During the month of November, board rooms and offices across Ireland were buzzing with the financial services catch phrase of 2011 – Fitness and Probity – leaking into conversations among directors, executives, lawyers and employees alike. Primarily designed with banks and insurance companies in mind, this new regime provides the Central Bank of Ireland (the "Central Bank") with extensive powers to designate and regulate, at an individual level, persons holding influential positions within all financial service providers regulated by the Central Bank, except credit unions.
Armed with 44 pages of draft guidance from the Central Bank explaining how to comply with the seven very short pages of Fitness and Probity Standards1 (the "Standards"), the Irish financial services industry was in a race against the 1 December 2011 deadline for compliance while continuing to lobby for change, all with the new threat of sanctions for non-compliance looming overhead. As Irish investment funds ("Funds") are more akin to products than to "companies" in the traditional sense of the word, lawyers advising Funds were left grappling with how to navigate Funds through a system designed principally for large brick and mortar institutions. In particular, while there was a level of acceptance for the new regime to apply to future Fund launches, lawyers were left with a real struggle to reconcile the levels of due diligence suggested in the draft guidance with:
- the performance of due diligence on individuals already holding influential positions, who would already have been approved by the Central Bank under the previous "Fit and Proper" regime; and
- the reliance of Funds on service providers that are themselves already heavily regulated and subject to the Standards in their own right.
The impetus for the Fitness and Probity regime lies primarily in the turmoil of the Irish banking system over the past several years and the general global shift toward greater levels of regulation in the financial sector. By setting out a code of competence and character requirements, the Central Bank is able to regulate not only the entities themselves at a high level but also the people running these entities.
The Central Bank was granted extensive powers under the Central Bank Reform Act 2010 (the "Act") to set out the Standards and, particularly, to investigate and suspend, remove or prohibit individuals from taking up or holding positions in regulated financial service providers ("RFSPs"), including Funds. The Act also provides the Central Bank with the ability to prescribe by regulation the types of positions within Funds, service providers to Funds (such as custodians, administrators and investment managers) and other RFSPs to which the Standards will apply – so-called "controlled functions" ("CFs").2 Further, a sub-set of the CFs, "pre-approval controlled functions" ("PCFs"), are 41 specifically named senior management and head of function positions that are considered so influential and important to the workings of RFSPs that the Central Bank must provide prior written approval for the appointment of individuals to those positions from 1 December 2011.
The PCF positions are broken into two sections: those applicable for all RFSPs; and those positions specific to certain types of RFSPs. For all RFSPs, PCFs include the board of directors, CEO and the Heads of Finance, Compliance, Internal Audit, Risk and Anti-Money Laundering Compliance. Additionally, for fund administrators, the Heads of Transfer Agency and Fund Accounting are also considered to be PCFs and for custodians, the Heads of Trustee (fiduciary oversight) and Custody. For those CF positions that are not PCFs, the RFSP will be required to analyse internal functions and determine whether a position is related to ensuring, controlling or monitoring compliance by the RFSP or is likely to enable the person responsible for its performance to exercise a significant influence on the conduct of the affairs of the RFSP.
By setting out a code of competence and character requirements, the Central Bank is able to regulate not only the entities themselves at a high level but also the people running these entities.
The Standards are simple. To hold a CF, including a PCF, one must be: competent and capable; honest, ethical and act with integrity; and financially sound. The problem lies with how an RFSP is to determine whether the CFs and PCFs in its organisation comply with those requirements. The Central Bank leaves the onus on an RFSP to determine, through due diligence, whether the CFs and PCFs in its organisation are compliant with the Standards. What amounts to sufficient due diligence, however, is up to the RFSP. While the Central Bank's guidance provides some suggestions in this area, the threat of sanctions for employing a person that does not meet the Standards had RFSPs frantically trying to determine how much due diligence is enough.
The November rush was particularly related to the PCF category, as the Standards became applicable to PCFs from 1 December 2011, despite the fact that the Guidance was not yet finalised (application to other CFs begins later in 2012). Rather than require all PCFs currently in their positions to be approved or reapproved by the Central Bank, it was left to the RFSPs to determine whether the persons holding PCFs were compliant with the Standards. To ensure the Standards were being implemented, the Central Bank requested a written submission, by 31 December 2011, to include a list of all PCFs in each organisation and a confirmation by the head of the company that the named persons meet the Standards.
While requiring such a submission may seem reasonable enough for an institution with a dedicated human resources department, it created some very real challenges for Funds. In Ireland, the majority of Funds are comprised of four or five directors who supervise the Fund and delegate all day-to-day activity to third-party service providers that are often RFSPs themselves.
This business model gave rise to three key questions that had to be addressed:
- Who is a PCF within a Fund that operates on a delegation model basis?
- Is the Fund responsible for ensuring that the persons carrying out delegated functions are compliant with the Standards?
- What kind of due diligence is appropriate for existing PCFs?
The first question resulted in definite answers for: directors; "Designated Persons" who carry out managerial functions on behalf of the board of directors in self-managed investment companies; and any designated heads of risk, compliance or internal audit. Varying opinions, however, arose as to whether Money Laundering Reporting Officers were included and questions were raised in relation to the specific requirement for Funds to include the heads of transfer agency and accounting valuations (as those are functions carried out by delegation to third-party administrators).
Is the Fund responsible for ensuring that the persons carrying out delegated functions are compliant with the Standards?
The second question necessitated significant engagement by Funds – how could a Fund that has no staff undertake to ensure that all of the people carrying out important functions in delegate service providers were compliant with the Standards? Also, if a service provider is already required to implement the Standards, what would be the benefit of duplicating due diligence? There were additional concerns as to how service providers regulated outside Ireland, for example US or UK regulated investment managers, should be treated. To a collective sigh of relief from Funds, the Central Bank clarified in its final guidance on the Standards, issued on 23 November, that the Standards do not apply to functions outsourced to a financial service provider regulated by the Central Bank or by an EEA or non-EEA regulator that performs functions comparable to the Central Bank. However, if a Fund outsources any CF or PCF positions to an unregulated service provider, the Fund must ensure that the unregulated service provider requires compliance with the Standards by the persons who carry out delegated functions on behalf of the Fund.
Realising the monumental task being asked of RFSPs, the Central Bank extended the deadline for the completion of due diligence to 31 March 2012. This welcome extension aside, Fund lawyers were still left with the third question, regarding how to advise clients on what due diligence should be undertaken regarding existing PCFs in the Fund. The aim for Fund lawyers was to provide a solution that was pragmatic and reasonable (given that Fund directors already must undergo a detailed authorisation process with the Central Bank) but robust enough to ensure that clients are not subjected to sanctions under the Act. Additionally, Fund lawyers were faced with the fact that, if a client Fund does not have either a human resources or compliance department, it might rest upon the lawyer to coordinate the due diligence exercises and to maintain associated records on an ongoing basis.
In a bid to minimise the pain involved in exercising this compliance burden, Dechert undertook to provide a standardised approach to due diligence for existing PCFs in Funds, by developing standardised fillable pdf forms based on: the Central Bank's guidance; the Standards; and the Central Bank's draft individual questionnaire to be completed by PCFs going forward. The Dechert questionnaire requested personal biographical information, an updated CV and confirmations as to a number of questions in relation to ethics, integrity and financial soundness. In addition to being easy for PCFs to complete, the standardised format reduced the amount of time required to review each submission (as problematic responses were easily highlighted).
While the new regime takes a step toward ensuring a solid foundation of expertise in financial institutions, only time will tell whether such a foundation will prevent future problems in the financial services industry.
While the matter of due diligence with respect to existing PCFs has been addressed and is underway, the practical issues for Funds do not end there. Going forward, all appointments to a PCF or, if relevant, a CF, in a Fund will require due diligence to be undertaken. For all PCFs, the Fund must complete due diligence on any proposed persons before being able to refer those persons to the Central Bank for pre-appointment approval and, for CFs, the Fund must undertake due diligence before hiring/appointing them.
Aside from the due diligence requirements, the preapproval requirements have impacted the approval process for Qualifying Investor Funds ("QIF"), which is designed so that Funds that do not propose any novel investment or structuring features can be authorised by the Central Bank within 24 hours of submitting an application. Previously, if an individual proposed as a director of a new QIF had already been approved by the Central Bank to serve as a director of another Fund, he or she could simply submit an updating declaration with the new QIF's application for authorisation. Going forward, however, such an individual will need to submit an individual questionnaire five business days in advance of the proposed date of the new QIF's application for authorisation so that he or she may receive prior written consent to act as director for the QIF.
To have the benefit of an online platform for the individual questionnaire process is welcomed; however, the efficiencies of the platform will be of more use to large financial institutions with staff that already have to administer such records. The Central Bank will issue the RFSP with a user account and then the RFSP will create sub-user accounts for persons they propose to be appointed to PCFs going forward. While this will likely work well for institutions with a human resources or compliance department that can manage the administration of this online system, it will be more difficult to administer from a Funds perspective and it is likely that this will become part of legal firms' offerings going forward.
Although the requirements were designed with very different structures in mind, Funds and their lawyers have made great efforts to find a way to embrace these new requirements while maintaining a practical approach. It is expected this same attitude will carry forward to the January 2012 implementation of the Corporate Governance Code for Investment Funds and Management Companies (the "Code"), a corporate governance document tailor-made for Funds, written by the Irish Funds Industry Association at the request of, and in conjunction with, the Central Bank. Although the Fitness and Probity regime is a stand-alone regulatory system, the regime's due diligence process will help to ensure that the Code's requirements for time capacity and balanced expertise on Boards are met.
As the global financial services industry increases regulation of businesses, it is possible that more and more countries may turn to an approach of regulating individuals, similar to that undertaken in Ireland. While it is important to ensure that all parties in a Fund, or other RFSP, are competent and capable of carrying out their responsibilities, it is impossible to tell whether a person who has acted with integrity in the past will always carry forth that trait into the future. As such, while the new regime takes a step toward ensuring a solid foundation of expertise in financial institutions, only time will tell whether such a foundation will prevent future problems in the financial services industry.
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