The Draft UK Financial Services Bill

Overview of the new regulatory structure for hedge fund managers

Originally published in the March 2012 issue

The Draft Financial Services Bill (the “bill”) introduced in final form in June reflects the UK government’s proposals for reform of the UK financial regulatory structure. The impetus for this comes largely from the perceived failings of the so-called tripartite system, which involved certain overlapping responsibilities of HM Treasury, the Bank of England, and the Financial Services Authority. The bill’s reforms are intended to restructure financial regulation in the UK and to provide the new regulatory authorities with more clearly defined areas of responsibility and certain new powers, without unduly interfering with the UK’s efforts to implement enacted and forthcoming European Union financial services legislation. Here we look at how the bill may affect UK-based hedge fund managers.

The new regulatory infrastructure

Under the bill, the FSA will cease to exist in its current form and the functions hitherto shared by the participants in the tripartite system will be reallocated and reorganised to three new regulatory authorities: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).

The FPC will be responsible for macro-prudential regulation, and will sit within the Bank of England. Its responsibility is the “identification of, monitoring of and taking of action to remove or reduce, systemic risks” (section 9C(2) of the bill). As such, it will not have direct control over regulated entities, nor any direct powers of intervention, and will achieve its objectives by directing the FCA or the PRA to implement the FPC’s macro-prudential measures using their own micro-prudential tools in respect of all or a class of regulated entities (authorised persons, recognised investment exchanges and incoming EEA firms subject to UK host state regulation, each as defined in Financial Services and Markets Act 2000).

One level lower as a subsidiary of the Bank of England, the PRA will be concerned with the micro-prudential regulation of those firms which the government believes should be subject to significant prudential regulation. These firms include banks, building societies, insurers and certain investment firms considered to be of systemic importance. These instructions will be subject to ‘dual regulation’ by the PRA as the micro-prudential regulator and by the FCA as the regulator for conduct of business and disciplinary purposes.

The FCA will inherit the disciplinary and conduct of business regulation roles of the FSA, as well as being the micro-prudential regulator of firms that are not dual regulated. It will be given new powers to make temporary product intervention rules. This includes power to block an imminent product launch or suspending an existing product for up to 12 months.

It will also have a new power to require firms to withdraw misleading financial promotions, coupled with a duty on the FCA to publish directions made under this new power in order to increase the
visibility of its activities and to clarify good and bad practice, and a new power to publish details of “warning notices” at the start of its enforcement proceedings against a firm. The FCA will inherit the FSA’s powers as the UK Listing Authority and it will retain responsibility for regulating recognised investment exchanges. The FCA will have a considerable degree of discretion when determining whether to invoke its powers to ban, or temporarily impose requirements on products. The trigger will be when it appears to the FCA to be necessary or expedient for the purposes of advancing its consumer protection or competition objective.

The bill expressly states that the power cannot be used to advance its market integrity objective (unless permitted by an order of HM Treasury) in response to concerns that the power is unlikely to be appropriate to the protection of professional or wholesale customers. However, somewhat controversially, the FCA will be able to make temporary product intervention rules, valid for up to 12 months,
without consultation.

As noted above, a main criticism of the tripartite system was its performance during the financial crisis. The bill thus includes a legislative mechanism for coordination between HM Treasury, the Bank of England, the FPC and the PRA in the event of a new financial crisis.

The draft FS bill sets out the legislative mechanism for coordination – in addition to prescribing communications, the Chancellor of the Exchequer, the Governor of the BoE and HM Treasury must agree a Memorandum of Understanding on coordination and management of crises. However, there remains some potential for conflict of interest between the PRA in its role as prudential supervisor of regulated firms, and the BoE in the operation of the Special Resolution Regime. The Government’s deadline for the completion of the necessary primary legislation and the transfer of powers to the new regulatory bodies is 1 January 2013.

Effect on hedge funds
The restructuring of the UK financial services regulatory framework by way of the bill thus ranges from macro- to micro-prudential regulation and to the regulation of day-to-day conduct of business.

However, from a UK hedge fund manager’s point of view, the substantive landscape of financial regulation should change little. Most of the areas that hedge fund managers are concerned with, such as authorisation of investment management firms, conduct of business rules, regulatory capital rules and market regulation will transfer directly from the FSA to the FCA. However, hedge fund managers should be aware of the FCA’s new powers, in particular its ability to suspend product sales, which could damage a firm’s reputation. Nor does it appear that there will be any change to the detailed regulation of hedge fund managers.

Perhaps the most significant change lies in the new regulator’s statutory aims. The FCA, unlike the FSA, will be concerned mainly with micro-prudential regulation and conduct of business regulation. Its ‘operational objectives’ are also much more focused on consumer protection, though the bill does list two other operational objectives – efficiency and choice and the preservation of market integrity. Existing provisions are amended to reflect the fact that these considerations will now govern the exercise of discretionary powers so that, for example, the prohibition on short selling in section 131B of the Financial Services and Markets Act 2000 would require consideration of the operational objectives, rather than maintaining confidence in, and the stability of, the UK financial system. Systemic stability is not an FCA concern, but mainly an issue for the FPC and, under its direction, the PRA, and systemic stability (macro-level) measures are carried out by the FCA only under the direction of the FPC rather than as a direct supervisory responsibility.

In most ways then, the changes are internal to the regulators, while for their ‘customers’ it is business as usual. Eventually, however, these internal changes will impress themselves onto the work of the newly created bodies. The FCA will be somewhat stronger than the FSA with its additional powers, more focused and, it is hoped, more effective. Certainly hedge fund managers may benefit from the increased stability the bill’s restructuring is supposed to achieve. But it remains an open question whether, at this time, restructuring is still a correct approach. The bill was drafted with EU legislative developments in mind, and it delicately avoids interfering with the ‘next steps’ of the European financial services regulatory evolution and the Lamfalussy process, setting the scene for the implementation of the next big adventure in European hedge fund regulation – the Alternative Investment Fund Managers Directive.

Richard Frase, a partner at Dechert in London, advises on all aspects of financial services law. Richard Heffner, an English solicitor and US-qualified attorney, acts as counsel for Dechert in London.