What can firms learn from the FCA H2O investigation? – Abdulali Jiwaji published in FT Adviser

The Financial Conduct Authority recently announced that H2O Asset Management had agreed to pay EUR 250mn to investors for “extremely serious” breaches relating to investments that they had been unable to access for four years. A former star of the European investment sector, which managed more than EUR 30bn at its peak, H20 was subject to savage criticism by the FCA for providing “false and misleading statements and documentation” including “fabricated records and minutes of meetings”.

The saga goes back to June 2019 when the Financial Times first reported that H20 had substantial exposure to illiquid securities tied to the German entrepreneur Lars Windhorst. This led the FCA to launch an investigation into whether H2O had carried out proper due diligence on investments relating to companies that were owned or introduced by Windhorst. The estimated value of those investments in August 2020 totalled EUR 1.64bn.

Media reports highlighting the close relationship between Windhorst and the French asset manager’s CEO, Bruno Crastes, precipitated a large volume of redemptions across H2O funds. In parallel with the FCA, the French Financial Markets Authority, the AMF, also took steps, requiring H2O to suspend all subscriptions and redemptions in various funds due to significant exposure to valuation uncertainty.

The enforcement action identified distinct breaches of FCA Principles:

• The FCA had concerns that H2O failed to apply due skill, care and diligence in relation to investment decisions, entering into high risk, unlisted and illiquid investments without having appropriately considered their merits and risk. There was also failure to comply with policies and procedures relating to gifts and hospitality, conflicts of interest, due diligence and record keeping.
• There were failings in risk management systems, in policies and procedures for decision making, appropriate governance arrangements, plus inadequate oversight, challenge and monitoring of the investment decision making process. Conflicts of interest also arose in failure to record gifts and hospitality provided by Windhorst to H2O staff and family members, which meant that activities that could have acted as an inducement to continue making investments with Windhorst were not properly overseen or challenged.
• H2O failed to be open and cooperative with the FCA. This involved H2O making false and misleading statements to the FCA in several areas, including: the levels of due diligence conducted on investments, provision of false documents to the FCA in relation to records and minutes of governance and oversight committee meetings, and failing to disclose and providing misleading information as to the extent of hospitality.

The FCA stated that it would have imposed a “substantial fine” for these breaches, but instead agreed that H2O would compensate investors with a EUR 250mn payment. In deciding whether to impose a penalty or issue a public censure, the FCA enjoys a wide discretion, according to the circumstances of each case.

Factors that may influence its decision include:

• Whether or not deterrence may be effectively achieved through public censure.
• If the person has made a profit or avoided a loss as a result of the breach, this may determine in favour of a financial penalty.
• Whether steps have been taken to ensure that those who have suffered loss due to the breach are fully compensated for those losses - this may determine in favour of a public censure.

Here, the FCA weighed the factors in favour of a public censure.  But the Collectif Porteurs association, representing 9,000 investors, has said that it considers the low level of reimbursement agreed by the FCA as “shocking” and suggesting it is not the UK regulator’s place to determine what compensation they receive. Notably, the French regulator did fine H20 EUR 75mn and sanctioned senior individuals (which proceedings are subject to an appeal process).

It is true that in serious cases of misconduct, the public censure option is unusual, with most previous examples relating to companies in liquidation or administration, where monies are owed to creditors. But conflicts of interest have seen the FCA impose significant penalties – for example, c.GBP 17.6mn on Aviva Investors Global Services in 2015, and c.GBP 9.1mn in respect of GAM International Management in 2022.In fact, the FCA’s detailed findings in respect of H2O underscore that, even without though a fine was not imposed in this case, the regulator expects asset managers to be scrupulous in identifying and managing conflicts of interest and their risks.