UK: Financial Services Bulletin - A Regular Bulletin of Selected Issues and Developments in Financial Services

Last Updated: 19 January 2000


Jonathan Macfarlane, Partner, Macfarlanes

Jonathan Macfarlane has recently joined the Investment Funds and Financial Services Group at Macfarlanes. First things first, Jonathan is not related to the family who gave the firm its name and has been used to answering that question since he joined the firm in 1978. Jonathan has been a partner since 1985 working mostly on mergers and acquisitions, flotations and share issues. He has advised several investment trusts both generally and on their launches, take-overs or further share issues.

Jonathan adds further depth and expertise to the Investment Funds and Financial Services Group, which continues to go from strength to strength.

League Tables - Consultation paper issued by the FSA

In October 1999 the FSA published a lengthy and somewhat controversial consultation paper on comparative information for financial services, in essence "league tables" for various types of investment products. With the rather grand title of the Comparative Information Scheme, the FSA has two principal objectives:
1) the league tables will address the supposed information imbalance in the financial services sector by giving consumers information so that they make more informed investment decisions; and
2) to encourage a more competitive financial services market In the FSA's opinion, the benefits of league tables would include the following factors:
  • More confident/educated consumers could purchase products without the need of advice, especially if the tables presented information in such a way that enables consumers to compare products and reach their own decisions.
  • Access to the league tables will enable consumers to be better equipped when dealing with financial advisers, and will enable them to judge the quality of the advice given. This would especially be the case when dealing with tied agents or appointed representatives.
  • Ultimately product providers will be under greater pressure to compete on product price and quality, thereby enhancing competition and benefiting consumers.

Types of product to be included
Although keen to extend the scheme to as many products as possible, the FSA is aware that some will have a higher priority. Criteria for inclusion include the following:

  • The product should be currently in the market.
  • The product should be mass market.
  • Priority should be given to those products for which consumers need the greatest assistance.
  • Priority to those products for which the consequences of an "uninformed" decision are most serious.
  • Priority to those products for which there are significant variations between the offerings of different companies.
  • Relevant, understandable and objective indicators should be achievable.

In its feasibility study the FSA in particular examined individual personal pensions, investment bonds, unit trust ISAs, savings endowments (10 years) and mortgage endowments (25 years) as being the types of product that could be covered by the scheme. However the FSA has not yet made any decisions on the type of products to be included in the scheme (and how they should be divided up) and are keen to hear feedback in this area.

Comparative indicators
The most controversial aspect of the consultation paper centres on which comparative indicators should (and should not) be included in the league tables. The FSA's criteria for inclusion were as follows:

  • The indicator should relate to the quality or value for money of the product or of the overall service.
  • It should be capable of presentation in a format that can be understood by consumers.
  • It should be capable of being verified independently.
  • Product providers should have little opportunity to manipulate their results.
  • They should vary from company to company.

As part of their feasibility study, the FSA and their consultants (the actuaries Bacon & Woodrow) looked at a range of possible indicators for inclusion in the scheme. Bacon & Woodrow recommended for inclusion: price (long term and short term); flexibility; buying; financial strength (for "with profits" products only); risk and return; range of funds; minimum payments; product features; customer services; and clarity of literature.

The FSA considers these to be a useful basis for discussion, that some may be combined, and that the case for inclusion is more clear cut for some than for others. It is however difficult to see how some of the above indicators can be compared in a meaningful and objective way without overly confusing the consumer audience.

Bacon & Woodrow also drew up a list of indicators which they recommended should not be included in the league tables, and this includes: past investment performance; future investment performance; commission/cost of advice; size/history of provider; reputation/brand awareness; and quality of advice.

In particular, the proposal that past investment performance should not be included has been the subject of strong criticism from trade bodies and IFAs. However, in the consultation paper the FSA is of the view that there are major doubts about the value of past performance as an indicator of future performance, and the fact that an individual product has performed well in the past may count for little in current market situations.

The scope and work undertaken by the FSA in producing this consultation paper has certainly been impressive, and marks a major departure from anything previously attempted by regulators in the UK. Although the FSA seem keen to press ahead with the proposals in some form it is likely that the final proposals will show a number of major changes from those contained in the consultation paper.

The Consultation Paper:

  • aims to promote informed investment decisions and a more competitive market
  • includes proposals for the types of product to be covered
  • contains controversial proposals for the types of indicator to be used

Feedback on the proposals is invited by 14 January 2000.

FSA issues policy statement on guidelines and waivers

The FSA has recently issued a policy statement setting out their approach to giving guidance and waivers to regulated firms. Under the current self-regulatory regime the approach of the FSA and the various SROs to the issues of guidance and waivers has been somewhat ad hoc. Under the powers to be given to it by the new primary legislation, the FSA is keen to develop an "open and responsive two-way relationship" with regulated entities, and aims to be helpful and forthcoming in such relationships. The FSA do however stress that the giving of guidance/waivers is not meant to be a substitute for regulated firms ensuring they properly meet their own regulatory standards and obligations. In the policy paper the FSA then goes on to distinguish between:

1) general guidance - ie published material available to everyone, eg guidance to be contained within the FSA Rulebooks
2) individual guidance - guidance given to particular firms in relation to their own circumstances; such guidance may be written or verbal and privately or publicly available
3) waivers - dispensations sent to individual firms which will disapply a particular rule.

General Guidance
It is the FSA's intention that general guidance will play a major role in its new Rulebook and it intends to build on the current approach by creating certain disciplines:

  • if the guidance is to be compulsory the FSA will ensure it has the status of binding requirements
  • the FSA will not operate on the basis of unwritten rules or standards
  • all guidance will be in the Rulebook, thereby establishing a degree of regulatory certainty The FSA is however conscious of the fact that the demand for guidance will generally exceed their capacity/resources to produce it. Therefore, in establishing new guidance the FSA will take the following into consideration:
  • the need to respond to new developments in the market and new government policies (eg pensions, savings vehicles, taxation)
  • the extent to which existing rules are open to different interpretations and whether the resulting uncertainty is having a detrimental effect on business or consumer protection
  • the demand for guidance on the issue in question
  • the number of persons affected

In the paper the FSA are keen to stress that where a firm acts in accordance with general guidance then, prima facie, it will be treated as having complied with the rule to which the guidance is linked.

Individual Guidance
The FSA is aware that the demand for individual guidance is an established feature of the existing regime which will carry forward. In setting out its policy the FSA seeks to draw a balance between the certainty which individual guidance provides, the retention of flexibility within more general rules, and the resource-intensive nature of obtaining guidance on demand.

However the FSA state that they aim to respond "quickly and substantively" to reasonable requests for guidance on regulatory requirements. It will continue to be given on an informal basis and without charge.

The FSA will give priority to new matters which relate to areas of regulatory uncertainty or difficulties which arise in amending established procedures to cater for innovative products, but organisations should not use the FSA as a first port of call. In particular larger organisations should be able to prove they have carried out their own analysis (including taking legal advice) before approaching the FSA. However the FSA does not intend to publish individual guidance. Where appropriate such guidance may be converted into general guidance and thereafter made available to all.

The current version of the Financial Services and Markets Bill gives the FSA the power to modify or disapply its rules in particular circumstances in relation to individual firms, but requires that such waivers are published. The FSA can give a waiver if compliance with the rules would be unduly burdensome or would not achieve the purpose for which they were made, and the waiver would not result in undue risk to persons whom the rules are meant to protect.

The new waiver power under the Bill is wider than that contained in the 1986 Act in a number of respects; in particular, it will cover a wider range of rules such as Cancellation Rules and the Collective Investment Scheme Regulations.

All waivers will be published unless the FSA is satisfied that publication would prejudice the commercial interest of the person concerned.

The Financial Services and Markets Bill and the Insurance Industry

The enactment of the Financial Services and Markets Bill could result in significant changes in the culture of regulation for insurance companies in the UK. Under the present legislation, the Treasury has responsibility for the authorisation and ongoing regulatory supervision of insurance companies; in practice the FSA has carried out this function since January 1999. Once the new Act is in place, insurance companies will become directly regulated by the FSA. First published in July 1998, the Bill is currently expected to come in to force towards the end of 2000. The exact scope of the Bill is not yet certain, and it can be difficult to predict how the new legislation will affect businesses.

Some insurance business is already regulated under the Financial Services Act 1986. For example, long term insurance contracts are investments for the purposes of the 1986 Act and any person who conducts related investment activity (for example, arranging or advising on life business) requires authorisation under the 1986 Act. Consequently, almost all life offices are presently regulated by the PIA (one of the organisations which will merge into the FSA) as well as the Treasury's Insurance Directorate (the functions of which are exercised by the FSA). For these businesses, the proposed regime is unlikely to cause major upheaval; furthermore, the Treasury claim that the change to a single regulator may even result in lower recurring compliance costs.

In February 1999 the Treasury issued a draft Regulated Activities Order which was intended to supply some of the detail missing from the draft bill itself. This draft makes broadly the same distinction between general and long-term insurance business as is reflected in the current regulatory environment, but, importantly, arranging, managing or advising on insurance contracts whether long term or general will now be a regulated activity, and the definition of "investment" has been expanded to include general as well as long-term business. The effect of this is that the draft Order could allow the FSA to make conduct of business rules in relation to general insurance business. Concerns in this regard remain, although they have been eased somewhat by the Treasury's assertion that it is not the Government's intention to extend the scope of regulation in this area.

The conduct of business rules that will apply to long-term business will be contained in the FSA's new Code of Conduct rules, which are unlikely to be radically different to the current PIA regime. This Code is likely to regulate how such an insurance company classifies its customers, the necessity and contents of customer agreements, the manner in which a firm may advertise and promote its products, training and competence requirements for individuals, and complaints procedures.

Authorisation of new insurance companies will become a statutory responsibility of the FSA, along with prudential supervision. In this respect, companies are subject to broadly the same rules whether writing long-term or general business. This change is unlikely to lead to a new approach: apart from the Treasury's statements that the scope of regulation will not be increased radically, the fact that in practice, broadly the same groups of people will actually process applications and deal with ongoing supervision will help to preserve continuity. However, the application process to the Treasury is somewhat different in certain areas to those used by the present financial services regulators: insurance companies face more scrutiny as to financial adequacy and perhaps less as to ongoing compliance. In other areas, for example the scrutiny of the individuals behind the company, the attitude of the Insurance Directorate and the present financial services regulators, and the procedures, are very similar. "Grandfathering" provisions (that is, automatic approval) will exist for companies which are already licensed to conduct insurance business.

Some degree of uncertainty persists as to the financial resources requirements which will apply to insurance companies. The present minimum solvency standards are set out in the Insurance Companies Act; the financial health of long-term insurance offices is gauged on actuarial principles. There are also EU-driven solvency standards, but as the UK imposes stricter terms on insurance companies, these rarely have any impact in practice. Quite how this area of regulation will develop is not entirely clear. A criticism that has been levelled at the Government's proposals for reform of the financial services market generally is that while the ideas are radical and often welcome in principle, the detail is missing. Despite further publications and pronouncements, this remains a serious issue. The regulatory environment for insurance companies probably will not change radically when the Bill becomes law, but there is enough in the draft legislation to cause concern for insurance companies, notwithstanding the Treasury's soothing words, and developments will be monitored closely.

The Permission Regime

The FSA has issued Consultation Paper 29 to explain how it will exercise its powers under Part IV of the Financial Services and Markets Bill to grant permission to carry on regulated activities.

The main thrust of the FSMB is to provide a single route to authorisation (which is the term still used) for all firms wishing to carry on regulated activity. The FSA considers, however, that fitness to carry on one kind of business does not guarantee fitness to carry on all kinds, and therefore when authorisation is granted it will be related only to particular activities. If a firm subsequently decides to extend its range of regulated activities it will have to seek the FSA's permission to add those new activities to those which it is already permitted to carry on.

This is akin to the current system under the Financial Services Act whereby at the time it is authorised, a firm will be given by its regulator a statement of Permitted Business/Business Profile which can only be extended by agreement with the regulator.

The FSA has concluded that the permission granted to a firm should consist of three elements:

  • the regulated activities which the firm undertakes
  • the investments which it offers
  • the types of customer with which it deals.

The Consultation Paper outlines the three elements of the regime as follows:

Regulated activities
Deposit taking; insurance business; investment business (broadly covering the same ground as the Financial Services Act does at the moment); Lloyds business (advising members on their business at Lloyds and managing syndicate capacity as a managing agent).

Investment types
As well as the familiar categories of investments set down in the Financial Services Act (shares, loan stocks, units in collective investment schemes, derivatives and so on), this element of the regime will now cover general insurance and not just long-term insurance as at present, plus Lloyds syndicate capacity and syndicate membership.

The detailed definitions of regulated activities and investment types will ultimately appear in a Regulated Activities Order.

Customer types
The Consultation Paper distinguishes private customer, intermediate customer, and market counterparty. This follows on from the FSA's discussion paper "The Future Regulation of Inter Professional Business".

As to the transition from the current regime to the new one, the Treasury has stated that firms currently authorised should not have to apply for authorisation under the new Act although it is likely that, for a period of perhaps two years after the new Act comes into force, the FSA will have a power to make particular firms reapply. At N2 (the date on which the FSA gets all its powers under the new Act) the FSA will issue firms with an authorisation certificate detailing the permission that they will have under the new regime. The FSA envisages sending firms a draft authorisation certificate a few months before N2. Firms will have the opportunity to raise any concerns with a view to finalising the certificate prior to issue at N2. N2 is currently expected to fall somewhere in the third quarter of 2000.

The FSA Principles for Business

The FSA has reviewed the responses which it received to Consultation Paper 13, and has issued a post-consultation version of the principles. They are:

1) Integrity
A firm must conduct its business with integrity.

2) Skill, care and diligence
A firm must conduct its business with due skill, care and diligence.

3) Management and control
A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems.

4) Financial prudence
A firm must maintain adequate financial resources.

5) Market conduct
A firm must observe proper standards of market conduct.

6) Customers' interests
A firm must pay due regard to the interests of its customers and treat them fairly.

7) Communications with customers
A firm must pay due regards to the information needs of its customers, and communicate information to them in a way which is clear, fair and not misleading.

8) Conflicts of interest
A firm must manage conflicts of interest fairly, both between itself and its customers and between one customer and another.

9) Customers - relationships of trust
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 judgment.

10) Customers' assets
A firm must arrange adequate protection for customers' assets which it is responsible for them.

11) Relations with regulators
A firm must deal with its regulators in an open and co-operative way, and must tell the FSA promptly anything relating to the firm of which the FSA would reasonably expect prompt notice.

The principles are a general statement of the fundamental obligations of authorised firms under the regulatory system. As was the case with the Ten Principles issued by the SIB in 1990, failure to comply with the principles may call into question whether a firm is "fit and proper" to carry on regulated business. Significantly, however, the FSA has said that in its view there may be some cases where it is appropriate to discipline firms on the basis of the principles alone.

This is the post-consultation version, not the final one. The final version will be issued by the FSA once it has its new rule-making powers under the Financial Services and Markets Act. Until that time it will be possible to revisit the text of the principles. In their final form, the principles will be among the high level standards to be included in the FSA Handbook of Rules and Guidance.

The principles do not differ radically from the SIB Principles of 1990, although some of the language has been refined and tightened up. The FSA has stated that principle 4, on financial resources, also takes into account non-regulated activities including activities carried on outside the UK. Conversely, those principles which relate to matters affecting customers, for example principles 6-10, will be applicable to firms based outside the UK but carrying on regulated business in the UK.

Investment Funds: FSA consults on charges to capital

The FSA have issued a further consultation paper on the proposed extension to the current regime of charging certain fees and expenses to the capital account of a unit trust or open ended investment company. At present only the periodic management fee of a manager or ACD can be charged to capital. A previous FSA consultation paper (CP14) had proposed extending this regime to allow other fees and expenses to be charged to capital under certain circumstances.

The new consultation paper (CP32), which also deals with a number of other issues, is a result of the replies received by the FSA in response to the original proposals and subsequent discussions within the CIS Forum. The response received was overwhelmingly in favour of the proposal and the FSA have therefore published draft regulations to implement them. The main points are as follows:

  • Any payments which can lawfully be made out of the property of a fund can be treated as a capital expense.
  • For capital growth funds an extraordinary resolution will be required in order to allow fees and expenses to be charged to capital. At present, no such fees (including the periodic charge) can be charged to the capital account of a "growth fund".
  • Income or balanced (ie an equal emphasis on capital and income growth) funds (which are currently allowed to charge the periodic fee to capital) will be able to charge other expenses to capital on giving 90 days' written notice to unitholders/shareholders.
  • Disclosure to investors should provide sufficient information in order for them to reach an informed opinion on managers' proposals.
  • Sufficient risk warnings regarding the potential for capital erosion must be set out in mailings and the scheme particulars/prospectus of the fund.

Chinese Walls

The case of Prince Jefri Bolkiah v KPMG has brought into question the effectiveness of Chinese walls, with potentially serious consequences for the financial services industry.

In simple terms, a Chinese wall is a notional barrier constructed to prevent information which is confidential and often price sensitive from passing between different parts of the same organisation or group of organisations. Chinese walls prevent inside information in the possession of persons in one part of an organisation from being misused by persons in another part and provide firms with a defence against a liability resulting from the possible legal consequences of conflicts of interests. In a sector where firms are increasingly providing a wide range of services to many clients, it is vital that Chinese walls can be relied upon.

The KPMG case suggests that the courts are sceptical about the effectiveness of Chinese walls. The case concerned His Royal Highness Prince Jefri Bolkiah, one of the crown princes of Brunei, and the Brunei Investment Agency, of which KPMG had been the auditors since 1983. Prince Jefri had subsequently retained KPMG to act on his behalf in connection with two claims being brought against him in London. This necessitated KPMG compiling a detailed analysis of Prince Jefri's business affairs. In the course of acting on this project - code named "Project Lucy" - KPMG collected a substantial body of information relating to the financial affairs of Prince Jefri, including the location of assets and the location of bank accounts.

After KPMG had ceased to act for Prince Jefri in connection with Project Lucy, they accepted a retainer to act for the BIA. Prince Jefri had at one time been Chairman of this organisation and the work for which KPMG were now to be retained (code named "Project Gemma") would involve them investigating for the BIA certain of Prince Jefri's former dealings, in order to substantiate a number of allegations being made by the BIA against Prince Jefri. It was clear that KPMG had information about Prince Jefri as a result of acting on Project Lucy which would be relevant to this new investigation.

KPMG set in place special arrangements in order to protect the confidentiality of information obtained by KPMG in these two separate activities. Great lengths were taken in the selection of staff to ensure that nobody who was in possession of confidential information was permitted to work on the investigation of BIA. Steps were also taken to avoid the risk of such information becoming available to those working on the project in the future. Work done in London was done in a separate project room with restricted access. Separate computer file servers were used and all electronic information relating to Prince Jefri was deleted from the KPMG's servers.

Despite these steps, and the fact that it was not found that confidential information had actually leaked through these information barriers, the House of Lords considered that the measures were not sufficient to preclude a potential conflict of interests arising. The House of Lords noted that the Chinese walls were supposedly operating within a single department of the firm and that the composition of the teams involved on the relevant projects changed quite often. In short, the House of Lords' objection was that the Chinese wall had been created ad hoc and that, in order to be effective, the Chinese wall should have been an established part of the organisational structure of the firm.

This interpretation has been thrown in doubt by the judgement of Laddie J in the subsequent case of Young v Robson Rhodes. An injunction was sought to prevent the merger of two accountancy firms by an individual who had instructed a partner in one of the firms to act as an expert witness in an action brought by a syndicate of Lloyd's names suing their auditors, who were the other party to the proposed merger. On the facts of this particular case, the court held that the ad hoc Chinese wall that had been put in place was sufficient to safeguard the confidential information in the possession of one of the partners. However, the court imposed additional conditions to make the Chinese wall effective, mainly that the relevant personnel (those individuals working on either side of the wall) could have no professional contact and should be physically separated into two offices. Social contact was, however, permitted.

The Judge distinguished this case from the KPMG case on the basis that KPMG used rotating personnel and a large number of staff. Therefore, enforcing confidentiality would have been more difficult.

The status of Chinese walls is uncertain. The House of Lords did confirm that Chinese walls of the sort used within most financial institutions will be effective, provided that a firm can demonstrate that the Chinese walls do exist and are effectively enforced. The key test appears to be the effectiveness of the Chinese wall, not the reasonableness of the measures taken by the firm.

The most useful guidelines are those set out by the Law Commission in a consultation paper published in 1992, which provide for:
  • physical separation of the various departments in order to insulate them from each other, often extending to such matters of detail as dining arrangements;
  • on-going educational programmes for staff;
  • strict and carefully defined procedures for crossing walls, and maintaining proper records where this occurs;
  • monitoring by compliance officers of the effectiveness of the wall; and
  • disciplinary sanctions where there has been a breach of the wall.
Macfarlanes' Financial Services Bulletins are intended to provide general information about developments which may be of interest. They are not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained. If you would like further information or specific advice, please contact Bridget Barker or Tim Cornick

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