Financial services: regime change

In just two years since its creation on 1 April 2013, the Financial Conduct Authority (FCA) has earned a reputation for being tough on market abuse. The new financial regulator set out to vigorously pursue the ‘credible deterrence agenda’ of its predecessor, the Financial Services Authority, which presided over one of the worst financial crises in history.

‘The FCA has done a good job of continuing that theme and promoting credible deterrence as a key objective,’ says Clifford Chance partner Carlos Conceicao, noting that regulators around the world are now using the English phrase. ‘Credible deterrence has been a successful UK export,’ he observes.

The level of fines imposed by the FCA has soared. In April, Deutsche Bank paid £227m to settle charges that it had manipulated Libor; last November five major banks – Citibank, HSBC, Royal Bank of Scotland, JPMorgan Chase Bank and UBS – were collectively fined £1.1bn to resolve allegations that they had tried to rig the foreign exchange (forex) market.

Yet there have been far fewer tough penalties and sanctions against individuals.

‘Firms, particularly banks, are willing to accept large fines and move on,’ says Tim Aron, a financial services regulatory partner at Arnold & Porter and deputy treasurer of the Financial Services Lawyers Association. ‘It is often cheaper for them to do that than to go through a long protracted enforcement process. But that sometimes means that no one is ever blamed for what happened.’

If the FSA was criticised for failing to sanction more senior managers connected to the banking crisis and other financial scandals such as payment protection insurance and interest rate swap mis-selling, its successor’s track record in this area has not been stellar either.

Last year, the number of investigations opened by the FCA rose by more than 20%, according to research by Pinsent Masons. But the regulator shifted its focus away from individuals towards corporates, with the number of investigations into individuals dropping by 31% since 2012, the last year of the FSA. The overall number of investigations also fell since 2012, from 134 to 109 in 2014.

‘Over the last 12-24 months, I have seen significantly fewer cases against individuals coming through because the time and resources of the regulator have been channelled into these huge scandals and investigations,’ says WilmerHale’s white-collar crime specialist Elly Proudlock, pointing to Libor and forex. ‘Now that those [cases] have pretty much been sown up, over the next 12 months we are going to see many more cases against individuals.’

It has not just been a question of priorities and the need to respond to events, but also a reflection of the difficulties of making individual responsibility stick. New rules coming into force in March next year are designed to make it easier for the regulator to take enforcement action against senior people in banks and other financial institutions.

‘The FCA will be under increasing pressure to go after individuals,’ Aron says. ‘The move towards individual accountability is going to be the next big theme in regulation.’

There are already signs of change. In March, the FCA banned a Rabobank trader from the UK financial services industry. The individual was alleged to have personally attempted to manipulate Libor. Earlier in the year, the FCA also banned and fined two senior executives at London-based brokers RP Martin over Libor manipulation.

Apportioning blame

In a speech delivered shortly after the launch of the FCA, Tracey McDermott, the regulator’s director of enforcement and financial crime, recognised that ‘fining firms alone is not enough – we must do something different. In order to achieve credible deterrence, senior managers must be held to account’.

Enter the Senior Managers Regime (SMR). This  will help the FCA apportion blame among senior bankers when things go wrong on their watch.

‘The SMR is the biggest thing to happen in the pursuit of the credible deterrence agenda,’ Proudlock says. ‘It will make it significantly easier to take enforcement action against individuals and win.’ The SMR will require senior managers at banks to submit a ‘statement of responsibilities’, setting out in detail which areas of the business they are responsible for when there is a regulatory breach. This will allow the regulator to clearly identify the individuals responsible.

The onus to prove wrongdoing will no longer be on the FCA. ‘As of March 2016, if you are a senior manager responsible for an area in which there are failings you will be presumed to be personally culpable unless you can prove otherwise,’ Proudlock says. Senior individuals will be liable to disciplinary action unless they can prove they took reasonable steps to prevent or stop the breach.

The framework for the new regime, which comes into force on 7 March 2016, is contained in part 4 of the Banking Reform Act 2013. The FCA and the Prudential Regulation Authority (PRA) are consulting on new guidance setting out: when the regulator would seek to apply the presumption of responsibility under the act; how it would apply it; and the steps a senior manager should take to rebut the presumption.

The reforms follow the recommendations of the Parliamentary Commission on Banking Standards set out in a June 2013 report. Under the approved persons’ regime, which the new rules for banks will supersede, individual accountability was often unclear and confused, making it difficult for regulators to bring to account those responsible for serious regulatory failure.

‘There has been a continuing effort in the enforcement world to take cases against senior management that has not been conspicuous in its success,’ says Blackstone Chambers’ Javan Herberg QC. ‘One example that went all the way to the Upper Tribunal is Pottage, where the FSA actually failed. The tribunal overturned significant parts of its case, so everyone has always known that it is extremely difficult to prove senior management’s responsibility. That is one of the reasons why they would say the new regime was needed.’

John Pottage was the former chief executive of the wealth management division of UBS. The FSA sought to fine Pottage £100,000 for failing to control the conduct of others, after a string of compliance problems were identified. But in 2012 the Upper Tribunal for financial services, which heard the appeal, held that the FSA had not established its case that Pottage had committed misconduct, and ruled that he had taken reasonable steps to improve the bank’s internal procedures and control.

Simon Morris, financial services partner at CMS Cameron McKenna, says: ‘That was a real shot across the FSA’s bows, and that still resonates with the FCA. They do not want to have any more Pottages so they have become rather more selective.’

As Proudlock notes: ‘The case really exemplified the difficulty faced by the FSA at the time, which was bringing these cases against individuals where they were presiding over a department that had huge failures in a certain area, but not being able to show that the individual was personally culpable because the burden of proof was on the FSA to show that they had behaved unreasonably.’

In future it will be the other way round. Which is just as well, because enforcement actions against senior individuals are almost always ‘strongly contested’, according to Aron, because people face much more serious consequences than corporates, including fines that they will struggle to afford and a ban from practice. ‘Individuals, unlike banks, aren’t able to pay their way out of the challenge,’ he says.

Making it personal may help reverse current trends. The number of cases heard by the RDC [Regulatory Decisions Committee] dropped by 59% in 2014, according to consultants Bovill. There was also a marked reduction of activity in the Upper Tribunal over the same period, according to Herberg.

‘[Financial] firms in this environment are not willing to take on their regulator, especially with all the public downside,’ he says, referring to a battering in public opinion the City has taken. Furthermore, he adds, by settling early banks and other financial institutions can get a 30% discount on the fine and avoid reputational fallout from the publication (introduced in 2014) of details from warning notices. These state the action the FCA proposes to take, giving reasons, and the opportunity for representations with the RDC, which makes the final decisions, after which matters can be referred to the Upper Tribunal, an independent body.

It is not just senior bankers, including chairmen and heads of main board committees, who will be under greater scrutiny. The new regulatory framework set out by the Banking Reform Act ‘widens the pool of people over which the FCA has jurisdiction’, Proudlock says. For example, employees with functions involving a risk of ‘significant harm’ to the bank or its customers will have to be certified as fit and proper by the bank on an annual basis.

The act also creates a new criminal offence of reckless misconduct when this leads to the insolvency of a bank. But lawyers say that the offence will be very difficult to prove and expect disciplinary action against senior managers to be significantly more common than criminal prosecution.

SMR has its faults – there are concerns about access to justice and its complexity.

Morris argues that the reversal of the burden of proof means ‘there is very little prospect in real terms’ of persuading the regulator that the senior individual took reasonable steps to prevent, stop or remedy the breach that occurred on their watch.

‘You then have to take your case to the Upper Tribunal. Pottage took the case to the tribunal because UBS, to its credit, backed him and paid the legal fees. Very few senior managers will be able to afford to take their cases to the tribunal unless their employer backs them or they have insurance cover – or they are rich,’ he says. ‘That’s a bit of a worry.’

‘The Parliamentary Commission on Banking Standards said that the old approved persons’ regime [APER] was one of immense confusion and complexity,’ Morris adds, arguing that the new rules will be equally confusing and complex. ‘APER applied across the whole industry. Now you have three different systems: one for banks; one for insurers; and one for everyone else.’

The SMR and certification regimes will initially only apply to individuals working for UK banks, building societies, credit unions and PRA-designated investment firms, although they may be extended to other financial-regulated firms in due course, and APER abolished entirely. A separate senior insurance managers’ regime, driven by the Solvency II directive, is expected to come into force on 1 January 2016.

Proudlock says the new personal liability regimes will add ‘massively’ to the regulatory compliance burden: ‘It will be the responsibility of firms, rather than the FCA, to certify every year that a certain person is fit and proper to do their role.’

The regimes will also bring new business for both contentious and non-contentious financial services regulatory lawyers.  

A major body of work for solicitors will be the new detailed ‘statements of responsibility’, to be submitted for approval by 8 February. These define the scope of a senior banker’s responsibility.

The process of preparing and carefully drafting these documents should not be viewed negatively by clients, says Gordon Dadds partner Alex Ktorides: ‘They should allow for a proper ongoing assessment of the people running your business. It is a good opportunity not just to sharpen your policies but also to think about interesting things, like having compliance champions embedded in your key departments.’

An increase in litigation is also expected. Conceicao, an expert in contentious financial services regulation and former head of the FSA’s wholesale group in enforcement, says: ‘In about two-thirds of cases where there is a breach, there are individuals under investigation. In future, it’s probably going to be in 95%-100% of cases. Therefore, there is going to be more work for lawyers.’

Narrow focus

There are three big differences between the FSA and FCA. First, there is the narrower focus of the new regulator.

The FSA was tasked with overseeing the entire financial services industry, but responsibility for ensuring that banks are financially stable now sits with the PRA, while the FCA focuses on protecting consumers. ‘We have three subject specialists rather than generalists,’ Morris says, referring to the holy trinity of the the FCA, the Bank of England’s PRA, and its Financial Policy Committee, which identifies potential risks or threats to the stability of the UK banking system. ‘We have probably now got the most business-like regulators in the world.’

Second, the FCA is imposing bigger fines than its predecessor. Despite the FCA’s limited success in sanctioning individuals, the regulator has earned a reputation as ‘a credible enforcement authority’, according to Conceicao.

In 2014 fines levied by the FCA totalled over £1.4bn, trebling from £474m in 2013, according to data compiled by City law firm RPC. This mirrors record-breaking fines in the US.

Conceicao is cautious however about gauging the regulator’s effectiveness from the number or size of fines imposed: ‘The FCA is a regulator. Fines are imposed when things have gone wrong. This may be a measure of enforcement activity but it doesn’t make it a measure of successful regulation.’

Third, the FCA is more intrusive and interventionist than the FSA was. For example, in a 2008 internal audit report the FSA admitted it had failed to properly supervise the now defunct British bank Northern Rock, Morris says.

‘The FCA are taking a much more active role in the supervision of [financial] firms,’ Aron says. ‘We are seeing more willingness to question, and less willingness to sign off on things that before they might have said was a matter for the firm. There’s more push back than we saw pre-2008 and in my view that’s a very big change.’

The FCA is increasing the use of ‘early interventions’ – which is when it steps in to compel the firms it regulates to change potentially risky business models and products or face the risk of their business lines being closed or their licence revoked. Last year, payday lender Wonga agreed with the FCA to write off £220m of customer debt, change its lending criteria and appoint a ‘skilled person’ to supervise its lending decisions.

The FCA’s interventionism extends to investigation and enforcement. ‘We have definitely seen a change in approach,’ says Proudlock, who compares the FSA investigations into Libor rigging and the FCA probe into forex trading: ‘What we saw in the Libor scandal was that firms were allowed to run their internal investigations more or less independently and then hand over whatever they found to the FSA. In forex, the FCA took a much tighter grip over the process. For example, firms weren’t allowed to interview certain key witnesses, or they had to record them and provide the recordings of the internal interviews to the FCA.’

In some respects, the replacement of the FSA has led to an evolutionary rather than revolutionary change in how financial crimes and misdemeanours are dealt with.

‘There was a change of name and a split of functions between the FCA and the PRA, but I don’t think it was away with the past and in with the new,’ Proudlock says. For example, the FCA’s practice of requiring senior individuals to give personal ‘attestations’ of compliance was pioneered by the FSA in 2012.

‘Early intervention’ has become a powerful enforcement tool for the FCA, but the idea was first mooted by its predecessor in 2010 as a new approach to regulation to avoid a repeat of the recent financial scandals. Finally, it was the FSA which launched a formal investigation into Libor manipulation in early 2010.

However, there are still concerns, Ktorides says: ‘The FCA has work to do to convince people that it is really supporting business, because people feel there is an increase in regulation but not in proportionality.’

The number of investigations into firms that were closed with no public outcome doubled from seven in 2012 to 14 in 2014, according to Pinsent Masons’ research. The data appears to highlight the ‘shoot first, ask questions later’ approach of the FCA, as set out by chief executive Martin Wheatley on taking up the baton from the FSA (although he reportedly told the Treasury Select Committee he regretted using the phrase).

Michael Ruck, a financial regulatory expert at Pinsent Masons and former FCA case officer, suggests that criticism levelled at its predecessor ‘may be the result of the FCA starting investigations with minimal evidence and then closing them if it didn’t find the evidence it expected’.

But he adds: ‘The difficulty firms face is that they are under investigation for a relatively long period of time, they put in a lot of time and resources, and then the FCA says that it is not going to take any action. Firms are quite relieved but they have also spent a lot of money and may have had to make an announcement to the market.’

Following a review launched last May, the Treasury issued a number of recommendations in December, including the need for greater transparency during FCA and PRA enforcement investigations.

Regulated firms may welcome this, especially given that from April the FCA added competition powers to its armoury. ‘The regulatory and supervisory functions of the FCA will put it in a good position to detect anti-competitive behaviour, which is famously difficult to detect,’ Proudlock says. ‘It may have a knock-on effect to incentivise firms to look at their practices in that area.’

Ktorides says this could also mean an increase in dawn raids – further  prompting the need for legal advice.

Marialuisa Taddia is a freelance journalist