The continuing shift towards substance and accountability in the funds industry

Substance has been a prevailing theme across the funds industry globally as national regulators and international authorities seek to ensure firms have an appropriate level of local operations, internal controls and management in a domicile in order to access the associated benefits of being there. An absence of fund manager substance can allow systemic risks to proliferate or potentially fraudulent activities to go unchecked, deficiencies which have an adverse impact on the integrity of the industry as a whole.

European regulators demand substance

In the lead up to Brexit, fund manager substance is a primary concern for EU regulators as they became increasingly uneasy about the prospect of foreign firms setting up so-called ‘letterbox’ entities inside European fund domiciles in order to acquire continued access to European investors. Initially, there was speculation the European Securities and Markets Authority (ESMA) would restrict delegation, whereby an asset manager subject to UCITS or AIFMD can outsource portfolio management from an EU management company back to the manager, often located in a third country outside of the EU. Delegation will not be restricted provided managers demonstrate appropriate operational substance within the EU entity delegating activity outside of the EU.

The efforts of EU regulators to ensure substance have been varied. For example, the Central Bank of Ireland’s (CBI) CP86 framework, which came into effect in July 2018, introduced changes around how fund management companies should structure themselves with a heavy emphasis placed on managerial roles that need to be undertaken, including a requirement for firms to have two resident Irish directors. Meanwhile, in August 2018, Luxembourg’s Commission de Surveillance du Secteur Financier (CSSF) issued detailed guidance on the organisation and substance of Luxembourg based management companies.  

Offshore hubs also ratchet up their responses

In response to the Financial Action Task Force’s (FATF) recommendations on combating money laundering and terrorist financing, the Cayman Islands introduced changes to domestic legislation. Through its revised AML Regulations, all funds domiciled in the jurisdiction – irrespective of whether they are registered or not with CIMA (Cayman Islands Monetary Authority) – must take meaningful steps to identify, assess and understand the money laundering and terrorist financing risks in relation to each of their investors. This will require firms to strengthen their existing compliance processes.

The EU Code of Conduct Group on Business Taxation has published its demands for companies located in non-EU countries to demonstrate economic substance in order to avoid being included on the so-called blacklist of non-cooperative non-EU, third countries. Non-EU fund centres, such as Jersey, Guernsey, the Isle of Man, Mauritius, and the Cayman Islands are introducing legislation in response to the EU’s demands.  

SMCR: Extending accountability to the funds industry

In the UK, the Senior Managers & Certification Regime (SMCR) will be extended from banks to asset managers from December 2019. Governance is at the heart of SMCR, as the UK Financial Conduct Authority (FCA) seeks to create a stronger framework for accountability within the asset management industry by requiring senior managers to sign a statement of responsibility and certifying staff as being fit and proper.

Given the UK regulator’s decision to prioritise governance, asset managers need to make a concerted effort to demonstrate that their oversight processes are watertight. The FCA will be scrutinising these arrangements in detail and has already started to reach out to managers to discuss their preparations for SMCR ahead of its 2019 year-end deadline.

The global shift towards substance and how the depositary can assist

The regulatory push on substance is a global one. The boards of fund managers and their funds need to be able to demonstrate effective local management and decision making is taking place. In order to do so, they will need regular, reliable and independent information from fund service providers. In particular,  independent depositaries, which perform on-going oversight over fund and manager operations, are ideally suited to help managers and funds ensure they are operating in accordance with these new obligations as they have:

  • access to accounting and other records for the fund;
  • regular dialogue with administrators, independent directors and senior management;
  • oversight of all other major fund service providers;
  • a thorough understanding of firms’ compliance obligations.

As a result, leveraging their relationship with the depositary is an excellent way for funds, managers and their governing bodies to demonstrate to regulators that they are “serious about substance”.