The FCA’s updates to compliance framework and reporting rules can, on occasion, go under the radar, posing a challenge for smaller in-house finance teams. A recent newsletter distributed to regulated businesses with limited fanfare is the latest example.
The latest point of emphasis concerns Common Equity Tier 1 items of limited liability partnerships (LLPs), with the FCA declaring that there have been more frequent instances where MIFIDPRU firms which have been set up as LLPs may run the risk of incorrectly treating their allocated profits as a CET1 item for the purposes of meeting their fund requirements.
This is a crucial point of discernment: the regulatory capital treatment of the profits of a LLP depends on both the specific terms of the partnership agreement, and the nature of members’ rights to those profits.
Most importantly, as the FCA is making it clear to businesses for their future reporting, where LLP agreements provide for automatic allocation of profits to members, or where members have immediate and unconditional rights to withdraw allocated profits, these amounts cannot be considered to qualify as CET1 capital, as they are effectively liabilities.
Even if these amounts appear in the equity section of the balance sheet, designated as ‘members’ interests’, they represent claims by members, and restrict the ability of a firm to use these funds to absorb losses.
The FCA is going some way to clarifying this area, with a proposed consolidation of the definition of capital for FCA investment firms directly into MIFIDPRU 3. Proposed in CP25/10, the consolidation would remove cross-references to the UK CRR, as well as other related technical standards. With these proposals however, the substantive treatment of the profits of a partnership would remain unchanged, and the key test would continue to be whether the partnership has an unconditional right to refuse to make profits available to partners.
Yet, depending on the relevant LLP agreement, there may not be an automatic allocation of profits to the members. Indeed, some amounts may still qualify as CET1 capital, where profits have not been allocated to specific members, or where LLP agreements contain provisions that constrain members’ access to allocated profits, if the partnership retains an unconditional right to veto making them available to partners.
As ever, the devil is in the detail of a specific LLP agreement, and measures such as profit-sharing mechanisms and distribution procedures may be relevant in any given instance. Firms should therefore pay consideration to whether members retain rights to profits in a manner which would preclude the firm from leveraging amounts to absorb losses.
The newsletter also clarifies that while its guidance focuses on LLPs, equivalent principles apply to the regulatory treatment of capital in any partnership structure where firms are seeking to designate such profits as regulatory capital.
The clear point to take from the FCA’s messaging is this: ‘we therefore expect firms, including LLPs, to be correctly identifying what can count as regulatory capital and is eligible for CET1 purposes.’
Such a sudden declaration might easily put a firm on the backfoot, and it may be the case that the nature of a firm’s partnership agreement prompts immediate adjustments to reporting and allocation in this light.
At HaysMac, we’re always monitoring for FCA developments, with our team poised to advise on any changes and adjustments. If you’re a partnership looking for clarity following the FCA’s news, reach out and let’s talk.
