SM&CR: Bringing Big Changes to HR and Culture

Nine ways for hedge funds to proactively prepare for regime changes

Martin Lovick, Senior Principal Consultant and Paul Henshaw, Senior Principal Consultant, ACA Compliance Group

With less than 100 days until implementation, the Senior Managers & Certification Regime (SM&CR) is set to have a significant impact on the way UK-based hedge funds manage themselves, thanks to rules that may alter their management structure, employment contracts, and general operational culture. This new set of rules from the UK’s Financial Conduct Authority (FCA) is far from being “just” a compliance exercise. It’s important for everyone at all levels of the firm to understand what these changes are, and to be prepared to support the integration of them into the hedge fund’s existing culture. As well, firms need to begin to manage this change as soon as possible – SM&CR comes into force on 9 December this year. 

This new set of rules from the UK’s FCA is far from being ‘just’ a compliance exercise. It’s important for everyone at all levels of the firm to understand what these changes are.

Below, this article explores nine ways hedge funds can be proactive about the changes that the SM&CR will bring:

1) Reconsider the organisational structure

Hedge funds – particularly small and medium-sized ones – are invariably structured less formally than a bank or an insurance company is. Roles and responsibilities may have developed organically and there may be a certain fluidity in how tasks are carried out.

However, the SM&CR demands that four prescribed responsibilities are allocated to specific individuals. These prescribed responsibilities are:

1) Performance by the firm of its obligations under the Senior Managers Regime, including implementation and oversight.
2) Performance by the firm of its obligations under the Certification Regime.
3) Performance by the firm of its obligations in respect of notifications and training of the Conduct Rules.
4) Responsibility for the firm’s policies and procedures for countering the risk that the firm might be used to further financial crime.

It’s important that hedge fund partners sit down and think through how they are going to allocate these prescribed responsibilities. 

For example, sometimes hedge funds are relatively informally structured, with a high degree of collective responsibility among a group of people who are accustomed to having roles and responsibilities picked up by different people at different times. In these cases, the hedge fund management team will have to think through how they wish to define roles and prescribed responsibilities more clearly considering SM&CR’s legal requirements.

For other hedge funds – particularly those founded by an industry “star” – decision-making can be concentrated in the hands of this founding individual. In these cases, the founder will need to actively delegate roles and prescribed responsibilities to individual team members and consciously support those team members in their performance of those roles. Certainly, one person can hold multiple SM&CR responsibilities – such as a person in charge of compliance or a chief operating officer. 

However, this can put enormous pressure on one individual to fulfil these compliance requirements – and distract that individual from other, business-focused activities. The FCA guidance also specifically states that firms should avoid assigning a wide range of responsibilities to an individual if they are not able to carry out those responsibilities effectively. Lastly, aggregation of prescribed responsibilities in one person can also result in significant key person risk. Alternatively, it’s not a good idea to give individuals roles and responsibilities without also delegating to them the ability to act appropriately to fulfil them. So, it’s important to give those with prescribed responsibilities the decision-making abilities and support they need to deliver compliance. 

Some hedge funds may need to make significant changes to their internal operating culture to accommodate the demands of the SM&CR’s prescribed responsibilities. It’s important that hedge fund management teams allocate the time and resources to carefully think through who will take on these prescribed responsibilities, and what they will need to carry them out. 

2) Match SM&CR prescribed responsibilities, as well as other duties, with the team’s capabilities

There are significant benefits to taking a more thoughtful approach here, the FCA will be looking to see how well considered the allocation of roles and responsibilities is. Helpfully, the FCA has published guidance on what they are looking for in March 2019 – FG19/2 Senior Managers and Certification Regime: Guidance on Statements of Responsibilities and Responsibilities Maps for FCA Firms. Some hedge fund senior management teams have tackled this project by first listing out all the roles and responsibilities they need to allocate to be compliant with SM&CR, including the prescribed responsibilities. Then, they’ve thought about which individuals have the experience, capabilities, or potential to pick up each of these individual tasks. In this way, the compliance requirements of SM&CR can be more explicitly matched to the talents and capabilities of individuals within the firm who can deliver them most efficiently.

What firms should avoid doing is allocating SM&CR roles and responsibilities based on interpersonal dynamics. While this advice applies to firms of all sizes, interpersonal dynamics can get in the way of more reasoned decision-making, particularly within smaller firms. It’s important that individuals keep in mind that compliance with SM&CR is the desired outcome, so it’s in the team’s best interests to allocate these responsibilities to the individuals most fit to undertake them. 

3) Be prepared to rework job descriptions, employment contracts and partnership agreements as a part of the SM&CR compliance process

The person who oversees human resources should be a member of the SM&CR implementation team. This is because key employment documents such as job descriptions, employment contracts, partnership agreements, letters of employment, and members agreements may all need to be consulted as part of this process – and updated.

HR should see who is currently responsible for carrying out duties required under SM&CR according to these documents – as well as according to “just what happens” within the firm day-to-day. Under the new rules, it may no longer be appropriate for someone who is more junior within the firm to be carrying certain responsibilities, for example. These documents may need to be updated to reflect the new roles and responsibilities that have been allocated to specific individuals because of SM&CR. Updates to these documents should be based on the Statement of Responsibility (SoR) for senior managers – this is a single document that sets out the aspects of the affairs of the firm which it is intended that the person will be responsible for under SM&CR. A senior manager holding senior management functions for separate regulated entities across a group will require one SoR per regulated entity. 

A job description may be more detailed than an SoR, in terms of outlining an individual’s day-to-day responsibilities. However, it should not contain anything that dilutes or is inconsistent with the SoR. Firms may also wish to create temporary responsibility for projects on SoRs, such as implementing a new CRM system or a new order management system. These temporary responsibilities could be on the individual’s SoR for six months or a year and then drop off. 

4) Create a process to review and update the Statements of Responsibilities

Firms are under a legal requirement to review their employees’ SoRs on a regular basis, and to keep them up to date. It is a good idea to review these SoRs on a regular basis – quarterly would be a good frequency, or after a material business change. For example, either a specific meeting could be set up, or else time could be set aside as part of a regular senior management meeting. 

Firms must resubmit these SoRs to the FCA whenever there is a significant change in responsibilities. One clear example is when a prescribed responsibility is reassigned from one senior manager to another. Be sure that any changes of responsibility are fully documented – and that where needed changes are reflected in job descriptions, employment contracts, etc.

5) Ensure outsourcing arrangements are compliant

Many hedge funds outsource elements of – or even the whole of – their compliance function. Other important activities, such as IT infrastructure or parts of customer service, could also be outsourced. Under the SM&CR, firms can continue to outsource a wide range of activities. However, firms must state clearly who within the organisation is responsible for that outsourced activity. That individual must have appropriate oversight of the outsourcing arrangement. Under the SM&CR, the individual who has responsibility for that outsourced activity has ultimate accountability for it in the eyes of the regulator, no matter who is performing the actual work.

6) Think through how the organisation’s culture may change

Hedge funds should be prepared for a variety of changes in their internal culture because of SM&CR. Apart from the impact of prescribed responsibilities and SoRs, there is also a new Code of Conduct written by the FCA with rules for all employees as well as specific rules for senior managers. These include:

Individual Conduct Rules:

Rule 1 You must act with integrity.
Rule 2 You must act with due skill, care and diligence.
Rule 3 You must be open and cooperative with the FCA and other regulators.
Rule 4 You must pay due regard to the interests of customers and treat them fairly.
Rule 5 You must observe proper standards of market conduct.

Senior Manager Conduct Rules:

SC1 You must take reasonable steps to ensure that the business of the firm for which you are responsible is controlled effectively.
SC2 You must take reasonable steps to ensure that the business of the firm for which you are responsible complies with the relevant requirements and standards of the regulatory system.
SC3 You must take reasonable steps to ensure that any delegation of your responsibilities is to an appropriate person and that you oversee the discharge of the delegated responsibility effectively.
SC4 You must disclose appropriately any information of which the FCA would reasonably expect notice.

This Code of Conduct can have an impact on firm culture, particularly smaller and medium-sized firms. For example, under the individual conduct rules, there are broad regulatory responsibilities that effect, and hold accountable, virtually everyone in the firm. Firm culture could change in another way too – often small and medium-sized hedge funds are used to a fluid operational culture. Key decisions may be made informally, for example. The SM&CR puts a new formality on hedge fund operations. Key decisions should now be taken in formal meetings that are minuted, for example, so that the firm can evidence its processes to the regulator.

7) Prepare for the possibility of things going wrong

Firms should consider what they should do if a person does not deliver on elements of their SoRs. Under the SM&CR, every senior manager has a Duty of Responsibility. According to the FCA, there are three components to how things could go wrong for a senior manager, if:

• there was a contravention of a relevant requirement by the senior manager’s firm;
• at the time of the contravention or during any part of it, the senior manager was responsible for the management of any of the firm’s activities in relation to which the contravention occurred; and
• the senior manager did not take such steps as a person in their position could reasonably have been expected to take to avoid the contravention occurring or continuing.

Because of this Duty of Responsibility, it is important that there is a clear downside for an individual if they should fail to deliver on their SoR duties. Overall, the firm should consider updating its disciplinary procedures considering the Code of Conduct and the Duty of Responsibility. The firm also needs to implement a process for breach reporting. Firms should also consider how they can take remedial action if something like this occurs, to ensure that SoR duties are ultimately delivered.

While the burden of proof lies with the FCA to prove that a senior manager didn’t take reasonable steps to ensure that the responsibilities within the SoR are delivered, firms should be sure that they are able to evidence compliance, and remediation in the event of compliance lapses.

8) Keep good records of SM&CR activities

Although there are no specific requirements under the SM&CR for recordkeeping, it is a good idea for firms to do this in any case. It is a sensible precaution against the possibility of an investigation or enforcement action against the firm. Firms should think about keeping records for at least five years. Sensible ways to document involve taking minutes at senior management meetings that include the appropriate people talking about their areas of responsibility. Those with responsibilities should also either create or receive regular reports on the area under their aegis. Reporting should focus particularly on risks and controls – it should show how the senior manager knows if something has gone wrong.

9) Consider the personal impact of new responsibilities on senior managers

Individuals may need coaching in how to fulfil the responsibilities that have been given to them, particularly if what they are being asked to do is new to them. Make sure that senior managers have the right training and knowledge for their responsibilities, and document that this training was provided. Senior managers who have been performing a function for some time may want to consider refreshing their knowledge through additional training. Overall, firms are required under the SM&CR to provide training to all relevant staff on how this regulation applies to their specific roles.

Senior managers must be proactive towards their new responsibilities. For example, they should not be taking the reports and other information they receive at face value – they should be actively interrogating it and looking under the bonnet. Senior managers should also be prepared to be an active participant around the board or partnership table. To foster this attitude among senior managers, there needs to be the right tone from the top – the most senior partners should encourage active engagement. At the same time, the most senior partners should be sure that those senior managers with specific responsibilities can take action when needed. In firms where authority may be based on the percentage of shares held, this could require cultural rebalancing. If people with less equity have responsibilities under the SM&CR, they need to have the ability to carry out those responsibilities.

In short, the SM&CR is bound to have significant implications for hedge funds, both from a HR and a cultural perspective. Firms – specifically senior leadership – should be thoughtful about how these changes will interact with both individuals and the organisation as a whole. Preparing for these changes now can give the firm time to let them settle in, in advance of the deadline to ensure smooth operational running.