Posted: 21st October 2016

First published by FT Adviser

When it comes to Mergers and Acquisitions (M&A) within financial services, due diligence has historically focused on financial, legal and commercial considerations, but how much attention do firms pay to the potential conduct risks associated with transactions?

Given the increased regulatory scrutiny associated with principles-based regulation, it has become more important than ever to get a view of the implications of current and historical conduct.

The FCA is increasingly interested in M&A activity linked to regulated businesses. Indeed, a recent, well publicised example of the regulator standing firm involved a software development company being forced to walk away from a £460m bid to buy a contracts for difference trading platform after concluding that it would not be able to gain regulatory clearance for the deal.

Even more pressing for acquiring firms are potential undisclosed legacy issues and historic cases of poor record keeping which have, in the past, come back to bite firms. The mis-sale of Payment Protection Insurance is one example which has affected several firms who unwittingly acquired back books containing these products.

Clearly, getting regulatory due diligence performed correctly is vital for acquiring firms operating within the regulated financial services environment.

What should Conduct Risk Due Diligence Focus On?

Conduct due diligence should not just be a tick box exercise, but rather it should go to the heart of the business model and strategy of the firm being acquired to really “get under the bonnet” and examine potential issues.

Indeed, even a firm’s culture should be analysed; all the more so given the FCA is now frequently linking instances of customer detriment to firms’ poor culture.

So what should acquiring firms focus on from a conduct perspective? We believe that these are the critical areas and highlight a few key questions that should be sufficiently answered ahead of any takeover:

  1. Business model analysis: what is the firm’s risk appetite and target market? What is the competitive landscape and what are the remuneration and incentivisation structures at play? What limits can this put on the acquired firm in terms of achieving compliance?
  2. Senior management and governance: what is the structure of the firm’s senior management and is it effective and providing adequate oversight of the business? How has the new accountability regime (where applicable) been embedded within the firm?
  3. Culture: what are the firm’s vision and values and what is the ‘tone from the top’? Does the acquired firm have a culture that takes a diligent yet proportionate approach to regulation, backed by retaining evidence of customer-centric decisions?
  4. Controls: how effective are the firm’s controls around conduct? This would include adequate record keeping; ensuring firms are able to provide assurance to regulators in the case of any future challenge.

It’s important that your firm looks at the historical performance of the prospective firm to be acquired through the conduct lens. It is also key to ensure that the operation is fit for purpose and compliant on an ongoing basis once the acquisition is complete – and that the acquirer is aware up front of any changes, and investment, required to ensure that this is the case.

What are the benefits of getting it right?

  • Regulatory approval: strong front-end due diligence will increase the prospect of FCA transaction approval
  • Fines and censure: increased protection against penalties associated with unrealised or crystallised risk
  • Best practice: firms will be able to align regulatory expectations and industry best practice prior to completion of the deal
  • Reputational risk: provides assurance to the buyer with regards to reputational risk
  • Inability to seek / obtain restitution: once the transaction is complete there is usually little ability to obtain restitution for historic problems discovered, so undertaking robust due diligence will help the acquiring firm avoid the risk of this situation occurring

Meet increased regulatory scrutiny with increased M&A scrutiny

Given the increased scrutiny of firms operating within financial services, regulatory due diligence at the front end of a deal will need to keep pace with the ever-changing and evolving regulatory landscape. Firms should not solely focus on legal and commercial matters, but conduct a detailed examination of the prospective firm by looking through the ‘conduct lens’ and performing a more invasive and comprehensive health check on a target ahead of any formal takeover.

Matt drage

Matthew Drage

Director of Consumer Finance’