Updating and improving the UK regime for asset management’, the FCA notes that the current system consists of rules structured around EU legislation. Based on a range of EU directives and regulations, there are often issues of clarity and consistency for UK firms, increasing costs and enhancing operational challenges.
This approach, by which requirements from different regulations are incorporated into the swirl of the UK regime, has led to confusion. The UCITS Directive, AIFMD and MiFID all affect asset managers, but due to differing law-making processes and various unaligned amendments, advice around key functions such as conflict of interest management and outsourcing are duplicated and inconsistent. This could emerge around technical details, resulting in identical or similar activity being regulated to different standards and companies unsure which approach to the rules they should be taking. It seems unsurprising, then, that confusion arises when it comes to regulatory compliance. If there are three different lists of instructions to follow, how do you know which is right? This could be another factor contributing to the lack of challenge seen from iNEDs, as highlighted by the FCA and the IoD in 2021.
“I think that despite the requirements of the FCA Rulebook, the conflict of interests for Authorised Corporate Directors in particular is too great,” muses Ocorian’s Spendiff.
Finding fixes
Concluding its 2021 report on fund governance, the Institute of Directors (IoD) made a series of recommendations to the FCA on how the UK’s fund governance framework could be improved in order to rebuild trust and ensure investor protection. The first of these is to “improve the credibility of independent directors in their oversight of funds on behalf of investors by strengthening their independence from investment managers”. This could take the form of transferring directorial appointment responsibilities to the FCA, guaranteeing that independent directors are qualified, truly independent and more trustworthy. Another suggestion is for the UK to lean into the US approach by appointing independent directors directly to the board of the fund entity, rather than the board of the AFM.
“The UK industry is more closely aligned to the US now than it was prior to Assessment of Value and Consumer Duty” says Devin McCune, vice president of regulatory and compliance at Broadridge, stating that regulatory oversight is now “very similar” to primary oversight responsibility in the US. However, he adds that these requirements are “in their infancy” and that “there is much learning and improvement occurring to the process”. He believes that fund oversight will improve as INEDs develop deeper knowledge of both the funds they are working with and the overall operational challenges that are confronting asset managers.
The IoD’s report also proposed the introduction of formal training for independent directors, along with increasing the scope of responsibilities that independent directors take on. This could include topics such as liquidity and investment sustainability, the IoD suggests, covering a broader range of investor concerns.
What appears to be the most obvious of solutions is the creation of a single rulebook, consolidating divergent guidelines and helping to boost the attractiveness and competitiveness of the UK market to domestic and international players. In a February 2023 consultation paper, the FCA asked for feedback on whether this would be a beneficial move to make, taking into consideration the potential costs and difficulties that the process could cause.
Unfortunately, any resolution that seems too good to be true usually is. As Joe French, managing director of Ocorian subsidiary Newgate Compliance, puts it: “If it were that easy, the FCA would have fixed it by now.”
A single rulebook would certainly help to improve consistency in the industry, French continues, and could improve clarity for industry participants if created with sufficient consultation, guidance and industry collaboration. However, oversimplification could present further issues.
Embracing a principles-led approach could leave too much space for subjectivity, “creating uncertainty and potential mistakes”, he explains.
Additionally, the broad spectrum of asset classes and structures that would come under the regime makes the creation of a single, comprehensive rulebook challenging. “Losing proportionate regimes, especially for diverse assets like real estate, might raise concerns.”
AIFMD
AIFMD was put in place in 2011, having been developed after the 2008 Financial Crisis. The directive aimed to regulate fund managers for alternative investments in what had been, up until that point, a less regulated sector in the EU.
With primary goals of investor protection, through stronger information disclosure compliance requirements, and a removal of systemic risk from the EU economy, the directive demands that asset managers identify conflicts of interest, promote fairness towards investors and ensure that disclosure, risk management and remuneration practices are applied appropriately.
Additionally, minimum capital requirements were introduced for funds (protecting against one of the instrumental factors that led to the 2008 crisis) and a number of safeguarding methods were implemented, delivered via custodians and depositories.
Looking towards the next iteration of AIFMD, “we anticipate that consumer protection regulations will be strengthened, accompanied by clarifications concerning fund management techniques”, says Universal Investment’s Noltenius.
He expects increased scrutiny around conflicts of interest, with a focus on disclosure obligations and checks.
“One change that would be welcome is to change the LTAF from an authorised to an unauthorised fund”, Ocorian’s Spendiff comments. He explains that one of the biggest contributions to low take-up has been the requirement for LTAFs to be operated by an authorised fund manager, few of which have experience of real assets.
Additionally, “few real asset managers have the ability or desire to become authorised managers” due to the “significant additional burden” that this places on them.
Noltenius predicts that asset management practices will also be in the line of fire, “particularly regarding the use of liquidity management tools and the handling of valuation uncertainties”.
What’s in the way?
In 2021, the IoD stated that there was “a pressing need to rebuild trust among ordinary investors” after a number of asset management industry scandals. Although consistent attempts have been made to improve oversight practices and operational resilience, there is still a way to go.
In spite of AIFMD’s intentions, and the intentions of the multitude of other fund oversight regulations and initiatives across the market, incidents of oversight faults and preventable, or minimisable, crises continue to emerge. The collapse of the LF Woodford Equity Income Fund in 2019 prompted finger-pointing at Northern Trust, as the fund depository, and Link Funds Solutions, as its Authorised Corporate Director (ACD), with the thought that they had failed in their fiduciary duties. Indeed, a number of items have come to light that show significant and continual lapses in judgement from overseers, bringing into question the efficacy of protective regulation and doing little to improve trust in the industry.
Spendiff explains that the UK’s authorised manager regime is no longer fit for purpose. “It reflects a time when the expectation was that the investment manager of a fund would be responsible for all aspects of its management, including transfer agency, fund administration and valuations,” he says. Even though these activities are generally outsourced they remain, technically, the responsibility of the authorised manager. Unlike in Europe, they are not regulated in their own right and go under-checked.
“There’s no real impediment to effective fund oversight, however the industry would greatly benefit from the establishment of a more uniform regulatory, legal and tax framework,” Universal Investment’s Noltenius shares. Such a system should harmonise regulation for both retail and professional investors, align with international standards and facilitate a “level playing field” for those involved in asset management. Implementing a “dedicated monitoring system” is essential to keep up with a constantly evolving legal landscape, Noltenius says. However, he acknowledges the financial barriers that may prevent smaller firms from bringing in such systems. The high cost of keeping up with regulatory changes “may result in fewer companies being able to compete”, he says, “possibly reducing the range of choices available to investors”.
Broadridge Fund Communications Solutions’ Johnson adds that “a constantly changing regulatory landscape is making it difficult for boards and managers to remain fully versed on regulatory changes that impact the funds they oversee”.
This issue becomes even more complex for global companies, which must keep up to date with a range of jurisdictions.
On top of that, Johnson observes that fund investments themselves have become more complex; fund structures are often complicated, making it “extra difficult to understand precisely what oversight is required”. All those involved in the oversight process need to be well versed in the “benefits and pitfalls” of new fund strategies, “fully understanding the risks that they can introduce” and challenging them sufficiently.
“A consistent approach to new regulations and increasing alignment on existing regulations would reduce complexity and help oversight,” he states.
Conclusion
Fund oversight processes are currently well intentioned but deficient. The industry is yet to develop a truly effective approach, something illustrated by a number of high-profile cases that have received publicity beyond the financial world and have become mainstream news stories.
The industry needs to continue to set effective checks and balances in place, to tighten its fund governance and value assessment frameworks, and to learn lessons from recent failures of fund oversight. These steps are important to prevent history repeating itself.
Similarly devastating, the 2008 Financial Crisis, attributed in part to regulatory and oversight failure, was the catalyst for Europe’s Alternative Investment Fund Managers Directive (AIFMD) and drew attention to the importance of sound oversight practices.
But regardless of the changes that the crisis ushered in, the effects on lives and livelihoods were incalculable and are still being felt today.
Changes to regulations and compliance rules may be onerous and exhausting, but their importance cannot be overstated. Even if the industry complains about the layers of oversight they must maintain, and the endless paperwork that regulators demand, not keeping up with obligations can have dire results.
State of affairs
In 2018, the Financial Conduct Authority (FCA) introduced the requirement for at least a quarter of authorised investment funds’ boards to consist of independent directors. Following the US approach, this strategy aims to embed an investor watchdog into funds’ practices, with the primary goal of championing the end investor’s interests.
However, a 2021 review of this business model — assessing whether conflicts of interest were being effectively raised — brought a number of concerns to light. Alternative investment fund managers (AIFMs) could not provide sufficient evidence of their governance procedures, and the contributions of independent non-executive directors (iNEDs) were of varying qualities. The review further identified a failure to challenge senior management decisions, whether due to independent non-executive directors’ unwillingness to voice issues or a lack of awareness of their duties or insufficient expertise.
A more recent FCA report, released earlier this year, stated that although the value assessments generated by fund managers had improved “significantly”, there is still work to be done. The lack of challenge from iNEDs has persisted, with information accepted at face value, and a large disparity noted between good and poor fund performance assessments.
To improve this persistent issue, Stephen Johnson, managing director of client delivery operations at Broadridge Fund Communications Solutions, advocates for “more specific expertise at board level.” He suggests that rather than relying solely on broad government experience, iNEDs should bring specialised expertise to their roles. “That’s not to say that other board members can relinquish responsibility,” he clarifies, “but oversight will be enhanced if there are diverse skills and experiences represented at a board level.”
“Independent directors at asset management firms have an inherent conflict of interest”, explains Paul Spendiff, head of business development for fund services at Ocorian. “They serve two masters: the shareholders of the asset management firm and the investors in the funds.”
FCA 2023
In its 2023 report, ‘Updating and improving the UK regime for asset management’, the FCA notes that the current system consists of rules structured around EU legislation. Based on a range of EU directives and regulations, there are often issues of clarity and consistency for UK firms, increasing costs and enhancing operational challenges.
This approach, by which requirements from different regulations are incorporated into the swirl of the UK regime, has led to confusion. The UCITS Directive, AIFMD and MiFID all affect asset managers, but due to differing law-making processes and various unaligned amendments, advice around key functions such as conflict of interest management and outsourcing are duplicated and inconsistent. This could emerge around technical details, resulting in identical or similar activity being regulated to different standards and companies unsure which approach to the rules they should be taking. It seems unsurprising, then, that confusion arises when it comes to regulatory compliance. If there are three different lists of instructions to follow, how do you know which is right? This could be another factor contributing to the lack of challenge seen from iNEDs, as highlighted by the FCA and the IoD in 2021.
“I think that despite the requirements of the FCA Rulebook, the conflict of interests for Authorised Corporate Directors in particular is too great,” muses Ocorian’s Spendiff.
Finding fixes
Concluding its 2021 report on fund governance, the Institute of Directors (IoD) made a series of recommendations to the FCA on how the UK’s fund governance framework could be improved in order to rebuild trust and ensure investor protection. The first of these is to “improve the credibility of independent directors in their oversight of funds on behalf of investors by strengthening their independence from investment managers”. This could take the form of transferring directorial appointment responsibilities to the FCA, guaranteeing that independent directors are qualified, truly independent and more trustworthy. Another suggestion is for the UK to lean into the US approach by appointing independent directors directly to the board of the fund entity, rather than the board of the AFM.
“The UK industry is more closely aligned to the US now than it was prior to Assessment of Value and Consumer Duty” says Devin McCune, vice president of regulatory and compliance at Broadridge, stating that regulatory oversight is now “very similar” to primary oversight responsibility in the US. However, he adds that these requirements are “in their infancy” and that “there is much learning and improvement occurring to the process”. He believes that fund oversight will improve as INEDs develop deeper knowledge of both the funds they are working with and the overall operational challenges that are confronting asset managers.
The IoD’s report also proposed the introduction of formal training for independent directors, along with increasing the scope of responsibilities that independent directors take on. This could include topics such as liquidity and investment sustainability, the IoD suggests, covering a broader range of investor concerns.
What appears to be the most obvious of solutions is the creation of a single rulebook, consolidating divergent guidelines and helping to boost the attractiveness and competitiveness of the UK market to domestic and international players. In a February 2023 consultation paper, the FCA asked for feedback on whether this would be a beneficial move to make, taking into consideration the potential costs and difficulties that the process could cause.
Unfortunately, any resolution that seems too good to be true usually is. As Joe French, managing director of Ocorian subsidiary Newgate Compliance, puts it: “If it were that easy, the FCA would have fixed it by now.”
A single rulebook would certainly help to improve consistency in the industry, French continues, and could improve clarity for industry participants if created with sufficient consultation, guidance and industry collaboration. However, oversimplification could present further issues.
Embracing a principles-led approach could leave too much space for subjectivity, “creating uncertainty and potential mistakes”, he explains.
Additionally, the broad spectrum of asset classes and structures that would come under the regime makes the creation of a single, comprehensive rulebook challenging. “Losing proportionate regimes, especially for diverse assets like real estate, might raise concerns.”
AIFMD
AIFMD was put in place in 2011, having been developed after the 2008 Financial Crisis. The directive aimed to regulate fund managers for alternative investments in what had been, up until that point, a less regulated sector in the EU.
With primary goals of investor protection, through stronger information disclosure compliance requirements, and a removal of systemic risk from the EU economy, the directive demands that asset managers identify conflicts of interest, promote fairness towards investors and ensure that disclosure, risk management and remuneration practices are applied appropriately.
Additionally, minimum capital requirements were introduced for funds (protecting against one of the instrumental factors that led to the 2008 crisis) and a number of safeguarding methods were implemented, delivered via custodians and depositories.
Looking towards the next iteration of AIFMD, “we anticipate that consumer protection regulations will be strengthened, accompanied by clarifications concerning fund management techniques”, says Universal Investment’s Noltenius.
He expects increased scrutiny around conflicts of interest, with a focus on disclosure obligations and checks.
“One change that would be welcome is to change the LTAF from an authorised to an unauthorised fund”, Ocorian’s Spendiff comments. He explains that one of the biggest contributions to low take-up has been the requirement for LTAFs to be operated by an authorised fund manager, few of which have experience of real assets.
Additionally, “few real asset managers have the ability or desire to become authorised managers” due to the “significant additional burden” that this places on them.
Noltenius predicts that asset management practices will also be in the line of fire, “particularly regarding the use of liquidity management tools and the handling of valuation uncertainties”.
What’s in the way?
In 2021, the IoD stated that there was “a pressing need to rebuild trust among ordinary investors” after a number of asset management industry scandals. Although consistent attempts have been made to improve oversight practices and operational resilience, there is still a way to go.
In spite of AIFMD’s intentions, and the intentions of the multitude of other fund oversight regulations and initiatives across the market, incidents of oversight faults and preventable, or minimisable, crises continue to emerge. The collapse of the LF Woodford Equity Income Fund in 2019 prompted finger-pointing at Northern Trust, as the fund depository, and Link Funds Solutions, as its Authorised Corporate Director (ACD), with the thought that they had failed in their fiduciary duties. Indeed, a number of items have come to light that show significant and continual lapses in judgement from overseers, bringing into question the efficacy of protective regulation and doing little to improve trust in the industry.
Spendiff explains that the UK’s authorised manager regime is no longer fit for purpose. “It reflects a time when the expectation was that the investment manager of a fund would be responsible for all aspects of its management, including transfer agency, fund administration and valuations,” he says. Even though these activities are generally outsourced they remain, technically, the responsibility of the authorised manager. Unlike in Europe, they are not regulated in their own right and go under-checked.
“There’s no real impediment to effective fund oversight, however the industry would greatly benefit from the establishment of a more uniform regulatory, legal and tax framework,” Universal Investment’s Noltenius shares. Such a system should harmonise regulation for both retail and professional investors, align with international standards and facilitate a “level playing field” for those involved in asset management. Implementing a “dedicated monitoring system” is essential to keep up with a constantly evolving legal landscape, Noltenius says. However, he acknowledges the financial barriers that may prevent smaller firms from bringing in such systems. The high cost of keeping up with regulatory changes “may result in fewer companies being able to compete”, he says, “possibly reducing the range of choices available to investors”.
Broadridge Fund Communications Solutions’ Johnson adds that “a constantly changing regulatory landscape is making it difficult for boards and managers to remain fully versed on regulatory changes that impact the funds they oversee”.
This issue becomes even more complex for global companies, which must keep up to date with a range of jurisdictions.
On top of that, Johnson observes that fund investments themselves have become more complex; fund structures are often complicated, making it “extra difficult to understand precisely what oversight is required”. All those involved in the oversight process need to be well versed in the “benefits and pitfalls” of new fund strategies, “fully understanding the risks that they can introduce” and challenging them sufficiently.
“A consistent approach to new regulations and increasing alignment on existing regulations would reduce complexity and help oversight,” he states.
Conclusion
Fund oversight processes are currently well intentioned but deficient. The industry is yet to develop a truly effective approach, something illustrated by a number of high-profile cases that have received publicity beyond the financial world and have become mainstream news stories.
The industry needs to continue to set effective checks and balances in place, to tighten its fund governance and value assessment frameworks, and to learn lessons from recent failures of fund oversight. These steps are important to prevent history repeating itself.
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