AFM boards must balance the interests of their fund investors and shareholders. The FCA market study suggests that this balance is not always being struck appropriately. It believes that this is partly because AFM boards are generally staffed exclusively by executives of the firm. To rebalance this and help ensure that the best interests of investors are subject to greater scrutiny and challenge, the FCA proposed rules requiring AFMs to appoint independent directors to their board. It proposed that AFMs appoint a minimum of two independent directors and for them to comprise at least 25% of the total board membership. The FCA has made final rules introducing this requirement as consulted on. But, it has extended their implementation period from 12 to 18 months.
What’s our view?
We had hoped that ‘smaller’ AFMs with assets under management below a certain threshold might be allowed only one independent director. But, it is not so, though the 18 month period before implementation will likely be welcome by AFMs generally, whatever the size of their assets under management.
AFMs generally will also welcome being able to choose whether the Chair of the board should or should not be an independent director. We hope that no disconnect arises between the ‘reasonable steps’ necessary under the senior managers and certification regime and the new responsibility of the AFM to take ‘sufficient steps’ where overall value cannot be justified and which can, in the classically English understated style, “be relied on as tending to establish contravention” of the duty to act in the best interests of fund investors.
There is potentially a disconnect between the new test of independence that the FRC has currently consulted on for purposes of the revised Governance Code and that which applies under these new governance rules for AFMs. That said, the test under the new rules does appear to allow an independent director of an AFM’s parent undertaking also to be an independent director of the AFM if meeting the other criteria for independence.
The focus will now turn to how AFM boards best justify providing overall value and identifying/appointing suitable directors who are both ‘independent’ and able both to manage conflicts of interest with other appointments and comply with competition law where those appointments involve other competing roles. Our sense is that this could be less than straightforward. The FCA previously estimated that their proposals would require the sector to appoint a further 480 independent directors. Some people questioned whether as many as that number are available. In the light of the final rules and unless both conflicts and competition law compliance are manageable, it may need to be even more than that number.
How does this fit in with the Senior Managers and Certification Regime (SMCR)?
The FCA consulted on a new specific prescribed responsibility for AFMs, as part of the extension of the SMCR to almost all financial services firms. This would make clear that a senior manager, usually the Chair of the board of an AFM, must take reasonable steps to ensure that the firm complies with its obligation to carry out the assessment of value, the duty to recruit independent directors, and the duty to act in the best interests of fund investors.
The FCA has decided to introduce this responsibility for AFMs as part of the extension of the SMCR. It intends to publish the rest of its final rules for the extension of the SMCR later this year.
When do the new governance requirements come into effect?
Final rules for the FCA’s governance remedies - requiring AFMs to assess whether their offering is in line with their need to act in best interest of investors, and the independent directors’ requirement - will come into effect on 30 September 2019.
What exactly is required for independent directors to be on AFM boards?
The FCA proposed that AFMs appoint a minimum of two independent directors and for them to comprise at least 25% of the total board membership. (If the AFM’s governing body comprises fewer than eight members, the AFM must instead ensure that at least two of its members are independent natural persons.)
Independent directors can serve for no more than ten years at once, and directors may not be eligible for reappointment to the same AFM until five years from the end of their last term. The FCA did not consider it necessary to propose a limit on the number of AFM boards an independent director can serve on. They would need to have enough experience and expertise to fulfil their role, but financial services expertise is not compulsory.
Do smaller AFMs still have to meet the new governance requirements?
The FCA also considered whether there should be a minimum value of assets under management before the requirement applies. But, it has decided to apply the requirement for independent directors to all AFMs.
What about conflicts between regulatory and directors’ duties?
The FCA don’t think the need to act in the best interests of fund investors conflicts with directors’ general duties. These duties are not limited to shareholders or financial success alone. The FCA accepts the concerns expressed about the word “solely” in COLL 6.6.26G (4) and has deleted it from the final guidance.
Will AFMs ever be required by the FCA to have boards composed of a majority of independent NEDs?
The FCA will monitor the success of the proposals, and will consider introducing a higher threshold of independence, including a requirement to have a majority independent board, at a later stage if needed.
Are there any transitional arrangements?
The FCA’s final rules clarify that AFMs which already have independent directors, before the implementation date, can keep them on their boards as long as they meet the independence requirements. Once the rules come into force, existing independent directors can serve for a maximum term of five years (renewed once to a maximum of ten years) - the clock starts on the date the rules come into effect.
Is this an opportunity to appoint more diverse NEDs?
The FCA encourages AFMs to look outside the pool of usual candidates in their search for independent directors. Amongst others, the FCA points towards the Investment Association’s recently launched five-year initiative to increase diversity in the boardroom, calling for greater diversity across a range of dimensions: gender, ethnicity, socio-economic background, LGBTI+, age and disability.
Does the Chair have to be an Independent NED?
The FCA has considered the arguments and concerns on independent Chairs and thinks that AFMs should decide this themselves because there may be good reasons to choose either option. (The FCA does not think that the substance of CP 17/25 (a SMCR CP) contradicted CP17/18, although it accepts that the language used may have been confusing.)
Who will meet the costs of appointing and supporting independent NEDs?
The FCA believes that the conclusions of its cost benefit analysis (CBA) still stand. It assumed, for the purposes of the CBA, that ongoing costs of the independent directors will be passed through to fund investors through higher charges. It did not, and does not, envisage that the costs would be paid directly from the fund to the independent directors. Rather, it considers that the costs would flow through the AFM (that is, that the AFM would charge the fund an additional amount to cover the payment by the AFM of the salaries and other costs associated with the independent directors). Whether the additional costs of independent directors should in fact be passed on to fund investors by the AFM charging the fund a higher management fee is, it considers, a decision for the AFMs.
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