Effective regulatory due diligence – The key to managing conduct risk assurance in mergers and acquisitions

Posted: 22nd November 2016

First published on Thomson Reuters Regulatory Intelligence on the 14th of November 2016

With the regulatory landscape in financial services changing rapidly and accountability for senior individuals increasing, avoiding ‘buying into’ regulatory issues when merging with or acquiring other organisations is more important than ever.

M&A activity is increasing across financial services, and this can largely be attributed to:

• Firms seeking to differentiate their market offering and build their brand by creating an end-to-end experience for customers
• The disruption caused by technology, leading to niche market opportunities arising for firms
• Distribution chains involving multiple parties creating operational challenges and increasing the cost of compliance, causing firms to consolidate their business models to achieve economies of scale

Both in the private equity and trade buying space, regulatory change is the primary driver of volatility in the market. However, traditionally in M&A transactions, financial, legal and commercial considerations have taken precedence over regulatory considerations.

With regulatory change being a major factor in the M&A space, now more than ever, acquiring firms should consider compliance as part of any potential transaction. If they fail to do so, they risk buying into issues which at best can negatively impact on the benefits of integration and, at worst, can cost them in the form of large customer remediation projects or the merger not obtaining regulatory approval.

In short; failure to perform robust regulatory due diligence is not an option in today’s regulatory environment, but what does a robust and effective approach look like? How can acquiring firms gain assurance that the deal on the table is a good one?

Proportionate focus in the right areas

The highest level of assurance can be achieved when firms have a clear methodology for assessing a potential deal.

If regulatory due diligence is proportionate – and the process of performing the acquisition is documented – then firms will not only avoid the potential ticking time bomb of regulatory issues, but they will be able to evidence the robustness of their approach to the regulator, as required.

In the ongoing assessment of their own model for performing regulatory due diligence, firms should ensure they are comfortable with the following elements of a deal:

Business model           

Has the prospective firm’s risk appetite and target market been assessed? This is the key to ensuring that issues aren’t hidden beneath the surface of a deal. Assessing the regulatory and competitive landscape the firm exists in against the risk appetite of the firm is important – as well as whether that risk appetite is appropriate given its market.

On this point; it is important for the acquiring firm to be comfortable that any remuneration incentives for staff in the firm they are looking to buy are linked to the delivery of good customer outcomes.

Being aware of past, current and potential future regulatory issues, as well as looking at firms’ legacy business, can help to provide additional assurance. Conversely, it can also be the prompt a firm needs not to pursue a deal.

Senior management and governance

The Senior Managers and Certification Regime (SM&CR) highlights the importance of the approach of senior leaders from a regulatory perspective. This will be extended to all FCA regulated firms by 2018.

How well has the firm embedded SM&CR or, if it is not yet caught under SM&CR, what compliance challenges might the firm face in the future? With the proposed extension of SM&CR to all Non-Executive Directors (NEDs), what challenges will this create for investors whom sit as NEDs within acquired firms? Firms should look to gain assurance over the regulatory impacts that SM&CR presents for all parties as part of a merger or acquisition.

Controls

How effective are the prospective firm’s controls around conduct?

Throughout the due diligence process, the acquiring firm should be able to build a view, based on hard evidence, of the firm’s control environment. If there are shortcomings noted, this should lead to further investigations into potential legacy issues which this may have caused historical – if as yet undiscovered – regulatory issues.

Culture

Culture is the sum of many composite parts; indeed, FCA chief Andrew Bailey asserted earlier this year that “it is not the job of regulators to enforce culture and to change culture”. However, it is through poor culture that many regulatory issues manifest themselves within firms.

Acquiring firms therefore need to gain a view of culture. Determining the state of a firm’s culture can be made significantly easier by looking through three ‘lenses’:

• Commercial – how closely aligned is the organisation’s culture to the firm’s strategic and commercial aims?
• Customer – how does culture support or detract from delivering the right customer experience and outcomes within the firm?
• Regulation – ultimately, an acquiring firm needs to provide the regulator with assurance that culture within the firm to be acquired is a good fit, and that it is appropriate and effective in driving the right conduct outcomes

Plotting a path to the benefits

By ensuring a robust approach to regulatory due diligence, firms can gain a host of benefits. Throughout the process of an acquisition and while taking into consideration the factors mentioned above, firms should constantly reflect on whether their due diligence process (and the deal itself) facilitates:

• Regulatory approval – approval of the transaction is of course the end goal, and robust due diligence can help achieve this
• Effective risk analysis – ensuring your process leaves no stone unturned will result in the highest level of assurance against future regulatory-related costs
• The avoidance of fines and censure – through gaining assurance that the back book is clear and that current business is conducive to good customer outcomes. Furthermore, after a transaction has taken place, acquiring firms may struggle to obtain restitution for any historic issues identified, and robust regulatory due diligence can help mitigate this
• The preservation of reputation – whether issues are uncovered that make a deal untenable, or a solvable issue presents itself, the acquiring firm can protect its reputation by either walking away or implementing a plan to solve regulatory issues as early as possible. The acquiring firm can also stipulate that issues are solved within the firm to be acquired before acquisition takes place
• Pricing assurance – issues identified by regulatory due diligence needn’t always result in a transaction being blocked and, indeed, robust due diligence can provide the information a firm needs to negotiate a realistic price – one that reflects the cost of correcting any issues, for example
• The compiling of evidence – the FCA will seek assurances that any regulated firm post-purchase is operating compliantly. Evidence compiled throughout the due diligence process can contribute significantly to this
• The understanding of best practice – aligning the firm with regulatory expectations will help ensure compliance and help to drive best practice prior to completion of the deal

Scrutiny and evidence result in protection

Given the increased focus of the regulator on M&A, conduct due diligence should be at the forefront of any deal in regulated industry.

Undertaking effective regulatory due diligence, in addition to the legal and commercial elements, can vastly improve the chances of a successful merger or acquisition; in terms of completing the transaction, in avoiding being impacted by the cost of hidden issues, and in helping to ensure the continued delivery of good outcomes for consumers.