UK: FSA’s Enforcement Process Review

The Financial Services Authority ("FSA") has recently published its Enforcement Process Review ("Review"), stemming from criticism made by the Financial Services and Markets Tribunal in the Legal and General case and also adverse comments made over the conduct of FSA’s splits investigations. Led by David Strachan, FSA’s director of retail firms and sector leader for insurance, the proposal is to implement the recommendations – intended to ensure that the Enforcement process is seen as fair – by year-end.

The Review focuses on the operation of FSA’s decision-making power within the Enforcement process, especially the decision to commence disciplinary action reserved to the Regulatory Decisions Committee ("RDC"), an FSA Board committee separate from executive management. The Review did not consider the role of the wholly independent Financial Services & Markets Tribunal ("FSM Tribunal"), nor the criteria for taking Enforcement action.

FSA has taken on board many of the comments received from firms and legal advisers alike during the consultation phase and states that it has sought to make the Enforcement process more transparent, and to achieve a higher degree of consistency in the way cases are handled and decisions reached. Most important, it is proposed to increase the separation between the RDC and Enforcement division and to make Enforcement and the firm, or individual, under scrutiny more equal participants before the RDC. Overall the Review’s recommendations bode well for the industry, although it remains to be seen how these are applied and interpreted in practice.

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The Financial Services Authority ("FSA") has recently published its Enforcement Process Review ("Review"), stemming from criticism made by the Financial Services and Markets Tribunal in the Legal and General case and also adverse comments made over the conduct of FSA’s splits investigations. Led by David Strachan, FSA’s director of retail firms and sector leader for insurance, the proposal is to implement the recommendations – intended to ensure that the Enforcement process is seen as fair – by year-end.

The Review focuses on the operation of FSA’s decision-making power within the Enforcement process, especially the decision to commence disciplinary action reserved to the Regulatory Decisions Committee ("RDC"), an FSA Board committee separate from executive management. The Review did not consider the role of the wholly independent Financial Services & Markets Tribunal ("FSM Tribunal"), nor the criteria for taking Enforcement action.

FSA has taken on board many of the comments received from firms and legal advisers alike during the consultation phase and states that it has sought to make the Enforcement process more transparent, and to achieve a higher degree of consistency in the way cases are handled and decisions reached. Most important, it is proposed to increase the separation between the RDC and Enforcement division and to make Enforcement and the firm, or individual, under scrutiny more equal participants before the RDC. Overall the Review’s recommendations bode well for the industry, although it remains to be seen how these are applied and interpreted in practice.

FSA commences disciplinary action to punish a firm or an individually approved person with a fine and a public reprimand; FSA follows a variant of this process when seeking to refuse, or terminate, individual approval or to require a firm to take stated steps, such as to compensate investors. The Review is principally concerned with the process for taking disciplinary action against firms, and for that reason we concentrate on this topic.

If, following an investigation, Enforcement staff consider that disciplinary action is justified, they present the matter to the RDC to decide whether to commence disciplinary action by issue of a Warning Notice. The decision whether or not to issue a Warning Notice is taken by the RDC following a meeting with Enforcement staff and consideration of FSA’s investigation report, any response prepared by the firm and a case review paper containing legal and policy advice. Many firms expressed concern during the Review that this case review paper was not made available to them. The Warning Notice is the disciplinary charges, setting out the conduct that FSA challenges, the rules or principles allegedly breached and the proposed disciplinary action.

A firm that has received a Warning Notice will have at least 28 days in which to make representations to the RDC. These may be made orally, in writing or both, and the firm’s intention will normally be to persuade the RDC to change its mind and reduce the proposed fine or withdraw the Warning Notice. Where a firm makes representations, the RDC (and sometimes Enforcement staff) may ask questions, but will not normally challenge the firm’s representations or make any response.

After considering the firm’s representations, the RDC will reach a decision. This will usually take the form of a Decision Notice, which is FSA’s decision to uphold the original case and penalty, sometimes amended in light of the firm’s representations. More unusually, the RDC may issue a Notice of Discontinuance, indicating that it has been persuaded to abandon the case.

A firm or individual may, within 28 days of a Decision Notice, refer the mater to the independent FSM Tribunal, which considers the whole matter afresh and decides what action FSA should take.

Firms expressed concern during the Review that:

• FSA sets "enforcement priorities" that might result in FSA taking Enforcement action where use of a supervisory tool might be more appropriate

• they did not have access to, and so could not comment on, Enforcement’s case review and other FSA papers that could influence the RDC’s view

• Enforcement staff had too much influence over the RDC – they prepare the brief and advise the RDC on issuing the Warning Notice, attend the firm’s oral representations and then give further commentary and advice on the issue of a Decision Notice

• the same RDC that had decided to issue the Warning Notice would usually hear the firm’s representations and decide on the Decision Notice, creating the impression that it had already made up its mind before the hearing

• the Decision Notice often did not reflect points made by the firm in its representations to the RDC.

FSA has kept its Enforcement process under continual review, and in July 2004 completed its end-to-end process review. Principally intended to speed up and simplify processes rather than to protect firms, its main recommendations were the implementation of a faster process for referring cases to Enforcement for investigation and shorter time targets for each stage of the process. The Review addresses a different purpose – how to appear fairer to firms while remaining efficient.

Although FSA considers that its current procedures fully meet statutory requirements, it has clearly recognised the importance of addressing the concerns expressed by many firms that they are not always treated fairly while in Enforcement. The Review has therefore recommended several core changes to the Enforcement process, both to increase separation and transparency between Enforcement and the RDC, and also to make the FSA more accountable and open to firms during the Enforcement process. FSA also confirms that investigations must be of the highest quality and the evidence must properly support the breaches alleged. These changes have enhanced the process, rather than radically changed it, and can be summarised as follows. Some changes can take effect immediately while others – principally those concerning formal decision-making and the penalty discount scheme – require consultation (see CP05/11) and are expected to be implemented by year-end.

The Review states the importance of FSA maintaining consistency within each of the referring divisions of Supervision and across the FSA in applying the criteria for whether or not disciplinary action should be taken. The delivery of a consistent approach is already assisted by Enforcement Relationship Managers ("ERMs") who interface between Supervision and Enforcement, and the Review recommends that a forum be established where the ERMs’ Supervision counterparts can share good practice with them. There should also be a fuller description of the responsibilities of ERMs and their counterparts in Supervision and FSA should draw up procedures in relation to the Supervision-Enforcement interface to promote a consistency of approach. The Review also assures firms that, once Supervision informs a firm that it will not be referring a matter to Enforcement, that decision will not be reviewed in the absence of any new information.

The key concern among firms was that the RDC relies on undisclosed confidential legal and policy advice from Enforcement in making its decisions and is, therefore, not receiving an impartial view of the case. The Review recommends that the RDC has its own team of legal advisers who will conduct a legal case review to help the RDC reach an impartial and objective view and, when appropriate, challenge the Enforcement view. This legal team will additionally assist the RDC if the case goes before the FSM Tribunal.

A further recommendation is that the RDC no longer takes part in settlement negotiations and only deals with the contested cases. This should address the concern that a firm cannot hold "without prejudice" settlement negotiations with the RDC because it remains responsible for deciding the case. Only FSA senior staff and the firm will now take part in settlement negotiations.

It is proposed that where a firm makes representations to the RDC following issue of a Warning Notice, the panel should include two new members additional to those who agreed to issue the Warning Notice. This is a welcome development, as it will help to overcome firms’ fear that seeking to persuade the RDC to change its mind is an uphill struggle. The actual composition of the RDC panels should be a matter for the Chairman or Deputy; at the Warning Notice stage it consists of both of them and two other members and, at the decision-making stage, two further new members will now be brought in.

While FSA considers that current procedures are adequate to explain FSA’s case to firms and disclose the underlying evidence – a number of firms might disagree! – the Review makes a significant recommendation intended to create a clearer perception of a "level playing field". This is that all substantive communications between the Enforcement case team and the RDC, whether oral or written and including the case review paper, but not material containing FSA or third party confidential information, should be disclosed to the firm. This will remove the inherent unfairness of a firm having to address the RDC in ignorance of what FSA has said about it. Legal advice that the RDC receives will, like a firm’s own legal advice, be privileged and normally non-discloseable.

Another key proposal is stopping the practice of Enforcement staying behind after a firm has made oral representations to discuss them with the RDC. This is particularly welcome as firms feel that it is unfair for Enforcement to enjoy greater access to the RDC than they do.

It is envisaged that, under the new procedures, the RDC representations meeting will be "livelier" than at present with more interaction between the RDC, firm and Enforcement. It should also be more focused because the RDC will give an indication of the key issues, as set out in the parties’ submissions, that it would like clarified at the meeting. This is also welcome because firms often feel that, without any response from the RDC, they cannot tell if their points are being understood, let alone agreed. In addition, either party will be able to make further submissions following the hearing and, if so made, these will be disclosed to the other party. The RDC will remain master of the procedure for the oral representations meeting, and the Review puts down a reminder that this meeting is not intended to be overly formal or adversarial, and that witnesses will not be heard.

Lastly, the Decision Notice should deal with the key points made by a firm when making representations to the RDC after issue of a Warning Notice.

The Review recommends that, no later than two months after the conclusion of an Enforcement case, FSA should usually offer those concerned the opportunity to comment on their experience of the procedure and the decision-making. Perhaps unsurprisingly, this will concentrate on the handling of the practical and procedural aspects of the case rather than its outcome.

As part of the Review’s drive to achieve greater transparency, it has recommended that further information is placed on FSA’s website about the operation of the RDC and its makeup, together with statistics on the number of cases it has completed and those where it has disagreed with Enforcement.

The Review paper also confirms FSA’s stance on the Enforcement process in a number of areas. While the overall practice and policies are unchanged, FSA’s explanations and clarifications help further to demystify the process. These areas include:

The Review has confirmed that FSA will retain its risk-based approach, and will continue to focus its limited resources on issues likely to have the greatest impact on its statutory objectives, as opposed to pursuing every rule breach. Selective use of the Enforcement tool is borne out by the statistics: according to the Review, 106 Enforcement actions have resulted in a published disciplinary outcome, involving 59 authorised firms, 38 approved persons and eight listed companies. In addition, there are 12 Enforcement cases pending at the FSM Tribunal as against a total population of 10,200 authorised firms, some 165,000 approved persons and 2,877 listed companies.

The Review confirms three drivers for Enforcement action with the net effect that FSA is more likely to identify rule breaches, and hence take Enforcement action, against large groups in relation to its selected priority topics:

• first, where Supervision selects themes, such as treating customers fairly, complaints handling or conflicts, this is usually chosen because of perceived sectoral weaknesses, and thus is likely to produce additional potential cases of non-compliance for consideration by Enforcement. In other words, Supervision’s focus will often determine Enforcement’s workload

• next, a crucial factor in the selection process is the importance of "sending out a message" to a particular sector or the industry as a whole. All other things being equal, Enforcement will tend to select those cases that are most likely to send out a clear signal to the industry. This means that a large firm with graphic or significant breaches will often be a suitable candidate for Enforcement

• lastly, the Review states that in practice the majority of Enforcement actions actually taken have been against "high impact" firms, namely large firms in either size or reputation, who have a large number of investors or volume of activity.

What the Review does not answer – and perhaps could never answer – is the concern of firms that are subject to Enforcement but have standards no different from their peers who have managed to avoid investigation.

The Review indicates that if a firm has a strong track record in taking its senior management responsibilities seriously, has been open and communicated the problem with FSA, and taken prompt remedial action where necessary, this may influence FSA’s decision to refer the case to Enforcement. FSA’s website shows examples of cases in which it has taken a decision not to commence Enforcement action on the basis of the way the firm has conducted itself. This is, of course, posited on the basis that the firm accepts that it has done wrong; in practice, many Enforcement actions concern conduct that a firm considers is acceptable but which FSA challenges.

The Review highlights the clear division between the supervisory relationship with the firm and the conduct of the investigation and notes that firms value this. However, the Review also includes a reminder that Supervision may need to brief the Enforcement case team on the firm’s history and compliance record, Supervision’s approach to the subject matter of the investigation, and the status of current issues within Supervision.

The Review confirms that the involvement of senior FSA management should continue in cases that are high impact, precedent-setting or require significant commitment of FSA resources.

It is clear from the Review that the FSA is still keen to promote and facilitate settlement wherever possible. While no consultation responses seem to have made this suggestion, the Review proposes a fine "discount system" where settlement is achieved early with a sliding scale of discount depending at which of four particular points settlement is achieved. Offers of fine reductions if a firm accepts settlement are already fairly common practice; the Review has simply formalised this practice. It states that the system is intended to save resources, get messages out to the market sooner and assist in the public perception of timely and effective action. But the key justification that settlement results in consumers getting compensation earlier is flawed. In many cases there is either no consumer loss or the firm has already agreed to pay it when required and, in any case, the disciplinary process cannot directly require firms to compensate.

Firms’ concern is not usually the size of the fine, which will rarely cause them significant financial detriment, but FSA’s view of their liability in the first place and the reputational damage that can result from adverse publicity. While the Review states that firms can continue to challenge alleged rule breaches and proposed penalty while considering early settlement, the financial encouragement to settle highlights FSA’s continuing desire that firms accept Enforcement’s case rather than challenging it.

The Review will result in changes to the Enforcement procedure and additionally current steps have been clarified.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 19/08/2005.