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Purpose of the paper
1. This paper seeks public comment on some further refinements to our initial proposals relating to exposures to related parties that were set out in Annex EAnnex E
of Consultation Paper No. 42.
2. We issued Consultation Paper No. 42
in December 2006 seeking public comment on a range of proposals to enhance the DFSA Rulebook to promote compliance with international best practice standards. Annex EAnnex E
of that paper contained proposals to amend the Investment, Insurance Intermediation and Banking Business (PIB) Module of the DFSA Rulebook to meet Core Principle 11 of the principles issued by the Basel Committee on Banking Supervision in October 2006. Core Principle 11 sets standards that Firms conducting Banking Business must meet to address risks arising from credit and other exposures to related parties.
3. The refinements we are proposing in this paper (see AnnexAnnex
) relate only to one aspect of our initial proposals, the scope of the definition of "Related Persons".
4. Public consultation on the proposals in Consultation Paper No. 42
ended on 19 February 2007. We did not receive any comments relating to any of those proposals. However, we consider that the proposal in this paper to expand the definition of "Related Persons" is sufficiently important that we should defer the finalising of the package of proposals that were dealt with under Consultation Paper No. 42
until the end of public consultation on this paper.
Who should read this paper?
5. The proposals in this paper would be of primary interest to Authorised Firms conducting or proposing to conduct Banking Business (i.e. a Prudential Category 1 Firm) or Investment Business as a Prudential Category 2 or 3 Firm or as an Islamic Financial Institution which is a Prudential Category 5 Firm. These proposals will also be of interest to Persons who intend to transact with such Authorised Firms.
How is this paper structured?
6. In this paper, we set out:
(a) defined terms in paragraph 9;
(b) scope of Basel Core Principle 11 in paragraphs 10 and 11;
(c) scope of our initial proposal in paragraphs 12–14; and
(d) scope of and reasons for the new proposals in paragraphs 15–23.
How to provide comments
7. All comments should be provided to the person specified below. You may, if relevant, identify the organisation you represent in providing your comments. The DFSA reserves the right to publish, including on its website, any comments you provide, unless you expressly request otherwise at the time of making comments.
What happens next?
8. The deadline for providing comments on these proposals is 19 April 2007.
Once we receive your comments, we will consider if any further changes are required to these proposals. We will then proceed to make the necessary changes to the DFSA Rulebook covering all the amendments resulting from Consultation Paper No. 42
and this paper. However, because the changes recommended in this paper and Consultation Paper No. 42
are still proposals, you should not act on them until the relevant changes to the DFSA Rulebook are made. We will issue a notice on our website telling you when this happens.
Comments to be addressed to:
Mrs Dhammika Amukotuwa
PO Box 75850
or e-mailed to: firstname.lastname@example.org
9. Generally, capitalised terms used are defined terms in the GLOSSARY (GLO) Module of the DFSA Rulebook. For example:
(a) "Controller" of an Authorised Firm means a Person who:
i. either alone or with any Associate holds 10% or more of an Authorised Firm’s shares or its Parent; or
ii. is entitled to exercise, or control the exercise of, 10% or more of the voting rights in respect of the Authorised Firm or its Parent; or
iii. is able to exercise significant influence over the management of the Authorised Firm or its Parent;
(b) "Close Relative" is defined to include a spouse, child, parent or sibling as well as a step child, parent or sibling;
(c) "Group" means an Authorised Firm’s Parent or Subsidiary, as well as a direct or indirect Subsidiary of such a Parent or Subsidiary; and
(d) "Parent" means a Holding Company.
Scope of Basel Core Principle 11
10. Basel Core Principle 11 requires supervisors to address risks of abuses and conflicts of interests that arise from banks’ exposures to related parties. To address such risks, supervisors should require that Firms should only enter into transactions with related parties on an arm’s length basis. Even where arm’s length transactions are to be undertaken with related parties, such transactions are to be subject to stringent controls. For example, persons likely to benefit from such transactions should not be part of the process of granting and managing the exposure. A limited exception is suggested in the case of employee compensation schemes, where credit can be extended on terms which are more favourable than those generally available.
11. Basel Core Principle 11 requires supervisors to define "related parties", and gives an indicative and non-exhaustive list of persons who might generally be considered as falling within such a definition. They are:
(a) a bank’s subsidiaries and affiliates,
(b) any party the bank exerts control over or that exerts control over the bank; and
(c) the bank’s major shareholders, directors, senior management and key staff, their direct and related interests, and their close family members, and corresponding persons in affiliated companies.
Our Initial proposal
12. To comply with Basel Core Principle 11, our initial proposal included requirements that would:
(a) prohibit an Authorised Firm from extending exposures to Related Persons on terms more favourable than those available to non- Related Persons except in the limited circumstances set out in (b);
(b) provide an exception to the above prohibition in relation to the provision of credit to Employees. The exception would apply where the Authorised Firm has policies and procedures approved by its Governing Body relating to the provision of such credit and those policies include requirements to deal with conflicts of interests, particularly to preclude Persons who will directly or indirectly benefit from such transactions being part of the process of approving or managing the exposure; and
(c) in any case, even where exposures are made to Related Persons on terms no more favourable than those available to non-Related Persons, preclude Persons directly or indirectly benefiting from such exposures being part of the approval or write off process of such exposures.
13. These proposals would apply to Authorised Firms in Prudential Categories 1, 2, 3 and 5.
14. Our initial proposals defined a Person to be a "Related Person" of an Authorised Firm if that Person is, or was in the past 2 years:
(a) a member of a Group or partnership (other than a Limited Liability Partnership) in which the Authorised Firm is or was also a member;
(b) a Controller of the Authorised Firm or a Close Relative of such a Controller; or
(c) a Director, Partner or an Employee of the Authorised Firm; or
(d) a Close Relative of a Director, Partner or an Employee of the Authorised Firm or that of a corresponding person in an entity referred to in (a) or (b).
Scope and purpose of the current proposal
15. We propose to alter the initial proposals set out in paragraph 12 above in three regards, i.e.:
(a) to expand the definition of Related Persons to capture entities in which Related Persons have a significant interest;
(b) to exclude certain Persons from the definition of Related Persons; and
(c) to strengthen the initial proposals relating to Employee credit. Inclusion of significant interests.
16. We propose to expand the definition of the term "Related Person" to capture any entity in which a "significant interest" is held by a Director, Partner or senior manager (or a Close Relative of such an individual) of:
(a) the Authorised Firm;
(b) a member of the Group in which the Authorised Firm is also a member; or
(c) a Controller of the Authorised Firm.
17. We will regard an individual referred to in paragraph 16 as having a "significant interest" in another entity if that individual:
(a) holds 20% or more of the shares of that entity, or its Parent, if that entity is a company; or
(b) is entitled to exercise 20% or more of the voting rights in respect of that entity.
18. We propose to expand the definition of a Related Person in this manner because:
(a) we have identified a risk that the purpose of the controls relating to related party transactions may be circumvented through exposures (such as loans) to entities in which a Director, Partner or senior manager of the Firm or their Close Relatives (or corresponding persons in affiliated firms) have a significant interest. The Basel guidance appears to recognise this as a risk; and
(b) this wider definition is broadly consistent with the approach adopted by a number of comparable jurisdictions such as Hong Kong and Singapore.
Exclusions for certain persons
19. We have also identified two subsets of Persons included within the terms "Partners" and "Employees" under our initial proposals that do not warrant being treated as Related Persons. This is because not all Partners and Employees occupy positions of influence within an Authorised Firm or its related entities that would enable them to expose an Authorised Firm to abuses of related party transactions.
20. On this basis, we have excluded limited partners of a limited partnership (whether formed under the Limited Partnership Law of 2004 or any similar law of a country or territory outside the DIFC) from our proposed definition of Related Persons, as limited partners play a role similar to that of shareholders of a company rather than Directors or senior managers.
21. Similarly, we also propose to treat as Related Persons only those Employees who are senior managers of the Authorised Firm, rather than all its Employees, as the opportunity for any abuse of related party transactions is more likely to arise in the case of senior managers.
Refinements to strengthening the initial proposals
22. We have also made some further refinements to the initial proposals to ensure that the objectives of the initial proposals are fully achieved. The most important refinement is to the requirements in the initial proposal relating to the exception for an Employee credit policy that allows more favorable credit terms than those offered commercially. We propose to make it clear that Directors, Partners and senior managers may benefit from an Employee credit facility where the facility is one that is widely available to Employees of the Authorised Firm.
23. In conclusion, we note that the controls adopted to deal with conflicts of interests and abuses arising from related party transactions vary quite significantly from jurisdiction to jurisdiction. However, we consider that our revised proposals address the risks identified in the Basel principles in a way consistent with international practice and without being overly restrictive.
Download this Consultation Paper in PDF formatPDF format.
Download Annex — Proposed amendments to Prudential — Investment, Insurance Intermediation and Banking Business Module (PIB) of the
DFSA Rulebook in PDF formatPDF format.