UK Investment Firms Prudential Regime — 10-Step Plan for Investment Managers

The new UK Investment Firms Prudential Regime (IFPR) will come into force 1 January 2022. This Update sets out 10 steps for in-scope investment managers to consider as they prepare for that 1 January 2022 start date. The 10 steps below are not exhaustive, given the different business models at hand, but should form a good base or starting point for most managers.

The IFPR will apply to:

• UK Markets in Financial Instruments Directive (MiFID) investment firms (including current “BIPRU” firms and “Exempt CAD” firms (so-called adviser/arranger firms)); and
• UK alternative investment fund managers (AIFMs) with MiFID top-up permissions (that is, collective portfolio management investment (CPMI) firms).

Firms that do not currently provide or carry on MiFID investment services or activities in the UK will not be affected by the IFPR.

The IFPR will be implemented through a new prudential sourcebook in the FCA Handbook, The Prudential sourcebook for MiFID Investment Firms (MIFIDPRU).

The IFPR is being introduced following a series of consultations, beginning with a discussion paper published in June 2020 (DP20/2), which provided an overview of the new regime, followed by two consultation papers (CP20/24 and CP21/7) and two policy statements (PS21/6 in response to CP20/24, and PS21/9 in response to CP21/7) containing near-final rules. The near-final rules reflect the overall position that the FCA has adopted across the first two consultations; the FCA has indicated it does not expect to make any changes to these rules before they become final.

The third and final consultation paper on the IFPR (CP21/26) was published on 6 August 2021. CP21/26 is consulting on draft rules for disclosure requirements and on certain technical issues including consequential changes to the FCA Handbook. CP21/26 is not expected to make any material changes to the consolidated near-final rules contained in PS21/9.

For more information on CP21/7, see our Update UK Investment Firm Prudential Regime — FCA’s Second Consultation — Implications for Investment Managers. For a summary of PS21/6 and PS21/9, see our July 2021 and August 2021 Updates.

Step 1: Determine your firm’s IFPR classification

A firm’s classification will determine the types of rules within the IFPR that will apply to it.

Firms subject to the IFPR will fall into one of two categories:

• small and non-interconnected (SNI) firms; or
• non-SNI firms.

SNI firms

SNI firms are firms that do not have permission to deal on own account and that satisfy all of the following conditions (SNI Thresholds):

• average assets under management (AUM) < £1.2 billion;
• average client orders handled (COH):
  • cash trades < £100 million per day;
  • derivative trades < £1 billion per day;
• average assets safeguarded and administered = zero;
• average client money held = zero;
• average daily trading flow = zero;
• on- and off-balance sheet total < £100 million;
• average total annual gross revenue from investment services and/or activities < £30 million;
• not a clearing member or an indirect clearing member firm; and
• not appointed to act as a depositary.

Non-SNI firms

Non-SNI firms are firms that exceed any one of the above SNI Thresholds.

What is AUM?

AUM is defined for these purposes as:

• discretionary portfolio management; and
• non-discretionary arrangements constituting investment advice of an ongoing nature.

Average AUM is calculated by:

• taking the total AUM as measured on the last business day of each of the previous 15 months;
• excluding the three most recent monthly values; and
• calculating the arithmetic mean of the remaining 12 monthly values.

Firms may exclude from their AUM calculation the value of any assets that have been formally delegated to them (to manage) by a “financial entity.” A financial entity is, broadly, an entity that has minimum AUM-based capital requirement similar to the K-AUM requirement or that forms part of the same financial conglomerate or prudential consolidation group as the relevant FCA investment firm. Since U.S. SEC-registered investment advisers are not subject to minimum AUM-based capital requirements, they would not generally be considered “financial entities” for this purpose; however, another UK or EU investment firm, AIFM, or UCITS management company would qualify as a financial entity.

What is COH?

COH is intended to capture (i) the execution of orders on behalf of a client and (ii) the reception and transmission of client orders. Average COH is calculated by:

• taking the total COH measured throughout each business day over the previous six months;
• excluding the daily values for the most recent three months; and
• calculating the arithmetic mean of the daily values of the remaining three months.

Firms that do not have the necessary historical data to calculate their average AUM and COH will be permitted to use reasonable estimates to fill any missing historical data until such time as they have sufficient data.

The FCA expects that approximately 70% of FCA investment firms will qualify as SNI firms.

A note on Exempt CAD firms

Certain firms in the investment management industry are currently Exempt CAD firms — that is, adviser/arranger firms that are MiFID investment firms and have a simple capital requirement of €50,000 (or a combination of capital and professional indemnity insurance). The Exempt CAD model is relatively common in the private equity industry (where the Exempt CAD firm is a sub-adviser to an offshore AIFM) and is also used by firms that do not need investment discretion (e.g., firms that assist only in distributing their parent AIFM’s funds or more broadly in the corporate finance industry).

The Exempt CAD category disappears under the IFPR and so such firms will need to calculate their variable capital requirement as SNI or non-SNI firms. The result will be a significant increase in such firms’ capital requirements (likely at least one quarter of annual fixed costs), albeit there is a five-year transitional period (see Step 10 below). In addition, Exempt CAD firms would be required to consider the new Internal Capital Adequacy and Risk Assessment (ICARA) process (see Step 6 below) for the first time, since such firms do not currently have to deal with the Internal Capital Adequacy Assessment Process (ICAAP), unlike BIPRU firms.

Exempt CAD firms could consider whether it is possible to opt out of being MiFID investment firms, in particular, by utilising the exemption in Article 3(1) of MiFID as onshored in the UK. A detailed discussion on the Article 3(1) MiFID exemption is beyond the scope of this paper, but we would be happy to discuss with any firm that might like to explore whether the exemption might be available to it.

Any firm that intends to opt out of MiFID will need to apply to the FCA for a variation of permission (VoP); a VoP can take four to six months or more to process. As such, firms that intend to opt out of MiFID would need to act as soon as possible.

Step 2: Calculate your firm’s FOR and PMR

This step is relevant for SNI and non-SNI firms.

SNI firms

SNI firms will be required to maintain an amount of “own funds” that is the higher of their:

• permanent minimum capital requirement (PMR), which for UK investment managers should generally be £75,000; and
• fixed overheads requirement (FOR), which would be an amount equal to three months of the firm’s “relevant expenditure” (being, broadly, a firm’s total expenditure for the preceding year but with certain deductions, e.g., profit distribution, staff bonuses, non-recurring expenses from non-ordinary activities, amongst others).

Non-SNI firms

Non-SNI firms will be required to maintain an amount of “own funds” that is the higher of their:

• PMR;
• FOR; and
• total “K-factor” requirement (see Step 3 below).

Step 3: Calculate your (non-SNI) firm’s total K-factor requirement

This step is relevant only for non-SNI firms; it is not relevant for SNI firms and SNI firms can thus move on to Step 4.

K-factors are a set of quantitative indicators intended to represent the risks that a non-SNI firm can pose to its clients, to the market, and to itself. The IFPR contemplates a range of K-factors, each with a co-efficient to be applied.

The overall K-factor requirement of a non-SNI firm is the sum of each of the K-factors applicable to its MiFID activities.

For most non-SNI investment management firms, K-AUM (assets under management) and K-COH (client orders handled) are likely to be the most relevant K-factors.

The K-AUM requirement of a firm is 0.02% of a firm’s average AUM, with average AUM being calculated as discussed in Step 1 above.

The K-COH requirement of a firm is equal to the sum of:

• 0.1% of its average COH attributable to cash trades; and
• 0.01% of its average COH attributable to derivatives trades,

with average COH in each case being calculated as discussed in Step 1 above.

Step 4: Consider your firm’s consolidation status

This step is relevant for SNI and non-SNI firms. As such, all firms should consider their consolidation status.

Under the IFPR, consolidated supervision will apply where there is an “investment firm group,” unless the FCA has granted permission to that group to use the group capital test (GCT — see below).

An investment firm group will consist (broadly) of a UK parent undertaking and certain of its subsidiaries and “connected undertakings,” of which at least one must be an FCA investment firm.

Prudential consolidation requirements will apply directly to (and at the level of) a UK parent entity. The consolidating UK parent entity will be categorised as either an SNI or a non-SNI firm. Generally, the same approach to firm categorisation and own funds requirements (discussed above) that applies to FCA investment firms on an individual basis will apply to UK parent entities on a consolidated basis.

As such, consolidating UK parent entities will be required to comply with, among other things, consolidated own funds requirements, liquid asset requirements, and disclosure requirements.

Group Capital Test (GCT)

Where the FCA permits an investment firm group to use the GCT, the UK parent entity will be exempted from applying the IFPR on a consolidated basis.

Instead, the relevant UK parent entity will be required to hold own funds instruments sufficient to cover:

• the sum of the full book value of its holdings, subordinated claims, and certain other specified instruments, in relevant entities in the investment firm group; and
• the total amount of its contingent liabilities in favour of the relevant entities in the investment firm group.

Step 5: Determine your firm’s basic liquid asset requirement

This step is relevant for SNI and non-SNI firms.

All firms will be required to hold an amount of liquid assets equal to one third of their FOR and 6% of the total amount of any guarantees provided to clients (we do not expect the latter to be of relevance to UK investment managers).

The FCA expects firms to satisfy their basic liquid assets requirements using a specified list of “core liquid assets,” including (but not limited to) cash, units or shares in short-term regulated money market funds and short-term deposits at UK credit institutions. Such assets are expected to be held by (i.e., in the name of) the relevant FCA investment firm.

Step 6: Establish your firm’s ICARA process

This step is relevant for SNI and non-SNI firms.

The IFPR will introduce an overall financial adequacy rule (OFAR) designed to determine whether a firm has sufficient financial resources to fund its operations.

The OFAR will require all firms to hold at all times sufficient own funds and liquid assets (i.e., financial resources) to cover the type and amount of risk they might face or pose to others, taking into account the nature, size, and complexity of their activities.

All firms will be required to establish an ICARA process. The ICARA process will replace the ICAAP that BIPRU and IFPRU firms are currently required to carry out.

The ICARA process is designed to supplement a firm’s own funds requirements and allow a firm to identify, monitor, and, if relevant, mitigate all material potential harms that could result from the ongoing operation or winding down of its business.

ICARA document and questionnaire

Firms will be required to review the adequacy of their ICARA process annually and report the outcome of their review to the FCA by completing an ICARA assessment questionnaire.

Firms will also be required to prepare an ICARA document annually, which the firm’s governing body must review and approve, providing (among other things):

• a summary of material harms identified by the firm and any steps taken to mitigate them;
• a clear explanation of how the firm is complying with the OFAR, including a clear breakdown of the following as at the review date:
  • available own funds;
  • available liquid assets;
  • the firm’s assessment of its threshold requirements; and
• the levels of own funds and liquid assets that, if reached, the firm has identified may indicate that there is a credible risk that the firm will breach its threshold requirements.

Additionally, where there is a material change in a firm’s business or operating model, it will be required to re-review the adequacy of its ICARA process promptly and submit an updated ICARA questionnaire within 20 business days of the governing body of the firm’s approving the ICARA document resulting from the relevant review.

Examples of material changes in business or operating models that may require a firm to review its ICARA process include where a firm launches a material new product or business line or merges with another business.

More generally, should a firm determine that additional own funds and/or liquid assets are required as a result of the ICARA process, the higher amounts would together constitute the firm’s “threshold requirement” and, in turn, represent the firm’s view of what is required to meet the OFAR unless the FCA advises otherwise.

Step 7: Update your firm’s remuneration policy and procedures

This step is relevant for SNI and non-SNI firms.

The IFPR will introduce a single remuneration code for all FCA investment firms (the MIFIDPRU Remuneration Code). The MIFIDPRU Remuneration Code will apply from 1 January 2022 or the start of the next performance period, whichever is later.

Different rules (basic, standard, or extended requirements) will apply depending on whether the firm is SNI, non-SNI, or large non-SNI firm. SNI firms will need to comply with only a small number of remuneration rules; broadly, such firms will be required to establish, implement, and maintain proportionate remuneration policies and practices.

Non-SNI firms

All non-SNI firms will be required to identify their material risk takers (MRT), set a ratio between variable and fixed remuneration in their remuneration policy, and have in-year adjustments, malus, and/or clawback arrangements in place for MRTs. That marks a significant change from the current rules for BIPRU firms, which are typically allowed to disapply all of the “pay-out process” rules, including malus/clawback arrangements.

Large Non-SNI firms

Large non-SNI firms (broadly, those with on-balance sheet assets and off-balance sheet items of more than £300 million over the preceding four-year period) will be required to:

• establish risk and remuneration committees;
• comply with pay-out process rules; and
• provide information on the structure and amount of remuneration awarded to their highest three earners.

Large non-SNI firms will not be able to disapply the pay-out process rules based on proportionality, though certain MRTs at large non-SNI firms may be exempt from the pay-out process rules.

CPMI firms

CPMI firms (i.e., UK AIFMs with MiFID top-up permissions) will be required to comply with the MIFIDPRU Remuneration Code with respect to their MiFID business. Where an MRT of a CPMI firm is carrying on MiFID business, they may be required to comply with both or the stricter of the AIFM Remuneration Code and MIFIDPRU Remuneration Code.

Step 8: Monitor concentration risk

This step is relevant for SNI and non-SNI firms.

All firms will be required to monitor and control all sources of concentration risk, including any concentration risk that may arise from (among other things) the location of the firm’s own cash deposits and sources of their earnings (e.g., the extent to which the firm’s assets are concentrated at particular banks, investment firms, and other entities). Non-SNI firms will be required to report to the FCA, on a quarterly basis, the value of their exposures/positions with each of their top five counterparties, the location of their own cash, and the percentage of their total revenue earned from each of their top five clients.

Step 9: Consider your firm’s approach to annual disclosures

This step is relevant for SNI as well as non-SNI firms.

All firms will be required to disclose publicly certain specified information on their websites on the same date on which they publish their annual financial statements, including qualitative and quantitative disclosures regarding their remuneration policies and procedures.

For example, all firms will be required to disclose the total amount of remuneration awarded to all staff, split between fixed and variable remuneration and, for non-SNI firms, between senior management, other MRTs and other staff.

Non-SNI firms

Additionally, non-SNI firms will be required to disclose (among other things):

• the types of staff they have identified as MRTs, including any criteria they have used to identify MRTs in addition to those specified in the MIFIDPRU Remuneration Code;
• the framework and criteria used for ex-ante and ex-post risk adjustment of remuneration, including a summary of how malus (where relevant) and clawback are applied; and
• the total amount of guaranteed variable remuneration and severance payments awarded during the relevant financial year and the number of senior management and other MRTs receiving those awards.

Large non-SNI firms

Large non-SNI firms will also be required to disclose (on an annual basis) the proportion of voting rights attached to shares they held “directly or indirectly” in issuers with shares admitted to trading on a UK regulated market and a complete description of their voting behaviour in the general meetings of such companies. This requirement would apply only where the proportion of voting rights that the large non-SNI firm held directly or indirectly in the relevant company is greater than 5% of all voting rights attached to the shares issued by the company.

Step 10: Consider whether transitional provisions apply

This step is relevant for SNI and non-SNI firms.

MIFIDPRU contains a number of temporary transitional provisions allowing firms to apply a lower own funds requirement than would otherwise apply. Such provisions are designed to provide a smooth transition for firms from their current regulatory capital requirements to the requirements under the IFPR.

The transitional provisions are likely to be most relevant to current Exempt CAD firms who, as explained in Step 1 above, have to date benefited from comparatively light touch regulatory requirements. The transitional provisions are also likely to be relevant for groups that will be subject to prudential consolidation (given that the UK consolidating entity will require historic data from certain of its subsidiaries and connected undertakings in order to comply with the consolidated requirements).

Exempt CAD firms will be permitted to gradually increase their capital over a period of five years from 1 January 2022.

For example, Exempt CAD firms will be permitted to substitute their PMR (e.g., £75,000) with the following alternative PMR:

• £50,000 for 2022;
• £55,000 for 2023;
• £60,000 for 2024;
• £65,000 for 2025; and
• £70,000 for 2026.

Exempt CAD firms will also be permitted to substitute their FOR (and, where relevant, their K-factor requirements) with the following alternative requirements:

• their transitional PMR for 2022, which would be £50,000;
• 10% of their FOR/K-factors requirements for 2023;
• 25% of their FOR/K-factors requirements for 2024;
• 45% of their FOR/K-factors requirements for 2025; and
• 70% of their FOR/K-factor requirements for 2026.

The full own funds requirement of the IFPR will then apply to Exempt CAD firms from the start of 2027, though some Exempt CAD firms may require additional own funds and/or liquid assets as a result of their ICARA process.

How Sidley Can Help

The Sidley team have been advising firms as well as trade associations from the start of the IFPR process, including throughout the development of the EU Investment Firm Regulation and Investment Firm Directive, which form the basis of the IFPR. We are well-placed to advise clients on all aspects of the new framework and would be happy to assist firms in their implementation efforts.