Compliance Code Cracker: Greensill and The Regulatory Perimeter

Evidence presented by Nikhil Rathi, chief executive of the UK Financial Conduct Authority (FCA), to the Treasury committee inquiry into Greensill Capital has helped to elucidate the regulator's analysis of the collapsed supply chain financier's business model. Two aspects of his evidence illustrate his concern with the areas of regulation where the predominantly unregulated area of commercial lending interacts with regulated business — securitisation and money laundering — and how the Greensill collapse has revealed informational deficiencies that need addressing.

According to the administrator of Greensill Capital UK Ltd (GCUK), the way the model worked was that the purchaser of trade goods or services, usually a major corporate (the obligor), was issued an invoice by a supplier. This was a small or medium enterprise (SME), which GCUK agreed to pay to the SME supplier at a discounted rate to the face value of the invoice. The invoice was referred to as a "receivable". Receivables were then sold to institutional investors, either by the direct assignment of the receivables themselves or by the indirect sale of notes backed by the receivables.

GCUK made a payment to the obligor's supplier on receipt of funds from the sale of the receivables or the related notes. On the maturity date of the notes (which was linked to the payment date of the underlying invoice), the obligor repaid GCUK at face value and GCUK, in turn, repaid the investors with the difference between the discounted amount paid by GCUK and the face value of the invoice reaped by the obligor constituting profit to be shared between GCUK and the investors. Sub-investment grade receivables benefited from trade credit insurance and were sold with the benefit of that insurance.

Paucity of information and notification requirements

In his oral evidence to the committee Rathi said it would be a very big step to start to seek to regulate all commercial lending in the UK. He also said that, as a general point in terms of non-bank finance, the FCA needed to have a mindset and a regulatory and legislative regime that at least allowed it to get more information. Given the generally unregulated environment, the FCA lacked the kind of information it would be entitled to demand from business conducted by authorised entities selling regulated products. If the FCA could access more information, he said, it could then take a decision with the government and with parliament as to whether more things needed to come into regulation or be supervised.

He thought the regulator sometimes had a "paucity of information and notification requirements". Notwithstanding that general point, he did focus on the fact that there may be an "interaction, intersection, with regulated activity, be it a bank or with capital markets". In such circumstances, he said, there was scope for the FCA to strengthen the information it was gathering about what those activities were and how they were being undertaken.

The securitisation element of Greensill's business model was such a point of interaction with the capital markets. In a letter to the committee, Rathi said that the structuring of loan notes and the provision of supply chain financing was carried out by GCUK and that the origination of a supply chain finance instrument was not a regulated activity. That is the case because the underlying assets to the securitisations — the trade finance receivables — are unregulated and the originator only needs to be regulated if the underlying assets are regulated.

Notwithstanding that position, he said, many of the activities related to the distribution and sale of the notes to institutional investors were regulated. GCUK would use special purpose vehicles (SPVs), such as Luxembourg-based Wickham SA, to issue notes based on the underlying unregulated trade receivables. The notes would be sold to institutional investors such as alternative investment fund Credit Suisse Virtuoso SICAV-SIF, which is an investment company with variable capital. The fund manager is stated to be Credit Suisse Asset Management.

Another Greensill entity, GCUK subsidiary Greensill Capital Securities Ltd (GCSL), arranged and distributed Greensill's loan notes to institutional investors and, (discussed here), was an appointed representative of Mirabella Advisers, he said. In his oral evidence he said Mirabella Advisers had permission to provide investment advice, to make arrangements with a view to transactions in investments and arrange deals in investments; Mirabella is a CAD exempt firm. He said GCSL was an appointed representative from August 10, 2017 to March 5, 2021 and could carry out activities that Mirabella was authorised to do. Rathi cited the relationship between Mirabella and GCSL as being a situation where "these businesses started interacting with capital markets and, although there wasn't anything reported in this case, under the Securitisation Regulation".

Reporting securitisations and the Securitisation Regulation

Only transactions meeting the definition of securitisation under the Securitisation Regulation (implemented in the Securitisation Regulations 2018 (as amended by the Securitisation (Amendment) (EU Exit) Regulation 2019) are reportable. Article 2 defines "securitisation" as a transaction or scheme, whereby the credit risk associated with an exposure or a pool of exposures is tranched (i.e., where the subordination of tranches determines the distribution of losses during the continuing life of the transaction or scheme). In contrast, a transaction which consists of pooling receivables and issuing notes without tranching (i.e., where all note holders are pari passu and do not benefit from any tranching) does not qualify as a securitisation for purposes of the regulation and is therefore not reportable.

According to Rathi it appeared to be the case that the Greensill securitisations were not reportable under the regulation because they appeared to fall into the latter category. Under art 7 of the Securitisation Regulation the originator, sponsor and securitisation special purpose entity (SSPE) of a securitisation are obliged to provide information to the national competent authorities including information on the underlying receivables on a monthly basis, in the case of asset-backed commercial paper. There are also extensive requirements as to documentation relating to the many aspects of the securitisation.

Money laundering regulation and Greensill entities

While securitisation was an area in which GCUK interacted through GCSL with the capital markets, the Money Laundering Regulations (MLRs) (discussed here) were an area where Rathi said in his oral evidence that there was a "nexus with regulation". The MLR regime, he said, was based on registration, not authorisation. In his letter, Rathi said that GCUK was an Annex 1 firm supervised by the FCA under the MLRs. He said that, under the MLRs, firms were required to identify their customers, monitor their transactions, pick up unusual or suspicious activity and, where appropriate, report any suspicions to the National Crime Agency. He cited reg 46 of the MLRs which required the FCA to monitor all firms it supervises under the MLRs using a risk-based approach.

The general approach the FCA has historically taken to the supervision of these firms has been a combination of reactive supervision in response to adverse intelligence alongside a targeted risk assurance programme, he said. The FCA told the International Monetary Fund (discussed here) that thematic reviews and event-driven reactive supervision would be the primary supervisory methods used for firms in the lowest two categories of money laundering risk. Rathi also referred in his evidence to the fact that, in the FCA's recent fees consultation, it had proposed to increase the fee for Annex 1 firms to fund additional supervisory work in relation to these firms, including further proactive supervision. This applies in the case of the highest-risk firms.

GCSL did not fall within the list of firms set out in reg 7 of the MLRs for which the FCA was the supervisory authority. Its parent, GCUK, by virtue of being an Annex 1 firm, was, however, required to ensure GCSL applied the relevant AML policies, controls and procedures referred to in reg 19(1) of the MLRs, to the extent that GCSL was doing business subject to the MLRs.

Possible changes to the perimeter

In his letter to the committee, Rathi indicated that there were some potential regulatory or perimeter changes which had been under consideration and had been highlighted by the collapse of Greensill. The areas of potential change were the appointed representative regime; investigation and penalty powers in the event of firm failure or deregistration under the MLRs; criteria for fitness and propriety under the MLRs; access to UK investors through listing securities on overseas markets that are not recognised overseas investment exchanges (ROIEs) or regulated markets; and employer salary advance schemes (ESAS).

In the letter he said, further, that under the MLRs, the criteria that could be considered when determining fitness and propriety for both assessing at the gateway and considering whether to cancel or suspend a registration were far more limited in comparison to criteria for taking similar action under the Financial Services and Markets Act 2000. He took the view that the regime could be strengthened if the criteria that could be used to determine fitness or propriety included, for example, specific criteria in relation to adequate governance and financial resilience.

In his oral evidence he referred to some work already under way on appointed representatives, to understand whether the regime was appropriate for the scale of capital markets activity that was being undertaken in contexts such as those in the Greensill case. The work is also considering whether the regulatory hosting model — where there were principals who did nothing else but "rent out their licence" — was appropriate. Rathi also referred in his evidence to work being carried out by HM Treasury into the overseas person exclusion which enables firms to act through UK markets without notifying the supervisor. He said the FCA needed to know to know what was going on in these areas, which are not formally regulated.

He also said in his letter that, in the FCA discussion paper on high-risk investments, it was seeking views on removing securities admitted to official listing on EEA exchanges and securities regularly traded on or under the rules of EEA exchanges from the definition of " readily realisable security". This is used in the FCA's financial promotion rules to identify those investments that can be generally promoted to retail investors.

In addition, he said the FCA would welcome greater consistency between the ROIE and wider UK regulatory regime and the list of overseas exchanges that qualify for specific UK tax treatment, e.g., the quoted eurobond exemption (QEE) (under s 882 of the Income Tax Act 2007 (discussed further here), as these tax treatments could drive institutional investor choice and behaviour.

He noted that HM Treasury is considering whether to extend the QEE to UK MTFs because the listing requirement of the QEE applies by reference to local regulatory arrangements in the territory in which a trading venue is regulated. These arrangements differ from territory to territory, so that in some cases local listing requirements are met and the QEE is available. This means that debt traded on MTFs in Luxembourg or Ireland, for instance, does attract the exemption, whereas the same securities traded on a wholesale UK MTF would not.

UK MTFs therefore suffer a significant commercial competitive disadvantage in attracting business. He said that was one example of the issue of regulatory arbitrage which needed to be considered in relation to the future of UK regulation and that HM Treasury was considering the framework under which financial products and services may be provided to UK investors from outside the UK.

With regards to ESAS he said that, while wider regulation might not be immediately necessary, the FCA should continue to closely monitor market developments and guard against risks to individuals including lenders "locking in" employers through linked commercial contracts, or cross-selling of inappropriate financial services products to employees. ESAS providers and major employers should draw up a code of best practice which the FCA should look to recognise in the case of authorised firms, he said.

Further information on compliance matters can be found here.

Written by:

Thomson Reuters Regulatory Intelligence and Compliance Learning

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