Corporate finance, venture capital and private equity firms should consider opting out of the new FCA prudential regime

Small MiFID firms, known as Exempt CAD firms, on the periphery of the FCA’s new prudential regime (IFPR) should seriously consider their options in order to save time, resource and money.

There are around 3600 investment firms that will be subject to Investment Firms Prudential Regime (IFPR) as currently consulted on in the UK. The application of the regime is driven by one thing – whether you are a MiFID firm.

About 2500 of these firms will be subject to a simpler regime (if they are labelled a small and non-interconnected firm via the ‘SNIF’ test). Over 1200 of these smaller IFPR firms are ‘Exempt CAD’ firms, who will (at least in the wholesale space) generally just hold capital of €50k to meet their prudential requirements. Larger firms should hold more based on their ‘wind down’ planning assumptions of course. But very straightforward requirements.

The new regime fundamentally overhauls the amount of capital needed and overall, the new prudential regime should be considered much more rigorous and demanding for these firms.

Firms now have just over 100 business days to prepare for IFPR. Based on industry surveys, many IFPR firms have not engaged with the new requirements and considered the implications for capital they must hold and policies and procedures. This is particularly relevant for Exempt CAD firms as the ‘jump’ in requirements from day one is significant and should not be underestimated.

If you are unsure as to your firm’s status (and are not confident in translating the arcane FCA jargon sent when you were authorised or contained in FCA returns) you should check the FCA Register and search for your firm: https://register.fca.org.uk/s/

Scroll down to ‘What can this firm do in the UK?’ and look at the ‘Restrictions’ and ‘Requirements’. An Exempt CAD firm should have a statement here stating something along these lines ‘Exempt CAD-may recv &trans ordrs &/or give inv adv’, the presence of which will confirm you are categorised as an Exempt CAD firm. This wording may vary a little as some requirements were added before a standard wording was designed and applied by the FCA when MiFID came into force.

How will opting out save time and money?

The latest (and last) FCA Consultation Paper (CP 21/26) states that ‘the estimated total one-off implementation costs imply average cost of around £74,000 and £34,000 per non-SNI and SNI respectively’. The FCA elaborate on this figure and its calculation in the CP and confirm that these estimates only cover implementation costs and do not include the additional capital to be held.

Some may argue these are conservative figures in the context of the changes required in a very short period. Exempt CAD firms will be subject to a multitude of new or expanded requirements that will require senior management intervention and consideration such as increased capital, group consolidation rules through to liquidity and remuneration rules and importantly, the development of an ICARA (Internal Capital and Risk Assessment (ICARA) which replaces the ICAAP). Given these facts, implementation costs may be higher than the average set out by the FCA, not to mention the additional capital that will be required once subject to IFPR which is significant.

Any CAD Exempt firm with reasonable expenditure on salaries, offices etc. will find capital requirements increase greatly from €50k to one quarter of their annual fixed overheads. Where firms utilise an external ‘service company’ owned/controlled with expenses they may also need to form a consolidated group. And therefore, will need to consider fixed overheads for the group (not just the regulated entity). This may have a bigger impact on groups involving fund managers, who typically utilise more complex structures and the expenses of the regulated entity are often kept deliberately low. There are ‘anti-avoidance’ provisions in place where expenses incurred on behalf of the firm by third parties must also be included in capital calculations (see MIFIDPRU 4.5.6R). Such firms will be captured under the rules even where there is no consolidated group.

Whilst firms can take advantage of the transitional rules to reduce the impact on capital requirements over 5 years, ensuring compliance will be costly and time consuming for senior management.

It is still unclear for many Exempt CAD firms how the transitional rules for capital resources will dovetail with the ICARA process and the potential need to hold greater capital from day one based on risks identified in the ICARA. As such, the transitional rules may not be effective in reducing capital requirements for all firms, potentially leading to a very large jump in regulatory capital needed from 1 January 2022. The FCA provide commentary on this in section 6.22 of Policy Statement 21/9.

Can firms opt out of IFPR?

Potentially. Although time is against any firm now trying to apply to change their regulatory licence before January 2022.

There will be cases where Exempt CAD firms can become exempt from MiFID under Article 3. Where a firm is exempt from MiFID under Article 3 the new regime does not apply. And therefore, the firm will be subject to a different prudential regime more suited to the risks inherent in their business model.

Exempt CAD firms can opt out by applying to the regulator to vary the licence they hold. Whether this is possible will depend on the firm’s business model (i.e., what regulated activities they are conducting). And yes, this is the difficult bit. And it is difficult because the UK regulatory perimeter (what is and isn’t regulated) is highly complex. The application of MiFID is driven by the regulated activities a firm has permission to carry out and the overlap of the UK Regulated Activities Order (RAO) and MiFID investment services conducted.

Prior to Brexit, many smaller firms consciously became Exempt CAD as they opted into MiFID or took a precautionary approach to the application of MiFID to their FCA licence. In doing so, Exempt CAD firms then could ‘passport’ into the EU and provide services (and even set up branches) in EU jurisdictions. Following Brexit, this advantage has disappeared. And it seems unlikely, in the short term at least, there will be an equivalence decision for MiFID firms to provide services into the EU on a similar basis. C’est la vie.

The FCA has also reminded firms of the many reasons why they should keep a review of the regulatory permissions they hold. The FCA has publicly committed to follow up where firms do not appear to be using the regulated activities they have permission for:

fca-reminds-firms-regularly-review-regulatory-permissions

Therefore, not only is a review of a firm’s FCA licence common sense, but it is also required and prompted by the regulator. A review should take place at least once a year and certainly before any new business lines, products or new activities are undertaken to ensure firms are managing their legal and regulatory risk and have the relevant licence.

There has been an attitude in the past of ‘collecting’ regulatory permissions to cover different eventualities, as if they add value to the firm. This is understandable to a degree (given the costs and timescales in varying an FCA licence) and the optionality having additional permissions can provide. Given the current regulatory climate however, it simply isn’t possible to keep extra, and unused permissions based on this attitude. The FCA does have powers to remove activities that are not used under FSMA, and these powers have recently been strengthened.

We would suggest all firms review their current licence, business activities and prudential category and be able to explain that these are still correct and how each activity (and associated requirement/limitation) is used and complied with.

Why are CAD Exempt firms caught by IFPR?

Despite their name, Exempt CAD firms are subject to MiFID. The ‘exempt’ in the name refers to the fact that unlike other MiFID firms, these firms are exempt from the Capital Adequacy Directive, the prudential counterpart to MiFID. This category is effectively disappearing, and these firms will be fully subject to IFPR in the future in the same way as other MiFID firms.

Most Exempt CAD firms fall into MiFID because they have (possibly in the distant past) agreed that they are undertaking the MiFID activity of ‘reception and transmission of orders’ and/or ‘investment advice’. These MiFID activities overlap with the UK activities (set out in the UK Regulated Activities Order) of advising on investments, arranging and making arrangements. See the FCA’s guidance in Table 1 PERG/13/Annex2.html (see A1 and A5 respectively) for more detail.

CAD Exempt firms should analyse their business model to determine if this is the case (or still the case). It is possible to be exempt from MiFID and conduct investment business and fall into a different prudential category set out in the Interim Prudential sourcebook for Investment Businesses (IPRU:INV) Handbook. There are several categories which may be relevant and reflect the risk posed by the firm with less detailed requirements and lower base capital. We provide some high-level examples here of the potential permutations below.

Many corporate finance firms and venture capital/private equity firms may find they are not providing personal recommendations or conducting reception and transmission of orders on a thorough analysis. For example, personal recommendations are provided to a person in their capacity as an investor (based on their specific circumstances). Where advice is provided to a person on an industrial, strategic or entrepreneurial objective and not in their capacity as an investor this may be considered the MiFID ancillary activity of “Advice to undertakings on capital structure, industrial strategy and related matters and advice and services relating to mergers and the purchase of undertakings.”. And therefore, no personal recommendations are provided.

Reception and transmission of orders includes ‘arrangements that bring together two or more investors, thereby bringing about a transaction between those investors’. Hence the overlap with the UK RAO activities of arranging/making arrangements. This can include a wide scope of activities and will be relevant for some Exempt CAD firms, for example if interacting with an investor who may be purchasing shares. It will depend on the status of each entity and a firm’s relationship with them.

Venture Capital and Private Equity firms conducting the activity of ‘managing an unauthorised AIF’ are often unaware of the various exclusions available when conducting this activity. Where regulated activities are conducted in relation to an AIF a considerable number of activities will be excluded from being regulated activities.

Speak to us if you need help with this change.