The Regulator with Teeth

Originally published in February 2002

The Financial Services and Markets Act 2000 (FSMA) came into effect on 1 December 2001. In addition to creating a "super regulator" for the financial services industry, the Act creates new exposures for company directors and their D&O insurers.

The Act revolutionises the way in which the UK’s financial services industry is regulated - the Financial Services Authority (FSA) becomes a super regulator, taking over the current responsibilities of the Securities and Futures Authority, the Personal Investment Authority and the Building Societies Commission, among others. The purpose of this article is not to review how the Act will affect the financial services sector - instead, its focus is on how the Act will impinge on the activities of company directors and the consequences for their D&O insurers.

Insider trading has, for a long time, been a criminal offence, punishable by prison. Other offences of market manipulation have been prosecuted under the Theft Act 1968 and for conspiracy to defraud - the prosecution of the ‘Guinness Four’ was a good example of this. However, the FSMA introduces a much wider principle of market abuse so that activities that went unpunished before 1 December 2001 may now be the subject of long and costly investigations and civil proceedings, and may lead to fines or public censure of those involved.

Market abuse is a civil offence (which means the standard of proof is the balance of probabilities rather than beyond a reasonable doubt) and the FSA, rather than a court, determines guilt. For behaviour to amount to market abuse, it must relate to a qualifying investment traded on a prescribed market (such as the London Stock Exchange) and fall within one of three statutory categories:

(i) ‘misuse of information’

(ii) behaviour likely to give a ‘misleading impression’ or

(iii) likely to ‘distort the market’

The test of whether behaviour constitutes market abuse is an objective one, with the ‘man on the Clapham Omnibus’ being replaced by the ‘Regular User of the Market’. Accordingly, it is not necessary to demonstrate any intention to mislead or abuse the market, merely that the behaviour had that effect. Although there are defences to this offence, the individuals involved will have to persuade the FSA that they acted reasonably.

As always, the devil is in the detail and the Code of Market Conduct provides guidance on the statutory provisions, describing the type of conduct that would amount to market abuse. Examples include:

1. releasing information through an ‘accepted channel’, eg the Regulatory News Service, which turns out to be false, and
2. disclosing confidential information to someone other than for a legitimate purpose, such as selective leaks to the press about a potential transaction.

Importantly, the Code is not conclusive, so conduct not mentioned in the Code may nonetheless constitute market abuse if it falls within the very wide statutory definition.

The FSA can investigate breaches of the Listing Rules, and listed companies owe it a general obligation of openness and co-operation. This means that if the FSA calls for information and documentation, companies (through their directors) are obliged to provide this, with relatively narrow exclusions. Following its investigation, the FSA may decide to initiate proceedings against the companies or their directors leading to fines or the public naming and shaming of transgressors. Further, if a breach of the Listing Rules has caused loss, the FSA can seek an order through the courts that the company or its directors repay any profits that they earned or even compensate the shareholders for any loss suffered. Companies and their directors can expect the whole process of the investigation and any resultant proceedings to be both costly and disruptive to their business.

Having been stung by the criticism of its regulation (or perceived lack of regulation) of Equitable Life and Independent Insurance, the FSA is likely to adopt a strict public profile going forward. A possible example of this approach is given in the FSA’s letter dated 28 September 2001 addressed to the Chief Executive Officers of all listed companies, reminding them of their continuing reporting obligations in the context of the recent tragic events in the USA. The FSA ominously warned that if companies unreasonably delayed in making the appropriate announcements as to how these events were expected to impact on their business, the range of sanctions available after 1 December 2001 was more onerous than before.

The FSA will be able to investigate the activities of regulated companies, requiring the co-operation of their directors, and of course the directors themselves may be subject to investigations and disciplinary proceedings or censure. The standard Investigation Costs extension found in UK D&O policies is therefore a major benefit to directors; but its existence has led to heavy losses on some accounts causing underwriters to review their terms and impose sub-limits.

In addition to its investigative powers, the FSA will be able to levy civil fines (with no upper limit specified) and so directors and underwriters ought to review whether these could be covered under their policies. Finally, the FSA has powers to obtain court orders requiring the giving up of profits or payment of compensation to victims where directors have breached the Listing Rules. Where these orders are compensatory, they may be covered under the policies. However, these powers will probably be rarely exercised.

On 1 December 2001 the regulatory landscape changed fundamentally and this article can do no more than ‘scratch the surface’. The FSMA potentially increases the exposures of directors of regulated companies. These typically already have D&O policies and so the FSMA may not represent a business opportunity for underwriters in the sense that it will probably not sell more policies. Instead, its effect is likely to be limited to increasing underwriters’ exposure to investigation costs, which is becoming one of the biggest risks in the UK D&O market.