Compliance Insight: UK regulators gain more power over overseas firms and individuals

July 3, 2013

By Jane Walshe, Compliance Complete

LONDON/NEW YORK, July 3 (Thomson Reuters Accelus) – The new regulatory structure that came in to being on April 1, 2013 introduced changes not just to the form of regulation, but also to its substance, including extensive new powers over unauthorised parent undertakings with operations on UK soil. 

Both the UK prudential regulator, the Prudential Regulation Authority (PRA) (which regulates deposit takers, insurers and a small number of investment firms) and the conduct regulator, the Financial Conduct Authority (FCA) (which regulates all firms from a conduct perspective, and also non-PRA-regulated firms from a prudential perspective) have powers to direct action from a “qualifying parent undertaking”, to advance their objectives, if certain criteria are met. A direction can be made requiring parent companies to supply documents and information, and the regulators also have the power to censure or fine them for breaches of directions. These powers are found in the Financial Services and Markets Act 2000 ss192A to 192N.

How the powers can be exercised

If the regulators are to use these powers, a number of statutory requirements must be met:

  • the parent must not be authorised itself;
  • it must be a UK corporate or have a place of business in the UK;
  • it must be an insurance holding company, financial holding company or mixed financial holding company.

The regulators will not be able to exercise this power in relation to non-UK parent entities which do not have a place of business in the UK, or non-financial parent entities. In both of these cases the regulators will try to identify another qualifying parent undertaking in the ownership chain to which it does have the power to issue a direction. It is likely also that in relation to non-UK parents, the regulators will closely liaise with the parent’s home state regulator.

This position can be contrasted with the proposals which have been made by the U.S. Federal Reserve in relation to U.S.-based banking operations, whereby all banks over a certain size will have to be held by a U.S. holding company that is adequately capitalised. This will ensure that the Federal Reserve is able to make whatever directions it pleases without prior recourse to another regulator, unlike the UK regulators. Further details about the U.S. position can be found here.

When will the power be exercised?

For the regulators to be able to exercise this power, either the “general condition” or the “consolidated supervision condition” must be met.

The general condition

In the case of the PRA, the general condition is that the PRA considers it desirable to give the direction to advance any of its objectives. The PRA’s objectives are:

  • To promote the safety and soundness of PRA-authorised firms, primarily by seeking to ensure that the business of PRA-authorised firms is carried on in a way which avoids any adverse effect on the stability of the UK financial system; and to minimise the effect that the failure of the firm might be expected to have on the stability of the UK financial system.
  • For insurers, to contribute to securing the appropriate degree of protection for those who are or who may become policy holders.

In a policy statement published in April 2013 concerning the power of direction over qualifying parent undertakings the PRA provided 16 examples of when it might use the power, including:

  • Insufficient quality or quantity of own funds or liquid assets or other assets that are made available to the authorised firms to meet their solo requirements.
  • Intra-group transactions and allocation of risks and financial resources (including large exposures, booking practices, other channels of contagion and arrangements for the mitigation of risk such as by reinsurance) which do not meet the standards expected by the PRA.
  • Group-wide recovery plans which do not meet the standards expected by the PRA.
  • Where there are barriers to the resolution of a firm or group that are most appropriate to offset or remove at the level of the parent undertaking.
  • Systems and controls to manage group risks which do not meet the standards expected by the PRA.
  • Complex or opaque group structures which hinder the authorised firm’s and/or the PRA’s ability to assess and manage the risks generated by the authorised firm’s membership of its group.

The emphasis is on resolvability of a firm and its financial soundness, insofar as issues with either might have the potential to have a negative effect on the stability of the UK financial system. The “general condition” when applied to the FCA’s use of the power is that the FCA considers that it is desirable to advance one or more of its operational objectives, which sit under the overarching objective of ensuring that relevant markets function well, and are:

  • To secure an appropriate degree of protection for consumers.
  • To protect and enhance the integrity of the UK financial system.
  • To promote effective competition in the interests of consumers.

These are very different from the PRA’s objectives, and focus on the impact of a firm’s activities on consumers rather than on the macroeconomic picture. A macroeconomic element is, however, present in the “integrity” objective, which encompasses the behaviour of those operating on markets and exchanges, and the effect which poor behaviour can have on the integrity of the system as a whole.

The FCA’s policy statement on the use of the power has given 23 examples of the types of scenario in which a direction might be appropriate, including:

  • The holding company sets financial objectives for the group, including the regulated entity, which conflict with consumer interests, for example, the holding company expects the firm to generate a specific amount of income, which leads to the firm to conduct high-pressure selling.
  • The holding company directs actions to the authorised firm and the authorised firm does not pay due regard to the interests of the consumers and treat them fairly, including communicating with them in a way that is clear, fair and not misleading.
  • The holding company fails to oversee the authorised firm’s arrangements to provide adequate protection for client assets, where applicable.
  • Where one or more directors of the parent company appear not to be fit and proper, or suitable.
  • Where the holding company directors exert dominant influence on the regulated entity’s board to obstruct its independence.
  • Inadequate oversight of the development of a new product by the group board of directors.

These examples provide a useful guide to those operating in a parent entity about the sorts of matters to which they should have regard if they are to offset the risk of receiving a power of direction from either UK regulator.

The consolidated supervision condition

The FCA and the PRA can issue a power of direction not only where they consider it to be desirable for the furtherance of their objectives, but also where the “consolidated supervision condition” is satisfied. This is where either regulator is:

  • the competent authority for the purpose of consolidated supervision that is required, in relation to some or all of the members of the group of a qualifying authorised person, in pursuance of any of the relevant EU directives; and
  • the FCA/PRA considers that the giving of the direction is desirable for the purposes of the effective consolidated supervision of the group.

The purpose of consolidated supervision is to enable firms to be protected by their supervisor from the adverse effects of being part of a group, for example, financial contagion, reputational contagion and leveraging. This provision ensures that the FCA and the PRA can impose directions on qualifying parent undertakings in an extremely wide set of circumstances, when taken together with the “general condition” above.

Application of approved persons regime to non-UK parents

Where the UK regulators are unable to take direct action against an overseas holding company because that company does not have a place of business on UK soil, it can still hold decision makers in that company to account via the requirement for a “parent entity SIF” (significant influence function holder within the approved persons regime), which means that the PRA and the FCA will be able to take enforcement action against a senior manager in a parent (wherever that parent is based) if he holds this controlled function and reneges on his duties.

Non-executive directors in an unregulated parent undertaking or holding company whose decisions or actions are regularly taken into account by the governing body of the UK authorised firm are required to have approval as a CF2 non-executive director within the approved persons regime. Those performing an executive function at the parent entity need to be approved as a CF1 director for the subsidiary company. In all cases the UK-regulated firm will be responsible for applying for the approvals. This is the case wherever the parent is located.

It is incumbent on UK compliance functions in international groups to educate and inform executives at group level about their potential obligations under the UK regulatory regime. The executives themselves are also subject to a personal duty to ensure that the area of the business for which they are responsible complies with the relevant standards and requirements of the regulatory system. More can be read about the duties of CF1s and CF2s here.

The UK regulators have the power to take enforcement action against directors in parent entities. In connection with this the recent report of the UK Parliamentary Commission on Banking Standards has recommended that more steps should be taken to increase mutual recognition of fines and enforcement actions when they occur, across different jurisdictions. There is currently no formal mechanism through which the UK and the U.S. may share information about individuals, although criminal convictions are considered. This position is likely to change at some point in the future.

The Commission’s report noted at para 654: “Of particular benefit would be an obligation on firms to take account of any misdemeanours recorded on the register in other jurisdictions before hiring staff. The need for such an obligation between the U.S. and UK is particularly important.”

Importance of managing intra-group relationships

Few group-level entities will relish the prospect of being made the subject of a UK regulatory direction, removing as it will their ability to organise and control group affairs as they see fit. There are, however, things that parent entities can do to lessen the likelihood of receiving a direction. First and foremost, parent entities which identify themselves as coming within the PRA or the FCA’s remit must ensure that they have a close relationship with their UK regulated subsidiary. The parent must be kept informed of all critical developments within the subsidiary’s business which may attract the attention of the UK regulators.

A parent that is well-informed about the business and operations of its UK-regulated subsidiary is less likely to be resistant to providing the subsidiary (and its regulator) with the information and support they require. An exception to this is where there is a conflict between the survival of the subsidiary and the health of the group as a whole, in which case the UK regulators will have no option but to intervene (i.e., a PRA-regulated firm will not be hung out to dry, to the detriment of the stability of the UK financial system, simply to preserve the overall strength of the group).

The parent entity SIF in a UK parent is most likely to be the appropriate conduit for the flow of information between the parent and the subsidiary.

Impact of parent’s behaviour on the subsidiary’s regulatory relationship

The FCA and the PRA will look at the behaviour of a parent when deciding whether to grant a firm permission to operate in the UK, and whether that permission will remain continuous. The threshold conditions, which are the conditions that all firms seeking authorisation must meet and continue to uphold throughout the period of their authorisation, include “effective supervision”. This condition means that the PRA and the FCA must be satisfied that there is nothing in the structure of a firm, or in the group of which it is part, that prevents it from being effectively supervised by the regulators.

Secondly, the “business to be conducted in a prudent manner” threshold condition requires that the PRA must be satisfied about the firm’s (and its managers’) ability to operate safely and to be able to be resolved effectively should the need arise. The concept of resolvability is critical to the PRA’s consideration of fitness to operate, and where a firm is part of a larger group, the attitude of the parent to this is also of interest to the PRA. Parent entities will undoubtedly be closely involved in their PRA-regulated subsidiaries’ resolution plans.

Importance of managing the relationship with the UK regulators

UK-regulated firms and their parents will need to communicate effectively with the PRA and FCA if they are to retain the confidence of the regulators. The PRA and the FCA are legally obliged to consider the desirability of taking action against the authorised person rather than the parent, before taking action against that parent, by virtue of FSMA 2000, s192C(5).

The PRA’s statement of policy says that in the following circumstances (although not exhaustively) action against the parent may be more appropriate than action against the regulated entity:

  • where action against the authorised firm fails to remedy the concerns, or where the PRA believes this to be the case;
  • where the authorised firm fails to comply or the PRA thinks it is likely to fail to comply;
  • where the authorised firm does not itself have the ability to effect the desired change;
  • where the issue can only be resolved effectively by the qualifying parent undertaking;
  • in cases of urgency.

No clarification as to what an urgent case may be has been provided, although the Annexes to the statement provide examples of possible scenarios in which the power may be exercised, as well as the sorts of directions that may be issued.

Either regulator can issue a power of direction to a parent where it has simply lost confidence that the firm itself will comply, or where it does not think that action against the firm will remedy the concerns. These are instances where the quality of the relationship between the firm, its parent and the PRA or the FCA will be of critical importance. Where the UK regulators engage with a firm and find it to be responsive (which in turn means that the parent must be responsive to the firm’s requests if these are made at the behest of the regulator), they are far less likely to invoke the statutory powers of direction.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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