Draft Alternative Investment Fund Managers (Amendment etc.) (EU Exit) Regulations 2018 Draft Venture Capital Funds (Amendment) (EU Exit) Regulations 2018 Draft Social Entrepreneurship Funds (Amendment) (EU Exit) Regulations 2018

John Baron Excerpts

Wednesday 9th January 2019 General Committees

[Mr John Baron (Basildon and Billericay) (Con)]

May I first thank the Minister for his opening comments, and say what a pleasure it is to speak under your chairmanship, Mr Sharma?

As the Committee discusses how we can ensure that those financial standards presently governed by the EU are transferred to our own regulatory bodies in good order, and that any deficiencies are made good, I would like to continue to develop the conversation we have started with the Minister regarding a real concern in the financial services industry about some present EU regulations that, if transferred wholesale, would continue to cause major concerns, particularly to investment trust investors. I double-checked that with the Minister’s authorities before the Committee sitting. I understand that investment trusts are caught by these regulations because they are deemed to be investment companies.

Let me start by briefly highlighting for Members my interests in the issue. I specialise in investment trusts, courtesy of my City days when I managed a lot of money for charities at Henderson’s and at Rothschild Asset Management. I wrote the Financial Times guidebook to investment trusts and my business specialises in investment trusts—I refer Members to my entry in the Register of Members’ Financial Interests.

The Minister will be more than aware that the EU’s core retail financial services regulations—known as package retail investment products, or PRIPs—have at their heart a key information document, which is supposed to be produced for every single investment trust and unit trust from 2020, in order to help investors better understand what they are buying.

Let me describe as clearly and succinctly as I can what an investment trust is. An investment trust is like any other public company, such as Marks & Spencer or Shell, but instead of managing clothes or oil, it specialises in financial products or investments. Investors have a wide range of investment trusts to choose from—more than 400—covering all areas of the investable world, if that is not a contradiction in terms, ranging from the UK market to very esoteric markets overseas, and specialist sectors within those markets. They are very old and some of them are quite large—one or two are now FTSE 100 companies, Scottish Mortgage being the prime example. They are becoming increasingly popular in the favour of private investors, who are increasingly recognising their ability to outperform benchmarks and outperform their open-ended cousins, unit trusts, over the long term.

The EU regulations we are looking to embody within UK law may have a good intention but the problem is the execution. Many in the industry believe that these key information documents are grossly misleading on the assessment and comparison of risk, grossly misleading on the projection of future returns, and certainly misleading on the comparison with similarly mandated sister funds within the unit trust industry. I suggest to the Minister that that could make for a perfect storm if no corrective action is taken. No wonder all three of the major trade organisations that oversee this particular area—the Investment Association, the Association of Investment Companies and the Personal Investment Management and Financial Advice Association—believe that these regulations should be scrapped or reworked. I am pleased to see that the FCA has instigated a call for evidence but I will later have questions for the Minister about that call for evidence and the follow-through.

Perhaps one needs to make the simple point that investment trusts, although they have a superior long-term track record, are actually riskier because they are more volatile than their open-ended cousins, unit trusts. When an investor puts money into a unit trust, that adds to the pot. When an investor takes money out, that detracts from the money that is managed in the pot. There is a direct relationship between the net asset value of the fund and the share price.

An investment trust is closed-ended. In other words, when one buys an investment trust, as when one buys Marks & Spencer or indeed Shell, one is not adding to their portfolio, but buying shares in the market. There is a disconnect between the net asset value and the share price. Therefore, that makes for volatility by the share price, which is why investment trusts are considered riskier than unit trusts over the short term, but actually they perform better over the long term. That is in part because as a company they can gear—as can all companies, such as Shell and Marks & Spencer—but also because they can take the long view, because they are not having to worry about redemptions and money coming in and out.

The Minister will be pleased to hear that I do not want to rehearse the arguments that we went through when we last discussed this issue, but I remind him that the key information documents—KIDs—being produced by the EU about investment trusts and a similar document that will have to be produced for unit trusts from 2020, are misleading. They are misleading on three counts. They are misleading on the assessment and comparison of risk. They are actually suggesting that investment trusts are less risky than unit trusts, which is clearly not the case. It is generally accepted in the industry that investment trusts are riskier because they are more volatile in the short term, but long-term investors can accept that volatility because they are hoping for better longer term returns, which, on average, investment trusts deliver. If one were just to believe the KIDs coming across from the EU, that logic is turned on its head. They say that unit trusts are riskier, which is simply not the case.

The documents also overstate expected returns because they extrapolate recent returns. KIDs produced in a bull market will suggest higher returns, whereas in a bear market they will suggest lower returns. We all know that past returns should be no guide when investing for the future. In a recent Association of Investment Companies report, 42 KIDs forecast 20%-plus returns per annum in a moderate performance bracket for investment trusts. Anybody who works in investment trusts or in the investment industry generally will understand that to achieve 20% per annum takes quite a bit of doing, and that you have to take on quite a bit of risk. Because of the way the KIDs are formulated, that is treated almost as the norm.

I suggest to the Minister again that if we are not careful and do not address that point, we will encourage the kind of investment behaviour that we should really be doing our best to avoid, which is buying high and selling low, because we simply extrapolated recent returns. That is the complete opposite of what people should do in the investment world. Extrapolating recent returns misleads investors, so there again the KIDs are no help.

I could go on about sister funds, but I am conscious that time is short and I do not think that this is going to be contentious delegated legislation, so I do not want to add to the Committee’s time. I remind the Minister of the importance of this issue. When we last discussed it on 10 October, we went into more detail—that was in a Delegated Legislation Committee and the shadow Minister, the hon. Member for Oxford East, was there as well. After that debate, the Minister kindly responded in a letter and, quite reasonably, made the point that the FCA is in the process of reviewing this scenario. He accepted that there were problems with the KIDs and that the FCA was looking into it. There had been a call for input, which closed on 28 September. The FCA is now reviewing responses, and the Minister suggested that he expects the FCA to publish its feedback statement this quarter.

That is well and good, but may I press the Minister on a couple of points? First, there is a role for Government in this situation. I accept that the FCA is the overarching regulatory body in this regard, but the Government, given that they are rightly making provision for the repatriation of EU powers in this field of finance, have a certain responsibility to ensure that the regulatory bodies are actually performing as they should. I gently suggest to the Minister that the FCA has been slow off the mark on the issue. All the regulatory bodies I quoted earlier suggest that that is the case. It is playing catch-up, and the problem with that is that it can make for hasty decisions and it can mean that the buffer of the timetable is hit more quickly than expected.

I ask the Minister to ensure that the FCA has liaised with the major trade organisations. Until fairly recently there has not been the sort of communication that one would have expected, or certainly anticipated, and that I hope he would have expected, given the delicacy and intricacy of what we are discussing. I ask him to try to ensure that the FCA is doing that and to get his officials to double-check that it is happening.

I also ask the Minister to look at the issue with a greater sense of urgency, if only because we will be leaving on 29 March. It is very likely that the regulations that we are putting in place will take effect, and if they take effect in their present form, they will be deficient. It is as simple as that. The FCA has clearly made that case, because otherwise it would not be calling for evidence. People have been beating the path to its door for quite a while now and it has finally decided to do something about it. I ask him to make sure that it is regarded by his Department as a matter of urgency.

We have a situation in which key information documents, produced under an EU regulation, are telling untruths when it comes to investing in investment trusts. They suggest that investment trusts are less risky than unit trusts. They extrapolate returns that are unrealistic and that one would have to take on quite a bit of additional risk to achieve. That in turn can lead to the sort of investment behaviour that we all think is bad, which is buying high and selling low.

I will not get into the complex issue of sister funds and so forth, but even there, when the key information documents compare investment trusts with unit trust sister funds, there are errors. That is an important point. People’s financial futures are—I will not say dependent—certainly influenced by those sorts of issues. As a society, we are rightly saying that people should take greater responsibility for their financial futures, but if they cannot rely on the accuracy of the information supplied by Government, under Government regulation, the Government need to look at that carefully and regard the matter with the sense of urgency I have suggested.

I will stop there. I look forward to the Minister’s response. As before, given that we have moved the discussion on, I do not expect a detailed response now—that would be unfair—but I expect some sort of response in writing, because the subject will not go away, particularly as the deadline approaches and as private investors are still not being well served.

--- Later in debate ---

[John Glen]

I thank my hon. Friend the Member for Basildon and Billericay and the hon. Members for Oxford East and for Glasgow Central for their exhaustive scrutiny of what I said and some of the issues. I put on the record my great respect for the assiduous way in which Opposition Front Benchers have conducted themselves during this process; I concede that it has not been optimal, in terms of the level of engagement and impact assessments. I will now try to faithfully respond to all the points; when I cannot, I shall write to the relevant Members.

Before I come to the issue of the level of engagement and impact assessments, I will address the point that the hon. Member for Oxford East raised. There were long discussions during the passage of the EU withdrawal Act, but that legislation does not give the Treasury the ability to make major changes to policy or legal frameworks beyond those appropriate to ensure basic continuity. We are acting within the spirit of that and doing so as professionally as we can, with as much work to consult and engage with the industry as possible.

We have not conducted a formal consultation on these SIs, but we have engaged closely with industry to ensure that there is a functioning legal framework in a no-deal scenario. That hints at the points raised, which I will come on to more substantively in a moment, about the fact that there are contested spaces in this area and that, in a no-deal scenario, there would be a significant imperative for a bigger corpus of legislation to set the industry fair in this country. Obviously, though, we anticipate and hope—well, not hope, but believe—that we will secure that deal.

The engagement has involved talking to asset management trade associations, representative bodies such as the Investment Association and wider financial services bodies such as TheCityUK, to get technical input to inform our work. That is across the United Kingdom as a whole. I chair the asset management taskforce and I had three or four meetings through 2018 where many of those concerns were also taken forward. I draw attention to the words of Chris Cummings, the chief executive of the Investment Association, who said on 7 December last year:

“In a possible no deal Brexit, HM Treasury’s commitment to remain open to international funds ensures that the UK will remain a world leading asset management centre and that UK savers will continue to have access to a full range of investment opportunities.”

We have worked to satisfy him, and other stakeholders like him, through this process.

I turn specifically to the issue of the impact assessment. The challenge in some areas has been that multiple statutory instruments will apply. We have grouped them together and taken them to the Regulatory Policy Committee to be looked at in the round, so it can then provide a more meaningful assessment of the impact.

I recognise that, as the hon. Member for Glasgow Central said, it is sub-optimal not to have it at this point, but the impact assessment that covers the SIs being debated today has been prepared and is going through the normal clearance and scrutiny procedures. We hope to have it published shortly. It will then cover the balance of those statutory instruments that we will be debating subsequently in these Committees over the next eight weeks, so I hope I will not need to make this apology again.

I emphasise that the point of this legislation is to minimise disruption to firms and their customers and maintain continuity of service provision as a whole. As such, these SIs will significantly reduce costs to business in a no-deal scenario, as without them the legislation would be defective. That is the principle on which we are doing this: we are doing it because the industry wants us to deliver it.

On the point made by the hon. Member for Oxford East about the temporary marketing permissions and the volume of notifications to the market, earlier in the year the FCA launched an online survey for EEA inbound passporting firms and funds, to help inform its preparations and identify firms for which a temporary permission may be relevant. In 2018 there were around 2,060 EEA alternative investment funds that had been notified via a passport to market into the UK. It is not expected that those firms will enter into the temporary marketing permissions regime.

The hon. Lady asked about the specific requirements on depositories. Authorised UK AIFs will be required to have a UK depository as a result of amendments to be made in a related collective investment schemes SI. Transitional arrangements are included in that SI to ensure that firms have sufficient time to make preparations, and unauthorised AIFs will be allowed to have an EEA depository.

The hon. Lady went on to ask about something that has often been raised: the cost to the sector. Again, we will need to see the overall cost, based on that impact assessment. UK investors will maintain their rights to funds in which they are already investing, and will continue to have access to funds currently marketed under a passport and enter the temporary marketing permissions regime. The main cost to firms that we have identified are familiarisation costs of the new legislation and transition costs, because of changes in legal definitions and reporting requirements for firms using the temporary marketing permissions regime. In due course, I think that will be seen to be a very modest sum.

Both Front-Bench spokesmen referred to the FCA resourcing. I will seek to provide more clarity on that. I managed to get the number of full-time equivalents, but I knew that if I gave some information, more would be requested, so I will seek that out. In its business plan it is funded by a levy and it would be able to move quickly, should it need additional resources.

With regard to UK fund managers passporting into the EEA, the Government are only able to take legislative action in relation to EEA fund managers who passport into the UK; we cannot determine the outcome the other way around. However, again, for the comfort of the Committee, I draw attention to the statement made by the chair of the European Securities and Markets Authority on 3 October 2018, in which he said:

“In the case of a no deal Brexit, NCAs and ESMA should have in place with our UK counterparts the type of MOUs that we have with a large number of third country regulators…ESMA has co-ordinated the preparations for such MOUs together with the EU27 NCAs.”

That is also supplemented by the remarks of Andrew Bailey of the FCA to the Treasury Committee last December, when he estimated that the cost of EU withdrawal for the FCA has been less than initially expected, thanks in part to the temporary permission regimes that the Government have enacted, and which the alternative investment fund managers SI and a number of others have set up.

[Mr Baron]

I take on board that the Minister has just quoted ESMA and all the rest of it. The trouble is that investment trusts are not well understood within the EU. It is all right for them to say, “We are happy with things,” but if they are inherently deficient, we have to step up to the plate.

[John Glen]

Let me just finish with the points made by the hon. Member for Oxford East and then I will come to my hon. Friend’s points.

On the point about regulations on UCITS, I think the hon. Member for Oxford East was asking whether removing the AIF-related reporting requirements for the EEA UCITS, despite their being defined as alternative investment funds, will reduce transparency, in essence. It will not. This instrument carves out reporting requirements on alternative investment funds for funds that obtain recognised status from the FCA, to be sold as UK retail investments. As a result of that recognition process, the FCA will already receive all the information necessary for the effective supervision of the funds.

I want to come to the points made by my hon. Friend the Member for Basildon and Billericay. He kindly offered me the device of writing to him by letter, but in essence he set out a series of concerns, which he raised previously in a similar Committee in October, about the distinctions between the investment trust and the unit trust, and the application of key information documents and how they can be misleading. He drew my attention again to the concerns of the different industry bodies. For the edification of the Committee, I wrote to him, as he pointed out on 26 October. In Q1 2019, the FCA will publish its feedback.

My hon. Friend’s point about the obligation of the Government versus the regulator is very fair. I will reflect on his comments and have a regular dialogue. I met the chairman of the FCA this week. I have regular conversations and meetings with the chief executive, and I will make those points to him. That has to be set within the context that I am not licensed by this process to innovate, although I recognise that we must also accept that over the last 10 years we have reached a level of authority and reputation, when it comes to regulatory breadth and depth of oversight, that is commonly welcomed.

My hon. Friend has quite reasonably drawn attention to the lack of familiarity in the EU framework with some of the instruments in some jurisdictions outside the UK, which means that the appropriateness of those conclusions has sometimes been contested. I very much understand the issue.

[John Glen]

I respect the deep—deeper than my own—personal experience of both hon. Members who have spoken about that matter. In terms of the previous engagement of the British Government through their representations as the documents were constructed, I cannot account for that now, but I am happy to write to the hon. Lady about it.

The point that my hon. Friend the Member for Basildon and Billericay is making is that, in the future, when we leave the EU, we will have to take account of the combination of responsibilities to broadly align with common expectations in like-minded investment communities and to attend to real challenges that lead to perverse investment decisions and outcomes for investors, which my hon. Friend is very familiar with.

I hope that has covered the points raised. If there are other points that I have not answered, I will be happy to write to hon. Members.

[Mr Baron]

May I remind the Minister of the sense of urgency that is required? It is not just that the date of the 29th is looming, but that the FCA, if one were being charitable, has been slow out of the traps—that is not just my opinion, but that of a number of trade bodies—and appears somewhat slow in coming to review the whole situation. Pressure from the Government would help.

[John Glen]

I accept that. In the context of Q1 of this year, with respect to no-deal preparations, the Financial Services (Implementation of Legislation) Bill on in-flight files is going through the other place at the moment to put in place a mechanism to have discretion to onshore, or not, files that are live. They have to be the priority at the moment, but the point is well made and I have heard it. I will make representations.

I hope I have demonstrated that the regulations are needed to ensure that alternative investment funds continue to operate effectively in the UK if the UK leaves the EU without a deal or an implementation period. I hope that the Committee has found the debate informative and will now be able to support the regulations.

Question put and agreed to.

Resolved,

That the Committee has considered the draft Alternative Investment Fund Managers (Amendment etc.) (EU Exit) Regulations 2018.

draft Venture Capital Funds (Amendment) (EU Exit) Regulations 2018

Resolved,

That the Committee has considered the draft Venture Capital Funds (Amendment) (EU Exit) Regulations 2018.—(John Glen.)

draft Social Entrepreneurship Funds (Amendment) (EU Exit) Regulations 2018

Resolved,

That the Committee has considered the draft Social Entrepreneurship Funds (Amendment) (EU Exit) Regulations 2018.—(John Glen.)