Locations
The goodwill problem
The Investment Firms Prudential Regime (IFPR) came into force at the beginning of this year but its effects are still being worked through.
One aspect of this could have enormous negative effects on corporate groups - particularly acquisitive groups acquiring or consolidating smaller regulated investment firms.
This arises because of new rules requiring a UK parent of an investment firm to satisfy at a group level, on the basis of consolidated figures, the capital and liquidity requirements applying to the regulated firm. Whilst similar rules applied previously to banks and to the larger "designated investment firms" that are prudentially regulated by the PRA, IFPR has extended these requirements to a much wider population of investment firms.
Complying with these requirements is not easy because of the requirement for goodwill, whatever the position under accounting rules, to be deducted from the group's capital resources. Where an acquisition creates significant goodwill on the balance sheet it may be difficult or impossible for the parent to comply. This is shown by the simplified illustration below.
Prudential consolidation
Assume Holdco acquires 100% of Investco (an investment manager) with entity balance sheets prior to acquisition as follows:
| Holdco (£) | Investco (£) | |
|---|---|---|
| Fixed assets | - | 20,000 |
| Cash/Net Current assets | 1,000,000 | 180,000 |
| Long-term Debt | (500,000) | - |
| Net assets | 500,000 | 200,000 |
| Ordinary Share Capital | 500,000 | 200,000 |
Assume Investco has an own funds requirement to maintain CET1 capital of £180,000. Investco easily meets this test as its ordinary share capital of £200,000 all counts towards this requirement with no deductions.
Assume Holdco acquires Investco for £950,000.
On consolidation (assuming no impairment of goodwill in the statutory accounts) the corporate group thereby created has the following opening consolidated balance sheet:
| Consolidated Balance Sheet Statutory Accounts (£) | |
|---|---|
| Fixed assets | 20,000 |
| Goodwill | 750,000 |
| Cash/Net Current assets | 230,000 |
| Long-term Debt | 500,000 |
| Net assets | 500,000 |
| Ordinary Share Capital | 500,000 |
Holdco is required to meet the same CET1 own funds requirement as Investco (£180,000). Holdco has ordinary share capital of £500,000 but needs to deduct from this the £750,000 goodwill item on the consolidated balance sheet. This reduces its CET1 capital figure to a negative figure of £250,000. Holdco therefore needs to obtain £430,000 in new CET1 capital to meet this requirement.
When does this problem arise?
The application of these rules is complicated and bespoke advice should be taken in each case, but broadly the requirement to meet prudential rules at a group holding company level will arise where a UK holding company (or other holding entity) is the parent of a "MIFIDPRU investment firm". A MIFIDPRU investment firm is specifically defined. Broadly it includes any UK firm regulated by the FCA (and not by the PRA) which provides any "investment services" except where an exemption applies.
There are some exemptions that will be helpful in many cases.
In particular, there is an exemption for an "article 3 exempt MIFID firm"[1]. In broad terms, the exemption applies to an authorised firm that does not hold client funds (or client assets) and its investment services are limited to offering investment advice and arranging transactions with other authorised investment firms or banks or regulated investment schemes. A firm to which this exemption applies is shown on the Financial Services Register as an "article 3 exempt MIFID firm". IFA firms are likely to have this status if they do not undertake discretionary management.
A further set of exemptions are listed in Schedule 3 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (the "RAO").
These include an exemption for a collective investment undertaking, pension fund or a depository or manager of such an undertaking or fund. This exemption should be used cautiously, however, since according to guidance from the FCA[2] a collective portfolio management investment firm is a MIFIDPRU investment firm, and so is subject to the requirements of MIFIDPRU. We are seeking to clarify with the FCA this apparent anomaly in the guidance.
Other potentially useful exemptions in Schedule 3 RAO include exemptions:
(a) for insurers;
(b) where the investment firm provides investment services exclusively within the group;
(c) where the investment services are provided incidentally in the course of a regulated professional activity; and
(d) the investment services consist exclusively in the administration of employee-participation schemes.
What if the Holdco cannot comply?
Where these rules apply and the holding company fails to meet the relevant requirements to hold capital (or other requirements relating to liquidity and reporting) then various sanctions may apply. The FCA may impose disciplinary measures on the holding company itself or on members of the management of the holding company where they failed to end or mitigate breaches of these requirements.
What can be done?
Where a holding company is obliged to comply with these requirements for prudential consolidation, but is unable to do so, there are various ways in which the matter can be resolved. These may include:
- further capitalisation of the parent;
- a group reorganisation to avoid having a UK holding company in the group;
- divestment of the investment company in the group, or changes to its regulatory permissions so that it ceases to be subject to these rules.
The appropriate solution will depend on the circumstances of the group and its aims as well as on taxation and practical issues.
Help is at hand
If you are concerned that the issues within this alerter may be of relevance to your situation please contact Nicholas Thompsell, Duncan Black, Simon Lafferty, or your usual Fieldfisher contact.
Nicholas Thompsell
+44 (0)330 460 6523
nicholas.thompsell@fieldfisher.com
Duncan Black
+44 (0)330 460 6472
duncan.black@fieldfisher.com
Simon Lafferty
+44 (0)330 460 6497
simon.lafferty@fieldfisher.com