UK: Getting Personal – The FSA´s Perspective on Senior Management Responsibility - Securities and Banking Update May 2005

The importance of senior management responsibility is already evident in all aspects of FSA regulation. But as the regulator’s increased focus on individual responsibility starts to bite, we review areas for potential compliance failings and the serious consequences for senior management.

February 2005 saw the 10th anniversary of one of the most infamous events in banking history. The story of how one man’s actions ultimately led to the collapse of one of the most respected institutions in international finance is well known to all. In 1997, prompted by perceived failings in the regulatory system, the Chancellor announced his plans for the establishment of a single financial services regulator in the UK. Consequently much has changed in the regulatory sphere, particularly with regard to the responsibilities of senior management. Ten years on, as the FSA embarks upon its new round of Arrow visits we examine the issues surrounding the role of senior management in running firms, and provide a timely reminder to business leaders of their significant regulatory responsibilities.

Underlying principles – spirit rather than letter

Much of the debate taking place at the time the new regime was developed focused around how senior management can be held accountable, and whether it is possible to design requirements for senior management in business which would prevent similar failures in the future. Thought leaders in the spheres of corporate governance and business ethics also stressed the importance of business leaders accepting special responsibility for leading with strong principles, echoing the principles based regulatory approach eventually adopted by the FSA. The eleven principles for Businesses form the foundation of the FSA’s Handbook of rules and guidance, and as Dr Thomas Huertas, Director of the FSA’s Wholesale Firms Division, stated in a recent speech that firms are expected to "abide by the spirit of the principles as well as the letter of the rules". It is worth noting that enforcement cases have been undertaken on the basis of the principles alone, and that the FSA intends to move further in that direction in the future.

David Kenmir recently pointed out that the FSA must have due regard to the responsibilities of those who manage the affairs of regulated businesses. This approach is reflected in Principle 3 of the principles for Businesses, which states that a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems.

Dr Huertas, in stressing the importance of the FSA principles, also placed significant emphasis on the responsibilities borne by the executives who run FSA authorised firms. He stated that "it is senior management’s responsibility to control risks and assure compliance, not the FSA’s". A key part of the FSA’s role is to evaluate how well senior management are fulfilling their responsibilities.

The Approved Persons regime demonstrates the importance which the FSA attaches to certain key "Controlled Functions" within firms. Under the regime individuals performing roles with significant influence over the affairs of a firm, and certain roles which have a direct bearing on the affairs of customers require specific approval from the FSA. This includes governing functions (such as the CEO, partners and directors), significant management functions (such as heads of business divisions and operations) and systems and controls functions (such as finance, risk and Internal audit). Particular importance is assigned to the "required functions", including the functions of apportionment and oversight, compliance oversight, and money laundering reporting officer.

The apportionment and oversight officer should ideally be the person in charge of running the business, for not only is he most able to reduce the probability that problems will occur, but, in the eyes of the FSA, the buck stops with him. He should therefore have the authority to create and maintain robust controls, and to foster a control culture within the firm, such that "a shortfall in compliance is a bonusreducing or even career-shortening event, regardless of the offender’s seniority or talents" (Dr Huertas). Senior management needs to be sure that, where appropriate, all areas of their business have appropriate systems and controls, and that it is absolutely clear who is responsible for what. If there are any grey areas around who is responsible for what, these should be addressed; such gaps in an organisations’ governance structure are often only exposed when things go wrong, by which stage the damage has been done.

Underpinning the Approved Persons regime are the Statements of Principle and the Code of Practice for Approved Persons. The seven Statements of Principle cover the behaviour the FSA would expect to see by Approved Persons. Statements of Principle 5-8 apply specifically to those performing a significant influence function and state that such persons must:

• take reasonable steps to ensure that the business of the firm for which he is responsible in his controlled function is organised so that it can be controlled effectively;

• exercise due skill, care and diligence in managing the business of the firm for which he is responsible in his controlled function; and

• take reasonable steps to ensure that the business of the firm for which he is responsible in his controlled function complies with the relevant requirements and standards of the regulatory system.

The apportionment and oversight officer bears the responsibility for the clear allocation of responsibilities to members of the senior management team. Once it has been made clear who has responsibility for what, senior managers must then ensure that appropriate systems and controls are in place which enable operations to be properly monitored. The final Statement of Principle stresses the responsibility of an approved person for ensuring compliance with the "relevant requirements and standards" of the system – complying with Principles as well as the letter of the law.

The FSA have also provided a Code of Practice to provide guidance on what those principles mean, along with the sorts of behaviour the FSA would not want to see. Persons performing controlled functions are accountable to the FSA as well as to their firm’s management board. They should ensure that their job descriptions are up to date, that responsibilities and reporting lines have been clearly defined and documented, and that their monitoring of their team’s performance and compliance with regulatory requirements is adequately evidenced.

Supporting and reinforcing the Principles for Businesses and the Approved Persons Regime are the FSA’s requirements for fitness and propriety, and training and competence. These contain basic requirements such as the need to have an appropriate board or group of partners for your firm, and for them to have the right balance and mix of skills to run the firm properly. Of equal importance is the need for a good Training and Competence (T&C) regime. As the FSA stated in a recent speech, "for all sorts of reasons apart from regulation, training is absolutely necessary" (David Kenmir, December 2004). T&C is fundamental to the correct and efficient functioning of the systems and controls established by senior management – without competent and adequately trained staff, senior managers’ responsibilities are only half fulfilled. In the light of the increasing attention paid by the FSA to compliance in these areas, it is senior management’s responsibility to consider whether their firm meets such requirements.

The FSA’s Senior Management Arrangements, Systems and Controls rules (SYSC) create an obligation for the appropriate apportionment and allocation of all significant responsibilities among directors and senior managers, and appropriate systems and controls to be established and maintained. The requirements are high-level obligations which leave firms with flexibility about how to implement them. The requirements broadly cover the following areas:

• Firms must clearly allocate responsibilities;

• The business and affairs of the firm must be adequately monitored and controlled by the senior management of the firm; and

• Firms must record these arrangements.

• Systems and controls must be appropriate to the business;

• Firms must have clear reporting lines; and

• The governing body of the firm must receive sufficient information to allow it to play its part in identifying, measuring and controlling risks – this information must be relevant, reliable and timely.

The FSA’s statutory objectives relate to the fair treatment of customers, to the protection of consumers, to confidence in the financial system and to the use of that system in connection with financial crime. These objectives are reflected in recent FSA initiatives in areas such as anti-money laundering, misleading financial promotions and treating customers fairly. For example, the FSA Business Plan 2005/06 states: "we expect the senior management of firms to embed the principle of treating customers fairly into their corporate strategy, their firm’s culture and their day-to-day operations". In order to fulfill their responsibilities and ensure compliance in these areas, senior managers needs to ensure that they have adequate procedures, systems and controls in place for record keeping, remuneration, risk management and internal audit, as well as for the broader issues around business strategy and organisation. Not only does management need to establish effective systems and controls, they need to ensure that they are working, that they are actively monitored, and that they provide the relevant, reliable and timely management information necessary to control the risks faced by the business.

The importance of senior management responsibilities is evident in all areas of FSA regulation. Firms wishing to issue stock on the Stock Exchange are bound by Listing Principle 2 of the Principle for Businesses, which states that "an issuer must take reasonable steps to enable its Directors to establish and maintain adequate procedures, systems and controls to enable it to comply with is obligations"; this principle is seen as fundamental by the regulator. The issue is so far-reaching that it pervades other legislation and regulations beyond FSMA and the Handbook: Good corporate governance (Sarbanes-Oxley), and compliance with health and safety legislation, company law and insolvency law are all areas brought into the discussion of senior management responsibilities by senior FSA figures.

The types of issues which the FSA look closely at in assessing how well firms’ managements are fulfilling their responsibilities have recently been set out by the FSA as:

• The extent to which control and compliance is part of the culture of the firm, – or does pressure to "deliver numbers always" interfere with the duty of "right behaviour always"?

• Does the firm adequately resource its audit and compliance functions?

• Does the firm have independent nonexecutive directors on its board who challenge the management effectively?

• How strong a voice do the Approved Persons have in determining how the business is run, or are they discounted?

• If a breach of the rules occurs, how does the firm handle the situation? Does the firm ignore the breach, or even attempt to hide it?

• Alternatively, does the firm report the breach, discipline those responsible, and take measures to lessen the probability that such breaches will occur again?

Firms should bear in mind that the FSA places significant emphasis on firms taking a holistic approach to establishing a sound compliance culture in authorised firms. Speaking in 2003, the FSA’s Carol Serjeant stressed the importance of a robust compliance environment stating that "the compliance environment within a financial institution is a fundamental protection against the spread of poor standards of conduct. We view with particular seriousness misconduct that occurs in the context of a firms inadequate investment in compliance procedures, policies and training." As well as providing sufficient resource to the compliance function, senior management should endeavour to incorporate compliance into areas such as strategy and ethics, remembering that, in the light of the FSA’s statutory objectives and Principles for Businesses, Compliance is more than just a set of rules.

Recent enforcement activity has provided frequent and contentious reminders of the difficulties faced by senior management in ensuring compliance with the legislation. In a recent speech on enforcement in respect of breaches of senior management responsibilities, the FSA recently outlined its approach. The starting point involves issues of whether trust in respect of senior management is justified, and whether breaches have occurred despite the reasonable efforts of senior management. "Among the first things we look at is the compliance regime within the firm." If a firm, which has sufficient systems and controls in place to enable it to do so, identifies and reports a problem to the FSA, this is seen as a genuine effort to comply. Together with significant efforts from senior management to undertake remedial action, this is looked upon by the FSA as a significantly mitigating factor.

However, former Director of Enforcement at the FSA Andrew Proctor had this to say about breaches which are aggregated by a poor T&C regime, poor systems and controls, and a poor compliance culture: "Where we see a combination like this, we really hit the firm hard". Outlined below are some examples of the kind of compliance failings related to senior managements’ responsibilities that have been subject to FSA enforcement action in recent months.

Some issues to be aware of over the coming months include the FSA intensifying its focus and capabilities in the area of Market Abuse, and monitoring how senior management manage the implementation of the Market Abuse Directive. Another priority in the area of supervision will be managing conflicts of interest. Senior management should be asking itself how it knows that the conflicts it faces are being sufficiently addressed. Firms also face a raft of European directives such as the Markets in Financial Instruments Directive (MIFID) which also need to be considered and implemented when appropriate.

Each of the cases listed above involved, to a greater or lesser extent, failings in firms’ systems and controls. Whilst senior management bears the responsibility for ensuring adequate systems and controls are in place, in the past senior managers themselves have not always been taken to task over such failures. However, this is about to change. In his recent speech the former Director of Enforcement at the FSA, Andrew Proctor, stated that the FSA intends to "take very direct action against the senior management responsible for the failure to put in place a proper compliance culture, proper training and proper standards of competence". He went on to say that when breaches occur, the new focus on responsible individuals will lead the FSA to ask "whether or not there is evidence that the senior management failed to make a serious effort to put in place an adequate compliance regime. We [the FSA] will then ask ourselves why we should not take that individual through enforcement."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.