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With the introduction of the current regulatory changes such as capital and liquidity adequacy, and consumer duty, it is important for business owners to stay informed and be responsive to the dynamics and complexities of the market.

To provide clarity in the midst of regulatory complexity, Louise Jeffreys, from Gunner & Co, interviewed Karishma Galaiya, our Senior Manager, to discuss the topline questions that you might be interested in.

Q1. Regarding the recent FCA CP23/24 paper regarding capital deduction for redress for personal investment firms, please can you give us a short summary of the consultation paper

Essentially, as the FCA quite succinctly put it, they ‘want the polluter to pay’. The number and amount of compensation made by the Financial Services Compensation Scheme (FSCS) as a result of consumer harm caused by Personal Investment Firms (“PIFs”) has increased over the last few years and therefore the FCA are consulting on proposals to require PIFs to be more prudent and set aside capital for potential redress liabilities at an early stage. Typically, many IFAs would be classified as PIFs. To be considered a PIF under the FCA requirements, the main source of the firm’s revenue should result from a firm’s activities related to permissions including, but not limited to, advising on investments and/or managing investments for retail clients. Too often those firms which have got things wrong do not take responsibility for their mistakes with the financial burden of those mistakes falling instead on the FSCS and its levy payers. The FCA sets out some shocking statistics: of the £973m that consumers received in redress between 2016-2022 for pensions and investment-related advice, £757m was covered by the FSCS due to PIFs leaving the market. Behind this £757m are 20,000 consumers who suffered harm and 75 firms who were responsible for 95% of this amount.

As well as a Dear CEO paper on the topic of redress for PIFs issued at the same time as the consultation paper, the consultation includes a chapter on broader improvements to the prudential regime for PIFs, which would include the vast majority of IFAs. To really highlight the importance the FCA is placing on this, the FCA is also running a pilot data collection for a sample of firms during the extended consultation period. The FCA have stated they will consider the results of this alongside consultation responses before making final rules expected to be published in H2 2024 and in force in H1 2025. In summary, the proposed rules build on the existing prudential requirements and there are 4 steps that IFAs that fall into the PIF category would need to take to comply:

• Step 1 Firm identifies potential redress liabilities (in line with existing requirements)
• Step 2 Firm quantifies potential redress liabilities, taking into account expected redress, PII cover and probability factor (of 28%).
• Step 3 Firm sets aside capital by deducting potential redress liabilities from capital resources (deduction built into RMA-D1)
• Step 4 If the firm is undercapitalised after setting aside capital, the asset retention requirement applies

Some other key points for IFAs that fall into the PIF category to consider:

• Complying with the Consumer Duty will enable firms to identify potential redress liabilities, and the new rules will mean that firms must then quantify these liabilities and set aside capital to meet them.
• Current proposals will mean that Principal firms will also have to quantify and set aside capital resources for potential redress liabilities for their ARs.
• The FCA want PIFs to be more prudent than the accounting baseline when it comes to their potential redress liabilities. So their rules would go further by requiring PIFs to recognise and deduct potential redress liabilities from their capital resources earlier than might be required under ordinary accounting principles.
• To ensure a PIF complies with its capital resources requirement at all times, it may need to quantify potential redress liabilities outside of its regular financial reporting cycle.
• For unresolved redress liabilities where a PIF is responding to a complaint, the FCA would expect a PIF that determines no redress is due to wait for 6 months until the referral period to the Ombudsman Service has expired before releasing the capital. In the event that a complaint was referred to the Ombudsman Service, the FCA would expect the PIF to continue holding capital until the Ombudsman Service has made a decision.
• The FCA are proposing to prescribe a probability factor using the market-wide data they hold on upholding rates for complaints against PIFs. 28% of pensions and investment complaints are upheld; therefore, PIFs would have to set aside capital for a minimum of 28% of their total potential redress liabilities.
• Where firms use the capital resources calculated under MIPRU, they will need to apply the same capital deduction for redress as would be applied under IPRU-INV 13. This is to stop them from gaining an unfair advantage over firms only subject to IPRU-INV 13.
• To ensure transparency, the FCA intend to publish information about which PIFs are subject to an asset retention requirement on the FS Register.
• Identifying a prospective redress liability is not an admission of wrongdoing on the PIF’s part, and the FCA will not treat it as such.
• There is a proposal to exempt PIFs which are subject to group supervision by the FCA and operate a consolidated ICARA process and PIFs which are subject to group supervision by the PRA under the CRR or SII and which operate a risk assessment process which achieves equivalent outcomes to a consolidated ICARA process.

Q2. What is the FCA proposing in the wider prudential changes to PIF firms?

The FCA’s existing prudential requirements for PIFs combine minimum capital requirements and the requirement to hold appropriate professional indemnity cover. PIFs are currently not subject to specific liquidity requirements. At present, their capital resources requirements are based on their income, without reflecting the scale of assets that they give advice on, specific risks that they face or their activities. However, going forward, the FCA believe that a comprehensive prudential framework should generally include a combination of the following elements:

• Regulatory rules around capital and liquidity adequacy: the FCA want PIFs to hold minimum amounts of regulatory capital and basic liquidity buffers. They specifically call out the well-known ‘quirk’: despite PIFs and former exempt CAD firms carrying out similar activities, PIFs have lower capital requirements than former exempt CAD firms. The FCA are essentially asking if there should there be additional capital requirements and liquidity requirements based on the activities (type and scale) a PIF undertakes, or the size and scale of the PIF, and if these are implemented, how could these requirements be calibrated to account for the most harmful and/or riskier activity. However, as the FCA sets out in the paper, this could be difficult to implement in practice and doing so, could lead to unintended consequences that prevent consumers from accessing important advice services if firms withdraw from providing the activities that will need them to hold more regulatory capital.
• Risk management, governance and credit and loss provisioning requirements so firms consider the level of resources they should have: The FCA could follow the approach in the IFPR and require firms to carry out a form of internal capital and risk assessment like the ICARA for MiFIDPRU firms to support consistent standards.  In practice, this would mean enhancing their risk management framework, identifying key risks in the PIF’s business and implementing mitigating controls. Key risks across the business should be considered, including complaints that may indicate wider and deeper issues that require potential redress. This process would help to identify where additional capital requirements would be required.

In addition to the above, stakeholders are encouraged to consider winding down planning requirements for PIFs, professional indemnity insurance alternatives if a firm cannot access PII in certain circumstances and whether additional reporting would enable the FCA to identify vulnerable PIFs and better supervise this market.

Q3. Since the paper was introduced at the end of last year, have there been any updates from the FCA on the direction of this consultation?

The FCA are really focusing on delivering better consumer outcomes and we have seen this come through in a number of different speeches, consultations and policy statements. In terms of redress, it is important that firms prioritise preventing situations where redress needs to be provided and enhancing their systems and controls to provide positive outcomes.  It is very interesting that the FCA added the discussion chapter on proposing wider prudential changes to PIFs within the same consultation paper; the FCA are looking to implement a more level playing field for advice firms in terms of prudential regulation.

The Dear CEO letter that accompanies this consultation paper indicates that the FCA is monitoring firms seeking to change their corporate structures in light of these ongoing consultation proposals, or otherwise seeking to avoid potential redress liabilities and complaints responsibilities. Firms should not deter their customers from pursuing a complaint or referring a complaint to the Financial Ombudsman Service. The FCA will be carrying out increased monitoring of firms applying to cancel or seeking to apply for new authorisations consistent with their current expectations of PIFs under the Consumer Duty. This is to prevent firms and individuals from attempting to avoid potential redress liabilities or otherwise trying to phoenix.

Q4. Looking specifically at the consolidation market, how do you think proposed changes will impact the M&A market, looking from a seller and buyer perspective (share vs asset purchase/ Deedpoll/cap ad in completion accounts)

The FCA published a Dear CEO letter alongside CP23/24, reminding firms they must not seek to avoid potential redress liabilities. Such behaviour could include changing their corporate structure to isolate liabilities and protect assets (including selling or transferring the client bank), overpaying dividends or allowing the firm to run into insolvency. The FCA are aware of these risks as they exercise their regulatory functions and are monitoring PIFs’ capital levels as part of their sector supervision. This means that both buyers and sellers in this space will have to (and should have already been) paying more attention to not only the monetary provisions for redress but also the systems and controls around this area and how effectively complaints are being dealt with. For buyers, when conducting due diligence on potential prospects, more attention should be paid to any underlying issues that could increase redress amounts paid, including doing a deep-dive analysis of root causes of complaints, checking if annual suitability reviews have been conducted and assessing if there are wider issues lurking in the seller. Where issues are found, it may mean the purchase price is negotiated down or the purchase falls through.

In the Dear CEO letter, the FCA stated that some firms and individuals apply to be authorised after they have provided services, such as financial advice, at other firms. Where they are confident in the quality of these services, they will often enter into a deed poll to accept responsibility for them. They may also do this where they are receiving a benefit from, or to avoid a loss associated with another firm. Under a deed poll, the new firm that receives the transferred business agrees to take responsibility for past services. Ultimately, if an applicant does not take appropriate steps to ensure customers are protected, we may refuse the application. In an M&A situation, the buyer of the assets signs the deed poll and is therefore responsible for the past liabilities. Again, this may lead to buyer firms taking into account potential redress liabilities into the purchase price, bringing an additional layer of complexity into the negotiations.

Q5. How will potential changes to capital adequacy requirements be measured and monitored by the FCA? Over what time period might a firm need to hold additional capital adequacy?

The FCA has stated that they will monitor PIFs’ capital through regular financial reporting in the Retail Mediation Activities Return (RMAR) every 3 or 6 months, with the PIF’s size determining the schedule of returns. They will build the new deduction into the RMA-D1 form so that they can monitor how PIFs are complying with the new requirements and proactively identify PIFs that may be calculating or reporting incorrectly.

In practice, the time period for which a firm may need to hold additional capital may be difficult to predict, given firms will have to wait until a decision is made if a complaint has been referred to FOS.  The FCA are proposing that for unresolved redress liabilities where a PIF is responding to a complaint if a PIF determines no redress is due, it should wait for 6 months until the referral period to the FOS has expired before releasing the capital. In the event that a complaint was referred to the FOS, the FCA would expect the PIF to continue holding capital until the FOS has made a decision.

Karishma Galaiya, Senior Manager