Exempt no more: the impact of the FCA’s IFPR consultations on exempt CAD firms

On 19 April 2021, the FCA published its second consultation paper on the Investment Firms Prudential Regime (IFPR). The IFPR closely follows the EU’s new Investment Firms Regime, which takes effect on 26 June 2021. The IFPR is due to enter force on 1 January 2022. 

The latest consultation paper builds on the FCA’s first consultation paper published in December 2020 in which the FCA proposed to align its rules largely with the EU regime (save for simplifying the current patchwork of types of firms, regimes and reporting requirements in the current FCA rules). Under the proposals, the concept of an exempt CAD firm (those restricted to providing investment advisory services and/or the reception and transmission of orders and which do not hold client money or securities) will disappear. Going forwards, such firms (as is the case for all FCA-regulated investment firms that are not systemic investment firms) will fall into one of two categories depending upon whether they meet given financial thresholds and the type of investment business carried out: small non-interconnected firms (SNI firms) or non-SNI firms. An SNI firm cannot deal on its own account or hold client money or client assets, but will benefit from increased proportionality in the regime. 

The effect of the FCA’s proposals in these two consultations will be to change the regulatory capital regime that applies to those firms currently classified as exempt CAD firms. These firms have historically benefitted from a comparatively ‘light touch’ regulatory regime with a minimum initial capital requirement of €50,000 (or professional indemnity insurance meeting the requirements prescribed by the FCA). For firms that previously fell within the definition of an exempt-CAD firm,  the FCA proposes to increase to the highest of:

1. £75,000 (the permanent minimum requirement (PMR) for those firms carrying on limited investment activities);
2. a new fixed overheads requirement (FOR) equating to one quarter of the firm’s fixed overheads from the previous accounting year; or
3. a new ‘K-factor’ requirement depending upon the activities undertaken and the risks of the investment business carried out.

All three of the above requirements will apply to exempt CAD firms where they fall under the category of a non-SNI firm. If the firm falls within the category of a SNI firm, then it will not have to calculate the new ‘K-factor’ requirement but will still be required to meet the higher of conditions (i) or (ii) above, potentially leading to a significant capital increase for those firms with high fixed overheads.

Under the FCA’s proposed regime, firms which currently meet the definition of “exempt CAD firms” will be required to meet new requirements including:

• the basic liquid assets requirement: an amount of core liquid assets (e.g. cash, short-term UK bank deposits) equating to at least one third of the firm’s FOR plus 1.6% of any guarantees given to clients. For some firms, trade receivables may be included as core liquid assets to meet the FOR element of the requirement, but not for any part of the requirement based on guarantees;
• basic remuneration requirements: all firms must have a clearly documented remuneration policy and comply with a number of basic remuneration rules.  The FCA proposals go beyond the EU Directive in applying remuneration requirements to SNI firms. Non-SNI firms will need to comply with the standard remuneration requirements and must identify all material risk takers and set an appropriate ratio between variable and fixed remuneration. Additionally, the largest non-SNI firms will be required to comply with extended remuneration requirements on deferral and pay-out of variable remuneration; and
• carry out an Internal Capital and Risk Assessment (ICARA): for many firms, this will be the first time that they will be required to go through and document their adherence to rules relating to identifying, monitoring and mitigating potential harms. The ICARA process will inform the appropriate own funds and liquid assets requirements that should apply to the firm, in addition to their own funds and basic liquid asset requirements.   In addition, firms must undertake recovery action/wind-down planning, and assess the adequacy of own funds and liquidity requirements. An ICARA Questionnaire must be filled out and approved by the governing body before being submitted to the FCA.

These new requirements mark a step change in the tightening of regulation relating to firms that are currently exempt CAD firms. However, there is some good news too: transitional arrangements for current exempt CAD firms see a gradual introduction to the increase in the PMR over five years. For larger exempt CAD firms where the FOR or ‘K-factor requirement’ might apply, transitional provisions cap these components to £50,000 (the transitional PMR) in the first year and then to a percentage of the FOR or ‘K-factor requirement’ using a sliding scale over five years. 

Firms should make sure to look out for the FCA’s third (and final) IFPR consultation paper which is expected in Q3 2021.