Individual approval for “group” personnel – the impact of FSA’s parent entity CF00 category

Newsflash: The new CF00 controlled function had been scheduled to come into effect on 1st May 2011. FSA has now announced that it is delaying the implementation of the new CF00 category because its Online Notification and Application (ONA) system is not yet ready to accept new applications and notifications. At least two months’ notice will be given for the new implementation date. Watch this space.

If already holding FSA approval, an individual will have to notify FSA that he or she is fulfilling the CF00 function. The FSA’s rules and guidance, and their changing policy and timetable, make it very difficult for firms to interpret and apply the new requirements.

1. What is new about this?

FSA first consulted on this matter in December 2008 in its Consultation Paper The Approved Person Regime – Significant Influence Function Review (CP 08/05). FSA proposed that the definitions of the controlled functions of Directors (CF1) and Non-Executive Directors (CF2) should be extended to include senior managers employed by an FSA-regulated firm’s parent or holding company where their decisions, options or actions were regularly taken into account by the firm’s governing body. These amendments were carried through into FSA’s July 2009 Policy Statement (PS 09/14), and the FSA handbook was amended in August 2009.

FSA issued a further Consultation Paper in January 2010 entitled Effective Corporate Governance (Significant Influence Functions and the Walker Review) (CP 10/03). This proposed a new “Parent Entity SIF” controlled function (CF00) in place of the extended CF1 and CF2 definitions and extended its scope to include all parent or holding companies other than EEA regulated firms. A Policy Statement (PS 10/15) confirming this approach was published in September 2010, and the new CF00 will soon be introduced into the FSA handbook, although (as noted above) there will be a six-month transitional period to give firms enough time to ensure compliance.

A response to the lessons from the Lehman’s case? FSA approves and regulates individuals holding governing and other functions, under the approved persons/APER regime; this is an increasingly significant part of the UK regulatory system, which is ‘super-equivalent’ and not replicated in other EU member states. The regime, under section 59 FSMA, is now being used against the background of the fall out from the financial crisis. There is a drive to impose greater personal responsibility - and liability - on those who manage firms. There are also concerns, demonstrated by the Lehman’s case, that UK firms, particularly those owned by foreign groups, are sometimes operated on a group basis (e.g. under matrix management) without sufficient regard to the risks and interests of the UK firm and its clients and creditors; this issue is
sometimes captured in the ‘global in life; national in death’ phrase.

FSA’s focus on bringing individuals at the parent/group level into personal regulation and FSA oversight in the context of the UK firm can be seen as one way to address these concerns. In PS 10/15, FSA emphasises the need for the firm’s governance to cope with conflict of interests that may arise in relation to individuals with responsibilities at both parent and subsidiary levels; these arise when the interests of parent and subsidiary diverge (a different type of conflict to the firm/client conflict under the MiFID provisions in SYSC).

2. Who falls within CF00?

The CF00 controlled function will apply to anyone who fulfils three criteria:

- A director, senior manager or employee

- Of an FSA-regulated firm’s parent undertaking or holding company. In this note we refer to the FSA-regulated firm as Firm and the parent or holding company as Group.

- Whose decisions or actions are regularly taken into account by the Firm’s governing body? We refer to the governing body as Board. This is a key element that we examine in detail below.

3. What if … ?

I am already individually approved by FSA?

You will need to consider your position carefully. Following PS09/14, FSA extended the CF1 and 2 roles to the parent level and some parent officers and employees were therefore registered for the first time. FSA is now reversing its previous policy of not having a discrete parent entity category; the new CF00 function will not overlap with the CF 1 to 6 functions (other than the new CF2(a) to (e) functions). These functions are effectively restricted in scope (reversing the PS09/14 changes) but do encompass any additional parent entity level control or influence. Individuals need to decide where they fall within the new approach and whether they wish to change arrangements to adjust their position (see ‘a possible course of
action’ below).

Some individuals may have registered as CF1 or CF2 following PS09/14. It may be appropriate for them to continue within these more narrowly defined roles or to switch to the new CF00 function.

Our parent undertaking or holding company is an EEA firm?

FSA cannot require an EEA firm to observe this requirement because it is inconsistent with EU directives, so you are not affected by the new CF00 category even if you fall within the definition.

4. What kinds of arrangements are caught?

FSA has created the new CF00 category using the powers granted to it by section 59 Financial Services and Markets Act 2000, which provides that a Firm should not allow any person to perform a controlled function – such as the newly specified CF00 function – without FSA approval. Section 59 additionally requires that the person performing the controlled function must do so under an arrangement entered into by the Firm in relation to its carrying on a regulated activity – for example, a Firm will enter into an arrangement with a director to oversee or run its business, and with a trader whom it employs to deal in securities on its behalf. These instances are clear enough, but the new CF00 category will apply to individuals working for or associated with a Group and not for the Firm, and who may not have any formal role with the Firm.

We therefore need to look for three elements:

- Do you work for Group? – This should be easy enough to determine.

- Are your decisions or actions regularly taken into account by the Board? We discuss this in section 5.

- Has the Firm entered into an arrangement with you for the performance of some part of its regulated activities? We discuss this in section 6.

5. Are your decisions or actions regularly taken into account by the firm’s board?

The answer will be “yes” only if all three of the following features are present:

- You take decisions or actions that have relevance to the Firm.

- You need to take decisions or give effect to actions with regard to the Firm to fall within the new CF00 category. This indicates that you must be recognised as holding some power or authority over the Firm, perhaps as Group’s appointed Country Officer, Global CIO or as a matrix manager with oversight over the Firm or some part of its business.

- Examples of your decisions might include approving the Firm’s budget, setting its strategy or vetoing a planned acquisition. Or you may be empowered to take action such as to approve the hiring of a new Head of Equity Trading or to dismiss the Chief Operating Officer.

- However if you simply offer advice to the Firm’s management, or advance your opinion on the merits of some proposed course of action, then you will fall outside the new CF00 regime.

- Your decisions or actions must be taken into account by the Firm’s Board.

- Your decision or action must be communicated to the Firm, perhaps by attending its Board meetings, by periodic conference calls or by granting (or refusing) ad hoc requests for budgetary or project approval.

- The Firm’s Board as a whole must receive and consider your decisions or actions, and not just an individual or division within the Firm. If they are only taken into account by an individual (however senior) or a team within the Firm, then this element will not be fulfilled. Nor will it necessarily be fulfilled if you just receive reports from, and provide supervision over, an individual within the Firm (often termed a “dotted reporting line”), but all dotted reporting lines to the parent level should be considered carefully as FSA views these as indicative of an ‘arrangement’ (see section 6 below). Firms therefore need to ensure, for example, that matrix style reporting does not effectively trump the board’s discretion and control.

- If your decisions or actions are actually taken into account by the Firm’s Board, it is sufficient if they are factored into its decisions. The Board need not be bound by them, nor need it always follow them.

- Your decisions or actions must be regularly taken into account by the Board.

- “Regularly” connotes a pattern of involvement and not just frequent involvement. It is likely to be fulfilled if your dealings with the Firm follow a pattern such as attending monthly board meetings or giving annual budgetary approvals. It is less likely to be fulfilled by intermittent participation, such as reviewing or contributing to the approval of a corporate acquisition or a strategic development.

What does FSA say?

FSA does not separately analyse these three elements, instead giving some examples that indicate its thinking. 1(footnote FAQs appended to FSA 2010/48 4 ) FSA considers that an individual may fall within CF00 when he or she is

- Formally included in a Firm’s reporting lines and decision-making structures or

- Has an informal but direct influence on the Board and

- (in either case) does one or more of the following:

- Takes an active role in running the Firm’s business, for example by sitting on a Group oversight committee;

- Has significant influence in setting or approving the Firm’s business strategy, or the objectives and remuneration of the Firm’s directors (in our view this has similarities with the role of a Chief Executive);

- Assesses the Firm’s management, performance or conduct (in our view this has similarities with the role of a non-executive director);

- Acts like a director (implicitly, executive or non-executive) or senior manager of the Firm;

- Where the Firm is the UK branch of an overseas company, significantly influences it.

In our view these examples do not sufficiently take into account the second and third elements. Whatever decisions the individual takes, they need to be taken into account by the Firm’s Board as a whole – and this must happen regularly. Someone who works for Group and takes an active role in managing the Firm –even when sitting on a group oversight committee – may merely give advice, or just give directions to a divisional manager, neither of which will be caught; on the other hand, some firms may rely upon group level committees, such as REMCOs. While setting the Firm’s strategy potentially falls within FSA’s formula, simply assessing the performance of the Firm’s management may not do so. Someone who works from Group and whose decisions on strategy are only intermittently taken into account by the Firm’s Board will also not be caught.

It should be remembered that even if each of these elements is present, another element must be met –the Firm has entered into an arrangement with Group for the performance of a regulated function. This is discussed in the following section.

6. Has the Firm has entered into an arrangement with you for the performance of some part of its regulated activities?

If your decisions or actions are regularly taken into account by the Firm’s Board so that you fulfil the element just discussed in section 5, you need to consider if both the following features are also present:

- The Firm has entered into an arrangement with you.

- This will be the case where the Firm has entered into a formal contract or other agreement with you, which is unlikely to happen with the CF00 category.

- Alternatively the Firm may simply have arranged for you to assume some responsibility in relation to its business, for example to oversee its internal audit function, or to assist in setting its strategy. FSA takes a broad view of “arrangement”, arguing that a Firm that allows Group to impose its requirements on the Firm’s affairs has implicitly entered into an arrangement with Group for this purpose. This is what FSA means by a Group officer “having an informal but direct influence on the Board”, as referred to in section 5.

- This arrangement is for you to perform some part of the Firm’s regulated activities.

- A Firm that is entirely autonomous will have its own governance function setting its strategy and budget and overseeing all aspects of its financial operations. It will also have its own operational, marketing and risk functions. Where a Firm is part of a Group it may cede certain of these functions to Group. For example, it may not have an independent risk and audit function, instead relying on that of Group. In such a case the Group Risk Officer (or equivalent) will probably have entered into an arrangement with the Firm to perform one of its regulated activities – the oversight of its risk management.

- FSA additionally considers that a Firm that does any of the following will probably be viewed as having entered into an “arrangement” with Group:

• Seeking Group’s prior approval on matters such as strategy, business planning, capital investment or an acquisition;

• Conforming to Group’s risk or control policies;

• Establishing reporting lines whereby Group executives influence its staffing, budgets or operations.

- In our view these three examples fall short of what would normally be recognised as an arrangement that a Firm enters into with its Group, and in any case FSA qualifies them by stating that a Group individual involved with a Firm is unlikely to fall within CF00 (and thus there will be no arrangement) when:

• He or she is carrying out a Group function rather than performing a function on behalf of the Firm; or

• The Firm’s Board is sufficiently independent or autonomous, and has adequate discretion on how it applies and responds to Group directions or proposals; or

• The Firm has the requisite senior officers in place, who are effective and have sufficient control over it; or

• Group is not unusually “hands on” or otherwise fulfilling each element of the definition.

A Group will typically require all member Firms to observe group-wide policies covering areas such as risk management, accounting, return on capital as well as cultural standards such as ethics, inducements and treating customers fairly. Where a Group sets standards of operation or governance and a Firm’s board adopts them, thereafter taking its own decisions within those parameters, it is difficult to view the Firm as having delegated any part of its regulated functions to an individual at Group level. Where a Group approves a Firm’s annual budget and requires that major unbudgeted items of expenditure are referred to it – a common requirement – it is difficult to view this as the Firm delegating its budgetary control
function to Group, rather than Group exercising its own budgetary process. In such cases we consider that unless each element of the statutory definition is present (which is unlikely to be a usual occurrence) a Firm will be performing its own regulated functions in accordance with Group’s general requirements but will not have entered into any arrangement with any individual at Group level.

7. What happens if I fall within CF00?

Three things.

- You must not commence the activities that bring you within CF00 until FSA has formally approved you. You must immediately stop if you are currently undertaking these activities. Both of these points are subject to the transitional provisions mentioned in section 1.

- The Firm (rather than Group) must satisfy FSA that you are fit and proper as interpreted by FSA. The focus is at present shifting from merely checking integrity to ensuring competence, and FSA may wish to interview you as part of the assessment process.

- Once individually approved by FSA, you undertake directly to FSA that you will take all reasonable steps to ensure that the Firm is run compliantly. (2 - footnote Statements of Principle for Approved Persons (APER) 5, 5 and 7 5 ) While your responsibility is in theory limited to that part of the Firm’s business over which FSA considers you have influence, it is important to note that the undertaking is unlimited and the actual scope of your influence is unlikely to be tightly defined. Current experience is that FSA interprets this requirement rigorously when taking enforcement action against an individual for breach.

FSA encourages a Firm to discuss the issue with its supervisor before proceeding to file an application for a CF00, especially where it is part of a complex or international Group. In an earlier consultation paper FSA stated that it did not expect to receive many applications for CF00, implicitly recognising that very few individuals would fulfil the requirements.

A possible course of action

One particular concern is that the imposition of APER 5 – 7 on holders of the new CF00 controlled function will expose them to liability to FSA for the Firm’s misconduct in areas over which they have no, or only limited, information and control (despite FSA’s assurances on the limited scope of CF00 liability). Firms faced with the possibility of Group executives falling within the scope of the new CF00 controlled function may therefore wish to consider the following options:

- Review the operation of the Firm’s governance to ensure that an individual who would otherwise be affected clearly falls outside the ambit of CF00 (and also outside other FSA governing functions and the Companies Act definition of a shadow director).

- If not practicable, then consider how best to structure the parent level role within the firm’s governance and FSA’s approved persons regime including the new CF00 function; for example, the individual might, as an alternative to CF00, be appointed as a director of the firm (CF1 or CF2) so that he or she receives the same management information, and is able to participate in the Firm’s governance on the same basis, as the other directors.

How we can help

We have assisted a number of firms to review their governance and to identify individuals potentially falling within CF00. We have advised affected firms on adjusting operations or lines of responsibility to ensure that those individuals are excluded.

In other cases we have assisted firms in obtaining FSA clearance that the individuals do not require to register as CF00. We can also draw on wide experience in assisting firms to review and benchmark their governance arrangements, for example in preparation for an ARROW visit. Our RegZone contains further materials about FSA’s governance regime.