UK: The FSA’s Enforcement Review Recommendations: A New Approach For The Regulator?

Article by Alistair Graham and Sona Ganatra

This article first appeared on the Complinet Securities & Banking UK website on 5 October 2005.

It has been two months since the Financial Services Authority published the results of its five-month review into its enforcement process. The long awaited review was led by David Strachan in response to the Financial Services and Markets Tribunal’s well publicised decision in the Legal & General case. It centred on the regulator tightening its investigation and enforcement procedures, while also making these more transparent to all involved, and establishing strict separation between the enforcement division of the FSA and the Regulatory Decisions Committee, the decision making body of the FSA.

The consultation process on changes to be made to the FSA Handbook as a result of the review’s recommendations closed on 19 September 2005. Any resultant changes are due to be implemented by the end of the year (those recommendations that did not require changes to the Handbook were adopted with immediate effect).

At this important juncture, this article considers the recommendations that were made in the review and their likely implications.

Overall, the City welcomed the recommendations of the review, which represented a serious attempt by the FSA to improve the business community’s confidence in the regulator, address concerns that have arisen over the past few years and inject greater independence and objectivity into all levels of the enforcement process.

Having had time in which to reflect upon the recommendations, however, questions have arisen as to what impact the recommendations will actually have upon the regulator and whether the recommendations go far enough in tightening the enforcement process.

In its attempt to inject more formality and consistency into the process, the FSA has accepted that implementing the recommendations in the review is likely to make proceedings more costly for the regulator. It has, however, said this will not lead to higher direct costs for those who fi nd themselves the subject of investigation. Whether this is the case remains to be seen. Nonetheless, given the increased disclosure obligations on the FSA and the addition, for example, of the "independent" lawyers reviewing cases before they go to the RDC, it is clear that there will be a trend towards longer and, as a result, costlier investigations for all involved.

The recommendations certainly have gone far to address the issue of transparency and the business community’s fears that the decision making body is overly influenced by the enforcement case team, which leads the investigation into an organisation. There are, however, still shortcomings in the set up of the RDC, principally the fact that it still comprises part-time members who may not necessarily have the time to examine each case thoroughly; only time will tell whether the dedicated legal team for the RDC will result in the independent status that it desperately needs.

Moreover, certain recommendations, for example the additional review of cases by independent lawyers, raise more questions and concerns than they answer.

Of principal importance to organisations are the recommendations surrounding settlement. Everyone agrees that early settlement should be encouraged, not least because it reduces the time and resources spent on often lengthy investigations. The elimination of the role of the RDC in this process should help make settlement discussions more effective. But whether the discount scheme recommended for early settlement will result in more cases being settled is questionable. The level of fine, in practice, is not of importance for most organisations, whose main concern is publicity of its misconduct or contravention of the FSA’s principles and rules.

Although important changes had been introduced to the enforcement process as a result of the FSA’s "End-to-End" review in July 2004, the Strachan review recommended further key changes. Of significance was the Strachan review’s recommendation of an additional stage to the enforcement process whereby lawyers in the enforcement division who are not part of the investigating team will carry out a thorough legal review of a case before it is referred to the RDC to consider whether a warning notice should be issued.

How this will work in practice, however, is left unanswered. What is the time frame in which the "independent" lawyers must review the case? And how much time, realistically, will those lawyers have to review the case thoroughly, given that they are likely to have their own case commitments? What will happen if the independent lawyers disagree with the investigating team on an aspect of the case? Will this simply turn into a "rubber stamping" process? Moreover, at what stages will the independent lawyers be involved? Will their input be required during settlement discussions in order to provide a detached opinion?

All that is clear is that this will inevitably make the enforcement process lengthier.

Although the RDC will be retained, maintaining a clear separation between those who investigate possible rule breaches and those who decide whether the conduct in question should be sanctioned as is required by the Financial Services and Markets Act 2000, the review did recommend that the membership of the RDC should be reduced from 24 to 16. It also suggested that members and their case workloads should be increased to approximately 140 hours per annum. In theory, this slimming down should result in the members developing expertise in a wider range of cases and, therefore, more consistency in the RDC’s approach. The issue still remains, however, that the FSA’s decision-making body is made up of part-time practitioners and non-practitioners who may not necessarily have the time to examine each case thoroughly and who rely on documents and analysis drafted by the enforcement case team.

In the light of the tribunal’s criticisms of the RDC’s processes and its relationship with the enforcement case team, the review recommended "significant measures to strengthen the RDC’s objectivity".

Overall, such changes should be welcomed as they increase the transparency and objectivity of the current decision making process and enhance the business community’s perception of the RDC. These recommendations will, however, inevitably introduce greater formality into the decision-making process, and therefore increase costs.

Key measures are:

• The creation of a dedicated legal function to provide the RDC with legal advice and assist in its decision-making and in finalising draft warning notices and drafting decision notices. As a result, the RDC will no longer be dependent upon the enforcement case team for such support. Although the legal advice given to the RDC will still continue to be confidential, the fact that legal advice will now be given by a new team that is independent of the investigation should increase confidence in the RDC’s decisions.

• All substantive communications (whether oral or written) between the enforcement case team and the RDC will be disclosed to the organisation under investigation. This should result in organisations having a better understanding of the case they have to meet and will go some way to alleviate the business community’s fears that the enforcement division has too much influence over the RDC.

• The enforcement case team will no longer have direct access to the RDC after the conclusion of a representations meeting, without the representatives of the organisation under investigation being present. Any further submissions to be made, either by the case team or the organisation involved, will now be disclosed to the other party. Again, this is in response to the concerns over the perceived influence the enforcement case team had over the RDC.

• The RDC, with the help of its new legal function, will now draft decision notices which will set out how the RDC has dealt with the representations made by the organisation under investigation. These recommendations are already being implemented. The FSA has encouraged organisations currently under investigation to request disclosure of materials put before the RDC to date, and recent statutory notices published by the FSA on its web site contain details of the representations given by the organisation.

Currently, the RDC sets "settlement parameters" for the case team that is conducting the settlement negotiations with the organisation under investigation, and approves the terms of the settlement. If an agreement is reached, a settlement agreement is signed that provides for the issuing of a decision notice by the RDC in an agreed form.

The review accepted the criticism of many organisations that the RDC’s involvement in cases in which an organisation is attempting to settle by agreement is illogical, as it risks undermining the objectivity that the RDC may subsequently need to bring to a case should settlement negotiations break down.

The review rightly recommended that settlement decisions should be the preserve of the FSA executive (by the means of two decision makers, one of which will usually be the director of enforcement), having regard to the FSA’s statutory objectives. This leaves the RDC deciding matters only in the absence of agreement.

As well as ensuring fairness in the settlement process, this should theoretically make the process more effective. Only two decision makers are required and the fact that they may have day-to-day knowledge of the case in issue or, at the very least, day-to-day contact with the case team, means that they should be able to deal with issues arising out of the settlement discussion with greater efficiency. The review also recommended introducing an explicit discount structure in the level of financial penalty that would otherwise have been recommended to the RDC (which would ultimately make the decision on the level of penalty) for those organisations who settle their cases early in the proceedings.

The review provides as follows:

a) a maximum discount of 30 per cent of the financial penalty for those cases settled at "stage one", the earliest stage of the enforcement process

b) a 15 per cent discount for cases settled in "stage two" (which ends upon the expiry of the period for making written representations in response to receipt of a warning notice)

c) a fi ve per cent discount for cases settled before the decision notice is issued.

Such a discount scheme, in principle, is welcome as it recognises the benefits of early settlement for both the organisation and the FSA. Upon reflection, however, the discount scheme is not the significant incentive it appears to be at first sight.

Firstly, it raises the question: a discount from what? Given that there are no "maximum" penalties for different offences and there is not a significant body of cases available to use as precedents, it will be difficult for organisations to determine just how significant the discount will be. Moreover, it leaves the FSA open to criticism: organisations may fear that the FSA will take into account the discount scheme when making its assessment on the level of penalty proposed in settlement discussions.

Secondly, there is a danger of inconsistencies arising in the level of penalties given and the considerations taken into account between the RDC in contested cases and the executive in settlement cases. Although the review calls for the executive’s members and the RDC to have regular dialogue to ensure consistency in the penalties given in contested and settled cases, it will be a number of years before a regular pattern/guidelines can emerge.

Although early settlement has its advantages both for the regulator and organisations under investigation, the discount scheme as drafted may result in organisations prematurely agreeing to settle. The maximum 30 per cent offered only appears to be available in the period from commencement of an investigation until the FSA has: (i) a sufficient understanding of the nature and gravity of the misconduct or contravention to make a reasonable assessment of the penalty; and (ii) that assessment has been communicated to the organisation under investigation.

Significantly, the proposed changes to the FSA Handbook state that this communication of the FSA’s assessment of the penalty need not be in a prescribed form but may include the provision of a draft warning notice. This leaves scope for argument that organisations may agree to settle before even having had access to documents that the FSA has relied upon in deciding to commence disciplinary proceedings (which are accessible pursuant to the Financial Services and Markets Act 2000 after a warning notice has been issued) in order to take advantage of the maximum discount.

Finally, and perhaps most importantly, it is unclear whether the discount scheme will, in practice, induce organisations to settle early. In most cases, organisations are less concerned with the level of the fine than they are with the wording of the statutory notices, which set out the FSA’s findings on the misconduct or contravention of the organisation and which, crucially, are public documents. The wording of those notices is and will continue to be a critical factor in settlement discussions with the FSA, not the level of fine.

As the review’s recommendations concerning settlement require changes to be made to the FSA Handbook, they were the subject of the consultation process mentioned previously. It will be interesting to see the results of the process and how the recommendations for settlement are implemented at the end of 2005.

The same can be said for the review as a whole. In general, its recommendations are welcome and are a positive attempt to address many of the criticisms raised over the years and increase confidence in the FSA. But whether public perception of the regulator will change and whether the recommendations will result in the FSA adopting a more formalised, transparent and effective approach remains to be seen.