The FCA has released an important discussion paper (FCA DP) describing its approach to the new investment firms prudential regime (IFPR). The new regime is based on the EU’s Investment Firms Regulation and Directive (IFR/IFD) and brings about significant changes in the prudential treatment of MiFID investment firms. Some of these changes are specifically aimed at those firms that have appointed tied agents. The FCA DP follows on from the EBA’s recent consultation paper (EBA CP) on technical standards which supplement the IFR/IFD.
Firms will have to include their tied agents’ activities within the calculation of their own funds requirement for the first time; this is likely to lead to an increase in their capital requirement and so could have an impact on their relationships with their tied agents.
What is a tied agent?
A tied agent is a type of exempt person (referred to in FCA rules as a subset of a wider group known as appointed representatives). If an FCA authorised MiFID investment firm enters into a contract with a tied agent and accepts responsibility for the activities of the tied agent then the agent does not itself require FCA authorisation. This arrangement requires that the appointing firm (“Principal”) has full responsibility for the acts and omissions of the tied agent. Assuming that the EBA’s proposals are adopted by the FCA, the price of this responsibility is about to go up.
How are Principals affected?
Unless they can meet all of the tests to qualify as a “small and non-interconnected firm” (SNI), Principals will be Non-SNI firms and so subject to the full application of the new regime; SNIs will only be subject to a limited application of the new regime. The dividing line between SNIs and Non-SNIs is an important consideration for firms with tied agents. Please see our previous alert for an overview of the classification of investment firms under the new regime.
A Principal that is a Non-SNI firm will need to maintain capital above the highest of three figures: (a) the permanent minimum capital requirement (PMR); (b) the fixed overheads requirement (FOR); and (c) the new K-factor requirement. An SNI is exempt from the K-factor requirement but will be required to meet the higher of PMR and FOR.
Certain activities of tied agents will be taken into account in the calculation of the Principal’s FOR and K-factors.
The fixed overheads requirement
A Principal’s FOR is calculated by taking one quarter of its audited fixed overheads from the previous accounting year, and deducting certain elements of variable expenditure such as discretionary bonuses and other discretionary appropriations of profits, as well as other non-recurring items. The EBA CP includes draft regulatory technical standards on the deductions which Principals can make from the FOR and provides that fees to tied agents should be excluded from the calculation of the FOR. However, where the fixed expenses of the tied agent are not recharged to its Principal then the EBA’s proposals require a tied agent’s fixed expenses that are incurred on behalf of its Principal to be included in the Principal’s total fixed expenses. In practice, this may mean that Principals and their tied agents will need to document which of the tied agent’s non-recharged expenses are directly attributable to the arrangements with the Principal.
While the FCA DP does not make reference to the treatment of tied agents for the purposes of the FOR, it would be consistent with the FCA’s general approach if it were to follow the EBA on this aspect. In the FCA DP, the FCA refers to the potential harm arising from “customer losses caused by the activity of tied agents” and has previously pronounced on a variety of concerns with certain Principal-tied agent relationships, including the failure by some Principals to monitor the type, volume and source of business of their tied agents.
The K-factor requirement
The K-factor requirement is the biggest change in the new regime, and will require a Non-SNI Principal to include the activities of its tied agents within its K-factor calculation. The K-factor requirement applies percentages (‘coefficients’) to the value of specific risks encountered by Principals. The new regime is intended to be a major improvement as it is calibrated to the specific risks of investment firms rather than banks. Please refer to our previous alerts which describes the K-factor components.
Tied agents provide advice to clients and receive/transmit orders so the most relevant K-factors are K-AUM (‘assets under management’) and K-COH (‘client orders handled’). K-AUM is calculated by taking the value of assets managed for clients under both discretionary and ongoing non-discretionary advisory arrangements, so that where the Principal has a tied agent which acts as an investment advisor, the value of the tied agent’s assets under management may need to be included within the Principal’s K-factor calculation.
To ensure that tied agent business is correctly accounted for within the Principal’s K-factor requirement, the EBA CP notes that the Principal should include the relevant amount of MiFID investment services and activities conducted through a tied agent within the total amount of business of the Principal, unless it would amount to ‘double-counting’. For instance, the Principal need not include orders from its tied agents if it is already capturing the same orders/transactions through the Principal’s own dealing activities. This means that a Principal will need to capture the amount and type of business conducted by its tied agents in order to calculate its own funds requirement. The FCA DP adopts the same approach as the EBA on this topic.
The general principles of consolidation are broadly modelled on the CRR/CRD prudential consolidation regime. However, the new regime extends the categories of related entities that are capable of forming part of the consolidation group to include tied agents. Further, the extended bases of consolidation – i.e. the circumstances which dictate that a potential ‘subsidiary’ entity should be consolidated with a parent – mean that Principals will need to determine whether their arrangements with their tied agents will give rise to a prudential consolidation group.
Where a Principal determines that a tied agent would form part of its consolidation group, the new regime includes a relaxation from the full rigour of prudential consolidation where the group is considered ‘sufficiently simple’ and the regulator deems it appropriate – this is termed the ‘group capital test’. In these cases, the Principal would only need to hold enough own funds instruments to cover the sum of the full book value of its holdings of its tied agents’ issued instruments and the total amount of those tied agents’ relevant contingent liabilities.