Newsletter

Insurance and reinsurance news January 2014

Changes of control of firms under the UK’s new regulatory regime

24 January 2014

The introduction of the new financial regulations in the UK in April 2013 has had a

meaningful impact on the process for getting approvals for the acquisition of regulated

firms. The process is now more timeconsuming and less predictable. Anticipating the

regulators’ concerns together with early and constructive engagement has become vital

to minimise the risk of delay or even of failing to obtain approval at all. In this

newsletter we discuss how the new regime is working in practice, focusing in particular

on how it affects insurers.

George

Swan

James

Smethurst

Romin

Dabir

Introduction

The Financial Services Act 2012 amended the Financial Services and

Markets Act 2000 (FSMA). It introduced socalled ‘twin peaks’’ regulation to

the UK through the creation of the Prudential Regulation Authority (PRA) and

the Financial Conduct Authority (FCA). In broad terms the PRA is responsible

for the prudential regulation of banks, insurers and a small number of very

significant investment firms. The FCA is responsible for conduct regulation of

all regulated firms, as well as for the prudential regulation of firms not covered

by the PRA.

Impact of Financial Services Act 2012 on change of control

regime:

The new UK regulatory regime has changed the way the rules which underpin

the change in control regime are applied. Those rules are derived from the

Acquisitions Directive (2007/44/EC), which was intended to create a

harmonised regime throughout the EEA.

Any application for approval of a change of control of a bank or insurer must

now be sent to the PRA. The assessment of the application will be led by the

target’s supervisory team at the PRA, rather than by a separate team in a

changeofcontrol department.

Section 187A FSMA imposes an obligation on the PRA to consult with the

FCA. So they work side by side in considering change of control applications.

The FCA may consider that there are reasonable grounds to object to the

proposed acquisition. In that event it may direct the PRA either to object to

the acquisition, or not to approve the acquisition, unless it does so subject to

certain specified conditions.

Given that each regulator now has an interest in policyholder protection, one

might think that the scope for disagreement would be minimal. The PRA has

been given a specific insurance objective, set out in section 2C of FSMA.

This is ‘contributing to the securing of an appropriate degree of protection for

those who are or may become policyholders.’ The FCA has a ‘strategic’

objective of ‘ensuring that the relevant markets function well’ (section 1B

FSMA). It also has a consumer protection ‘operational’ objective. This is

‘securing an appropriate degree of protection for consumers’ (section 1C

FSMA). To a certain extent, therefore, the regulators objectives are aligned.

However, the focus of each regulator has proved to be different.

The PRA set out its approach to insurance supervision in its paper ‘the PRA’s

approach to insurance supervision’ (April 2013) (the PRA Approach

Document). It made clear that it will view policyholder protection through the

prism of safety and soundness:

‘Policyholders are protected both by the PRA as prudential regulator and by

the Financial Conduct Authority (FCA) as conduct regulator. The FCA seeks

to ensure that consumers are treated fairly in their dealings with insurers,

whereas the PRA’s focus is to ensure that policyholders have an appropriate

degree of continuity of cover for the risks they are insured against. Ensuring

continuity of cover requires insurers to be able to meet claims from, and

material obligations to, policyholders as they fall due, which, in the case of

some policies, may emerge after many years…'

There is thus a recognition of the longterm nature of some insurance

liabilities. For life insurers, the PRA is likely to focus on the longterm capital

strength of firms. We have seen evidence of this in a number of applications

in which we have advised.

The FCA’s concentration on fairness concerns may cause some tension in

this regard. This applies particularly when it comes to applications for a

change in control in respect of insurers with a withprofits book.

Impact of new regulatory environment on change of

control regime:

RBS’s takeover of ABN Amro and Lloyds TSB’ takeover of HBoS led to

serious systemic problems within the banking sector. These transactions,

together with others lessons of the financial crisis (in particular, the focus on

governance) have informed the regulators’ current approach to change in

control applications. We are seeing an ever closer scrutiny of changes in

control and requests for consent for approved persons connected with

acquisitions than used to be the case.

What this means in practice:

Requirement for premeetings and submission of draft forms

It is now commonplace for the PRA to request an initial meeting to discuss

the proposed acquisition, particularly on more complex or significant deals.

The PRA frequently requests submission of the application for approval in

draft form before accepting the formal submission. This was not the practice

of its predecessor, the FSA.

One might expect that to shorten the time required by the regulators to

assess the final submission, but this has not always been our experience.

The statutory clock on the application does not start until the PRA

acknowledges receipt of a complete application. In practice, the submission

of forms in draft can introduce a great deal of uncertainty to the timetable.

This clearly makes negotiation of any sale and purchase agreement

(including any longstop date for the transaction) and planning for completion

more complicated. The importance of early and thorough preparation has

increased, though this can be difficult where the details of the transaction

(particularly the holding structure and governance) have not been finalised.

Unusual information requests

We have recently seen requests from the regulators for information that has

not previously been required in the change of control context. For example,

both regulators have requested details of due diligence findings on the target.

It is difficult to see how this request can be justified in the context of a

process designed to assess the fitness and propriety of the proposed

controller, not the target. The FCA’s approach here raises concerns around

client confidentiality and the legal privilege that may attach to any adviser’s

due diligence report. It would be an unwelcome result if these requests

resulted in less rigorous due diligence being undertaken in future or if the

format for the reporting of due diligence was changed to avoid regulatory

scrutiny. It may be, on the other hand, that some regulatory focus on this

issue, short of requiring privilege to be waived, is justified to ensure that

bidders have focused on the issue.

We have also seen new requests by the regulators for copies of the board

minutes where the proposed transaction was discussed and approved by the

potential acquirer.

There is a possible explanation for these new requests; It is that the regulator

may be looking for evidence that the potential acquirer has taken the decision

to acquire following a proper process of due diligence and subject to sufficient

challenge at the board. There may, however, be alternative, less intrusive

means that the regulator could employ to satisfy itself of this.

Increased focus on future governance of target

The regulators are placing an increased emphasis on good governance. This

is particularly evident from the PRA Approach Document, where there are

multiple references to the importance of that factor. We believe this is likely to

affect the PRA’s assessment of two issues in particular:

(i) the proposed holding structure of the firm; and

(ii) the internal oversight and risk management structures and processes.

The PRA has made clear that it will scrutinise closely holding structures that

are particularly complex and which involve entities located outside the UK:

‘In cases where the most senior legal entity within a group is a holding

company, which is not itself authorised under the United Kingdom’s statutory

regulatory regime, the PRA will expect to have extensive contact with its

board and senior management, and will consider whether it is suitable to

exercise control over a regulated firm. The PRA will expect the holding

company to take responsibility for the group as a whole having due regard to

the PRA’s objectives. And the PRA will consider whether the insurers’

membership of a group affects whether the insurer satisfies the Threshold

Conditions, including if the ownership structure compromises the ability of the

insurer to be supervised effectively by the PRA.’

Complex acquisition structures (e.g. multiple intermediate holding companies)

or which involve offshore controllers are likely to be subject to particular

scrutiny with the regulators, focusing on how the UK authorised firm will fit

within the overall governance and control framework.

The PRA has emphasised that the board of the authorised firm should have a

mix and balance of skills, so that collectively it can understand the breadth of

the firm’s business. The PRA will require most, but not all, board members to

have relevant experience of financial services.

This emphasis on competence and experience of the board is likely to

increase following the recent debate regarding the appropriateness of Mr Paul

Flowers’ appointment as nonexecutive chairman of The Cooperative Bank

plc. Indeed, in the wake of that debate, we have already heard calls from

members of the Treasury Select Committee for reforms to, and a tightening

up of, the approved persons regime still in place for nonbanks.

The PRA Approach Document emphasises the importance of independent

directors as a means of ensuring that the executive and management of the

insurer are properly held to account for their decisions. Potential acquirers

should therefore consider carefully whether the proposed board contains the

appropriate balance of executive and independent directors. They should be

prepared to explain in detail any proposed changes to the governance of the

UK authorised firm, including identifying particular individuals whom the

acquirer proposes to appoint as additional or replacement senior

management. Transactions where key members of the UK authorised firm’s

management team will remain with the seller, or are otherwise likely to leave

on completion, will require the acquirer to satisfy the regulators that people

with appropriate experience and competence will either remain or be

appointed at closing.

There will also be an issue as to whether individuals the acquirer proposes to

appoint are appropriately qualified and experienced to undertake the roles for

which they are being put forward. Where individuals will have to be approved

by the regulator, sufficient time should be factored into the transaction

timetable to ensure approval can be obtained before closing. The approval

form must be submitted by the authorised firm, which is ultimately responsible

for attesting to the fitness and propriety of the candidate so the acquirer

should be prepared to work with the UK authorised firm to ensure it is

comfortable with the proposed candidate.

Where an individual’s experience for the particular role is a potential issue, an

acquirer should be prepared to consider whether a backup candidate is

needed. We have seen several recent examples of the PRA pushing back on

proposed corporate structures, either for lack of experience in the use of such

structures, or what it perceives as an unbalanced board as a result of there

being too few independent directors. We believe this is likely to continue to

be an area of contention.

More purposive approach to interpretation of the law

The PRA has repeatedly made clear that it intends to adopt a more ‘judgment

based’ style of supervision. It will rely less on evidence of strict compliance

with the letter of the rules and more on ensuring that their spirit and purpose

are being adhered to. We have seen some evidence of this in the regulators’

approach to assessing change of control applications (for example, in relation

to the identification of controllers) as noted above. It is likely that this trend

will continue and strengthen.

Potential for lastminute delays and glitches in the process

Assessments of change of control applications are reviewed by the firm’s

supervisory team (PRA) and change in control team (FCA) and then referred

to more senior levels for final approval. The level of approval required

depends on the size and significance of the target firm. Notwithstanding an

extensive review and information gathering exercise at the first stage, the

subsequent senior review can result in further requests for information or

even changes to the deal terms. This could result in delays while any

additional information requested is gathered, or any changes requested by

the relevant regulator to the proposed acquisition are negotiated.

Possible loss of flexibility?

There is a danger that the regulators’ flexibility to consider applications may

be eroded. The European Securities and Markets Authority (ESMA) has

recently submitted to the Commission a draft regulation setting out the

information to be provided to a regulator in relation to a proposed change of

control of an investment firm. Once made, the regulation will replace existing

guidelines on the same subject which apply in relation to all changes of

control.

Certain important flexibilities under the guidelines have not been preserved in

the draft regulation. While this is not directly relevant to insurers, given that

the PRA’s constituency includes some major investment firms, insurers too

may find the PRA less willing to dispense with the provision of information

which is either not material or not relevant to the transaction in question.

Comment

The change of control regime for insurers is clearly becoming more

burdensome in practice. This reflects the general approach of the PRA to

achieving its regulatory objectives, its emphasis on ‘judgmentbased

supervision’ and the increased complexity of the new regime. The changes

have made it more challenging for firms to plan for acquisitions in the

regulated sector.

A careful strategy aimed at avoiding problems is essential. It should be based

on early engagement with the PRA and FCA and an understanding of their

respective concerns and priorities.

For more information, please contact:

George Swan

T +44 20 7716 4695

E george.swan@freshfields.com

James Smethurst

T +44 20 7832 7478

E james.smethurst@freshfields.com

Romin Dabir

T +44 20 7785 5479

E romin.dabir@freshfields.com