Written by Matt Raver
Written by Catherine Ruberry
Regulatory Policy and Development Manager
The FCA has been most active recently in its output of Portfolio letters – like thematic reviews, distilling the regulator’s primary objectives and concerns, tailored to a discrete sector of the industry. In September alone, it addressed portfolio reviews to Wholesale Banks, Wholesale Insurers, Personal and Commercial insurers, Life insurers, Providers of Funeral Plans – and Platforms. Corporate Finance firms (“CFFs”) are the latest to attract the full beam of regulatory scrutiny.
This letter is addressed to Chief Executives of firms in the Corporate Finance Firm sector, from the catchily titled “Director of Infrastructure and Exchanges Supervision, Policy and Competition – Markets”.
The harms and supervisory priorities set out in the letter are also of interest to other types of investment firm including asset managers and brokers. Many of the concepts discussed – such as consumer protection, appropriate classification of clients, market abuse, financial crime and resilience, have been articulated by the FCA in other guises, and their inclusion in this letter is not surprising.
The FCA sets out the harms it considers most likely to arise to consumers and markets from the CFF business model; its intended strategy; and its expectations of the sector, the firm – and its CEO, with a clear nod to the Senior Managers and Certification Regime (“SMCR”), leaving no doubt about their responsibility for ensuring the firm’s compliance.
This isn’t a one-off exercise. Earlier this year, the FCA issued a survey to all Corporate Finance firms, and to keep appraised of key risks in the sector, it proposes to update this annually.
The corporate finance sector
Corporate Finance firms form a more select cohort than most; around 500 firms, which mainly advise corporate clients seeking to raise funds (typically from institutional investors), or to execute strategic transactions. Providers of ancillary services like corporate broking or investment research may also fall within the net. CFFs are different in that they usually treat the corporate issuer as a client, and investors as a “corporate finance contact” – (i.e., not as a client, and therefore not obliged to advise or provide protections, as if acting for them in an adviser/client relationship).
CFFs source capital for business, encouraging job creation and economic growth. Especially, they help small and medium sized enterprises raise capital, form prices and maintain liquidity in secondary markets. They have a vital role in the financial ecosystem, contributing to the integrity, transparency and competitiveness of UK capital markets.
The FCA recognises that CFF business models and activities are very diverse, the risks posed by these different firm types varying accordingly.
Unsurprisingly, the sector has faced adverse market conditions since Russian hostilities broke out. A downturn in IPO & M&A activity had led to cost rationalisation and consolidation but the FCA considers the sector has been generally resilient and upheld market integrity. When firms venture into higher risk business during periods of low activity, the FCA expects stronger controls accordingly.
The FCA alluded to a raft of recent major reforms designed to make the UK’s primary and secondary wholesale markets more effective, including The UK Listing Review and The Future Regulatory Framework Review.
These propose major changes to the UK regimes for admission to trading, listing and public offers and should streamline the issuers’ process for raising primary and secondary capital. After the consultation period, the FCA will make rules to implement the new regimes.
Also impacting Corporate Finance firms are the
- Investment Research Review;
- Stronger financial promotion rules for high-risk investments, since December;
- Authorisation gateway for permission to approve financial promotions for unauthorised persons;
- The Consumer Duty, in force since 31 July 2023, obliging in-scope firms to put consumers’ needs first
The FCA enumerates four main “Drivers of harm”. These will vary between diverse types of firm, and it is for CEOs to identify those which apply.
- Unsuitable products to consumers
Many CFFs offer a service both to retail and elective professional clients. Sometimes the lines are blurred as they may advise a small business or local authority that does not meet the regulatory criteria to be an elective professional client and is therefore classified as a retail client. Some enable fundraising from individual investors, who are not their clients but treated as “corporate finance contacts”.
Retail clients may lose important protections and compensation rights if wrongly categorised as professional. This may cause them harm, as also may CFFs’ treating them as “corporate finance contacts” when the relevant conditions are not met. This may happen when an investor is led to believe that they are being treated as a client, unless the firm fails clearly to indicate that this is not the case, it is neither acting for the investor nor offering client protections. Where a firm/investor relationship does not meet the conditions for being a “corporate finance contact”, or evolves into a client relationship, the FCA holds the firm responsible for providing client protections to the investor.
Many CFFs make use of the exemption, under the Financial Promotion Order, for communications to sophisticated investors and high net worth individuals. Where retail investors are wrongly classified as such, they may venture into high-risk products and sustain losses they cannot afford.
Harm may also occur where firms don’t consider the client category of the recipient for a financial promotion, or the rules applying to communications with retail clients. A “corporate contact” may not be a client of the firm in the course of the firm carrying on a regulated activity but be a client in the context of receiving a financial promotion.
Many CFFs operate a business model that includes unregulated activities. Some retain FCA permissions they have not used and do not require – especially retail customer permissions not used for regulated activity, or not limited to corporate finance business. The FCA believes the FCA authorisation may offer a spurious credibility to unregulated activities, leading customers erroneously to believe they have been afforded certain protections.
- Market abuse
The risks are greater in CFFs who act for listed corporate issuers and routinely hold inside information, and also trade in listed securities for the firm and their clients. The FCA has found some CFFs with poor systems and controls such as ineffective information barriers, insufficient processes to identify inside information, inadequate wall crossing control and incomplete insider lists. Other errors occurred around market soundings, failing to obtain prior content before disclosing inside information, or to communicate to recipients when no longer inside.
Market integrity may also be undermined by poor conflicts management and lack of transparency. Some firms fail to identify and record all conflicts of interest, both those inherent in their business model, and those emerging from clients and transactions. Conflicts registers may be incomplete. Conflicts emerging from staff directorships or shareholdings in corporate clients may not be properly discussed.
Personal account dealing (“PAD”) is another area of risk in terms of insider dealing and conflicts of interest. Some firms don’t adhere to procedures, securities are not properly added to restricted lists, or staff trade without compliance approval.
- Financial crime
Some CFFs work with overseas clients and investors or advise on cross-border transactions. Foreign activity and complex corporate structures, sometimes using offshore trusts and vehicles, may obscure the ultimate source or recipient of funds raised, or counterparties involved. To avoid significant harm to consumers and markets, CFFs need to carry out robust financial crime due diligence and, especially in the wake of Russian hostilities, to avoid sanctions breaches.
- Financial resilience
Of lower risk to markets and consumers are the many CFFs who whose role is purely advisory. Their failure might impact clients mid-transaction or relying on specialist advice but cause little harm to markets or consumers.
However, many CFFs hold significant client assets, are liquidity providers or advise a number of AIM or AQUIS listed clients. In their case, a disorderly failure might significantly impact markets and consumers and undermine confidence in the sector as a whole.
To combat these harms, the FCA sets out four supervisory priorities.
- Client categorisation
Firms must comply with the client categorisation rules in relation to clients to whom they provide a service, while carrying on a regulated activity. This includes following the criteria for a client to be treated as a per se professional or an elective professional.
The FCA will be targeting firms with reviews of their client categorisation practices, making sure they follow appropriate procedures, including opting up clients to elective professional status. The FCA will challenge firms if not clear that retail clients have been correctly categorised; or, where the firm may not have the right customer permissions for its business model.
The next annual CFF Survey will require data about investors, and the products marketed to them, allowing for a thorough review of investor categorisation practices.
Any abuse of the corporate finance contacts regime or financial promotion exemptions may lead to “robust action”, including restrictions on business.
- The Consumer Duty
This is limited to firms that conduct retail market business, or able materially to influence retail customer outcomes. It is unlikely to apply to many wholesale activities.
However, many CFFs deal both with clients and “corporate finance contacts” and must assess the extent to which the Duty applies to both sides.
The FCA expects firms to exercise judgment and properly to assess the extent of the Duty’s application. This requires them to look at the entire distribution chain, and whether they can determine, or materially influence, retail customer outcomes.
The Duty applies to the client categorisation process itself. Encouraging clients to seek professional client classification, in order to circumvent retail client protections, would breach the Duty. Where incorrectly classified, a firm must reclassify the client, and restore the correct level of protection.
On the investor side, the Duty may apply where a retail investor is treated as a “corporate finance contact”. It applies when firms communicate or approve financial promotions relating to retail market business that are likely to be received by a retail customer. A person to whom such a promotion is communicated, or likely to be communicated, is a client of the firm that communicates or approves it – including any “corporate finance contacts”.
Likewise – unless the conditions are met, treating retail investors as “corporate finance contacts”, to circumvent client protections, would breach the Duty; as would incorrectly classifying them as sophisticated or high net worth, to attract Financial Promotion Order exemptions, or to avoid regulatory rules applying to retail client communications.
The CFF Survey collected data about firms’ approach to the Duty. Focussing on firms with retail clients, the FCA will require firms that consider they are not impacted, to explain their rationale. Where firms fail to comply with the Duty, senior managers will be held to account.
- Dealing with problem firms
CFFs must use their regulatory permissions for a legitimate business purpose and maintain a permission profile that accurately reflects what they do.
Incorrect FCA Register permissions may mislead consumers concerning the level of protection or appear to endorse a firm’s unregulated activities. Firms must review their permissions, retain only those they need and notify the FCA if their business model has changed. The FCA may vary or cancel firms’ unused permissions.
The FCA thinks CFFs should have the “corporate finance business” limitation to their designated investment business, or retail customer permissions if this reflects the firm’s business model. Firms that do not may be invited to vary their permissions.
The FCA needs to maintain reliable communication with the firms it supervises and expects CFFs to be open and transparent. Contact details on CONNECT must provide a current and regularly monitored email address. Where information requests repeatedly go unanswered, the FCA will consider enforcement action to cancel permissions.
As a data-led regulator, the FCA expects complete, accurate and timely RegData submissions and responses to information requests. Currency, units, period and description of data requested all require close attention. Any gaps, errors or missing returns will be challenged.
- Market abuse
Controls need to ensure compliance with the UK market abuse regime and be calibrated for firms’ individual business models.
Conflicts of Interest must be identified, recorded and managed.
CFFs must assess conflicts arising both from their inherent business model, and from new clients and transactions.
The FCA has been reviewing firms’ systems and controls in particular aspects of the UK’s civil market abuse regime, their personal account dealing policies and conflicts of interest requirements. It considers the firm’s role in transactions, and its systems, controls, policies and procedures, generally and in relation to these. Of especial interest are the firm’s approach to insider lists, access logs, wall crossings and market soundings. Compliance should be challenging and monitoring these activities and escalating to senior management any issues around market abuse, conflicts of interest or PAD. Further, the FCA proposes to make targeted cross-firm PAD reviews in its next supervisory cycle.
This portfolio letter provides a ‘snapshot’ of the FCA’s supervisory priorities for the Corporate Finance sector, which mirror and offer a remedy to four identified “drivers of harm”.
The letter is supplemented by requests for information via surveys to assist the FCA in its supervisory efforts, and examples of situations where the FCA may take supervisory or enforcement action against firms.
By addressing portfolio letters to the CEO, the FCA sets the tone that the appropriate regulatory response to the key harms should originate at the very top of an organisation and permeate through it.
A firm receiving a portfolio letter (whether in the Corporate Finance sector or otherwise) should internally acknowledge the letter, analyse its content and as applicable adjust its systems and controls framework.