Not only are we in a climate that sees enforcement action becoming more and more prevalent, we are increasingly seeing the battle lines for future enforcement being drawn as the new regulatory regime approaches.
This issue includes a contribution on US enforcement from our colleagues in Mishcon's New York office; there is no doubt that the regulatory regimes of the UK and US are overlapping and have a significant impact on one another in this global economy.
We hope you find our thoughts useful.
On the Horizon
FSA makes its views known on early publication of Warning Notices
In Enforcement Watch 5 “FSA pushes for enhanced FCA powers”, we commented on the FSA's written submissions to the Joint Committee on the draft Financial Services Bill.
We highlighted in particular areas that, if they went through, were likely to have a real impact on enforcement/contested applications in future. One such area related to the publication of Warning Notices.
We believe that publication of Warning Notices will carry great risks for the subjects of enforcement action. In its written submissions, the FSA argued that the publication proposal did not go far enough. Specifically, it objected to the requirement for the FCA to consult the subject of the Warning Notice before publishing. It stated that most subjects were likely to object to details being published and it feared satellite litigation would result.
In her recent oral evidence to the Joint Committee, Margaret Cole (Interim MD of the FSA Conduct Business Unit) added some further colour to this position, emphasising:
- the proposal was only to publish fairly limited details;
- this is consistent with what happens in civil process generally, and it would be in the interests of transparency and consumer protection;
- many firms take the view that they have to announce details of ongoing FSA enforcement action to the market in any event;
- it would counter the suggestion that the regulator has closed door processes;
- the need to consult in every case before publication erodes and undermines the use of the power;
- consultation would lead to satellite litigation in every single case.
In the context of the reputational risk that firms may face from publication, it was put to Margaret Cole that the Practitioner Panel had suggested that approximately 30% of Final Notices do not bear a great deal of resemblance to the associated Warning Notice. Her view was different. Margaret Cole first pointed out that they only intended to publish brief details of Warning Notices, suggesting then that this should not be a concern. Further, she said that, where the matter was being defended, only about 5% of cases where there was a Warning Notice did not subsequently proceed to a Decision Notice.
In our view, in an industry where trust can be key, publication in relation to Warning Notices has the scope to cause huge business detriment, regardless of the level of detail published. Indeed, there have been high profile examples of business destruction when it has become known that the FSA is investigating. If it turned out that the Warning Notice was unfounded, a business may have been lost unnecessarily. We do not agree that there should be any publication relating to Warning Notices. If the proposal is enacted that details relating to them can be published, our view is that the FCA must consult the subject of the Warning Notice in order to understand the impact on the particular business.
The Joint Committee seems to share Margaret Cole’s view (see “The Joint Committee reports on draft Financial Services Bill”), but the Treasury Committee does not (see “Treasury Committee publishes report into FCA”). The Government has since published the Bill (see “Treasury publishes Financial Services Bill”) and has stuck to its original proposal, permitting publication of details, but only after consultation. This is a hot topic and we shall have to see where it ends up.
FSA’s focus on NEDs in retail arena a shape of things to come
The FSA is looking to adopt a step change in the supervision of retail conduct, with its supervision in this area to become more intensive and intrusive. One reason is no doubt because it does not consider that firms are treating conduct as a strategic issue at a senior level.
Against that background, in December 2011, the FSA ran a conference for Non Executive Directors, focussed on retail conduct issues. This was quickly followed by the FSA’s consultation on proposed guidance for NEDs on their role in ensuring customers are treated fairly.
Currently, the FSA has all manner of high level rules about senior management responsibility, but nothing that in any way approaches the quite full detail set out in these speeches and the proposed guidance. Although only guidance, the proposed text uses phrases such as “we expect NEDs to consider…” and “a NED should…”. These have an air of prescription about them. If this wording is adopted following the consultation, our view is that this will come to be treated as a Code of sorts, and that it will be the yardstick against which NEDs are judged.
If the NED guidance is produced, we see it as giving rise to enforcement action in the (probably quite distant) future for a variety of reasons, such as:
- the more intensive and intrusive supervision highlighted above;
- the FSA’s push for “personal accountability”. This is especially against a backdrop of the continuing agenda of credible deterrence and the lack of individual scalps in respect of a number of high profile failures;
- the focus on treating customers fairly is intensifying; and
- the FSA’s stated expectation that NEDs must play a pivotal part within firms’ governance by ensuring firms are meeting their regulatory responsibilities.
Individuals will no doubt have pause for thought before accepting a NED position, particularly in these times. In one sense, however, they may find their responsibilities in the retail arena easier to achieve with increased guidance from the FSA. What they must do, however, is to ensure (i) that they are fully familiar with what the FSA puts out in relation to their role and (ii) that they use it to assist them. Given the direction of travel, NEDs may well in future face enforcement action in the retail industry. If they do, the new guidance is likely to form a key part of any action.
FSA report on RBS failure opens up enforcement debate
The FSA has now published its long awaited report into the failure of RBS. The report is voluminous and touches on a variety of areas. It makes interesting reading, not least because in some respects it is as much about the failures of the FSA as it is about the failures of RBS. For current purposes, however, we focus on the enforcement aspects of the report.
With the fudged exception of the public settlement with Johnny Cameron covered in Enforcement Watch 1 (see “The FSA do a deal with Johnny Cameron (RBS)”), there has been no sanction/public censure of any senior RBS executive or Board Member in connection with the Bank’s failure. The FSA is plainly acutely aware of public disappointment in this “failure”.
It appears that Enforcement’s investigations into the collapse of RBS focused on three areas:
- Decision making and controls within RBS’ Global Banking and Markets. The losses suffered by this Division (whose head was Johnny Cameron) were exacerbated by the sub-prime debt crisis and by the expansion of this aspect of the business in 2006.
- The decision to acquire ABN AMRO.
- The preparation of investment circulars by RBS in connection with the acquisition of ABN AMRO and with equity issuance exercises.
The Report states that Enforcement’s focus during its investigations was the possibility of action against individuals within the Bank, rather than against the Bank itself. The FSA’s view was that action against individuals would send a clearer message to market participants about accountability than imposing a sanction on a (failed) bank. However, Enforcement clearly had difficulties in marrying up their desire to send a strong message to the market with the legal regime in which they operated. In his foreword, Lord Turner explains the legal difficulty in bringing enforcement action. First, he explains that there is no provision for no-fault (“strict”) liability for board members of Banks. Second, he states that decisions taken by a Board which are, in hindsight, commercially unwise cannot give rise to sanction in the absence of a decision which is unreasonable or clearly deficient.
In order to illustrate this point, it is worth considering the Report’s discussion of the RBS Board’s decision to acquire ABN AMRO11. There is criticism of the Board for making its decision on the basis of inadequate due diligence of the target (remarkably the due diligence appears to have been no more than obtaining two lever arch folders and a CD ROM). The Report states that while the Board can be criticised for oceeding with such inadequate due diligence, an enforcement case for inadequate due diligence would have “minimal chances of success given that there are no codes or standards against which to judge whether due diligence is adequate, and given that the limited due diligence which RBS conducted was typical of contested takeovers.” In short, it appears that the FSA concluded that it would not be able to establish that the decision was outside the bounds of reasonableness.
What this all leads to is a debate about whether the law ought to be changed to make sanctioning of executives easier in these circumstances.
In his foreword, Lord Turner raises the possibility that banks ought to be treated differently because of the risk they pose to society and the taxpayer in the event that they fail. He argues that there is a strong argument for new rules which ensure bank executives and Boards place greater weight on avoiding downside risks. He raises two possible reforms:
- Strict liability for poor decision taking. He recognises that this may create injustice and face human rights challenges;
- An automatic incentives based approach. For example, Lord Turner suggests executives of failing banks might be automatically banned unless they could demonstrate the action they had positively taken (in other words, not strict liability, but at least a presumption of guilt without needing a hearing). Alternatively, he talks about the strengthening of deferral and forfeiture remuneration structures designed to penalise them. Lord Turner notes however that these may not amount to sufficient disincentive.
He concludes that the options to achieve his goals merit careful public debate. Indeed, there has already been some.
For his part, giving evidence to the Joint Committee on the draft Financial Services Bill on 10 November 2011, Hector Sants (CEO of the FSA and CEO designate of the PRA) appeared to doubt the desirability of a regime based on strict liability. In his evidence, he struck a real note of caution about bringing action against executives for making decisions which, with hindsight, are not seen to have been the best option to have chosen. Whilst still stressing full accountability for actions taken, he envisages that such an environment would effectively kill off the possibility of achieving forward based regulation.
Serious Fraud Office Director Richard Alderman argues that the absence of any finding of individual responsibility at RBS means that the law should be changed. However, he has raised the stakes. His proposal is for a change to the criminal law to introduce an offence of being recklessly involved in or running a financial institution. This seems to ignore the real likelihood that, had Enforcement been able to establish that senior management of RBS had been reckless, FSA enforcement action could have been brought against them.
The Government recognises that some of the options would represent a radical change and has since said that the Treasury and the FSA will publish a joint consultation document on the topic in the spring. The debate on the regime for punishing individuals is set to run.
11 This was the most significant of the decisions under review by Enforcement and was one of six factors identified by the FSA as giving rise to the failure of RBS
The Joint Committee reports on draft Financial Services Bill
In June 2011, the Treasury published a draft Financial Services Bill, largely consisting of amendments to FSMA, the Banking Act and other statutes. Shortly thereafter, the Joint Committee was appointed to consider and report on the draft Bill. That Report was published in December 2011. The Report is wide-ranging, and we focus on three aspects particularly relevant to enforcement matters.
First, there is the issue of early publication of Warning Notices. We discuss in fuller detail in this issue (see “FSA makes its views known on early publication of Warning Notices” and “Treasury Committee publishes report into FCA”) the significance of the early publication of details relating to Warning Notices - we set out our views on it, the views of the FSA, and the views of the Treasury Committee. The Joint Committee effectively sided with the FSA, and it made a different recommendation from that made by the Treasury Committee. The Joint Committee agreed that details relating to Warning Notices could be published, and it recommended removal of the requirement to consult before disclosing. It thought, however, that the FSA should be required to publish guidance as to how it will exercise its discretion in respect of disclosure. The Treasury has since published the Bill (see “Treasury publishes Financial Services Bill”. It has left its proposals as they were – an ability to publish details, but only after consultation with the person concerned. The issue of publication of details relating to Warning Notices is critically important in enforcement, and the debate is set to run.
Second, the Joint Committee comments on appeals from decisions of the regulator to a different, more judicial body, the Tribunal. In certain cases, the draft Bill provides that, if the Tribunal chooses not to uphold the decision of the regulator, it will not usually be able to substitute its own decision, but instead will have to refer the matter back to the regulator so that it can reconsider. This would not for example be the case in disciplinary matters, but would for example be the case in supervisory action taken in pursuit of wider public policy aims (eg a decision to vary a person’s permission to carry on regulated activities). There are plainly potentially concerns about this. For example, if the Tribunal cannot substitute its own decision, the review might look toothless. Nevertheless, the Joint Committee agreed with the proposal in the draft Bill, arguing that the regulators were better placed to reach an informed judgment. If enacted, this would, in our view, be regrettable. The dangers of the regulator as investigator, judge and jury are obvious, and they are all the more potent as the regulator becomes increasingly aggressive. Nevertheless, the Government has since elected to retain this proposal in the Bill (see “Treasury publishes Financial Services Bill”).
Third, in light of the FSA’s report into the RBS failure discussed elsewhere in this Issue (see “FSA report on RBS failure opens up enforcement debate”), it is worth commenting briefly on the proposals regarding reports into regulatory failures. In general terms, the Joint Committee is happy that it should be standard practice to publish a report after a major regulatory failure. One interesting aspect is how the requirement to report on regulatory failure interacts with ongoing enforcement action. Whilst the Joint Committee does not address the underlying way to deal with this, it recommends that the impact on other regulatory activity (including enforcement action) be taken into account when deciding on the conduct of a regulatory failure investigation. In the Bill it has since published, the Government has taken on board the recommendation (see “Treasury publishes Financial Services Bill”). Depending on how this all plays out, we may well find that, despite public clamour for a report, the report is long delayed by enforcement activity.
Treasury Committee publishes report into FCA
In September last year, the Treasury Committee announced an inquiry into the new Financial Conduct Authority (the FCA). Between October and December, it held four evidence sessions as part of its inquiry.
On 13 January this year, it published its report. The report summarises various key parts of the evidence and makes a number of recommendations for the Government’s consideration ahead of the drafting and publication of the new proposed legislation. We highlight two areas of particular interest coming out of the report.
The first relates to communications between the regulator and firms. The Treasury Committee emphasised that it was essential for the FCA to improve communication with firms. One particular aspect it stressed was that greater steps should be taken to ensure that when formal regulatory material is released by the FCA, it is clear to firms what is expected of them. For example, it discouraged the culture of "regulation by speech". It recommended that if regulatory material was released in this way, the regulations concerned should also be clarified in adequate detail at the time to all firms affected. In our view, this is to be welcomed. Where firms do not properly know what is expected of them, they are susceptible to enforcement action based on vague notions or high level principles.
The second concerns the early publication of Warning Notices, a topic we have commented on in previous Issues of Enforcement Watch. In this edition of Enforcement Watch, we set out our detailed concerns about the risks of early publication of Warning Notices, and we set out the views of the FSA on the topic (see “FSA makes its views known on early publication of Warning Notices”). The Treasury Committee has set out its views.
The Treasury Committee expresses itself to be concerned that a general rule permitting the FCA to publish early Warning Notices in respect of specific firms (which in some cases could subsequently prove to be unfounded) risks unreasonable reputational damage for which there may be inadequate redress. It is mindful of the risk to natural justice as the regulator can be investigator, judge and jury. Accordingly, whilst Margaret Cole’s evidence was that the proposed power did not go far enough, the Treasury Committee recommended that the Government continue to consult on the proposed power to issue early Warning Notices. In fact, the Government did not take on board this recommendation when it published its Bill (see “Treasury publishes Financial Services Bill”. Instead, it chose to retain the ability to publish details about Warning Notices.
Treasury publishes Financial Services Bill
The Treasury published its draft Financial Service Bill in June 2011. Between July and December 2011, the draft was subject to pre-legislative scrutiny (see "The Joint Committee reports on draft Financial Services Bill"). Following this scrutiny, the Treasury published the Financial Services Bill in January 2012.
The Bill is provisionally scheduled for a second reading on 6 February. The Government is looking for Royal Assent by the end of this year, with a view to the new system being operational in early 2013. We will have to see how it progresses in the coming months.
The Bill plainly covers a very wide range of matters. We comment in detail elsewhere in this issue on the treatment of three enforcement related issues during the pre legislative scrutiny phase (see "The Joint Committee reports on draft Financial Services Bill"). We set out below how they have ultimately been treated in the Bill.
First, there is the question of early publication of Warning Notices12. The Treasury notes that there were divided views on the topic. Whilst industry broadly opposed the power and called for further safeguards, the FSA and some consumer groups strongly supported it, calling for the removal of the need to consult before publication. The Government concluded that its proposal in the draft Bill struck the right balance. It has left its proposals unchanged. Accordingly, the Bill allows for details to be published but requires the person in question first to be consulted.
Second, there is the question of appeals from decisions of the regulator to the Tribunal (a more judicial body). The draft Financial Services Bill proposed that, in some cases (non disciplinary matters and those involving specific third party rights), although the Tribunal could choose not to uphold the decision of the regulator, it would nevertheless have to remit it back to the regulator for decision. Accordingly, the regulator would be making the decision, not the Tribunal. Whilst it appears that a number of respondents objected strongly to this, readers of this issue will see that the Joint Committee supported it. The Government has decided to retain its proposal. It believes that its proposal is consistent with the judgement led approach of the new authorities.
Finally, there is the question of reports into regulatory failures. Whilst recognising the importance of them, they note the Joint Committee recommendations about taking into account the impact reports may have on ongoing regulatory activity (including enforcement action). The Government has amended the relevant provisions accordingly.
12 This is the (in our view, controversial) new proposal to publish details of disciplinary action at a relatively early stage.
Spotlight on the US
US District Court rejects SEC/Citigroup Settlement Agreement
On 28 November 2011, Judge Jed Rakoff of the United States District Court for the Southern District of New York rejected a proposed settlement between the United States Securities and Exchange Commission (“SEC”) and Citigroup Global Markets Inc. in a strongly-worded fifteen (15) page opinion. (Judge Rakoff’s decision is available here).
Details of the Case
Although the SEC does not always commence a formal lawsuit against an alleged wrongdoer, in this case it chose to do so. The proposed settlement was presented to Judge Rakoff in the form of a Final Judgment concluding the lawsuit the SEC had commenced against Citigroup.
The SEC alleged in its lawsuit that Citigroup created a $1 billion fund with a substantial percentage of negatively projected assets, and then misrepresented those assets as attractive investments. At the same time, the SEC alleged, Citigroup took a short position in the same assets it was positively advertising. According to the complaint, this scheme allowed Citigroup to realise profits of $160 million while investors lost $700 million.
The proposed settlement would have prevented Citigroup from committing future violations of the Securities Act of 1933. It would also have required Citigroup to pay $285 million in disgorged profits, interest, and civil penalties, and to institute internal measures designed to prevent recurrences of the securities fraud perpetrated. On the other hand, Citigroup would not have had to admit or deny the allegations made against it. However, Judge Rakoff rejected the proposed agreement, finding that it was not in the public interest.
The standard of review applied by the Court was whether the settlement agreement is “fair, reasonable, adequate, and in the public interest,” emphasising the need for any agreement to protect the public. Because Citigroup did not admit or deny any of the allegations in the complaint, Judge Rakoff concluded there was no evidential basis upon which he could evaluate the proposed settlement agreement and determine whether it was in the public’s interest. Additionally, Judge Rakoff criticised the practice of accepting settlement agreements that do not include admissions, stating that such agreements “serve various narrow interests of the parties.” Specific to the agreement before him, Judge Rakoff noted that it was far more favourable to Citigroup (facing a charge only of negligence and a fine that was relatively small for the behemoth company) than to the SEC, and did almost nothing for the (allegedly) duped investors. The SEC has announced its intention to appeal Judge Rakoff’s decision.
Judge Rakoff’s rejection of the settlement is in and of itself significant. The fact that the SEC has decided to appeal the decision indicates just how seriously the SEC is treating it. If the decision is upheld by the Court of Appeals, it may have significant repercussions for future SEC settlement agreements, especially for the region over which the Court of Appeals presides (known as the Second Circuit - the region includes the states of New York, Connecticut, and Vermont). For example, an upholding of Judge Rakoff’s decision may end the practice of defendants neither admitting nor denying allegations.
SEC to step up use of Deferred Prosecution Agreements
In January 2010, as part of its Enforcement Cooperation Initiative, the United States Securities and Exchange Commission (“SEC”) announced that it would begin using “deferred prosecution agreements,” or DFAs.
A DFA is a formal written agreement in which the SEC agrees to forego an enforcement action pursuant to the terms of the specific agreement in exchange for cooperation from the potential defendant and compliance with certain prohibitions and undertakings. Cooperation by the target (the key to the SEC’s decision on which enforcement mechanism to employ) has four components:
- self-policing prior to discovery of misconduct;
- self-reporting of misconduct and conducting a review of the circumstances;
- effective remediation; and
- cooperation with law enforcement authorities following discovery of the misconduct. (More information on DFAs is available here).
In May 2011, the SEC entered into its first DFA for violations of the U.S. Foreign Corrupt Practices Act (“FCPA”). The SEC alleged that Tenaris SA had bribed Uzbekistani government officials during a bidding process for a contract to supply oil and gas pipelines. Tenaris won the contract and according to the SEC made almost $5 million in profits. In exchange for the deferred prosecution, Tenaris agreed to pay $5.4 million in disgorgement and prejudgment interest, as well as a $3.5 million criminal penalty agreed to in a Non-Prosecution Agreement entered into with the U.S. Department of Justice. It also agreed to institute enhanced due diligence requirements relating to the retention and payment of agents, to provide FCPA-related training, to require certification of compliance with anti-corruption policies, and to notify the SEC of any complaints or charges against Tenaris or its employees related to corruption or bribery laws. (Additional information on the Tenaris DFA is available here.)
The SEC decided to enter into a DFA with Tenaris because of the company’s proactive response to its discovery of the bribery. Tenaris learned of the bribery during an internal review and promptly informed the SEC. On its own, the company instituted new anti-corruption practices and policies. Tenaris also fully cooperated with the SEC’s subsequent investigation, and promised future cooperation.
The SEC has stated that it intends to use DFAs more in the future because of their benefits in obtaining cooperation from potential defendants. It remains to be seen just how prevalent the use of DFAs will be in the coming year (and in future years).
For the companies in question, the availability of DFAs can plainly be beneficial as they provide an opportunity for them to avoid prosecution.
However, DFAs carry risks for an accused company. For example, unlike a traditional settlement agreement, a DFA does not rule out future prosecution. Rather, the deferral only remains in place for as long as the accused company continues to cooperate with the SEC to the SEC’s satisfaction. Any further perceived or alleged violation by the company could cause the SEC to terminate the DFA and prosecute its case.
Dodd-Frank Whistleblower Provision
Section 992 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (commonly known as “Dodd-Frank”) provides for payment of an award to any individual who voluntarily provides the SEC with information leading to a successful enforcement action with sanctions of more than $1 million. The award can be anywhere from 10%-30% of the total sanctions collected by the SEC or any related criminal case. The rules governing the whistle blower provision took effect in August 2011.
A critical issue that was debated was whether the whistleblower should be required to first report the alleged SEC violation internally to the firm’s compliance department. Not surprisingly, major corporations and their counsel advocated strongly for such a requirement. The final version of the provision contains no such requirement, but does leave open the possibility of a higher payment to a whistleblower who initially reports internally.
In the first seven weeks of the programme (August 12 - September 30, 2011), the SEC received 334 tips from individuals both inside and outside the United States. To date, no award payments have been publicised by the SEC. Additional information on the programme and how to report tips is available at:
Whistleblower provisions are a common feature of U.S. federal legislation. For example, in addition to the provision in the Dodd-Frank Act, whistleblower provisions are also included in the Federal Claims Act and certain major federal labour laws. Indeed, the existence and use of such provisions has become more prevalent in recent years as payments to whistleblowers have become larger. With respect to the Dodd-Frank whistleblower provision, it is likely that plaintiff-side attorneys will seek to exploit the provision in a similar way to how they have done in equivalent provisions in other federal legislation. We would expect to see a significant increase in the amount of litigation brought pursuant to this provision in years to come.
Dear CEO letters and client money breaches lead to substantial fines
14 September and 5 December 2011:
The FSA has recently handed out two large fines as a result of failures relating to client money. Integrated Financial Arrangements PLC (Integrated Financial) has been fined £3.5m and Towry Investment Management Limited (Towry) has been fined £494,900. They would have been fined £5m and £707,000 respectively, but each was reduced by 30% for early settlement.
Details of the cases
As part of its thematic review into client money, the FSA sent relevant firms a Dear CO letter in March 2009. In January 2010, the FSA then sent a Dear CEO Letter enclosing a Client Money and Assets Report. The letter asked firms to ensure the report was properly considered, including at Board level, and asked firms to confirm they were fully compliant with the client money and asset rules.
Integrated Financial: Integrated Financial is the UK's biggest wrap platform, which allows independent financial advisers to consolidate their clients’ portfolios in a tax-efficient way under one administrative umbrella. The average amount held by Integrated Financial as client money between December 2001 and June 2010 was £508m.
The FSA visited Integrated Financial in May 2010. It concluded that Integrated Financial had failed to put in place adequate risk management systems in relation to client money. The visit for example revealed that the firm had failed to perform client money calculations to check whether its client money resource was at least equal to its client money requirement. As a consequence, Integrated Financial failed to fund any shortfall in its client money bank accounts.
Further, the FSA found for example that in relation to three of its 28 client money bank accounts, Integrated Financial failed to put in place adequate trust documentation to ensure that client money was protected.
No clients suffered any loss or detriment as a result. Nevertheless, as a result of the firm’s failures, the FSA concluded that Integrated Financial had breached Principles 31 and 102, as well as the associated rules contained in the Client Assets Sourcebook (CASS).
Towry: Towry is an independent discretionary investment manager. It received money on behalf of its clients for the provision of a variety of investment and brokerage services. This money was subject to the requirements and standards set out in CASS.
Towry operated client money bank accounts under the normal approach to segregation, such that all client money was paid into those accounts. During the ten year period in question, Towry held an average of £50.6m of client money at any given time.
Towry responded to the January 2010 Dear CEO Letter only four business days after the FSA had sent it, stating that the firm was fully compliant. However, Towry failed to ensure that its response was properly considered before submitting it to the FSA. The reality was that the firm was not compliant; and this only became apparent after the FSA later discovered Towry’s breaches as part of a CASS thematic visit to the firm in November 2010.
The FSA found that Towry’s failure to provide an accurate response to the FSA was a breach of Principle 113. As to the client money failures, the FSA determined that Towry had breached Principle 102 as it had failed to protect its clients’ money adequately throughout the ten year period in question. In particular, it failed to:
- Perform timely reconciliations of its client money requirement against its client money resource;
- Maintain accurate records in respect of client money;
- Ensure that client money was properly segregated.
As in the Integrated Financial case, although there was no actual client detriment, Towry’s CASS breaches could have placed clients’ money at risk of potential loss or delay in distribution if the firm had become insolvent.
There are a number of interesting aspects that arise from these cases.
First, client money issues are not going away. Issues 2, 3 and 4 of Enforcement Watch covered the reasonably large number of client money cases in which the FSA has successfully taken action. The Integrated Financial and Towry cases show that client money is still very much on the FSA’s agenda. Moreover, the FSA was explicit that it would continue to take enforcement action against non compliant firms in this area.
Second, the way the cases came about is likely to be repeated in the future. The FSA is intervening earlier and the new FCA proposes to do the same. We have been consistently commenting that early intervention is likely to lead to increased enforcement actions, and that those actions are likely to come out of thematic reviews. These cases are yet further examples of this trend.
Third, the levels of the fines are of some significance. The majority of the above failings relate to a period before the imposition of the FSA’s new penalty setting policies that we covered in Issue 1, (see Enforcement Watch 1“Harsher Penalty Setting Introduced”). Accordingly, in both cases, the FSA set the penalty by reference to its previous rules. We pointed out in Issue 2 (see Enforcement Watch 2 “The FSA gets tough on the client money rules”) that whilst not a tariff or precedent, a fine based on 1% of the average amount of client money might for the old rules come to have some form of persuasive precedent value. In Towry, the headline figures incorporated a component representing approximately 1% of the average client money balances. In Integrated Financial, the fine was also calculated by reference to 1% of the average client money balances.
Finally, the breach of Principle 11 in relation to Towry is interesting. The FSA was explicit that Towry did not deliberately seek to keep information from it. Nevertheless, the FSA found that Towry’s failure properly to consider the FSA’s Dear CEO Letter before sending a clean response amounted to a failure to be “open and co-operative”. Dear CEO Letters need to be addressed with the utmost seriousness, and the utmost care needs to be taken in communications with the FSA.
1 Principle 3 states that a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems.
2 Principle 10 provides that a firm must arrange adequate protection for clients’ assets when it is responsible for them.
3 Principle 11 requires firms to deal with the FSA in an open and cooperative manner and to disclose anything relating to the firm of which the FSA would reasonably expect notice
Credit Suisse fined nearly £6m for SCARPs sales failings
25 October 2011:
The FSA has fined Credit Suisse (UK) Limited £5.95m for systems and controls failings in relation to its sales of Structured Capital At Risk Products (SCARPs4). The penalty would have been £8.5m had Credit Suisse not agreed to settle early.
Details of the case
Between January 2007 and December 2009, approximately 600 Credit Suisse customers invested more than £1 billion in over 1,700 SCARPs.
The FSA identified concerns during a routine supervisory visit in December 2009. This led to an FSA investigation. The FSA ultimately identified a number of serious failings in Credit Suisse’s systems and controls relating to the SCARPs sales. The failings included:
- Inadequate systems and controls to assess customers’ attitudes to risk;
For example, some of the terms contained in the booklet that customers were obliged to complete in order to determine their risk profile may not have been clear to inexperienced investors. Further, Credit Suisse could not demonstrate the interaction between a customer’s attitude to risk and / or its investment objective.
- Failing to take reasonable care to evidence adequately that the SCARPs it recommended were suitable in light of customers’ overall portfolios;
- Failing to put in place adequate systems and controls concerning the recommendation of leverage to customers;
- Failing to put in place adequate systems and controls concerning the levels of issuer and investment concentration within customers’ portfolios;
There was for example often no documentation to show that issuer or investment concentration had even been considered when transactions were recommended.
- Failure to monitor staff effectively to ensure they took reasonable care about the suitability of their advice.
For example, it was the responsibility of the Credit Suisse Team Leaders and Sector Heads to supervise the work of the Relationship Managers. Yet, in many instances, the number of Relationship Managers within the scope of oversight of a Team Leader or Sector Head was too high, or the relevant management had too many competing responsibilities. This restricted effective monitoring of the work carried out by the Relationship Managers.
The FSA considered that Credit Suisse’s breaches were especially serious: because of the significant amount of customers’ money placed at risk; due to Credit Suisse’s position as one of the leading private banks in the UK; the fact that the failings spanned 3 years; because of the failure to monitor staff effectively.
In sum, the FSA found that there was an unacceptable risk that customers were sold SCARPs that were not suitable for them. The FSA fined Credit Suisse £5.95m (reduced from £8.5m due to early settlement). It did not consider whether any individual advised sales were in fact unsuitable. But Credit Suisse has agreed to a review of sales and to provide redress to the extent sales were unsuitable.
As with the HSBC and Coutts cases reported on elsewhere in this issue (see “HSBC receives largest ever retail fine” “Coutts fined £6.3m for AIG Fund sales failings”), this is another unsurprising example of the FSA coming down heavily on suitability issues.
Suitability (and the ability to demonstrate it) is likely to continue to be a key area of risk in the wealth management industry. See in that context also our features in Issues 3 and 5(see Enforcement Watch 3 “The FSA sends a tough message on suitability” and Enforcement Watch 5 “Dear CEO letter to wealth managers suggests action to come”).
Although a heavy fine, the fine is only part of the picture. Credit Suisse is also agreeing to pay redress where unsuitable sales are found. The FSA says that this was taken into account in determining the level of financial penalty. The FSA gives no estimate of the likely cost of redress.
Readers may be interested also to read the judgment of Mr Justice Teare in the case of Zaki and Others v Credit Suisse (UK) Limited  EWHC 2422 delivered in October last year. This involved the unsuccessful attempt of a Mr Zeid to claim damages from Credit Suisse in respect of a number of structured financial products he purchased from them.
4 SCARPs are complex financial products that provide customers with an agreed enhanced level of income over a specified period, but which also expose them to the potential risk of losing some or even all of their capital.
Coutts fined £6.3m for AIG Fund sales failings
7 November 2011:
Coutts has been fined £6.3m (discounted from £9m for settling early) in relation to its failings concerning its sales of the AIG Fund. It will also compensate customers who have suffered a loss as a result of its failures.
Details of the case
Between December 2003 and September 2008, Coutts sold the AIG Life Premier Access Bond and Premier Bond, Enhanced Variable Rate Fund (“the Fund”) to 427 customers, with investments totalling £1.45 billion.
The Fund invested in financial and money market instruments. However, unlike a standard money market fund, it aimed to deliver an enhanced return by investing a material proportion of the Fund’s assets in asset backed securities and floating rate notes.
During the financial crisis, the market value of some of the assets in the Fund fell below their book values and, following Lehmans in September 2008, AIG’s share price fell sharply and suddenly. A large number of investors sought to withdraw their investments and there was a run on the Fund. As a result the Fund was suspended. Subsequently, (i) customers were permitted to withdraw 50% of their investment at full value (capital plus accrued interest) and (ii) to leave the remaining 50% in a protected fund until July 2012, obtaining at that stage the full amount of their investment, but only as it stood at December 2008. Those that did not follow this route suffered an immediate loss on the amount withdrawn.
Although the FSA found a large number of different failings in relation to Principle 95, they essentially fall into two categories:
- Failing to take reasonable care to ensure the suitability of its advice. A key contributor to this was that Coutts did not take the necessary steps to understand all of the Fund’s features and risks in order sufficiently to consider how they should be taken into account when it was being sold to customers.
- Failing to respond appropriately to issues affecting the Fund in the latter stages. Subsequently failing properly to investigate and address questions identified about its past sales of the Fund and then carrying out a compliance review that was inadequate.
Coutts was fined £6.3m, after taking account of a 30% discount for early settlement. In addition, Coutts agreed to implement a comprehensive past business review of its sales of the Fund overseen by an independent third party and to compensate all customers who had suffered loss as a result of its failings.
As with the HSBC and Credit Suisse cases reported on elsewhere in this issue (see “HSBC receives largest ever retail fine” “Credit Suisse fined nearly £6m for SCARPs sales failings”), this is another unsurprising example of the FSA coming down heavily on suitability issues. As we comment in the HSBC case, this fine is entirely consistent with the messages the FSA has previously been sending out on suitability (see Enforcement Watch 3 “The FSA sends a tough message on suitability” and Enforcement Watch 5 “Dear CEO letter to wealth managers suggests action to come”).
The main significance of the case is probably in the size of the fine and the allied compensation that Coutts will need to pay. These will no doubt be heeded by firms in the context of the FSA’s credible deterrence generally.
Additional take aways from the case are limited. One may simply be that firms should have a careful read of the Final Notice in case it helps highlight for them those aspects of diligence that the FSA finds acceptable and those that it does not. Beyond this, it is maybe significant to note that one of the factors that contributed to the seriousness with which the FSA regards the case was Coutts' failure properly to respond to the situation once issues had been raised. For example, in its compliance review, the checklist used by compliance was poor, as it was process driven and not customer outcome focussed.
5 Principle 9 states that a firm must take reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely upon its judgement
Failure to engage with responsibilities leads to Compliance Officer SIF ban and fine
18 November 2011:
Dr Sandradee Joseph, who breached Principle 6 whilst working as a Compliance Officer at a hedge fund management company, has received a £14,000 fine and been banned from performing any significant influence function.
Details of the case
In January 2008, Dr Joseph joined Dynamic Decisions Capital Management (DDCM), where she held the Compliance Oversight controlled function (CF10) and the Money Laundering Reporting controlled function (CF11).
In the wake of the collapse of Lehman Brothers, DDCM’s investment strategy for a fund it managed resulted in catastrophic losses (approx 85% of the fund’s assets under management between October and December 2008). With a view to concealing these losses, in late 2008, a senior employee entered into a number of contracts for the purchase and resale of a bond. Concerns were voiced about the bond.
DDCM’s prime broker was clearly one of those with concerns. It raised certain issues and terminated its relationship with DDCM. Dr Joseph failed properly to read the broker’s letter of resignation or to give adequate consideration to the matters raised in it.
In addition, two institutional investors raised serious concerns in a number of communications, copied into Dr Joseph. At one point, one set out its concerns about the legitimacy and provenance of the bond. Both submitted redemption requests.
The FSA concluded that, in her role, if Dr Joseph became aware of concerns that the firm was not complying with its regulatory obligations, she should have taken steps (i) to ensure those concerns were investigated, (ii) to verify if those concerns appeared to be legitimate, and (iii) if so, to take appropriate action.
In fact, the FSA found that Dr Joseph fell short in that she failed to act with due skill, care and diligence in breach of Principle 66. For example, what had been raised with her ought itself to have raised concerns (i) that DDCM was not complying with its regulatory obligations, (ii) that the bond was not a legitimate financial instrument, (iii) that an attempt was being made to commit fraud against DDCM and the fund, and (iv) that potentially a senior employee might have been guilty of serious misconduct concerning his honesty and integrity. She failed to act on clear concerns raised about the bond and sought to absolve herself of all responsibility for compliance at DDCM in relation to the bond. She relied for example on her mistaken belief that external lawyers had advised on the bond.
Dr Joseph was found to be not fit and proper; this was as a result of failures of competence and capability. She received a ban from holding any significant influence function. In addition, she received a fine of £14,000.
Because she agreed to settle during the course of the FSA investigation, she qualified for a 30% reduction on her penalty, which would otherwise have been £20,000.
Final Notices that come out of the FSA (as opposed to decisions from the Tribunal) can be frustrating for those not involved in the particular case. There is often a sense that there is significant detail beneath the surface that helped inform the outcome, but that will never see the light of day. This can especially be the case where the Final Notice is the result of settlement negotiations, as is this case with Dr Joseph.
So, all we have to go on in those cases is what appears in the public domain. In this case, it would be interesting for example to have more information on why the headline penalty figure was set at £20,000, where other serious cases have far higher penalties. (The Final Notice says that the financial penalty imposed is considered to be “proportionate in relation to the seriousness of the misconduct”). In addition, it would be interesting to know quite what discussions there were on the scope of the ban, where the FSA found competence and capability failings only, rather than integrity issues. Further, whilst Dr Joseph was a CF10 and CF11, and clearly owed obligations as such, she was not a director. It would be interesting to know how that in reality impacted the way she conducted herself.
As much as there is unknown material, what is clear, however, is that Dr Joseph fell obviously short of what was required and received a serious sanction as a result.
6 An approved person performing a significant influence function must exercise due skill, care and diligence in managing the business of the firm for which he is responsible in his controlled function.
HSBC receives largest ever retail fine
2 December 2011:
The FSA has fined HSBC Bank Plc £10.5m (after applying a 30% discount for early settlement). The fine was for inappropriate investment advice provided to elderly customers by one of its subsidiaries, NHFA Limited. In addition to the fine, HSBC estimates that the amount of compensation to be paid to NHFA’s customers will be approximately £29m.
Details of the case
NHFA was acquired by HSBC in July 2005. It was the leading supplier in the UK of independent financial advice on long term care products to help pay for care costs, with a market share in recent years approaching 60%. Between 2005 and 2010, NHFA advised 2,485 elderly customers to invest in asset backed investment products, typically investment bonds, to fund long term care costs. The products were sold to individuals entering, or already in, long term care; and in many cases these elderly customers were reliant on the investments to pay for their care.
A review undertaken by a third party of a sample of 421 relevant customer files found unsuitable sales in relation to 87% of the files. The FSA found that in breach of Principle 97, NHFA and HSBC failed to take reasonable care to ensure the suitability of NHFA’s advice to its customers. The sales process at NHFA failed to:
- provide a consistent approach to assessing customers’ attitude to risk;
- take into account all the relevant financial and personal circumstances of customers;
- give sufficient consideration to the use of other suitable forms of investment;
- provide customers with adequate suitability letters.
The FSA considered the failings particularly significant for a number of reasons. These included (i) the fact that NHFA’s customer base was particularly vulnerable (the average customer age was almost 83) and (ii) the mis-conduct occurred over a period of approximately five years.
HSBC is undertaking a past business review to determine whether customers of NHFA or their families are entitled to redress. In addition to the £10.5m fine, HSBC has indicated that it expects the amount of compensation to be paid to NHFA customers will be approximately £29m.
In one sense, this is another unsurprising example of the FSA coming down heavily on suitability issues. It sits alongside the £5.95m fine handed out to Credit Suisse on 25 October and the £6.3m fine handed out to Coutts on 7 November 2011 (see “Credit Suisse fined nearly £6m for SCARPs sales failings” and “Coutts fined £6.3m for AIG Fund sales failings”). Although not in the same markets, it is entirely consistent with the messages the FSA has been sending out on suitability (see Enforcement Watch 3 “The FSA sends a tough message on suitability” and Enforcement Watch 5 “Dear CEO letter to wealth managers suggests action to come”)
The fine, however, is the largest ever retail fine. It would have been £15m, but for a 30% discount for early settlement. In addition, the FSA points out that HSBC has been given full credit both for its proactive approach to addressing the failures and also for implementing a comprehensive redress package for customers. The suggestion is that, without these, the fine would have been significantly greater.
What is perhaps most interesting about the case is the relationship of NHFA to HSBC. HSBC acquired NHFA in 2005. However, the indications are that it was not properly integrated into the HSBC Group operations until some years later. For example, mis-selling was not detected until a review in 2009. The failures at NHFA emphasise the need for regulated firms to ensure that, where they acquire a new business, they implement appropriate systems and controls to manage and effectively oversee the new business’s activities. This includes positioning the new business in reporting structures that allow the wider group promptly to identify and monitor any risks associated with the new business.
7 Principle 9 provides that a firm must take reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely upon its judgement.
£2.8m fine for putting customers at risk of being treated unfairly
16 December 2011:
The FSA has fined Combined Insurance Company of America (CICA) £2.8m (after applying a 30% discount for early settlement) for failing to embed a culture that ensured its customers were treated fairly.
Details of the case
CICA sold accident and sickness insurance products on an advised basis via self-employed sales agents. During the period investigated by the FSA (April 2008 to October 2010), CICA had more than 500,000 policyholders and received £47 million in premiums in respect of the policies in question.
CICA was found to have breached Principle 38 and Principle 69 by failing effectively to manage its sales, claims and complaints handling processes to ensure customers were treated fairly. There were a whole host of systemic failings identified across the firm’s business, including:
- CICA’s sales agent recruitment and training procedures. For example: the recruitment procedures focused on the quantity rather than the quality of recruits; there were no minimum qualification requirements for its sales agents; employment references were not always obtained; the induction training did not include a robust method to measure each representative’s ability to complete a Demands and Needs Statement used to record customers’ requirements and reasons for the advice given.
- CICA’s sales agent attrition rate was consistently around 200% per annum and the average length of service in the period considered by the FSA was only three months. This created inexperience among the sales team that could impact on the quality of customer outcomes.
- CICA failed to implement adequate systems to ensure that its customers would receive suitable advice and be treated fairly. For example, there was insufficient room on the Demands and Needs Statement to record the full details of any policies which customers held with other insurers; the Demands and Needs Statement did not record sufficient information to enable advisers to assess customers’ ability to afford a product.
- CICA failed to put in place adequate controls around representatives’ behaviour. For example, it failed to take effective action against representatives who were the subject of customer complaints or found to have breached company rules.
- Sales agents were paid on a commission only basis, with insufficient emphasis on the quality of their sales. Whilst a sales agent’s commission was subject to a claw back if a policy lapsed within the commission earn-out period, CICA did not set quality targets nor undertake any root cause analysis as to why policies lapsed.
- CICA processed around 2,500 customer claims per month and, although it did monitor some of its claims handling function, it failed to put in place adequate controls to ensure that claims were handled fairly. There were no systems in place to use claims data to identify issues or drive improvements within the business. Nor was there any trend analysis in relation to declined claims.
- CICA failed to identify and record all customer complaints. There was no evidence that the firm used the findings of complaint compliance reviews to change its complaint handling operations. Management information provided to the Board failed adequately to show or explain numbers, trends, anomalies or issues. It instead focused on the cost of complaint handling.
CICA agreed to cease writing any new business as from 26 October 2010. It also agreed to a past business review to identify any customer detriment and to provide appropriate loss as a result of CICA failings.
CICA settled early and accordingly received a 30% discount, resulting in a fine of £2.8m. Without this discount, the fine would have been £4m.
It is no surprise that the FSA should fine a firm for failings of this nature, placing as it did its customers at risk of being treated unfairly. The interest in this case is perhaps three fold.
First, the fine is fairly substantial in itself. Further, it would have been a fair deal more if CICA had not already begun to take steps to address some of the issues and also agreed to conduct a past business review and to provide redress.
Second, whilst there has been much emphasis by the FSA on treating customers fairly, insurance cases have not tended to dominate the headlines.
Third, the FSA frequently co-operates with other regulators internationally. This case appears to be a less common case in that the FSA worked closely with its Irish counterparts. The Central Bank of Ireland has taken its own enforcement action for similar misconduct at the Irish subsidiary of CICA.
8 Principle 3: A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems.
9 Principle 6: A firm must pay due regard to the interests of its customers and treat them fairly.
Substantial fine for failure to avoid files being altered
17 January 2012:
The FSA has imposed a fine of £2,170,000 for failings by Direct Line Insurance Plc (Direct Line) and Churchill Insurance Company Limited (Churchill) to prevent files that the FSA had requested from being improperly altered.
Details of the case
The FSA initially identified a number of areas for improvement in relation to complaints handling at Direct Line and at Churchill (the Firms). It subsequently informed the Firms in February 2010 that it would undertake a sample review of closed complaint files to further assess effectiveness.
In preparation for this review, the Firms asked a major accountancy firm to do a sample review. 28% of the 110 files reviewed failed the assessment.
In response to this, in March 2010, senior management initiated their own internal review of closed complaint files with a view to ensuring that files were complete and to ensure that there had been no customer detriment. Senior management also arranged for the Firms’ customer relations management to carry out two conference calls during which they told staff about the 28% failure in the sample review and that this was unacceptable. During the calls, messages delivered included:
- A similar failure during the FSA's review, which was beginning soon, could lead to enforcement action for the firm;
- Staff should consider what they might do to ensure that files were in a state that would pass FSA inspection and if that required staff to review their closed complaint files, they were encouraged to do so;
- If staff took immediate action and changed things now, this would be an extremely positive result;
- Staff found not to be operating to the required standard would face disciplinary investigation; and
- Staff were reminded that the most important thing was to get the right outcome for customers
As part of the internal review, the Firms asked staff to add evidence that had been relied on in reaching a decision where that evidence was already referred to in the files. This was consistent with the FSA’s letter proposing a review. The Firms identified a significant risk that staff might make improper alterations to the files, and the Firms took steps to mitigate the risks. Nevertheless, some of these files included alterations of the type subsequently criticised by the FSA (see below) eg the addition of reference numbers.
The FSA then asked for and received 50 files for review. At this stage, no instructions were issued to staff with sufficient clarity that, whilst files should be complete (eg by adding evidence referred to in the file, but missing because held electronically), they should not be otherwise altered. It was particularly important that clear instructions were given because the earlier conference calls increased the risk that files could be altered improperly.
Following a detailed internal investigation by the Firms, it was subsequently discovered that 27 of the 50 files had been improperly altered before they were sent to the FSA, and seven internal documents were found to contain staff signatures forged by one member of staff. The majority of the alterations were found to be minor in nature eg addition of telephone voice recording numbers.
In sum, the FSA found the Firms to be in breach of Principle 210 because they failed to take adequate steps to ensure that the 50 files would not be improperly altered before they were provided to the FSA. The Firms settled the case at an early stage and therefore qualified for a 30% discount. Without the reduction, the fine would have been £3.1 million.
Although this is an atypical case, it of course comes as no surprise that files presented to the FSA should not be improperly altered. Nevertheless, there are a number of interesting features of this case.
First, it provides a certain amount of guidance about what the FSA expects firms to instruct their staff who are responsible for collation of evidence for the FSA. Firms would do well to read certain parts of the Final Notice with real care. It would be a shame if firms that would otherwise suffer no enforcement action in respect of the underlying subject matter did so simply for how they dealt with an FSA request.
Second, it is an interesting example of penalty setting. The penalty was set under the relatively new 5 stage process (see Enforcement Watch 1 “Harsher Penalty Setting Introduced”). This was a case with limited objective elements under the process. In effect, the FSA came to a figure based on a rather more subjective view. It decided on a level 3 degree of seriousness under step 2, and made no adjustment to this except for a discount for early settlement.
Third, the level of fine is substantial. In a case even where the majority of alterations are described as being minor in nature, this sends a signal about the significance of firm’s dealings with the FSA in a manner that guarantees the integrity of information. It should be read alongside the Towry case reported on elsewhere in this issue in terms of dealings with the regulator (see “Dear CEO letters and client money breaches lead to substantial fines”).
10 A firm must conduct its business with due skill, care and diligence