Compliance code cracker: Taking steps to ensure compliance with the regulatory system – FCA guidance for senior managers | Thomson Reuters Regulatory Intelligence and Compliance Learning


Recent disclosures made under the Freedom of Information Act by the Financial Conduct Authority (FCA) have revealed a significant reduction in the number of investigations relating to Senior Managers and Certification Regime (SMCR) cases. Notwithstanding this apparent reduction in enforcement activity, there has been some disquiet about the regulatory implications that difficult compliance issues— such as implementing the new Russian sanctions and crypto-assets — may have for senior managers.

As discussed further here, there has also been concern about the factors that senior managers should take into account when considering what would constitute “reasonable steps” to avoid a contravention of a regulatory rule occurring (or continuing). The “duty of responsibility” “reasonable steps” provision is found in the controversial s 66A5(d) of the Financial Services and Markets Act 2000 (FSMA).

Guidance is provided in 6.2.9EG of the Decision Procedure and Penalties Manual (DEPP) of the FCA Handbook, and in COCON 4.2 in the context of related FCA “reasonable steps” rule COCON 2.2.2R, called senior management conduct rule 2 (SC2).

SC2 states: “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.”

DEPP guidance on reasonable steps

DEPP 6.2.9EG provides that when determining under s 66A(5)(d) of FSMA whether a senior management function (SMF) manager has taken such steps as a person in their position could reasonably be expected to take to avoid the contravention of a relevant requirement by the firm occurring (or continuing), there are certain considerations to which the FCA should have regard.

These include, under DEPP 6.2.9-EG(6), whether the SMF manager (where they were aware of, or should have been aware of, actual or suspected issues that involved possible breaches by their firm of relevant requirements relating to their role and responsibilities) took reasonable steps to ensure that the issues were dealt with in a timely and appropriate manner.

COCON 4.2.13G provides, with regards to SC2, that where a senior conduct rules staff member becomes aware of actual or suspected problems that involve possible breaches of relevant requirements and standards of the regulatory system within their area of responsibility, they should take reasonable steps to ensure these are dealt with in a timely and appropriate manner.

This may involve an adequate investigation to establish whether any systems or procedures have failed, and if so, why. They may need to obtain expert opinion on the adequacy and efficacy of the systems and procedures.

A recent FCA enforcement action against Tim Haywood, former investment director and business unit head at GAM International Management Ltd (GIML) (a subsidiary of GAM (UK) Ltd (GAM)), was brought — for reasons of timing — under Statement of Principle 7 of the pre-SMCR approved persons regime (APER). This action provides some further (indirect) guidance as to the interpretation of SC 2.

SC2 is expressed in almost the same terms as Statement of principle 7. Furthermore, the guidance on APER 7 in APER 4.7.13G is expressed in almost the same terms as that provided for SC2 in COCON 4.2.13G.

APER guidance on reasonable steps

APER 4.7.13G provides that — where the approved person performing an accountable higher management function becomes aware of actual or suspected problems that involve possible breaches of relevant requirements and standards of the regulatory system falling within their area of responsibility — they should then take reasonable steps to ensure they are dealt with in a timely and appropriate manner.

It also says that this may involve an adequate investigation to find out what systems or procedures may have failed, and why, and that it may be necessary to obtain expert opinion on the adequacy and efficacy of the systems and procedures.

The FCA said that it had fined Haywood £230,037 for a breach of, inter alia, Statement of Principle 7. This requires an approved person, when performing an accountable higher management function, to take reasonable steps to ensure that the business of the firm for which they are responsible, in their accountable function, complies with the relevant requirements and standards of the regulatory system.

The FCA said, specifically, that Haywood had failed to take reasonable steps to ensure that the firm he worked for had complied with the relevant regulatory rules requiring that conflicts of interest were managed fairly with regards to some investments, referred to as “Laufer 1” and the “SCF Fund”.

The post-2008 financial crisis Report of the Parliamentary Commission on Banking Standards recommended, with regards to the creation of the SMCR, that the rules should explicitly encapsulate expectations about behaviour which were absent from the existing statements of principle for individuals, including the management of conflicts of interest. This has not been done.

Managing conflicts of interest is, however, a specific requirement under Principle 8 of the FCA’s Principles for Businesses and Senior Management Arrangements, Systems and Controls (SYSC) 10. Principle 8 provides that a firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client. GAM was found to be in breach of this principle on both counts.

The FCA said Haywood was investment director and business unit head of a fixed-income team — called the Absolute Return and Long Only team (ARLO) — which operated in London and New York during the relevant periods. The FCA also said that ARLO managed multiple funds or mandates in which GIML was either the investment manager or delegated investment manager.

As head of the team, the FCA said, Haywood was responsible for the overall investment management of 26 funds and mandates during the relevant periods. The FCA also said that GIML’s investment of client funds to finance an entity, Laufer, owned by a business partner, Greensill (discussed here, here, here, here and here), presented a conflict between the interests of GIML and its clients.

The FCA said this had provided an incentive for GIML to finance Greensill, through investing client funds in Laufer for its own benefit as opposed to those of its clients.

Potential incentives

The FCA also said that documentation received from Greensill at the time of the Laufer 1 investment contained three potential incentives to GIML in connection with the GAM and Greensill business relationship. Although none of them had been taken up by GIML, they had raised conflicts of interest issues between GIML and its clients, it said.

The potential incentives were a “fee ramp” guaranteeing the amounts GIML would earn from its management of specific supply chain finance funds; an “equity warrant” over Greensill shares; and a “first-and-last-look” arrangement which allowed GIML the first opportunity to launch further Greensill funds.

The FCA said that Haywood had failed clearly and explicitly to raise any of the conflicts of interest issues with his line manager or to make any record of the conflicts of interest issues and how he had dealt with them. Furthermore, it said, he had proceeded with the investment of client funds without first checking or ensuring that the conflict of interest (COI) officer and/or COI committee had considered the conflict of interest issues and were content for the investment to proceed.

Failure to check in such circumstances features in APER 4.7.7G as guidance applicable to Statement of Principle 7. This provision is very similar to COCON 4.2.16G, applicable to SC2. Both provisions address failure to review systems following the identification of possible breaches of regulatory standards or requirements.

The FCA found that Haywood was investment director and a designated co-investment manager responsible for the decision to invest GIML client funds into Laufer 1 while also being the key individual at GIML managing the day-to-day relationships with Greensill. This meant that it was especially incumbent upon him to take all reasonable steps to ensure that GIML complied with the COI policies and its regulatory requirements in respect of fairly managing conflicts of interest.

It concluded that Haywood had failed to take reasonable steps to ensure GIML had fairly managed the conflicts of interest issues, in breach of APER 4.7.13. As noted above, this is equivalent to the COCON 4.2.13G guidance for SC2.

The FCA also said that Haywood had failed to identify or object to the fee ramp arrangement before the Laufer 1 investment was made. It said he should have documented the due diligence he had carried out and prepared a recorded credit analysis of Laufer, Greensill and the Greensill Group.

It concluded that it had been incumbent on him to take all reasonable steps to ensure that GIML documented and recorded how it had addressed any conflict of interest issues to comply with its conflicts of interest policies, but had failed to do so.

Greensill connection and conflict between clients — the SCF Fund

The FCA said that the SCF Fund was a co-branded fund launched by GAM and Greensill in June 2016. It consisted of A class (voting) shares owned by Greensill and B class non-voting shares for ordinary investors in the fund. Haywood was instrumental, the FCA said, in the setting up of the fund and its subsequent operation. It said he was a designated co-portfolio manager for the SCF Fund and the principal point of contact for Greensill at GIML.

It also said that on July 11, 2017, the C class of shares was launched in part to enable an overseas company, Company B, to invest in the fund. It said that Company B had stipulated, as a condition of its participation, that it would only invest in its own receivables as it did not wish to be exposed to third-party credit risk.

The FCA said that, to accommodate this, the C class was designed to invest exclusively in notes backed by Company B’s receivables subject to each of those receivables being insured, with Company B as the end investor. The C class of the fund was created for the benefit of Company B, and GIML-managed funds acted as the initial purchasers of Company B’s receivables with the intention that they would receive a financial return.

The proceeds of these transactions were used to subscribe to C class shares. The C class then purchased the securities from the initial purchasers which, the FCA said, constituted a “cross trade” and presented a potential conflict for GIML between the interests of one of its clients, Company B, and its other clients.

It also said greater consideration should have been given as to whether this matter should have been escalated as prescribed in the conflicts of interest policy, but Haywood failed to escalate the matter to his line manager or to the COI officer, or to the compliance or the COI committee or the GIML board of directors. The FCA found that he should have done.

As a result, the FCA found Haywood had failed in respect of the conflicts of interest issues arising out of the SCF Fund despite his seniority and the fact that, as a GIML board member, he was responsible for setting an appropriate tone to GIML staff.

In addition, he had failed to verify that all of the B cross trades: were in compliance with the cross-trade policy; had delivered a financial benefit to the initial purchaser; had been correctly tagged on GAM’s order management system; and that an adequate rationale for the B cross-trades had been recorded on this system.

As a result, it said, loss was suffered in 19 trades. The cumulative loss was $26,181, reflecting the interest accrued on the notes and associated hedging costs during the period for which they were held. GIML compensated the relevant funds in full for the loss incurred.

Further information on compliance matters can be found https://podcasts.apple.com/gb/podcast/compliance-clarified-podcast-by-thomson-reuters-regulatory/id1548510826 here.