Updated capital requirements for advisers would ‘reduce reliance’ on compensation scheme, says FCA

The new requirements, intended to come into force on a transitional basis in June 2016, would ultimately require advisers to set aside either a minimum of £20,000 or 5% of annual investment business income, whichever is higher, in order to “absorb routine losses and legitimate redress claims” as well as make it easier to wind up a firm if necessary. The new requirements would come fully into force on 31 July 2017, according to the timetable set out in the FCA’s consultation on the proposals.

Then-regulator the Financial Services Authority (FSA) first proposed new prudential requirements for so-called personal investment firms (PIFs) in 2012, alongside the Retail Distribution Review (RDR). However, the FCA postponed the introduction of the new requirements in order to give affected firms enough time to absorb the changes required of them by the RDR.

Financial regulation expert David Heffron of Pinsent Masons, the law firm behind Out-Law.com, said that the updated proposals would be “broadly seen as positive by firms” as they “improved and simplified” the FSA’s earlier proposals while also “meeting the regulatory objective of increasing the firms’ capital resources to absorb routine losses and legitimate redress claims”.

“The delay in implementation of the new capital resource requirements and the transitional period will also be seen as helpful,” he said.

Under the current rules, investment firms that employ 25 advisers or fewer are only required to hold £10,000 in capital; while those with more than 25 advisers or that are part of a ‘network’ must hold the higher of £10,000 and an ‘expenditure-based requirement’ (EBR) depending on the size of the business. The FSA’s original proposals would have increased both the flat rate capital requirement and the EBR, which would not have been differentiated based on adviser numbers.

The FCA’s updated proposals would consist of a new minimum capital resources requirement of £20,000 plus a new income-based requirement, calculated as a percentage of the firm’s annual income amount earned in the previous year. This would be set at 5% for most PIFs, and at 10% for those firms with permission to trade as principal, hold client money or manage portfolios. During a 12-month transitional period, running from 30 June 2016, the minimum requirement would be £15,000.

According to the consultation, which closes on 7 September, the existing capital requirement of £10,000 is “insufficient” to provide firms with a cushion in the event of a compensation claim. An average redress claim for a pension or investment-related failure settled by the FSCS, which is the UK’s industry-funded statutory compensation scheme to cover the cost of claims against firms that have gone out of business, is £11,000, according to the FCA.

“A PIF, holding the current minimum capital resources and a [professional indemnity insurance] policy with a £5,000 per claim excess, which then experienced two legitimate claims, would have insufficient capital,” the FCA said in the paper. “We do not want compliant PIFs to fail unexpectedly under normal operating conditions.”

The FCA does not currently propose making changes to professional indemnity insurance requirements. It has, however, restated its commitment to considering the case for an introduction of a ‘longstop’ time limit on claims to the Financial Ombudsman Service (FOS) and will publish a paper with its proposals later this year.

“The fact that the FCA will be consulting on a longstop on complaints, notwithstanding the Alternative Dispute Resolution Directive, which placed this in some doubt, is very welcome news for firms,” said David Heffron.