3 The Regulatory System in the United Kingdom

This chapter examines the regulatory system currently in place in the United Kingdom. It provides an overview of the structure and objectives of regulation, the role of the regulator and the techniques that are employed in regulating firms and individuals who engage in investment business.

3.1 Background: the financial crisis and regulatory reform

3.1.1 Responding to the financial crisis In the UK, as elsewhere, the onset of the financial crisis exposed deficiencies in financial regulation and led to calls for regulatory reform. The Treasury Select Committee1 led the way, with its hearings into the collapse of Northern Rock exposing serious deficiencies in supervision and risk management.2 In October 2008, the Chancellor of the Exchequer asked Lord Turner, the newly appointed chairman of the FSA, to review the causes of the crisis and to make recommendations on the changes in regulation and supervisory approach needed to create a more robust banking system for the future. The Turner Review3, published in March 2009, made a

1

The Treasury Select Committee is a Parliamentary (House of Commons) committee that scrutinises the

activity of the regulatory authorities in the UK.
2

See House of Commons Treasury Committee, The Run on the Rock HC 56-1 (Fifth Report of Session

2007-08).
3

FSA, ‘The Turner Review, A regulatory response to the global banking crisis’ (March 2009) at

http://www.fsa.gov.uk/Pages/Library/Corporate/turner/index.shtml. See also the FSA publication that accompanied the Turner Review: FSA Discussion Paper 09/2 ‘A regulatory response to the global banking crisis’ (March 2009) at http://www.fsa.gov.uk/pubs/discussion/dp09_02.pdf. For a more detailed discussion of both see I MacNeil ‘The Trajectory of Regulatory Reform in the UK in the Wake of the Financial Crisis’, 11(4) European Business Organization Law Review (2010) 483.

number of recommendations to create a stable and effective banking system. In particular it focused on the need for an increase in the quantity and quality of overall capital in the global banking system so as to allow banks to absorb losses without threatening financial stability or requiring governments to intervene through so-called ‘bailouts’. It also recommended that liquidity regulation and supervision should be recognised as of equal importance to capital regulation, reflecting the experience during the crisis in which many solvent banks experienced problems in disposing of illiquid assets to meet their obligations. Turner also recommended that much more emphasis should placed on macro-prudential analysis and supervision, focusing on stability of the financial system as a whole rather than just the solvency of individual financial institutions. Finally, while Turner identified deficiencies in the FSA’s supervisory approach, he favoured retention of the FSA as an integrated regulator, although he did recommend that the supervisory approach should be changed to a more intrusive approach with a greater emphasis on risk-taking by large complex banks.

Even before the Turner Review was published, legislation had been passed to deal with three aspects of the regulatory system which had been exposed as deficient following the collapse of Northern Rock in the autumn of 2007. The first was an increase in the level of deposits covered by the Deposit Guarantee Scheme.4 This was intended to limit the possibility of a ‘run’ on a bank similar to that experienced by Northern Rock once rumours of its financial problems began to circulate. The second was the introduction of a statutory financial stability objective for the Bank of England by the Banking Act 2009. That objective requires the Bank to ‘contribute to protecting and enhancing the stability of the financial systems of the United Kingdom’.5 The third was the introduction of a ‘special resolution regime’ under the Banking Act 2009, enabling the Tripartite Authorities6 to intervene in failing banks. The significance of that regime is that the authorities are freed from the constraints that would otherwise be imposed by the law of corporate insolvency. In particular it permits earlier intervention and the imposition on shareholders and creditors of a
4

The increase (effective from 1 October 2007) resulted in deposits up to £35,000 being fully covered by

the Financial Services Compensation Scheme established under FSMA 2000: prior to that the maximum payable in respect of a protected deposit was £31,700, comprising 100% of the first £2,000 and 90% of the next £33,000. For the current deposit protection arrangements see ch 6.27.
5 6

See s2A of the Bank of England Act 1998, inserted by s238 of the Banking Act 2009. The Treasury, the Bank of England and the FSA.

range of solutions devised by the authorities such as a sale of the institution to a third party.

3.1.2 The Financial Services Act 2010 Following publication of the Turner Review the Treasury published a consultation paper entitled ‘Reforming financial markets’ in July 2009.7 It made a number of legislative proposals which were ultimately enacted in the Financial Services Act 2010 (‘FSA 2010’). While that Act made no changes to the institutional structure of regulation, it did introduce some changes in response to the financial crisis and the Turner Review. They are set out below.

Financial stability The FSA 2010 provides that financial stability should be one of the regulatory objectives of the FSA, replacing ‘public awareness’. The Act adopts a rather circular definition of the meaning of ‘financial stability’8 with the result that the real meaning is something that awaits clarification, most likely through its practical implementation by the regulatory authorities.

Remuneration of executives of authorised firms The FSA 2010 empowers the Treasury to make regulations about the preparation, approval and disclosure of executives’ remuneration reports in relation to authorised firms. These provisions reflect political pressure in the wake of the financial crisis to constrain remuneration and risktaking and to make executives more accountable to shareholders. The Act also empowers the FSA to require authorised firms to have a remuneration policy that is consistent with the effective management of risk.9

Short-selling rules The FSA 2010 provides express powers to the FSA to make rules either prohibiting or requiring
7 8

Cm 7667. New section 3A of FSMA 2000 (inserted by s1(3) FSA 2010) provides that: ‘The financial stability

objective is: contributing to the protection and enhancement of the stability of the UK financial system.’
9

See further Ch 10.2.5.

disclosure of short-selling. There were no express powers under FSMA 2000 and therefore the temporary rules made by the FSA in 2008 were based on the premise that short-selling or failure to disclose short-selling constituted market abuse.10 The express powers provided by FSA 2010 strengthen the legal basis for short-selling rules and remove the need for them to be justified by reference to market abuse considerations alone.

FSA disciplinary powers The FSA 2010 extended the FSA’s disciplinary powers in several significant ways. These powers are considered in paragraph 3.9.2 below.

Consumer redress schemes The new provisions in FSA 2010 relating to consumer redress schemes enhance the powers of the FSA to require authorised firms to conduct a review of past business and pay compensation to consumers. While the old provision of FSMA 2000 (s404) required Treasury and Parliamentary authority for such action, the new provisions11 enable the FSA to make rules establishing such a scheme in appropriate cases and to require compensation to be paid.

Power to require information

FSA 2010 provides for an expansion in the information-gathering powers of the FSA contained in FSMA 2000. Previously, the FSA’s powers could be exercised only within the regulatory perimeter, albeit that this extends to collection of information on unregulated activity that is undertaken by a regulated entity and on exposure to unregulated counterparties of regulated entities. The expanded power12 will enable the FSA to collect information that is relevant to the stability of the financial system directly from owners or managers of investment funds or persons

10 11 12

See ch 13.5 for a discussion of short-selling and market abuse. FSMA 2000, ss 404, 404A-404G. FSA 2010, s18.

connected to them and service providers to authorised firms.13 While the effective exercise of this power may in some cases be limited by the territorial limits of the FSA’s jurisdiction (e.g. in respect of ‘offshore’ funds managed from the UK), its overall effect is likely to be beneficial in facilitating the development of a more complete picture of the nature and scale of risk accumulation and transfer, especially in the less transparent areas of the market.14

3.1.3 Reform proposals

In February 2011 the government’s reform proposals were fleshed out in more detail when the Treasury published its consultation paper “A new approach to financial regulation: building a stronger system” (hereafter ‘Treasury Cm 8012’).15 That was followed in June 2011 by a further consultation document and white paper including draft legislation.16 The proposals will result in significant changes to the institutional structure, regulatory objectives and style of regulation. Each of these issues is discussed in more detail below.

The original plan was for the new regulatory framework to be in place by the end of 2012 17, but

13

Moreover, the Treasury is empowered to prescribe further categories of person in respect of whom the

FSA’s extended information-gathering power may be exercised.
14

While the transaction reporting regime established by article 25 of MiFID provides regulators with

transaction details from the OTC market in respect of trading in financial instruments admitted to trading on regulated markets, there remains a substantial volume of OTC trade that is not in such instruments (e.g. credit default swaps). See further Ch 13.1.
15

Cm 8012, available at http://www.official-documents.gov.uk/document/cm80/8012/8012.pdf (16 August

2011).
16

H M Treasury, White Paper: a new approach to financial regulation: the blueprint for reform (Cm

8083, June 2011).
17

Treasury Cm 8012 stated (at para 8.2) that: ‘The Government is committed to putting the new regulatory

architecture in place by the end of 2012. The Government believes that this remains an appropriate and achievable target.’

that target was dropped 18 in Cm 8083 in favour of the more open-ended formulation that ‘the Government remains committed to implementing these reforms as quickly as possible, recognising the need to minimise regulatory uncertainty for firms’. Also relevant in this context is the review of structure and competition in banking undertaken by the Independent Banking Commission. The Commission published an interim report in April 201119 and its final report in September 2011. [It will be necessary to insert a new paragraph here following the final report in mid September 2011]

3.2 Regulatory objectives

The regulatory objectives of the system of regulation established by FSMA 2000 are set out in sections 3-6 of the Act.20 They provide a form of high-level control and accountability over the actions of the FSA since the Act requires the Authority to discharge its general functions21 in a way that is compatible with the regulatory objectives.22 Market confidence The market confidence objective is maintaining confidence in the financial system. The financial system includes financial markets and exchanges, regulated activities and other activities connected with financial markets and exchanges. This objective therefore extends beyond
18

The Treasury Select Committee had expressed concern over the potential effect of too short and rigid a

timetable on the quality of legislation: see House of Commons Treasury Committee, Financial Regulation: a preliminary consideration of the government’s proposals, HC 430-1 (Seventh Report of Session 2010/11) Vol 1, ch 2.
19

Independent Banking Commission, Interim Report, Consultation on Reform Options. See G Walker,

‘The Independent Commission on Banking: interim findings and comment’ 5(3) LFMR 213.
20

This was an innovation when the Act was passed as the FSA 1986 had not referred to regulatory

objectives.
21

The general functions of the Authority are stated by s2(4) of FSMA 2000 to be: (a) rule-making; (b)

issuing codes; (c) giving general guidance; and (d) determining the general principles and policy for the performance of its particular functions.
22

FSMA 2000, s2.

activities which are regulated activities under the Act. Market confidence does not imply a policy of preventing all failures but involves minimising the impact of failures and providing mechanisms to protect consumers.23

Financial stability The financial stability objective of the FSA is: contributing to the protection and enhancement of the stability of the UK financial system. In considering that objective the Authority must have regard to— (a) the economic and fiscal consequences for the United Kingdom of instability of the UK financial system; (b) the effects (if any) on the growth of the economy of the United Kingdom of anything done for the purpose of meeting that objective; and (c) the impact (if any) on the stability of the UK financial system of events or circumstances outside the United Kingdom (as well as in the United Kingdom). The Authority must, consulting the Treasury, determine and review its strategy in relation to the financial stability objective.

The protection of consumers The consumer protection objective is securing the appropriate degree of protection for consumers. In considering what is appropriate, the FSA must have regard to risk, expertise, the need for information and advice and the general principle that consumers should take responsibility for their decisions. ‘Consumer’ is defined broadly and includes (a) companies and persons entering into transactions in a business capacity; and (c) persons who derive rights from persons who are ‘consumers’.24

23 24

See FSA publication ‘Reasonable Expectations: Regulation in a Non-Zero Failure World’ (2003). FSMA 2000, ss425A and 425B. The OFT retains responsibility for licensing and supervision under the

Consumer Credit Act 1974.

The reduction of financial crime The reduction of financial crime objective is reducing the extent to which it is possible for a business carried on (a) by a regulated person or (b) in contravention of the general prohibition against carrying on regulated activity without authorisation, to be used for a purpose in connection with financial crime. Financial crime includes any offence involving fraud or dishonesty; misconduct in, or misuse of information relating to, a financial market; or handling the proceeds of crime. The offence includes an act or omission that would be an offence if it took place in the United Kingdom. The Act itself establishes offences falling within the scope of this objective, such as making misleading statements and engaging in market manipulation.25

The Act also refers to principles of good regulation to which the FSA must have regard in carrying out its duties.26 They are: (a) the need to use its resources in the most efficient and economic way; (b) the responsibilities of those who manage the affairs of authorised persons; (c ) the principle that a burden or restriction which is imposed on a person, or on the carrying on of an activity, should be proportionate to the benefits, considered in general terms, which are expected to result from the imposition of that burden or restriction; (d) the desirability of facilitating innovation in connection with regulated activities;27 (e) the international character of financial services and markets and the desirability of maintaining the competitive position of the United Kingdom; (f) the need to minimise the adverse effects on competition that may arise from anything done in the discharge of those functions;

25 26

FSMA 2000 s 397. FSMA 2000 s 2(3). For a general discussion of innovation in financial services see S Lumpkin, ‘Consumer Protection and

27

Financial Innovation: A Few Basic Propositions’ OECD Journal, Financial Market Trends, 2010:1, 117139: and E Engelen, I Erturk, J Froud, A Leaver & K Williams , ‘Reconceptualizing financial regulation: frame, conjuncture and bricolage’, Economy and Society, Vol 39, Issue 1, (2010) 33-63.

(g) the desirability of facilitating competition between those who are subject to any form of regulation by the Authority; (h) the desirability of enhancing the understanding and knowledge of members of the public of financial matters (including the UK financial system).

The experience of the financial crisis has caused some re-evaluation of these principles. Thus Treasury Cm 8012 indicated that principles (d), (f), (g) and (h) are likely to be removed when the new regulatory framework is put in place. Part of the reason for this is a policy decision that each of the new regulatory authorities should have a single regulatory objective that should not be complicated by potentially conflicting objectives. In the case of (d), it is clear that there is a more cautious approach to the benefits of financial innovation as a result of the key role of innovative products in the financial crisis. In the case of (f) it is argued that the competition objective will be subsumed into the objectives and operation of the Prudential Regulation Authority and the Financial Conduct Authority28: in the former case the financial stability objective will strengthen the competitiveness of the UK system whereas in the latter case the clean, fair and efficient markets objective will have the same effect. In the case of (f), the creation of the Consumer Financial Education Body (‘CFEB’) by the Financial Services Act 201029 gives effect to that regulatory objective in a specific manner by requiring the FSA to establish a body to enhance the understanding and knowledge of the public of financial matters and the ability of members of the public to manage their own affairs.

3.3 The institutional structure of regulation

Prior to the May 2010 general election, the conservative party had made clear that it intended to disband the FSA and place the Bank of England at the centre of a reformed regulatory system. The proposed new system follows the ‘twin peaks’ model that has already been adopted in some other countries, with prudential regulation and conduct of business regulation to be undertaken by separate

28 29

See below ch 3.3 for more detail about these new regulatory bodies. See s2(5), inserting a new s6A into FSMA 2000.

regulatory bodies.30 Underlying that approach is the proposition that the two forms of regulations are very different in nature and are therefore best undertaken by separate agencies. Prudential regulation focuses on capital, liquidity and balance sheets while conduct of business regulation focuses on a firm’s business process and its relationships with customers. Another relevant factor is that there may be conflicts between the objectives and outcomes of each type of regulation and that separate agencies avoid the likelihood that an integrated regulator may not enforce regulation if it threatens solvency. Thus, for example, if action proposed by a conduct of business regulator weakens the financial position of an authorised firm, an integrated regulator may be less willing to take the necessary action because it is concerned about financial stability whereas an independent conduct of business regulator is not directly concerned with that issue. That argument for a ‘twin peaks’ approach is however only as good as the independence of the relevant regulators and in any system it is quite likely that there will be external and political pressures to act and not to act in specific situations.

While similar to some other systems31, the proposed UK model does have distinctive characteristics, in particular the positioning of the central bank (the Bank of England) at the centre of the regulatory system, with the result that it has responsibility both for monetary policy and financial stability. The proposed new structure responds to perceived deficiencies in the old system, in which the FSA operated as an integrated regulator (within a ‘Tripartite’ system in which the Bank of England was responsible (under the Triparite MOU, but not the legislative framework) for financial stability and the Treasury for policy. In particular, the Treasury highlighted the following problems resulting from the Tripartite structure: - the Bank of England, while having statutory responsibility for financial stability32, has only limited tools to deliver it; - the FSA, by contrast, has regulatory tools for delivering financial stability, but with such a wide mandate prior to the crisis – including consumer protection, public awareness, market confidence and the reduction of financial crime – was not
30

The EU regulatory framework does not require this type of institutional structure but does require a clear

division between prudential and conduct of business regulation for the purposes of the ‘passporting’ regime and the allocation of responsibilities to home and host states: see ch 2.6.
31 32

Such as Australia, Hong Kong and the Netherlands. Under the Banking Act 2009. That responsibility was not formally recognised by FSMA 2000.

sufficiently focused on stability issues; and - perhaps most significantly, the linkage between firm-level and systemic stability issues has fallen between the institutional cracks, with no one body having the remit to tackle this fundamentally important issue. This has created a significant area of regulatory ‘underlap’ within the UK’s framework.33

Another aspect of the UK reform is a policy of separating macro-prudential regulation (to be located in the Bank of England) from micro-prudential regulation (to be located in the PRA). Thus the Bank of England will have responsibility for financial stability (to be given effect through macro-prudential regulation), for operating the special resolution regime for failing banks introduced by the Banking Act 2009 as well as the traditional role of any central bank as the ‘lender of last resort’ to banks who can no longer raise funds in the markets. The Treasury consultation paper argues that: By locating these distinct but complementary functions within the Bank of England group, the Government will ensure that systemic and firm-specific regulation are coordinated, and that the market knowledge and economic expertise of the central bank is fully brought to bear on financial stability.34 The Treasury consultation paper also indicates that the Treasury is likely to take a more active stance in determining the style of regulation that it is adopted within the new structure. While the FSA had a relatively free hand in developing its style35 – most obviously characterised by ‘light touch’ and ‘principles-based’ regulation – the initial indications are that the new legislative framework and Treasury guidance will play a greater role in the new structure. This is evident in the extensive discussion of the regulatory style and approach that should be adopted by the PRA and FCA in the Treasury consultation Cm 8012.

It remains to be seen how far the reform of the institutional structure will lead to better regulation and supervision. Some commentators have argued that there is little or no evidence that different

33 34 35

Cm 8012 at p4. Cm 8012 at p5. S2(4)(d) of FSMA 2000 expressly provides for the Authority to develop the general principles and

policy for the performance of its particular functions.

institutional structures were better able to avert or mitigate the crisis than others36: on that view there is little point in principle in reforming the institutional structure in response to the crisis. Focusing more specifically on the UK, it has been argued the FSA’s performance before and during the crisis does not justify its break-up.37 While it does seem clear that regulatory reform could have focused only on the regulatory rules and style of supervision without disturbing the institutional structure, perhaps the crucial issue is whether the reform to the institutional structure will strengthen the capacity of regulators to act at the appropriate time to constrain risk-taking and protect financial stability. Only time will tell if that is the case.

3.3.1 The Financial Policy Committee

The Financial Policy Committee (‘FPC’), which was established on an interim basis in February 2011 as a committee of the Court of Directors of the Bank of England, will sit at the top of the UK’s new regulatory structure.38 It will undertake the macro-prudential function that will be formalised in statute in due course and will contribute to the Bank’s financial stability objective by identifying, monitoring, and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system. That function will encompass research and analysis, the provision of advice to the Treasury and coordination with the ‘twin peaks’ regulators who will carry out supervision of financial firms. The FPC’s function will also involve using the ‘levers’ which are at its disposal to achieve its objectives. They include:
• public

pronouncements and warnings; macro-prudential policy in Europe and internationally;

• influencing • making

recommendations to bodies other than the PRA and FCA;

• powers over the PRA and FCA: to make recommendations (backed up by a ‘comply-orexplain’ mechanism), and to direct the regulators where explicitly provided for by
36

See e.g. J Cooper, ‘The Regulatory Cycle: From Boom to Bust’, ch 28 in I MacNeil and J O’Brien (eds)

The Future of Financial Regulation (Hart Publishing, 2010).
37

E Ferran, ‘The Break-Up of the Financial Services Authority’ at http://ssrn.com/abstract=1690523 (21

August 2011).
38

These comments on the role of the FPC are based on Treasury Cm 8012 (February 2011).

macro-prudential tools designed in secondary legislation.

The FPC will eventually supersede the Financial Stability Committee established under the Banking Act 2009 once the new statutory framework is in place. The new FPC has a broader remit and more extensive powers within the regulatory system than the committee it will replace, which was focused only on the Bank of England’s financial stability objectives and powers. That change reflects the new regulatory structure that is being put in place by the conservative government under which the Bank of England is at the centre of and to a large extent controls the system of financial regulation.39 3.3.2 The Prudential Regulation Authority The PRA will be established as a subsidiary of the Bank of England and will undertake prudential regulation and supervision of deposit-taking institutions, insurers (including the Lloyd’s of London insurance market) and systemically significant investment firms. The identification of systemically significant investment firms will be based on their capacity to pose risks to financial stability as a result of the nature and scale of their activities. Only firms which have permission to deal in investments as a principal will fall into this category and within that only the larger firms will be regarded as systemically significant. Thus, large ‘broker-dealers’ or investment banks (irrespective of whether they take deposits) will fall within the scope of regulation of the PRA. The strategic objective of the PRA (in common with the FPC) will be the promotion of financial stability, while its operational objective will be promoting the safety and soundness of PRA authorised firms in a way that does not rule out the possibility of firm failure.40 As regards style of regulation, the PRA will continue with and extend the ‘principles-based’ approach developed by the FSA, focusing on compliance with the spirit as well as the letter of the rules. It will also develop a ‘Proactive Intervention Framework’ which is intended to support the capacity of regulators to act at the appropriate time. In the words of the Treasury Cm 8012:
39

The Labour government had proposed to legislate to replace the Standing Committee of the Tripartite

Authorities with a Council for Financial Stability: see H M Treasury Cm 7667 at p138. The conservative opposition (now in government) opposed the creation of the Council on the basis that it did not address fundamental defects in the current institutional structure: see Hansard (House of Lords, Report and Third Reading) 8 April 2010 column 1663.
40

See further The Bank of England, Prudential Regulation Authority, Our Approach to banking

supervision (May 2011) and Our approach to insurance supervision (June 2011).

The framework will have two clear purposes: firstly, to create presumptions that regulatory actions will be taken at certain points with a view to increasing probability of recovery, and secondly to initiate coordination measures between the authorities so that the failure and/or resolution can be more effectively controlled with minimum systemic disruption. The introduction of this framework will ensure that the judgement-led approach will be applied proactively where a supervisor has concerns and that action is taken.41

3.3.3 The Financial Conduct Authority

The FCA will undertake conduct of business regulation for all authorised firms. These firms will therefore be ‘dual regulated’ by both the PRA and the FPC. Importantly, however, it will also undertake prudential regulation and supervision for investment firms that are deemed not to be systemically significant (and therefore excluded from the PRA’s remit). Thus, measured by number of firms, the FCA will undertake prudential regulation and supervision of more firms than the PRA, although measured by scale and complexity the activity of the PRA will be greater. The UK Listing Authority (UKLA) will also form part of the FCA as will conduct issues in the ‘wholesale’ markets such as the operation of the ‘market abuse’ regime. The FCA’s strategic objective will be protecting and enhancing confidence in the UK financial system while its operational objective will be: facilitating efficiency and choice in the market for financial services; securing an appropriate degree of protection for consumers; and protecting and enhancing the integrity of the UK financial system. Given the FCA’s strategic and operational objectives, its prudential regulation will focus less on acting to avoid the failure of firms and more on preventing consumer detriment. In the event of failure, the FCA’s main objective will be to ensure that customers are not disadvantaged and that risks to confidence in the UK’s financial system are minimised. The control of style of regulation by the government via the Treasury is evident to an even greater extent than in the case of the PRA. Thus Treasury Cm 8012 sets out in extensive detail how the FCA will be expected to engage in regulation and supervision. In particular it requires the FCA to focus on consumer detriment through a more interventionist approach than had been practised by the FSA in the past and to intervene at an earlier stage in the lifecycle of financial products where consumer detriment is likely rather than waiting for the harm to occur.

41

Cm 8012 p51.

3.3.4 Hierarchy and collaboration in the new institutional structure The introduction of a ‘twin peaks’ system, combined with the enhancement of the role of the Bank of England in financial stability and the ‘resolution regime’ for failing banks, represents a significant change from the FSMA 2000 structure under which the FSA acts as a integrated regulator for all matters in respect of all authorised firms. In particular the new structure raises issues regarding the hierarchy of the regulatory authorities and the extent to which they will collaborate. The issue is of considerable practical importance since the theoretical division between ‘prudential’ and ‘conduct of business’ on which the ‘twin-peaks’ model is based cannot be applied quite so easily in practice. In some areas, such as decisions on granting or limiting authorisation or the operation of the ‘approved persons’ regime, it may not be entirely clear whether the matter falls with ‘prudential’ or ‘conduct of business’ regulation and it may indeed be better to assume that it falls within both. So far as hierarchy is concerned, the proposed solution reflects greater political control (through the Treasury) and the central role of financial stability as a regulatory objective within the new system. Thus, the Treasury will be able to provide ‘guidance’ to the FPC, which in turn will be able to issue directions and recommendations to the PRA in respect of macro-prudential tools.42 The FPC will also be able to require information from the PRA but will not have any powers over individual firms. The PRA will in turn have a power of veto over actions proposed by the FCA which are likely to lead to the disorderly failure of a firm or wider financial instability. The PRA and FCA will also be subject to a statutory duty to coordinate activity with each other, and that will be supported by crossmembership of boards and a statutory obligation to prepare a MOU that deals with specific regulatory processes for which cooperation is essential.

3.3.5 Accountability of the regulators

While the FSA was established with the intention of creating an independent regulator, FSMA 2000 does provide for a degree of accountability to government ministers, Parliament and

42

Relevant tools are counter-cyclical buffers; variable risk weights; leverage limits; liquidity tools;

collateral requirements: see Cm 8012 p25.

stakeholders.43 The most significant form of ministerial control is the power of the Treasury to appoint and remove the chairman and members of the governing body of the FSA. This gives the Treasury a significant role in influencing the manner in which the FSA approaches its regulatory remit. It is possible for the Treasury to require the FSA to alter its rules but only when they have a significantly adverse affect on competition44 or in order to comply with the UK’s EU or international obligations.45 It is also possible for the Treasury to commission value-for-money audits and to arrange independent inquiries into regulatory matters of serious concern.46 Some measure of Parliamentary scrutiny of the FSA is made possible by the requirement that its annual report be laid before Parliament.47 The FSA is also in principle subject to Select Committee scrutiny but serious doubts have been expressed over the effectiveness of such oversight.48 The main mechanism for securing accountability to stakeholders has been the requirement that the FSA establish Consumer and Practitioner Panels.49 The FSA must consider representations made by either Panel and if it disagrees with it, must give the Panel a statement in writing of its reasons for disagreeing. The need for greater accountability on the part of the regulatory authorities has been one of the main concerns in the development of the new regulatory structure in the UK. The June 2011 White

43

See generally A Page, ‘Regulating the Regulator—A Lawyer’s Perspective’ in E Ferran

and C Goodhart (eds) Regulating Financial Services and Markets in the 21st Century (Oxford, Hart Publishing, 2001).
44

FSMA 2000 s 163. FSMA 2000 s 410. See ss 12 and 14 FSMA 2000 respectively. See e.g. the Penrose Report (2003) into the collapse of

45

46

Equitable Life at http://www.thecashquestion.com/penrose/intro.pdf. (21 August 2011). In 2010 the new coalition government decided to award compensation to the policyholders of Equitable Life as a result of maladministration in the regulation of Equitable Life: see http://www.hmtreasury.gov.uk/fin_equitable_life.htm (8 August 2011).
47

FSMA 2000 sch 1 para 10(3). See Page (above n 42) at p 134. FSMA 2000 s 8.

48

49

Paper50 proposed many changes to the governance of the regulators and to their accountability. Of particular note are the following proposals: - The Financial Policy Committee will be required to publish a record of each meeting within six weeks. - The PRA (and FCA) will be under a duty to make a report where there may have been regulatory failure, and that the trigger will be set out in legislation. The National Audit Office will be able to initiate value for money (VFM) studies of the PRA.51 The draft legislation provides for audit of the FCA by the National Audit Office (which will enable the NAO to launch value for money (VFM) investigations in to the FCA).52 3.4 Authorisation

The FSMA 2000 adopts the basic rule, on which most systems of financial regulation are based, that authorisation is required to engage in regulated activities.53 Authorisation is achieved, in most cases, by applying to the FSA for permission to engage in the relevant activity. 54 An applicant must meet the ‘threshold conditions’ contained in the Act before permission will be granted.55 These conditions cover several matters and in particular leave considerable discretion to the FSA in deciding whether three requirements are met. The first is whether the applicant (and the group of which it is a member) has adequate financial resources in relation to the regulated activities it seeks
50

Above n 16. Section 6 of the National Audit Act 1983 provides that the NAO can undertake a VFM study of any

51

body whose accounts are required to be examined and certified by, or are open to the inspection of, the Comptroller and Auditor General. As to the role of the Comptroller and Auditor General see the History of the National Audit Office at http://www.nao.org.uk/about_us/history_of_the_nao.aspx (8 August 2011).
52 53 54 55

See Cm 8083, above n16. This is the ‘general prohibition’ contained in s 19 FSMA 2000. Under the ‘twin-peaks’ model dual regulated firms will require authorisation from both PRA and FCA. See s41 of and Sch 6 to FSMA 2000.

to carry on. The second is the nature of the risks that are undertaken and how they are managed. The third is whether the applicant is a fit and proper person (natural or legal) having regard to all the circumstances. These tests formed part of the authorisation procedure under FSA 1986. Special provisions apply to firms from other EU Member States who wish to become authorised by exercising rights under the EU financial market directives or the TFEU Treaty. 56 Such firms are able to exercise ‘passport’ rights so as to be recognised as authorised persons in the UK. There are also a number of important exemptions from the requirement for authorisation. These issues are discussed below.

3.4.1 Permission Permission is normally granted only for specified activities and may be subject to requirements imposed by the Authority.57 That in itself constitutes authorisation for the purposes of the Act, with the result that any form of permission means that the criminal offence of engaging in unauthorised activity cannot be committed. However, engaging in activity in respect of which a person does not have permission is a regulatory contravention which will result in disciplinary action being taken by the FSA. It is not, however, a criminal offence and the contravention has no effect on the validity of a contract. The scope of permission can be varied at the request of an authorised person subject to meeting the ‘threshold conditions’ in relation to all permitted activities. The Authority is empowered to vary or revoke permission in three circumstances: first, when an authorised person fails to satisfy the ‘threshold conditions’; second, when an authorised person fails, within 12 months, to carry on a regulated activity for which he has permission; and third, when it is desirable to meet any of its regulatory objectives.

3.4.2 EEA (European Economic Area) and Treaty Firms It is also possible for authorisation to be achieved by an EEA firm exercising its rights under the various EU Directives which give effect to the TFEU Treaty principles of freedom of establishment

56 57

See Ch 2.6 for an overview of the EU regime. See generally Pt IV of FSMA 2000. A requirement to ‘ring-fence’ the ‘retail’ activities of banks so as to

protect them from the risks inherent in investment banking could be implemented in part through this regulatory technique.

and freedom to provide services.58 This is referred to in FSMA 2000 as the exercise of ‘passport rights’ by EEA firms. The EU Directives relating to banking, insurance and investment are based on two principles. The first is a ‘single licence’ under which a firm authorised in an EEA state is entitled to provide services or establish a branch (but not a subsidiary) in other EEA states. The second is ‘home country control’ under which a firm is supervised by its home state in respect of all its business conducted under the single licence. Subject to satisfying certain conditions associated with the exercise of these rights (mainly the giving of notice to its home state regulator), an EEA firm qualifies for authorisation in the United Kingdom.59 It is also possible for an EEA firm to gain authorisation for an activity in respect of which there is no EEA right to carry on the activity in the manner proposed by the applicant. For this to occur, the firm must have authorisation in its home state and the laws of the home state must provide equivalent protection or conform with a relevant provision of EU law.60 This possibility is referred to by FSMA 2000 as the exercise of ‘treaty rights’ and is designed to ensure that the UK conforms with EU law relating to freedom to provide services.61

3.4.3 Exemptions A number of exemptions from the general prohibition against engaging in regulated activity without an authorisation are provided by FSMA 2000. Section 285 establishes the general framework under which investment exchanges and clearing-houses62 are regulated. It provides that investment exchanges and clearing-houses which have been ‘recognised’ by the FSA are exempt from the general prohibition in section 19 of the Act. There are two important aspects of exempt status. First, the exemption is not a true exemption from the regulatory framework of the FSMA 2000 because exchanges and clearing-houses can only become recognised if they meet certain

58 59 60 61

See Ch 2.6. FSMA 2000 s 31(1)(b) and sch 3. FSMA 2000 s 31(1)(c) and sch 4. The TFEU Treaty rules relating to freedom of services are broader than the regime established by the

financial market directives, hence the need for this rule.
62

See Ch 12 for more detail regarding the nature and operation of exchanges and clearing-houses.

criteria.63 Second, the scope of the exemption is limited. For a RIE it relates to activities carried on as part of the business of an exchange or in connection with the provision of clearing services. For a RCH it relates to activities connected with the provision of clearing services by the clearing-house. There is no exempt person status in respect of other activities undertaken by RIEs or RCHs. Any application for permission in respect of such other activities is to be treated as an application relating only to that other activity. Appointed representatives are also exempt from the requirement for authorisation. They are persons (human or legal) who act on behalf of an authorised person in carrying on a regulated activity. They cannot themselves be authorised persons. The exemption applies only if:64 • the appointed representative is a party to a contract with an authorised person, referred to as the principal, which permits the appointed representative to carry on regulated activities and complies with such requirements as may be prescribed; and • the principal has accepted responsibility in writing for the conduct of those regulated activities. The consequence of accepting responsibility for the actions of an appointed representative is that the principal bears responsibility for them in any disciplinary action taken by the FSA or civil action taken by a customer. There is, however, a limitation of the principal’s liability in respect of criminal offences in that the knowledge and intentions of the appointed representative are not attributed to the principal unless in all the circumstances it is reasonable for them to be attributed to him. The type of activity carried on by appointed representatives and some aspects of the relationship between the principal and appointed representative are controlled by regulations made by the Treasury.65 Although appointed representatives do not require authorisation, they require approval under the ‘approved persons’ regime if they undertake ‘controlled functions’ in respect of the principal’s business.66 Members of designated professions are also exempt from the general prohibition against

63 64 65

See Ch 12 for more detail. FSMA 2000 s 39. The Financial Services and Markets Act 2000 (Appointed Representatives) Regulations 2001, SI

2001/1217 (as amended). See Ch 6.1.2 for more detail.
66

See below Ch 3.8.4.

engaging in regulated activity without authorisation. This is mainly an issue for firms of accountants, solicitors and actuaries who in the normal course of their business may find themselves engaging in regulated activities (eg an accountant engaging in tax-planning advice on pensions or a solicitor arranging for the investment of a trust fund). The main problem faced by the regulatory system is differentiating between cases in which such activity can safely be left outside the regulatory perimeter (leaving it to be controlled by the relevant professional body) and cases in which the scale of the regulated activity justifies treating members of professions on an equal footing with other authorised persons. The central provision of the Act is that a professional firm or person can only be exempt if the carrying on of regulated activity is incidental to the provision of professional services.67 Whether or not regulated activity is incidental to a profession is determined by the ‘Professions Order’68, which distinguishes between completely non-exempt activities and non-exempt activities that are subject to conditions. If the ‘incidental business’ requirement is breached there is no exemption available and the firm or person can be considered to be undertaking unauthorised activity. However, the likelihood of that occurring is reduced by the requirement that designated professional bodies should make rules that give effect to the ‘incidental business’ requirement. Moreover, the firm or person must not receive from any other person any pecuniary reward (such as commission) for which he does not account to his client. This is not a prohibition on charging clients for services comprising regulated activities. The intention is that there should be no payment made to the member of the profession that is hidden from the client. The Treasury is authorised to designate professional bodies for the purposes of this exemption. To qualify for designation a professional body must show that it has rules which satisfy the conditions mentioned above. It must also demonstrate the legal basis for its regulatory function in respect of the profession. Following designation, responsibility for oversight of professional bodies lies with the FSA. It is required to keep itself informed of the manner in which professional bodies exercise their supervisory function and the way in which members of the profession carry on their activities. The FSA also has residual powers to ‘knock out’ the exemption for the professional body in whole or in part or to ‘knock out’ a particular firm if it is not a fit and proper person to carry on the relevant

67 68

FSMA 2000 s 327(4). See also article 2(1)(c) of MiFID. The FSMA 2000 (Professions) (Non-exempt activities) Order 2001, SI 2001/1227.

regulated activity subject to an exemption.69

3.4.4 Jurisdiction The ‘general prohibition’ contained in section 19 FSMA 2000 applies to the carrying on of regulated activity in the United Kingdom. Section 418 identifies five cases in which a person carrying on a regulated activity, who would not otherwise be regarded as carrying it on in the UK, will be regarded as carrying it on in the UK. They relate to cases in which persons based in the UK (according to various criteria) carry on regulated activities overseas (whether in the EU under Treaty or Directive rights or elsewhere in the world). The general principle is that such persons are treated as carrying on regulated activity in the UK and therefore subject to the FSMA 2000 system of regulation. This is consistent with the general ‘home country control’ principle that is now well established in the EU and gaining increasing acceptance across the world.

3.4.5 Unauthorised activity Engaging in regulated activities without authorisation is a criminal offence.70 It is not, however, a criminal offence for an authorised person to engage in activities for which no permission has been granted by the FSA, but this may give rise to disciplinary action. An agreement made by a person acting in contravention of the general prohibition (ie an unauthorised person) cannot be enforced against the other party.71 The latter is entitled to recover any money or property transferred and compensation for any loss sustained as a result of having parted with it. However, provision is made for a court to allow an agreement made by an authorised person to be enforced against the customer if it is just and equitable to allow the agreement to be enforced.72 The court must consider whether the

69

See respectively ss 328 and 329 FSMA 2000. FSMA 2000 s 19. FSMA 2000 s 26. In effect, a party entering an agreement with an unauthorised person is given the

70

71

option of enforcing the agreement. That section does not apply to unauthorised deposit-taking, in respect of which there is a special provision in s 29.
72

FSMA 2000 s 28.

authorised person reasonably believed he was not contravening the general prohibition.73 3.5 Regulated activities

The definition of regulated activities is central to the system of regulation because it defines the sphere of activity in respect of which authorisation is required. Section 22(1) FSMA 2000 provides as follows: An activity is a regulated activity for the purposes of this Act if it is an activity of a specified kind which is carried on by way of business and— (a) relates to an investment of a specified kind; (b) in the case of an activity of a kind which is also specified for the purposes of this paragraph, is carried on in relation to property of any kind. This rather opaque formulation creates two routes through which activity may be regulated. The first is that it is a specified activity relating to an investment of a specified kind.74 The second is that it is a specified activity carried on in respect of any property. The purpose of paragraph (b) of section 22(1) is to bring within the scope of regulation activities that would not otherwise be regulated. For example, property (land and buildings) is not a specified investment but paragraph (b) allows direct property investment to be brought within FSMA 2000 in certain circumstances. This has occurred in respect of direct property investment undertaken by collective investment schemes and stakeholder pension schemes.75 The Treasury is authorised to make an order defining what is meant by a specified activity or specified investment and has made the Financial Services Services and Markets Act 2000 (Regulated Activities) Order 200176 (hereafter the ‘RAO’). The RAO provides a more detailed definition of specified activities and investments than the Act itself. Before turning to the detail of the RAO, it should be noted that, to fall within the scope of FSMA 2000, the relevant activity must satisfy three
73

For an example of such an agreement being enforced see Helden v Strathmore Ltd [2010] EWHC 2012

(Ch).
74

Paragraph (a) of s 22(1) (quoted above). Arts 51 and 52 respectively of the RAO. SI 2001/544.

75

76

requirements. First, the activity must be carried on by way of business. Whether an activity is carried on in this manner is determined by an order (the ‘Business Order’77 ) made by the Treasury.78 Persons (natural or legal) acting solely for their own account do not fall within the scope of the Act. Second, the activity must relate to a specified investment or be carried on in relation to property of any kind. Investments are defined in schedule 2 to the Act and the RAO and are discussed in more detail in Chapter 4. Finally, the activity must be of a kind specified by schedule 2 FSMA or the RAO. The activities specified by the RAO are set out below.79

Accepting deposits This activity has been the traditional foundation on which banking regulation has been based in the UK. It reflects the emphasis in banking regulation on the protection of depositors. Certain types of deposit made other than in the context of banking business (eg a deposit that is a pre-payment for goods) are excluded from the RAO. Deposits will not be considered to be accepted by way of business if a person does not hold himself out as accepting deposits on a day to day basis and any deposits which he accepts are accepted only on particular occasions. However, the point at which this threshold will be crossed is not entirely clear and over-reliance on the exemption opens up the real possibility of engaging in unauthorised activity.80 Issuing electronic money

77

See the FSMA 2000 (Carrying on Regulated Activities by Way of Business) Order 2001 (SI 2001/1177)

for more detail.
78

See Helden v Strathmore Ltd [2010] EWHC 2012 (Ch) at para 85 for a discussion of the ‘by way of

business’ test in s 22 FSMA 2000 and the ‘business of engaging in that activity’ test in article 3A of the Business Order.
79

This section is intended to provide an overview of the RAO. As each regulated activity is subject to

detailed conditions and exceptions, reference must be made to the RAO to decide whether a particular activity falls within its scope.
80

See FSA v Anderson [2010] EWHC 599 (Ch) for an instance in which the exemption was held not to

apply as a result of the regular taking of substantial deposits with a view to making money on the interest rate ‘spread’ as between the rate paid to depositors and the rate achieved on the invested fund.

The RAO has recently been amended to include the issuing of electronic money.‘Electronic money’ means electronically (including magnetically) stored monetary value as represented by a claim on the electronic money issuer which— (a) is issued on receipt of funds for the purpose of making payment transactions; (b) is accepted by a person other than the electronic money issuer.81

The EU Directive on Electronic Money requires that issuers be authorised by the relevant authority in their home State and that a register of issuers be maintained by that authority. The primary requirements of the Directive and the Regulations in respect of the issuance and redemption of electronic money are that:

An electronic money issuer must— (a) on receipt of funds, issue without delay electronic money at par value; and (b) at the request of the electronic money holder, redeem— (i) at any time; and (ii) at par value, the monetary value of the electronic money held.82 Insurance Effecting or carrying out a contract of insurance as a principal is a regulated activity. While there is no general definition of a contract of insurance in FSMA 2000, the RAO does refer to contracts that cover ‘miscellaneous financial loss’.83 While the FSA has issued guidance84 on the identification of

81

The Electronic Money Regulations 2011, SI 2011/99, art 2. The Regulations implement EU Directive

2009/110 on the taking up, pursuit and prudential supervision of the business of electronic money institutions with effect from 30 April 2011. As it represents ‘stored value’, electronic money is not consumer credit within the meaning of the Consumer Credit Act 1974.
82 83

SI 2011/99, art 39. SI 2001/544, schedule 1, part 1, para 16. It was held in Re Digital Satellite Warranty Cover Ltd [2011]

EWHC 122 (Ch) that this covered extended warranty insurance even though the obligation was to repair or

insurance contracts for the purposes of FSMA 2000, it does not provide clarity with regard to the issue of whether credits default swaps (‘CDS’) fall within the definition.85 The RAO excludes from its scope the activities of EEA insurers carried out under freedom of services and in relation to co-insurance, in respect of which there are EU Directives in force. Annuity contracts (such as personal pensions or ‘insured’ group pensions) are included within the definition of insurance as is ‘breakdown’ insurance provided by motoring organisations. Dealing in investments as a principal This category applies most obviously to market-makers86 and ‘proprietary trading’ activities within investment banks, whose business consists principally of buying and selling investments as a principal with a view to making a profit. The RAO makes clear that this category of specified activity applies only to persons engaged in dealing as a business and not persons who deal in investments in the course of carrying on a separate business (eg fund management).87 Dealing in investments as agent Buying, selling, subscribing for or underwriting securities or relevant investments (such as options) as an agent is a specified activity. There are exclusions from this type of activity. An important one relates to transactions arranged by an agent who is not an authorised person where the client enters the transaction on advice given by an authorised person. Another exclusion is acting as an agent in respect of ‘hedging’ risks (such as fluctuations in currencies or commodity prices) arising in a business that is not engaged in ‘regulated activity’ (eg oil companies).

Arranging deals in investments replace rather than pay money. It followed that the sale of such warranties without authorisation from the FSA was a breach of s19 FSMA 2000.
84 85

See FSA Handbook PERG 6. See further Gullifer and Payne, Corporate Finance Law (Hart Publishing 2011) at Ch 5.3.3, referring to

a leading legal opinion that has been widely relied on to support the view that CDS are not insurance. The issue carries significant implications for the regulatory position of participants in the CDS Market.
86

On the role of market-makers, see Ch 14.1.2. The RAO also makes clear that companies who (a) issue their own shares or (b) purchase their own

87

shares to be held in ‘treasury’ under s 724 of the Companies Act 2006 do not engage in regulated activity.

Making arrangements for another person (whether as principal or agent) to buy, sell, subscribe for or underwrite particular investments88 is a specified kind of activity. This category is intended to deal with persons involved in making arrangements for other persons in circumstances in which they are not the agent of that person. An example would be a person operating, on an independent basis, a system that enables investors to buy and sell securities from each other (a ‘multilateral trading facility’89). Included in this category are arrangements made for another person to enter into a regulated mortgage contract. However, mere ‘introductions’ to an authorised or exempt person with a view to the provision of independent advice or the independent exercise of discretion (eg as an asset manager) are excluded.90 Managing investments Managing investments belonging to another person, in circumstances involving the exercise of discretion, is generally a specified kind of activity.91 Managing the investments of an occupational pension scheme (defined in the RAO as a scheme limited to providing benefits to a defined category of employees) is, subject to exceptions, a specified activity. Authorisation is not required if a trustee92 does not hold himself out as providing an investment management service or if the trustee is not acting in a business capacity. A trustee does not act in a business capacity when: • routine investment decisions are delegated to an authorised person with relevant permission, an exempt person or an overseas person; or • the trustee is a beneficiary of the scheme (eg an employee); or • the trustee has no part in routine investment decisions.93 The activity of managing investments is not carried on by a person acting under a power of
88

See art 25 of the RAO. See Ch 12.3.2. Art 38 of the RAO, but note that the exclusion does not apply to insurance contracts. Art 37 of the RAO. A trustee is responsible for the investment of trust funds and an occupational pension fund is a trust

89 90 91 92

fund. See generally ch 5.1.
93

Art 66(3) of the RAO and art 4 of the Business Order (SI 2001/1177).

attorney if all routine investment decisions are taken by an authorised person with permission to carry on this activity. Assisting in the administration and performance of a contract of insurance This specified activity is in principle wide-ranging but subject to several exclusions which narrow its scope considerably. 94 The following do not fall within this specified activity: (a) expert appraisal; (b) loss adjusting on behalf of a relevant insurer; or (c) managing claims on behalf of a relevant insurer95, and that activity is carried on in the course of carrying on any profession or business. Safeguarding and administering investments This is a regulated activity if the assets include any investment which is a security or contractually based investment or may do so.96 It is immaterial that the title to assets is held in uncertificated form.97 An authorised person with permission to engage in this activity is a ‘qualifying custodian’. Arranging for another person to safeguard or administer investments is a regulated activity but mere introduction of a customer to a qualifying custodian is not a regulated activity.

Sending dematerialised instructions This category is intended to bring within the scope of FSMA 2000 persons involved in sending instructions relating to the transfer of legal title to securities that are held in dematerialised form (ie ownership is recorded in a computer system rather than on a paper certificate). 98 The activity relates to instructions sent within a relevant system in respect of which an Operator is approved under the Uncertificated Securities Regulations 2001. There are exemptions from the scope of this activity, notably in respect of participating issuers (who are not normally engaged in regulated activity).

94 95 96

Articles 39A and 39B of the RAO. Meaning an insurer that is authorised to carry on insurance business under FSMA 2000. Art 40 of the RAO. See Ch 4.12 as to the meaning of uncertificated securities. Art 45 of the RAO. See Ch 4.4.2 regarding dematerialisation.

97

98

Collective investment schemes 99 The following are specified activities: (a) establishing, operating or winding up a collective investment scheme; (b) acting as trustee of an authorised unit trust scheme; (c) acting as the depositary or sole director of an open-ended investment company (OEIC). These activities are also specified for the purposes of section 22(1)(b) FSMA 2000, with the result that they are regulated activities when carried on in respect of property of any kind (eg investing scheme assets in land and buildings, which are not specified investments).100 Stakeholder and personal pension schemes Establishing, operating or winding up a stakeholder or personal pension scheme101 is a specified kind of activity and is also specified for the purposes of section 22 (1) (b) FSMA 2000.102 Operating an occupational pension scheme is not a specified activity under the RAO, but, as noted above, managing the investments of such a scheme may be a specified activity. Advising on investments This is generally a specified activity. Included within the scope of the activity is advice given to a person in his capacity as agent for an investor or potential investor. Also included is advice given on insurance contracts (both life assurance and general insurance): this extension of the scope of the activity of ‘advising’ became effective on 14 January 2005 and a new section of the FSA Handbook entitled ‘Insurance: Conduct of Business Sourcebook (ICOB)’ was created for this purpose. ICOB also implemented two European Community measures that have significant implications for general insurance broking, the Insurance Mediation Directive103 and the Distance

99

The structure, operation and regulation of collective investment schemes is discussed in Ch 4.10. Art 4(2) of the RAO. See Ch 4.12 for the meaning of these terms. See the comment on collective investment schemes in the text above. Dir 2002/92/EC [2003] OJ L9/3.

100 101 102

103

Marketing Directive.104 Advising on mortgages is covered by a specific regulated activity (below). Generic investment advice in newspapers and other publications is excluded if it does not advise on particular investments or lead or enable persons to deal in securities. Providing basic advice to a retail consumer on a stakeholder product is a distinct form of specified activity.105

Activities linked with Lloyd’s of London Underwriting contracts of insurance as a principal in the Lloyd’s insurance market is covered by the specified activity of insurance (above) in the RAO. Other activities which are specified are:106 • Advising a person to become, or continue or cease to be, a member of a particular Lloyd's syndicate;107 • Managing the underwriting capacity of a Lloyd’s syndicate as a managing agent; • The arranging of deals in contracts of insurance written at Lloyd’s by the Society of Lloyd’s (ie the activity of a Lloyd’s broker). Funeral plan contracts Entering as provider into a funeral plan contract is a specified activity, subject to exclusions.108 The purpose of a funeral plan contract is to meet the costs of the funeral of the customer. Regulated mortgage contracts Mortgages often represent a major and often the largest long-term financial committment of households. Despite this, mortgages were not included in the definition of investments under FSA 1986 with the result that neither mortgage lending nor advising on mortgages fell within the scope of regulated activities under that Act. The regulatory gap was eventually filled in 1997 by a self-regulatory ‘Mortgage Code’, which was overseen by a body called the Mortgage Code Compliance Board. However, it soon became clear that some form of statutory regulation would be introduced. The Treasury’s initial proposal was to bring mortgage lending with the scope of regulated activities and appropriate provisions were included in the RAO. They did not, however,
104 105 106 107 108

Dir 2002/65/EC [2002] OJ L 271/16. Article 52B of the RAO. Articles 56-58 of the RAO. Generic advice on whether to become a member of Lloyd’s is not included in this activity. Art 60 of the RAO.

come into effect as originally planned in September 2003. Instead, regulation of mortgage lending was introduced at the same time as regulation of mortgage advice on 31 October 2004. From that date, a number of activities that are undertaken in respect of ‘regulated mortgage contracts’ are specified activities,109 and a new part of the FSA Handbook, the Mortgage Conduct of Business Rules (MCOB), took effect. To qualify as a ‘regulated mortgage contract’, the following conditions must be met:110 (a) the borrower must be an individual or trustee; (b) the contract must be entered into after mortgage regulation comes into force (31 October 2004); (c) the lender must take a first charge over UK property; (d) the property must be at least 40 per cent occupied by the borrower or his immediate family. The following are specified activities in respect of such contracts: • entering into or administering;111 • arranging;112 • advising.113 Appointed representatives (aka ‘tied agents’) do not have the option of becoming authorised for the purposes of mortgage advice, as the FSMA does not permit the same person to be both exempt from authorisation114 in respect of some activities and authorised for others. Professional firms that carry on regulated activity that is incidental to their profession can engage in a similar fashion in arranging and advising on mortgages. This activity does not include recommending
109

See the FSMA 2000 (Regulated Activities) (Amendment) (No 1) Order 2003, SI 2003/1475. See art 61 of the RAO. Loans that do not fall within this definition (eg a mortgage which is

110

a second charge) may be subject to regulation under the Consumer Credit Act 1974. Responsibility for licensing under that Act lies with the Office of Fair Trading (OFT).
111 112 113 114

Art 61 of the RAO. Art 25A of the RAO. Art 53A of the RAO. Under s 39 FSMA 2000, appointed representatives are exempt from authorisation.

particular products to clients, for which authorisation is necessary. With the introduction of mortgage regulation, the scope of the financial promotion regime115 has been extended to include promotion relating to arranging and advising in respect of regulated mortgage contracts. Regulated agreements relating to land and homes The RAO specifies as regulated activities entering into and administering three types of agreement that have become quite common in recent years as techniques to release equity tied up in a home so as to fund retirement or care home expenses. The three types of agreement are as follows: (i) Home reversion plans. Under this type of agreement a provider agrees to buy an interest in land or a home. The seller remains entitled to live in the property but that right terminates on the occurrence of specified events such as admittance to a care home. (ii) Home purchase plans. This type of agreement is similar to (i) above except that the seller does not lose the right to occupy the home. In this case the purchase price effectively acts as a form of income for the seller over the specified period, but leaves the seller with no asset at the end of the period. (iii) Sale and rent back agreements. Under this form of agreement the seller transfers ownership to the provider but then has the right to remain in the home as tenant rather than owner. Agreeing to carry on activities Agreeing to carry on most of the activities referred to above is a specified activity.116 This brings within the scope of FSMA 2000 persons who have not yet commenced the relevant activity but have agreed to do so. It has implications for persons who plan to provide services in respect of which they do not currently have permission.

115

See 3.6 below. Exceptions are accepting deposits, effecting and carrying out contracts of insurance or carrying on any

116

of the collective investment scheme activities or activities in relation to stakeholder pension schemes.

Dormant account funds The Dormant Bank and Building Societies Accounts Act 2008 put in place a legislative framework that allows dormant accounts (ie those that have been inactive for 15 years and therefore appear to have no claimant) to be used for social and environmental purposes. As part of that framework the Act enables the creation of so-called ‘reclaim funds’ to whom dormant accounts can be paid. Two activities associated with such reclaim funds are specified activities: the meeting of repayment claims to (dormant) account holders or their successors 117 ; and the management of dormant account funds (including the investment of such funds) by a reclaim fund.

Exclusions applying to several specified kinds of activity This part of the RAO excludes certain types of activity from its scope. They are: (a) some of the activities of trustees and personal representatives; (b) activities carried on in the course of a profession or non-investment business which are a necessary part of that business and are not remunerated separately; (c) the provision of information on an incidental basis about an insurance contract; (d) activities carried on in connection with the sale of goods or the supply of services; (e) transactions between members of corporate groups and joint enterprises; (f) activities carried on in connection with the sale of a body corporate; (g ) activities carried on in connection with employee share schemes; (h) various activities carried on by an overseas person.

The general policy of these exclusions is to ensure that the scope of regulated activities does not require businesses and professional firms whose main activity is not financial services to be authorised under FSMA 2000. 3.6 The financial promotion regime

117

In which case the designation of the account as ‘dormant’ is effectively lifted.

The financial promotion regime had no direct counterpart under FSA 1986. It has two main purposes. First, it prohibits financial promotion on the part of unauthorised persons. Authorised persons are permitted to engage in financial promotion and when they do so are regulated by FSA rules.118 Second, it unites in a single regime a variety of regulatory controls relating to financial promotion that had in the past existed under FSA 1986, the Banking Act 1987 and the Insurance Companies Act 1982. These controls related to the advertising, marketing and sales techniques used to promote the financial products falling within each of the three regulatory regimes (above) that pre-dated FSMA 2000. Of particular significance in the context of investment were the controls over advertising (s 57 FSA 1986 and rules made under it), unsolicited calls (s 57 FSA 1986 and relevant rules), promotion of unregulated collective investment schemes (s 76 FSA 1986) and promotion of certain long-term insurance contracts (s 130 FSA 1986). By consolidating these controls, the Financial Promotion Regime provides a single point of reference for determining whether a person can engage in financial promotion. Financial promotion is not the same as regulated activity. While the distinction introduces considerable complexity into the regulatory system, it has been justified on the basis that the FSA should be able to take action when an unauthorised person attempts to induce a potential customer into a transaction without waiting until regulated activity has commenced. Under FSA 1986, ‘investment business’ included ‘offering’ to engage in such business, with the result that promotion fell within that Act’s definition of regulated activity.119 That is no longer the case as under FSMA 2000 an unauthorised person contravenes the general prohibition only at the stage of agreeing to carry on a regulated activity and not before.120 It has also been justified on the basis that the territorial scope of the financial promotion regime should be broader than that of ‘regulated activities’ so as to limit promotions aimed at the UK from overseas persons falling outside the scope of the RAO. Section 21 of the FSMA forms the basis of the financial promotion regime. It provides:

118

These rules form part of the Conduct of Business Sourcebook (COBS, part 4) rather than being part of

the financial promotion regime itself.
119 120

See sch 1 p 2 FSA 1986 (repealed). See art 64 of the RAO. The reference to ‘agreeing’ indicates that there must be a legally binding

contract for the carrying on of a regulated activity.

(1) A person (‘A’) must not, in the course of business, communicate an invitation or to engage in investment activity. (2) But subsection (1) does not apply if (a) A is an authorised person; or

inducement

(b) the content of the communication is approved for the purposes of this section by an authorised person.
(3) In the case of a communication originating outside the United Kingdom, subsection (1)

applies only if the communication is capable of having an effect in the United Kingdom.

A number of points can be made. First, ‘in the course of business’ appears to mean in the course of any business and not just regulated activity. ‘Communicate’ appears to include not just the source of the communication but also persons involved in its delivery (in whatever format) to the potential customer. The FSA in its Financial Promotion Guidance121 takes the view that a person communicates where he is responsible for giving or transmitting material to a third party. Thus publishers and broadcasters who publish advertisements fall within the regime while printers, postal services, advertising agencies and courier services would either not be considered to be communicating or could take advantage of the 'mere conduit' exemption.122 ‘Engaging in investment activity’ is defined by section 21(8) as: (a) entering or offering to enter into an agreement the making or performance of which by either party constitutes a controlled activity; or (b) exercising any rights conferred by a controlled investment to acquire, dispose or convert a controlled investment. ‘Controlled activities’ and ‘controlled investments’ are defined (at some length) in an Order made by the Treasury under section 21 FSMA 2000.123 Although, these categories overlap to a significant extent with ‘specified activities’ and ‘specified investments’ under the RAO, there are important differences. In general, the exclusions set out in the RAO do not apply, so that while a person may not require authorisation because he is not carrying on a regulated activity by way of business, he may find that his communications are subject to the financial promotion prohibition. The restriction on financial promotion does not apply to a communication if the content of the
121 122 123

of,

underwrite

See FSA Handbook, PERG 8. Art 18 of the Financial Promotion Order (below). The FSMA 2000 (Financial Promotion) Order 2005 SI 2005/1529, replacing SI 2001/1335.

communication is approved for the purposes of section 21 by an authorised person. The approval process is controlled by Conduct of Business Rules made by the FSA.124 As far as territorial application is concerned the prohibition applies to communications originating outside the UK that are capable of having an effect within the UK but does not generally apply to communications made to persons receiving it outside the UK or which is directed only at persons outside the UK. 125 The restriction does not prevent the provision of information to a customer at the customer’s initiative nor communications that enable such a customer to acquire a controlled investment or to be supplied with a controlled service.126

3.7 Rule-making

3.7.1. Powers The nature of FSMA 2000 is that it is an enabling statute. It contains only a basic framework for the system of financial regulation, leaving much of the detail to rules made by the regulator and the style of supervision adopted by the regulator. The rule-making powers of the FSA are therefore central to the whole system. The FSA has both general and specific rule-making powers. The general rule-making power authorises the FSA to make such rules applying to authorised persons with respect to them carrying on any activities (whether or not regulated activities) as appear necessary or expedient for the purpose of meeting any of its regulatory obligations.127 Statutory recognition that rules may apply in different ways to different persons or activities allows the Authority to continue the practice of distinguishing between different types of customer and investor in its rulebook.128 There are also
124 125 126

See FSA Handbook, COBS 4.10. Article 12 of the Financial Promotion Order. Article 13 of the Financial Promotion Order. FSMA 2000 s 138 (as amended by s3(4) FSA 2010). The FSA 2010 extended the FSA’s general rule

127

making power to include any regulatory objective: it had previously been limited to rules that were necessary or expedient to protect consumers (which included professional investors as well as retail investors).
128

See s 156(1) FSMA 2000.

specific rule-making powers.129 Also relevant here are the FSMA provisions relating to the manner in which the FSA carries out its functions. One of the FSA’s general functions under the Act is making rules and the Act requires that in discharging its general functions, the Authority must have regard to, inter alia, the principle that the costs of regulation should be proportionate to the benefits.130 The rule-making procedure under FSMA 2000 is more formal and detailed than that under FSA 1986.131 The FSA must publish a draft of proposed rules for public consultation and must take account of any representations when making the rules. Such representations are likely to be made by the Consumer and Practitioner Panels which the Authority is required to establish and maintain.132 The consultation draft must be accompanied by an explanation of the purpose of the proposed rules. The FSA must also, in most circumstances, publish a cost-benefit analysis with a draft of the rules. If the rules differ significantly from the consultation draft, the FSA is required to publish details of the difference and another cost-benefit analysis.

3.7.2 The FSA Handbook

The FSA has used these powers to make its rulebook, the Handbook of Rules and Guidance.133 The Handbook is divided into several blocks, which are in turn divided into topics. There are seven main blocks as follows: 1 High-level standards. This contains, inter alia, statements of principle applicable to businesses and approved persons. 2 Prudential standards. This block contains standards for regulatory capital and liquidity for banks,
129

See ss 144-47 FSMA 2000 which empower the Authority to make price stabilising rules, financial

promotion rules, money laundering rules and control of information rules.
130

FSMA 2000 s 2(3)(c). The costs of regulation are borne initially by authorised persons and

ultimately by investors (assuming that such costs are passed down the chain of transactions to final investors).
131 132

See s 155 FSMA 2000. See ss 8-10 FSMA 2000. The handbook is available online at www.fsa.gov.uk (22 August 2011). See the Reader’s Guide to the

133

Handbook for details regarding structure and content.

insurers and investment firms. 3 Business standards. This block contains the Conduct of Business (‘COBS’) and Market Conduct (MAR) sourcebooks. 4 Regulatory processes. Included in this block are the Authorisation (AUTH), Supervision (SUP) and Enforcement (ENF) manuals. 5 Redress. This contains the complaints and compensation sourcebooks. 6 Specialist sourcebooks, including those applicable to collective investment schemes, recognised exchanges and the Lloyd’s insurance market. 7 Listing, Prospectus and Disclsoure. This block contains the UKLA Listing Rules, the rules for public offers and prospectuses and the disclosure obligations of issuers whose securities are listed.

The status of each provision in the Handbook is indicated by a letter attached to it as follows: R indicates rules, which can be general rules made under section 138 FSMA 2000 or rules made under other specific powers provided by the Act. Included in this category are the FSA’s Principles for Businesses. Most of the rules in the Handbook create binding obligations on firms. If a firm contravenes such a rule, it may be subject to enforcement action and, in certain circumstances, to an action for damages. D indicates directions and requirements given under various powers conferred by the Act. They are binding upon the persons or categories of person to whom they are addressed. P indicates Statements of Principle for Approved Persons made under section 64 of the Act. The Statements of Principle are binding on approved persons.

C indicates ‘safe harbours’ (conclusive descripitions of compliant behaviour in respect of the market abuse regime) specified under section 119(2) of the Act.

E indicates evidential provisions, specified in s149 of FSMA, which are discussed below.

G indicates guidance given by the Authority under section 157 of FSMA (discussed below). It follows from this structure that the FSA Handbook comprises diverse provisions that have

different effects. Some have no binding effect (guidance). Others are binding but are expressed with differing levels of detail (principles and rules). Some are binding but only for the purposes of disciplinary action by the FSA but are not actionable in law (principles).134 Others serve the purpose of more clearly delimiting the scope and application of related rules (safe harbours and evidential provisions). Evidential provisions are intended to make clear when compliance with or contravention of one rule (A) will result in compliance with or contravention of another rule (B). An evidential provision must either provide that contravention of rule A tends to establish contravention of rule B or that compliance with rule A tends to establish compliance with rule B. Their effect is to move the burden of proving compliance with rule B on to a firm when it is in contravention of rule A and of proving contravention of rule B on to the FSA when a firm is in compliance with rule A. In that sense they create rebuttable presumptions of compliance with or contravention of the binding rules to which they refer. ‘Safe harbours’ differ from evidential provisions in two important ways. First, they relate only to the market abuse regime. Second, behaviour in conformity with a safe harbour is, by virtue of section 122 FSMA 2000, conclusively not market abuse. In this sense, safe harbours provide guarantees in respect of behaviour while evidential provisions do not. Guidance can consist only of information and advice and therefore cannot impose obligations.135 It can take the form of general guidance given to the public, regulated persons or a class of regulated persons or, alternatively, specific guidance given to an individual or firm.136 Compliance with guidance provides no immunity from regulatory action taken by the FSA in respect of a contravention of the Act or rules made under it, but the FSA has made clear that action will not normally be taken against a firm or individual in respect of behaviour in line with general or specific guidance.137 Finally, the FSA may also, in some circumstances, give directions. For example, when it decides to modify or waive the application of a particular rule, the FSA gives a direction to that effect. There are normally particular conditions attached to the making of directions.

134 135 136 137

See Ch 3.6 and 3.9.6 for more detail. See ss 157 and 158 FSMA 2000. The FSA can make a reasonable charge for guidance given to a person on request. See FSA Policy Statement, The FSA’s Approach to Giving Guidance and Waivers to Firms (Sept 1999).

3.7.3 Principles vs. rules

A contrast is often made between regulatory systems as regards the extent to which they are based on principles and rules respectively.138 According to this approach, principles are broadly based standards that encourage compliance with their spirit as well as their letter. Their broad formulation permits the regulator considerable discretion in interpreting and applying the principles but, viewed from the perspective of the regulated community, they create some uncertainty as to the precise nature of the regulatory obligations. By way of contrast, a system that focuses more on rules formulates regulatory obligations more precisely and concentrates on compliance with the letter of the rules: this provides greater certainty to the regulated community but opens up more scope for ‘creative compliance’139 which respects the letter of the rule but not the spirit. While it is often claimed that systems are either ‘principles-based’ or ‘rules-based’, it is probably more accurate to say that all system use both principles and rules to varying degrees and that the differences relate to the extent to which each is employed.140

The FSA has been a strong proponent of the ‘principles-based’ approach, primarily on the basis that it represents a better way to structure regulatory obligations that a more rules-based approach. Prior to the global financial crisis, the FSA’s case for ‘principles-based’ regulation was that: 141 (i) Detailed prescriptive standards have not in the past prevented misconduct; (ii) the current volume and complexity of FSA standards acts as both a barrier to entry and a barrier to compliance;

138

See generally J Black, M Hopper and C Band, ‘Making a success of Principles-based regulation’ 1(3)

Law and Financial Markets Review 191- 206 (2007).
139

See generally D Mc Barnet and C Whelan, Creative Accounting and the Cross-eyed Javelin Thrower

(Chichester, John Wiley, 1999).
140

See C L Ford ‘New Governance, Compliance and Principles-Based Securities Regulation’ available at

http://ssrn.com/abstract=970130 . A cursory glance at the sheer scale of the FSA Handbook of Rules and Guidance (see www.fsa.gov.uk ) serves to illustrate the point.
141

See Andrew Whittaker, FSA Director General Counsel, ‘Professional and Financial Regulation —

Conflict or Convergence?’ (Speech delivered at the Fountain Court Chambers Conference, 31 January 2006), available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/0131_aw.shtml4.

(iii) prescriptive rules divert attention towards compliance with the letter rather than the spirit of the standard; (iv) many issues are not dealt with adequately by prescriptive standards, or can be dealt with in that way only at the cost of making the system overly complex; (v) prescriptive standards are costly for FSA and consumer resources. While the FSA’s principles-based approach was widely viewed as successful in the pre-crisis era, the onset of the global financial crisis, and in particular the severity with which it affected UK financial institutions and the broader economy, caused some re-evaluation. It was clear ever since the FSA Chief Executive remarked, that ‘A principles-based approach does not work with individuals who have no principles’142 that some change was likely in the FSA’s approach. While there is little evidence to date of any substantial change in the formal position of principles within the FSA rulebook, both the FSA’s re-denomination of ‘principles-based’ regulation as ‘outcomesfocused regulation’ and the change in basic regulatory philosophy and style outlined below143 suggest that there may well be significant changes ‘in action’. On the other hand, a recent test-case144 brought by the British Bankers Association (‘BBA’) challenging the manner in which the FSA treated Principles as imposing obligations on authorised firms provides important legal authority for the FSA’s principles-based approach. The dispute in this case focused on whether it was lawful for the FSA to rely on Principles to impose obligations on firms requiring them to compensate customers for their breach. The context of the dispute was that the FSA had responded to widespread concern about consumer detriment resulting from mis-selling of payment protection insurance (‘PPI’) in connection with consumer loans by amending the FSA Handbook rules and guidance on handling PPI sales complaints and issuing an Open Letter identifying common failings. The BBA challenged the lawfulness of the FSA Policy Statement that set out these changes by arguing that: - the FSA could not rely on Principles to create obligations for firms since they are not actionable in

142

H Sants, ‘Delivering intensive supervision and credible deterrence’, Speech at Reuters Newsmakers

Event (12 March 2009) www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0312_hs.shtml.
143 144

See below Ch 3.8.3. R (ex parte British Bankers Association) v FSA [2011] EWHC 999 (Admin).

law; - that since the FSA had made specific (conduct of business) rules on PPI sales, it was unlawful for the FSA to provide in its Policy Statement that a customer might be entitled to redress by reference to Principles which conflicted with or augmented those specific rules; The High Court rejected both of these arguments and, in so doing, provided an important endorsement of the lawfulness of the FSA’s policy of principles-based regulation. The court’s reasoning provides a succinct overview of the legal context and the manner in which principles-based regulation operates: The Principles are the overarching framework for regulation, for good reason. The FSA has clearly not promulgated, and has chosen not to promulgate, a detailed all-embracing comprehensive code of regulations to be interpreted as covering all possible circumstances. The industry had not wanted such a code either. Such a code could be circumvented unfairly, or contain provisions which were not apt for the many and varied sales circumstances which could arise. The overarching framework would always be in place to be the fundamental provision which would always govern the actions of firms, as well as to cover all those circumstances not provided for or adequately provided for by specific rules. Thus, the FSA has a solid legal basis for continuing to rely on Principles as a source of obligations. However, that in itself does not resolve the issue of whether the principles-based approach represents the best way for the FSA to pursue its regulatory objectives. Indeed, to the extent that the PPI test case can viewed as a case study of the failure of principles-based regulation (prior to FSA intervention) to secure appropriate outcomes for consumers in situations where there are gaps in the detailed rules, it might well be argued that it does not support a principles-based approach to regulation. However, that is probably an overly pessimistic reading of the case and a more balanced view would be that the case demonstrates the capacity of principles-based regulation to signal to authorised firms how to deal with (inevitable) gaps in detailed rules by reference to high-level principles. 3.8 Risk-based regulation 3.8.1 Risk-control strategies145 While the descriptor ‘risk-based regulation’ is of relatively recent origin, the technique itself is not. The concept of controlling excessive or abusive instances of activity that is prima facie
145

This section is drawn substantially from I MacNeil ‘Risk Control Strategies: An Assessment in the

Context of the Credit Crisis’ ch 9 in I MacNeil and J O’Brien (eds) The Future of Financial Regulation (Hart Publishing, 2010).

socially beneficial has a long history both within discrete regulatory regimes and in the general law. taking Regulatory regimes generally adopt three high-level strategies for controlling risk146

: prohibition, limitation or remedy (see Table 1). Whilst in principle each represents a

different approach, there is some overlap and regulatory regimes typically combine the three approaches. The three generic approaches remain the same irrespective of the institutional arrangements for regulation within any system, although there may well be issues as to how well each strategy can operate when responsibility is split across different regulatory authorities.

The prohibition strategy is used for three main purposes: (i) to control entry

147

into

regulated activity (ii) to constrain the activities of authorised firms and (iii) to prohibit conduct within the system that directly threatens the objectives of the regulatory system. Examples of the first within the UK regulatory system are the criminal offence of engaging in regulated activity without authorisation and the prohibition on ‘controlled activities’ being performed by anyone other than an ‘approved person’.
148

An example of the second is the constraint imposed on

authorised firms by the concept of ‘permitted activities’, which represent the sub-set of regulated activity in which an authorised firm is permitted to engage. An example of the third is the ‘market abuse’ regime.
149

The attraction of the prohibition strategy is that it draws a clear

dividing line between what is and what is not permitted. It does, however, have several disadvantages. First, at least in it simplest form, it is a crude mechanism that lacks flexibility. Moreover, in its more sophisticated forms (e.g. the market abuse regime) it risks losing legal certainty since the prohibition become so nuanced that it can be difficult to understand and to apply. Second, the prohibition strategy limits the potential role of the regulator as a supervisor as opposed to an enforcer of regulatory rules. The extent to which that occurs will depend on how the prohibition is framed. Thus, for example, a ‘fit and proper’ test for entry into regulated activity by firms and individuals can in itself open up a broad role for a regulator even within a

146

Risk-taking behaviour is a sub-set of the entire set of risks that a regulatory system confronts. It is most

obviously linked with credit risk, market risk and systemic risk.
147

And is some cases exit: see the rules on de-listing of SEC-registered companies, which constrain the

ability of companies to de-list in the United States.
148 149

Respectively, FSMA 2000 s19 and s59. FSMA Part XVIII, implementing the EC Directive on Market Abuse (Dir 2003/6, OJ L96/16).

system that emphasises prohibition. Third, the prohibition strategy is open in some cases to avoidance through regulatory arbitrage. That will be the case particularly when activities can be transferred to jurisdictions in which the activity is not prohibited or can be functionally replicated through alternative techniques (e.g. ‘off-balance sheet’ financing or derivatives).

Table 1 Generic Risk Control Strategies

Prevent

Limit

Remedy

Substance Process Ex ante Ex post

Prohibition

Risk threshold

Liability standard

Licensing

Supervision

Deterrence

Enforcement:exclusion/ containment/penalty

Negotiated correction/penalty

Enforcement: restitution/ compensation/penalty

The limitation strategy is more sophisticated in the sense that it permits activity subject to the observance of risk thresholds that cannot be exceeded. Such risk thresholds can be either quantitative (e.g. regulatory capital requirements by reference to tiers of capital) or qualitative (e.g. the requirement to have ‘adequate financial resources’). From the perspective of process, the limitation strategy focuses on supervision, undertaken through provision of information and direct contact between regulators and the firm. As the experience of the credit crisis has shown, breach of risk thresholds tends to be dealt with as a matter of negotiated correction rather than formal enforcement. This reflects both the priority given to supervision over enforcement within the limitation model and the practical constraints imposed on the possibility of formal enforcement where regulators have failed to use their full range of powers prior to the emergence of a crisis. In such a situation, regulators cannot credibly claim that there has been noncompliance when the exercise of discretionary powers would have averted (or at least mitigated)

the crisis.

150

The limitation strategy is particularly appropriate in situations where alignment of
151

the interests of regulated firms and their customers creates an incentive to observe the regulatory thresholds without resort to enforcement. It also offers the potential to respond more quickly

through supervision than through formal enforcement. The drawback of the limitation strategy is that it depends heavily on the capacity of the regulator to engage in effective supervision and, as recent events demonstrate, that may not always be a realistic expectation. The remedial strategy attracts less attention as a regulatory technique probably for two reasons. One is that regulation is often equated with a model in which the regulator has an active supervisory role, whereas the remedial strategy does not envisage such an active role for the regulator but relies instead on the deterrent effect of the liability standard. The limitation strategy typically gives a significant role to the courts in enforcing the liability standard, although it is also possible for this process to take place within the regulatory system.
152

By setting a standard
153

that may trigger liability (to investors, customers) a liability standard has the capacity to control risk-taking ex ante, at least to the extent that risk-taking can be causally linked with harm. A

second reason for its lower profile is that the remedial strategy bridges the divide between the general law and discrete regulatory systems (in the pure sense as something distinct from law) and can therefore be characterised as much as a general legal strategy as a regulatory strategy associated with risk-based regulation. However, it remains the case that the remedial strategy plays an important role in many systems of financial regulation. Prime examples in the UK are the liability associated with false or misleading statements in prospectuses and disclosures to the

150

This was the position in respect of regulatory capital since the FSA was already empowered to require

levels of capital above the minimum requirement prior to the financial crisis.
151

That has been the case with regard to the recent strengthening of the regulatory capital of banks but

only as a result of the onset of the financial crisis. It is clear that banks (and their counterparties in the wholesale markets as well as regulators) were prepared to tolerate much lower levels of regulatory capital during the boom years.
152

For example, FSMA 2000 authorises the FSA on its own initiative to make restitution and

compensation orders in connection with regulatory contraventions (see s384). While there is little formal use of this power it does provide a ‘stick’ to back up negotiated settlement in individual or industry-wide cases (e.g. pensions mis-selling).
153

It is for this reason that a liability standard is of little use in controlling systemic risk, whereas it does

have a major role to play in regulating individual transactions.

market and actions in damages or for restitution for regulatory contraventions. In the United States, securities class actions stand out as the most distinctive example of the remedial approach. The strategy in principle encompasses both public and private enforcement, albeit that the relative role of each will depend on a range of factors.
154

The objective of enforcement under

the remedial model is to secure compensation (or restitution) in respect of loss caused by breach of the liability standard. That objective also represents a restriction on the potential use of the strategy since there are instances in which the avoidance of the materialisation of risk is such a priority within the system that it is inappropriate to deploy a regulatory strategy that focuses on resolution ex post.
155

Regulatory systems can and do adopt different combinations of the three generic strategies outlined above. It is the mix that largely defines the individual character of any regulatory system and it is likely to be driven by a range of different factors. The legislative framework has a direct effect on the mix to the extent that it adopts clear choices as between the three strategies. As far as the UK system is concerned, the legislative framework does adopt the prohibition and remedial strategies to a significant extent but does not emphasise the limitation strategy. That does not mean, however, that the limitation strategy is excluded. On the contrary, the wide discretion enjoyed by the regulator in the UK in defining its approach to regulation opens up the possibility of adopting the limitation technique across the board. That is precisely what has occurred through the adoption of risk-based regulation. Linked with this is the fact that the UK legislative framework does not deal with the issue of the risk preference that should be favoured by the regulatory system and it has therefore fallen to the FSA to delimit tolerable risk. In so doing, the FSA has implicitly prioritised the limitation strategy, albeit that there are important elements of the prohibition and remedial strategy within the system. The limitation strategy offers a more active role and greater flexibility to a regulator than do the other two options and in that sense is hardly a surprising choice within a system that leaves the determination of basic regulatory policy to the regulator.

154

They include the powers of the regulator and the incentives for private lawsuits in the legal system

generally and in the system of financial regulation.
155

That argument applies both to the risk of insolvency of individual firms and systemic risk, although it is

possible for ex post mechanisms such as deposit protection to prevent the materialisation of (insolvency and liquidity) risk.

Another factor that should influence the mix but does not always clearly do so is how the system of financial regulation meshes with the general legal system and in particular the extent to which corporate and fiduciary law as well as governance codes provide a normative substratum on which the system of financial regulation is built. That issue is relevant not only for the determination of whether regulatory intervention should occur but also for the manner in which it should occur. In this context, attention should be paid to the regulatory strategies adopted in regimes that operate in parallel with FSMA 2000.156 They are significant since, to the extent that they pursue similar objectives to the FSMA, different regulatory strategies are liable to lead to confusion and lack of coherence. The principles/rules debate is also relevant in this context since principles-based regulation maps very directly on to the limitation strategy with its focus on flexibility and supervisory engagement.

3.8.2. Risk assessment and monitoring The FSA now operates what it refers to as a ‘risk-based’ system of regulation. The risks to which this refers are those that pose a risk to the achievement of the statutory objectives set by FSMA 2000.157 This is a fundamentally different perspective of risk from that of an authorised firm that is managing risk within its business albeit that the risks faced by firms must inevitably form the focus of the FSA’s general functions. Essentially the risk with which the FSA is concerned is the risk of regulatory failure, meaning failure to achieve the statutory objectives set by FSMA 2000.158 In identifying and assessing risks the FSA focuses on their impact (the scale of the effect on the statutory objectives if the issue or event crystallises) and their probability (the likelihood of the particular issue or event crystallising). Firms that are assessed by the FSA as being ‘low impact’ (in the sense of posing little risk to the achievement of the statutory objectives) do not have an individual risk assessment or mitigation programme. They are monitored through the more traditional approach of scrutinising returns made by firms and conducting sample exercises to monitor compliance standards. For those firms subject to individual risk assessment, the FSA identifies the following types of risk:
156 157 158

Such as corporate governance: see chs 9 and 10. See above 3.2. See generally FSA publication, The FSA’s Risk Assessment Framework (2006).

(a) Firm specific risk. This is the risk that arises from the structure and method of operation of a particular business. It can be broken down into two components: (i) Business risk. This is the risk that arises from the nature of the business. For example, in banking there is a risk of customers defaulting on loans and in general insurance there is the risk posed by the multiple occurrence of insured risks (eg as a result of an earthquake). (ii) Control risk. This risk arises from the way in which a business is organised and operates. It includes issues such as the management structure, internal controls and the way in which the business sells financial products to or advises customers. (b) Environmental risk. This category describes risks that are external to the firm but which directly or indirectly affect firm specific risk. It comprises the following types of risk: (i) Political/legal. This would include threats to a firm’s business posed by changes in legislation. (ii) Socio-demographic. An example would be the long-term effect on an annuity provider of increasing life expectancy. (iii) Technological. An example is the threat posed to recognised investment exchanges by developments in computerised dealing systems.159 (iv) Economic. Changes in interest rates may, for example, increase loan defaults for banks. (v) Competition. Some firms may face pressure from new competition (domestic or international). (vi) Market structure. This may be affected by changing customer preferences (eg a preference for renting over home ownership ) or regulatory developments. The next step is to link these risks to the statutory objectives. This is achieved through an assessment of how these risks affect one or more of seven regulatory risks, which are termed ‘risk to objectives’ (RTO) groups. In essence the RTOs provide a technique for mapping business and control risks on to the statutory objectives. The RTOs are as follows: Financial failure. This is the risk posed to market confidence and consumer protection from the failure of a firm. Misconduct and/or mismanagement. An example is the risk to consumer protection and market confidence arising from ‘miss-selling’.160
159 160

See Ch 12 for further discussion. See Ch 6 for a discussion of ‘miss-selling’.

Consumer understanding. This is the risk posed to the consumer protection and public awareness objectives by lack of understanding on the part of consumers of products bought from firms. Incidence of fraud or dishonesty. This poses a threat to the financial crime, consumer protection and market confidence objectives. Incidence of market abuse. This also poses a threat to the financial crime, consumer protection and market confidence objectives. Incidence of money laundering. This poses risks for the financial crime objective. Market quality. This is the risk posed to market confidence and consumer protection arising from possible deterioration in the functioning of a market. In respect of each firm, the business and control risks are scored against the RTO groups. This process provides an overall probability score in respect of each statutory objective that falls into one of the following catgeories: high, medium high, medium low or low. The next step is for the FSA to develop a risk mitigation programme (RMP) by reference to the score of a particular firm.161 In doing so the FSA takes account of the principles of good regulation by aiming to ensure that the intensity of the RMP is proportionate to the risk posed by the firm. The RMP is then communicated to the firm together with an indication of the regulatory period, which is the period between formal risk assessments. The period varies between 12 and 36 months according to the risk profile of firms and when longer than 12 months, an interim risk assessment will be undertaken which may result in changes to the RMP.

3.8.3 ‘Light-touch’ regulation

Although the FSA never explicitly endorsed the ‘light-touch’ descriptor162 with which it became associated, there can be little doubt that it was in the ascendancy prior to the financial crisis and represented a de facto limitation on the very broad powers and extensive discretion that were

161

See Appendix 2 to FSA Publication The FSA’s risk assessment framework (2006) for an example of a

RMP.
162

See p86 of the Turner Review (above n3), referring to it as ‘somewhat of a caricature, and a term which

the FSA never itself used.’

given to the FSA by FSMA 2000. The approach was described by the FSA itself in the following terms: The historical philosophy was that supervision was focused on ensuring that the appropriate systems and controls were in place and then relied on management to make the right judgment. Regulatory intervention would thus only occur to force changes in systems and controls or to sanction transgressions which were based on historical facts. It was not seen as a function of the regulator to question the overall business strategy of the institution or more generally the possibility of risk crystallising in the future. 163

In the wake of the crisis, changes to the model of supervision were implemented through the ‘Supervisory Enhancement Programme’, which focused attention on ‘high-impact firms’ (‘HIFs’, firms whose failure has the potential to have systemic implications). It was based on the premise that ‘The new model of supervision is designed to deliver a more intrusive and direct regulatory style than the FSA has previously adopted and requires a ‘braver’ approach to decision-making by supervisors’.164 Among the changes it introduced were:
•

A compulsory and irreducible programme of regular meetings with the senior management, control functions and non-executive directors of firms subject to our ‘close and continuous’ regime (that is, HIFs). This is to establish and communicate to the firm the minimum level of interaction the FSA expects, and will now include: • an annual meeting with the firm’s senior management to focus specifically on the business and strategic plans for the firm; • an annual meeting with the external auditors; and • specific items of management information to support these meetings (such as annual strategy documents, operating plans, particular Board reports and the Management Letter provided from the external auditors). A regulatory period between formal ARROW assessments of maximum two years for each HIF. During this period, we are now holding more formal internal ‘checkpoints’ on a six-monthly basis to provide more FSA senior management input and oversight of the supervisory approach for the firm. Increased scrutiny of candidates for Significant Influence Functions (SIFs), particularly the Chair, CEO, Finance Director and Non-executive Directors of HIFs. This scrutiny includes interviewing SIF candidates where appropriate and a greater focus on their personal accountability in post.

•

•

163 164

FSA Regulatory Response, above n3 at para 11.14. FSA Regulatory Response, above n3 at para 11.15.

•

A new group of supervision advisory specialists who will conduct a regular quality review of the supervisory process for all HIFs. It will also provide support to the supervisory teams.165

3.9 Risk control and supervision under FSMA 2000

3.9.1 Risk as a Determinant of Regulatory Response Risk identification and assessment, driven by the statutory objectives, lies at the heart of the regulatory system in the UK because it is what determines the regulatory response. In principle the regulatory response encompasses the entire range of powers that are made available to the FSA by the legislative framework. The appropriate regulatory response will depend on a range of factors. If there are no regulatory rules in place, the risk must justify regulatory intervention and the FSA follows economic orthodoxy in maintaining that intervention is only justified when there is market failure. Moreover, even when there is some evidence of market failure regulatory intervention will only be justified when other mechanisms (e.g. contracts
166

) cannot mitigate the

risk effectively. If there are already regulatory rules in place, risk identification and assessment across the market may result in changes to the rules or a decision that the matter can be adequately dealt with through supervisory engagement. In that sense, the determination of the regulatory response at the market level is linked with the model of supervision for individual firms since the latter can be adjusted by the FSA for different levels of risk tolerance. As risk tolerance levels rise for individual firms, it can be expected that the capacity of the system to generate rules or rule changes will decline and vice versa. There may also be a form of reflexive relationship here since it may also be expected that a greater tolerance of risk across the system will feed back into greater tolerance of risk at the firm level.

3.9.2 Risk as a Determinant of Supervisory Intensity at the Firm Level

165

Extracted from FSA document, Supervisory Enhancement Programme: closing summary (February

2009).
166

Contracts can only operate in this way when there is access to adequate information and regulation will

often be framed (in the form of disclosure obligations) to allow it to occur.

The ‘ARROW’ risk model used by the FSA to model the risk of individual firms focuses on the impact of the occurrence of a risk event and the probability of the event.
167

The risk profile of a

firm is a combination of these two characteristics and results in a firm being categorised as falling into one of four risk categories: low, medium low, medium high and high. In the case of low impact firms, the FSA undertakes supervision primarily through remote monitoring of the firm and thematic assessment. For other firms, the FSA undertakes individual assessments that vary in their intensity according to the risk profile of the firm and result in a risk mitigation programme (‘RMP’) being agreed with the FSA. The FSA monitors the RMP and follows up the actions within it to ensure that its objectives are achieved. In the periods between these formal assessments the FSA undertakes ‘baseline monitoring’ for all firms and ‘close and continuous monitoring’ for firms that are designated ‘high-impact’. These two processes are intended to identify emerging risks promptly, verify the reliance placed on senior management and the control systems of a firm and keep up to date with organisational and personnel changes in complex firms.
168

In cases where the FSA encounters an

uncooperative or obstructive attitude from authorised firms or has reason to doubt assurances given by the senior management it has powers to require an independent investigation or a skilled person report.169 Crucially, the ARROW risk model can be adjusted to reflect changes in the risk tolerance of the FSA. In the FSA’s own words:
170

We have constructed the ARROW II risk model to be very flexible. The model contains parameters that can be set by our senior management to reflect their risk appetite.

167

For more detail see chapters 3 and 4 of The FSA’s risk-assessment framework (2006). Under the new

regulatory structure, a ‘Proactive Intervention Framework’ will be developed and implemented: see The Bank of England, Prudential Regulation Authority, Our Approach to banking supervision (May 2011).
168

It seems clear that the model may not always work as it should and the FSA itself has admitted as much

in the context of its supervision of Northern Rock: see FSA document The supervision of Northern Rock: a lessons learned review (March 2008).
169

See FSMA 2000 ss 166, 167 and 168 and FSA Handbook SUP 5.3. The effect of these provisions is to

remove barriers to the availability of information but the timing of the provision of the information and its interpretation may nevertheless remain problematic.
170

FSA, The FSA’s risk assessment framework p15.

This approach provides a mechanism through which changes in the FSA’s risk tolerance have a direct effect on the RMP of individual authorised firms and on the process of supervisory engagement. The regulatory rules that form the basis for risk-based supervision are discussed below. As shown in Table 2 they are based primarily on the limitation and risk threshold strategies identified in Table 1 (above).

3.9.3 Risk Control through Capital Adequacy and Liquidity Rules The principle of controlling risk-taking in banks by reference to the capital of the bank has a long history, at least in its most basic form. Risk-weighting of assets was introduced by the first Basel Accord while the second Basel Accord refined the system and emphasised the role of supervisory engagement and market discipline in ensuring capital adequacy for individual institutions. In the EU, the Basel Accords were implemented by a series of directives which have overlaid a market integration framework objective on the Basel rules and applied them to investment firms which face market risk as a result of trading in financial instruments. Both the Basel and EU systems have focused on the solvency of individual institutions, with much less attention being paid to systemic risk or liquidity, both of which have featured prominently in the credit crisis. Table 2 Risk Control under FSMA 2000 Risk
Failure to meet regulatory capital requirements (solvency & liquidity) Risk threshold FSA Principle 4 FSA GENPRU Internal systems and control (firms) Risk threshold FSA Handbook SYSC Competence and integrity (individuals) Prohibition Risk threshold FSA Handbook APER

Strategy

Substance

In the UK context, the minimum levels of regulatory capital set by the Basel accords and the EU Directives are of limited practical relevance for two reasons. First, market counterparties may demand higher levels of capital as a condition for access to certain forms of money-market finance and higher levels of capital will, ceteris paribus, generate a higher credit rating for a bank’s own debt, thereby lowering its funding cost. Second, the FSA is empowered to set individual capital adequacy standards for banks in the form of individual capital guidance (ICG) which then represents ‘a regulatory intervention point’ for the purposes of supervision.
171

However, following the principles-based approach that prevails in the UK, responsibility for ensuring adequate regulatory capital and liquidity rests with the management of an authorised firm. This is made clear by the FSA Handbook:
172

A firm must at all times maintain overall financial resources, including capital resources and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.

Moreover, the FSA makes clear in its risk assessment of individual firms that:

173

The FSA’s issuance of the ICG should not be seen as an alternative to the responsibility of a firm’s management to monitor and assess the level of capital appropriate to its needs.

Thus, in theory the regulator is in a powerful position as regards capital adequacy in that it can both adjust the required level of regulatory capital and, even if that goes wrong, can ultimately hold the senior management to account for getting it wrong. That seems too good to be true and in reality it is. The problem for the regulator is twofold. First, if it fails to set the ICG at a sufficient level, it is difficult to hold the senior management to account (even if possible in a technical legal sense) when the regulator has failed to identify and/or act on the problem. Second, even if the regulator acts against the senior management there may be little to gain since some form of systemic risk may already have been activated. Of course, to the extent that action

171 172 173

See ‘The FSA’s risk-assessment framework’ (August 2006) p39. FSA Handbook, GENPRU 1.2.26R. FSA, The FSA’s risk assessment framework (August 2006) p38.

against the senior management in those circumstances would promote deterrence and individual responsibility, there would be some benefit for the system a whole.

3.9.4 Risk Control through the ‘Senior Management, Systems and Controls’ (SYSC) and ‘Approved Persons’ (APER) Components of the FSA Handbook In tandem with the regulatory capital regime, the UK regulatory system attempts to control risk taking through two distinct but related components of the rulebook. One (SYSC) focuses on organisational structure, governance and risk management while the other (APER) is more clearly focused on the competence and integrity of individuals who carry out a range of functions referred to as ‘controlled functions’.
174

The FSA may designate a function as a controlled function
175

if one of the following conditions is met:

(a) the function is likely to enable the person responsible for its performance to exercise a significant influence on the conduct of the authorised person’s affairs, so far as it relates to the regulated activity; or (b) the function will involve the person performing it in dealing with customers of the authorised person in a manner substantially connected with the carrying on of the regulated activity; or (c) the function will involve the person performing it in dealing with the property of customers of the authorised person in a manner substantially connected with the carrying on of the regulated activity. Significantly, the scope of APER is much wider than SYSC since APER operates without

174

One of the innovations of FSMA 2000 was to introduce an ‘approved person’ regime (‘APER’ in the

FSA Handbook) under which persons performing ‘controlled functions’ require the approval of the FSA. Approval is subject to the FSA being satisfied that the relevant person is ‘fit and proper’ to perform the relevant controlled function. Controlled functions are defined in general terms by s59(4)-(9) and more specifically by the FSA Handbook – see FSA Handbook SUP 10.
175

S59(5)-(7) FSMA 2000.

reference to the seniority of the relevant individual.176 The objective of the SYSC component of the FSA Handbook of Rules and Guidance is expressed by Principle 3 of the Principles for Business:
177

A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems. In more detailed terms the FSA Handbook describes the purposes of SYSC as being:178 (1) to encourage firms’ directors and senior managers to take appropriate practical responsibility for their firms’ arrangements on matters likely to be of interest to the FSA because they impinge on the FSA’s functions under the Act; (2) to increase certainty by amplifying Principle 3, under which a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems; (3) to encourage firms to vest responsibility for effective and responsible organisation in specific directors and senior managers; and (4) to create a common platform of organisational and systems and controls requirements for firms subject to the CRD179 and/or MiFID180. The third of the purposes listed above represents the first step in a move towards individual responsibility because it requires the implementation of management systems that provide a basis for identification of individual responsibility. The second step is the link between SYSC and the mechanisms that are available for taking enforcement action against individuals. Persons to whom SYSC functions are allocated are automatically included within the APER regime because such functions are designated as ‘controlled’. This has the effect that the sanctions 181 available
176

It should be noted that the scope of APER is limited by the fact that the regime does not apply to firms

who carry on regulated business in the UK under an ‘EEA’ or ‘Treaty firm’ authorisation. This respects the ‘single licence’ and ‘home country control’ principles of the EU regime.
177 178 179 180 181

These are high-level principles that bind authorised firms. See FSA Handbook SYSC 1.2. The EC Capital Requirements Directive: Dir 2006/49, OJ L177/201. The EC Markets in Financial Instruments Directive: Dir 2004/39, OJ L145/1. The relevant sanctions provided by FSMA 2000 are: withdrawal of ‘approved person’ status (s 63); a

financial penalty (s 66); or a public statement of misconduct (s 66). A prohibition order (under s 56)

for breach of APER are available in respect of persons performing or failing to perform SYSC functions. Moreover, it has been noted that close linkage in rule formulation between the SYSC and APER ensures that failings in relation to SYSC can be positively identified as contraventions of the APER regime, thereby opening up the possibility of action against an individual.182 Furthermore, accessory liability, in circumstances in which an approved person is ‘knowingly concerned’ in a contravention for which a firm bears primary responsibility, represents another route for enforcement action against individuals.183

3.9.5 The Role of Regulatory Discretion in Risk Control Regulatory discretion is a key feature of risk-based regulation in the UK. It is evident both at the level of design of the regulatory system and at the level of the regulator’s relationship with authorised firms. At the level of design, the legislative framework leaves considerable freedom to the FSA to select the appropriate regulatory technique (e.g. disclosure, conduct of business regulation) and to determine the structure of its rulebook (e.g. as between principles and rules) and to allocate responsibility for regulatory compliance (as between authorised firms and individuals). This remains true even when account is taken of the substantial extent to which the UK regulatory system is based on standards and regulatory rules emanating from international sources (such as the Basel Committee) and the European Union. At the level of the regulator’s relationship with individual firms, discretion is evident in: the manner in which the regulator can issue individual capital and liquidity guidance to a firm that exceeds the levels set by the FSA Handbook; the ability to review and update a firm’s risk mitigation programme (‘RMP’) as a result of specific events that affect a firm; and the ability to adjust the permitted activities of an authorised firm when it is desirable to meet the Authority’s regulatory objectives.
184

preventing an individual from engaging in specified regulated activities is a broader sanction that is not limited to the approved persons regime and is regarded by the FSA as a more serious penalty than withdrawal of approval.
182

See, J Gray and J Hamilton, Implementing Financial Regulation: Theory and Practice (Wiley, 2006),

75.
183

See FSMA 2000 s 66; see also the enforcement action against Deutsche Bank/David Maslen discussed

in MacNeil (below n185).
184

FSMA 2000 s45.

3.10 Compliance and Enforcement

All authorised firms are required to establish procedures and working practices that will ensure the firm is in compliance with FSMA 2000 and rules made under it. Principle 3 of the FSA’s Principles for Business (PRIN) provides that ‘A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems’.

Contravention of the Act or a rule is likely to result in a range of measures being taken against the relevant firm, and in some cases, individuals within the firm. These measures include disciplinary action taken by the FSA, a criminal prosecution or a private action in damages brought by a client for breach of statutory duty. However, FSMA 2000 does not require that the Authority take enforcement action and therefore both the occasions on which enforcement occurs and the form that it takes are matters that have been left to the FSA to determine as a matter of policy.

3.10.1 The role of enforcement in the regulatory system185

According to the ‘responsive regulation’ model, enforcement represents only the final option that is available to secure compliance with regulatory obligations.186 Other options that are available include persuasion and more intensive supervisory engagement. Applied to the financial sector, this model corresponds quite closely to the approach that has been adopted by the FSA, according to which, at least in the pre-crisis era, it was not an enforcement-led regulator. From an international perspective it is well-known that the FSA is much less active than its US counterpart the SEC in taking enforcement action: even adjusting for different levels of market capitalization, the number of enforcement cases initiated by the SEC and the financial penalties

185

This section draws substantially on I MacNeil ‘The evolution of regulatory enforcement action in the

UK Capital Markets: a case of “less is more”’ (2007) 2 Capital Markets Law Journal 345.
186

See generally I Ayres and J Braithwaite, Transcending the Deregulation Debate (OUP, 1992).

imposed are much greater.187 One interpretation of the low incidence of enforcement in the UK is that the FSA does not give it sufficient prominence. One influential commentator has argued that the greater intensity of enforcement action in the US contributes towards a lower cost of capital, as evidenced by the enduring valuation premium188 that can be observed for foreign companies (including those from the UK) that cross-list in the US by comparison with their peers who do not cross-list.189 The argument in essence is that cross-listed firms gain a valuation premium by ‘bonding’ to the system of regulation in the US, which is superior to other systems largely because of its strong focus on enforcement action. According to this approach, the most obvious disparity in enforcement activity as between the FSA and SEC lies in the area of insider dealing restrictions, which can be viewed as a possible explanation of the (sustained) valuation premium recorded for companies that cross-list in the US. If a strong emphasis on enforcement is indeed capable of generating such a beneficial outcome, a strong case would have to be made for its rejection in the UK context. In response, the FSA would no doubt counter that formal enforcement action is only one of the regulatory tools available to the FSA to deal with contraventions.190 Alternatives, which focus more on an ex ante rather than an ex post approach to dealing with contraventions include supervisory action, theme work 191 and the policy consultation process. That debate is a particularly difficult one to resolve because it is not easy to estimate the impact that either the level of enforcement or its mix (as between different techniques) has on compliance.192 While it is clear, for example, that the FSA devotes proportionately much less resource to enforcement than does the SEC, it is not entirely clear what may safely be concluded from such an observation. It would be rash to conclude, for example, that the low-level of enforcement in the UK results in a lower level of

187

For the relevant statistics see John C. Coffee Jr, “Law and the Market: The Impact of Enforcement”

http://ssrn.com/abstract=967482 at pp 35-37.
188

As measured by Tobin’s q (calculated for this purpose as:

(book value of total assets – book value of equity + market value of equity) / book value of total assets.
189 190 191 192

See Coffee, above n187. See the FSA Enforcement Guide at para 3.2. This refers to investigation and supervisory engagement on specific issues across a range of firms. See generally Howell E. Jackson & Mark J. Roe “Public Enforcement of Securities Laws: Preliminary

Evidence”, available at http://ssrn.com/abstract=1000086.

compliance. That would imply that the other regulatory activities in which the FSA engages have a lower compliance value than enforcement action, yet there is no clear evidence of that being the case. Equally, it would be wrong to conclude that a higher level of enforcement activity in the US implies a higher level of compliance: it may simply be the result of a higher ratio of enforcement action to contraventions. In the wake of the financial crisis, however, the FSA has shifted its policy to concentrate on what it terms ‘credible deterrence’, which focuses more on the capacity of enforcement against particular firms and individuals to encourage better compliance across the system as a whole. Recent high-profile investigations into insider-dealing rings said to be operating among market professionals193 has provided plenty of high-profile evidence of the new approach but it remains to be seen how far it will be carried into other areas, especially since the FSA has in the past emphasised that supervisory engagement was often a superior alternative to formal enforcement.

3.10.2 Disciplinary measures and sanctions The FSA has a range of disciplinary measures at its disposal.

Public censure
The most straightforward sanction is public censure,194 which simply involves publication of the fact of a contravention of the Act or rules made under it by an authorised person. The FSA is not required to establish a contravention of the Act or its rules according to any objective standard before issuing a public censure.195 This sanction relies on the deterrent effect that adverse publicity can have on reputation in the financial market. Financial penalty Another option is to impose a financial penalty. This was a power that the FSA lacked under the FSA 1986 regulatory system: only the self-regulatory organisations (SROs) were empowered to impose financial penalties and that was a matter of contractual agreement between the SROs and authorised persons rather than a statutory power. There is, in principle, no limit to the amount of

193 194 195

See e.g. ‘Seven charged over insider trading ring’, Financial Times 31st March 2010. See s 205 FSMA 2000. See FSA Handbook DEPP 6.4.2G regarding factors relevant to the issue of a public censure.

the penalty but the FSA is required to publish guidance on its policy regarding penalties and the amount of penalties.196 No firm, except a sole trader, may pay a financial penalty imposed by the FSA on a present or former employee, director or partner of the firm or of an affiliated company.197 A penalty may be imposed at the same time that authorisation is withdrawn.198

Variation or cancellation of permission Although not categorised by FSMA 2000 as disciplinary measures, there are several other options that might be considered by the FSA in response to a contravention. One is a variation in the regulated activities included in an authorised person’s ‘permission’.199 In the past, this was limited to circumstances in which an authorised firm no longer met the ‘threshold conditions’ for authorisation but that restriction was removed by the FSA 2010 so as to enable the Authority to vary permission to meet any of its regulatory objectives. At the same time the Authority was authorised to suspend permission or to impose restrictions or limitations that it considers appropriate.200 A second, and more drastic, response would be complete cancellation of permission to engage in any regulated activity. That, in itself, does not result in withdrawal of authorisation because a separate direction from the FSA is required for that to occur.201 The purpose of this procedure is to ensure that when an authorised person is no longer able to engage in regulated activity as a result of cancellation of permission, it remains subject to the jurisdiction of the FSA because it is still an authorised person.

Prohibition orders
196 197

See ss 206 and 210 FSMA 2000. The guidance is published at DEPP 6. FSA Handbook, GEN 6.1.4A R. For background see FSA Policy Statement PS 11/3, Decision Procedure and Penalties manual and Enforcement Guide review (February 2011).

198

See s10 of the FSA 2010, amending s206 of FSMA 2000. Cancellation of permission had already been

permitted at the same time as the imposition of a financial penalty.
199

This is possible at the FSA’s initiative under s 45 FSMA 2000. See new s206A FSMA 2000, inserted by s9 of FSA 2010. FSMA 2000 s 33.

200 201

The FSA may prohibit an individual (ie a human person) from performing any regulated activities carried on by an authorised person if it considers that the individual is not a fit and proper person to carry on that function.202 The prohibition may apply to any or all regulated activity and may prohibit employment by a particular firm or type of firm. An order may also prohibit an individual from performing functions in relation to the regulated activity of an exempt person (such as an appointed representative or a recognised investment exchange or clearing house) and persons covered by an exemption under Part XX (provision of financial services by members of the professions). In most cases the FSA will consider whether the particular unfitness can be adequately dealt with by withdrawing approval203 or other disciplinary sanctions, for example public censure or financial penalties, or by issuing a private warning.204 The FSA will consider making a prohibition order only in the most serious cases of lack of fitness and propriety. In the case of an individual who is not an approved person, a prohibition order may be the only enforcement option. The FSA will also take into account other enforcement action against the individual by the FSA, other agencies or professional bodies. It is an offence for an individual to perform or agree to perform a function in breach of a prohibition order. 205 The offence is one of strict liability (not requiring mens rea) but it is a defence for the accused to show that he took all reasonable precautions and exercised all due diligence to avoid committing the offence. The FSA may, on the application of the individual named in a prohibition order, vary or revoke it. An authorised (or exempt) person is required to take reasonable care to ensure that no function of his, in relation to the carrying on of a regulated activity, is performed by a person who is prohibited from performing that function by a prohibition order. Such orders are recorded in the register maintained by the FSA.206 Reasonable care would appear to require that an authorised

202 203

FSMA 2000 s 56. This refers to approval under the APER regime to perform ‘controlled functions’. FSA Handbook EG part 9 sets out the FSA’s policy on making prohibition orders. The

204

Authority considers that a prohibition order is a more serious penalty than the withdrawal of approval (in relation to an approved person) because a prohibition order will usually be much wider in scope.
205

S56(4) FSMA 2000. As required by s 347 FSMA 2000.

206

person search the register before engaging any employee. Any breach of this duty of care is actionable at the suit of a private person who suffers loss as a result of the contravention.207 Approved persons The FSA is empowered to take disciplinary action against approved persons if two conditions are met.208 The first is that the person is guilty of misconduct. This will occur if an approved person has failed to comply with the FSA’s Principles for Approved Persons or has been knowingly concerned in a contravention on the part of an authorised person. The second is that it is appropriate in all the circumstances to take action against the approved person. In this regard, statements made by the Authority shed some light on what will be considered appropriate circumstances:209 For example, action will be unlikely where an individual’s behaviour was in compliance with the rules imposed on his firm in respect of his controlled function and The FSA does not consider that it would be appropriate to discipline senior managers, approved for the purpose of [s 59 FSMA 2000], simply because a breach of the regulatory requirements has occurred in an area for which they are responsible. There will only be a breach of a Statement of Principle where there is personal culpability.210 The Authority must bring disciplinary proceedings against an approved person within three years211 of becoming aware of the misconduct. It is also possible that the Authority might simply give a private warning rather than take formal action.212 The FSA is also empowered to take action

207

FSMA 2000 s 71(1). FSMA 2000 s 66. FSA Consultation Paper 26, ‘The Regulation of Approved Persons’ (1999) paras 98 and 115

208

209

respectively.
210

See FSA Handbook, APER 3.2.1E for factors relevant in determining if approved

persons are in compliance with the Principles.
211

Extended to three from two by s12 FSA 2010, amending s66(4) of FSMA 2000. That change is linked

with the increased focus on individual responsibility in the reforms introduced by the FSA 2010.
212

See FSA Handbook, Enforcement Guide (EG) 7.10-19.

against persons registered with SROs under arrangements that pre-dated the ‘approved persons regime’, in respect of contraventions occurring before the FSMA 2000 took effect.213 The Authority will generally be able to take action against such persons in respect of contraventions that relate to activities which, if performed after the commencement of FSMA 2000, would be considered ‘controlled activities’. The sanctions available to the FSA if misconduct on the part of an approved person is established are a financial penalty or public censure. As a separate matter, the Authority is now also empowered to impose a financial penalty on an individual who performs a ‘controlled function’ without approval if the individual could be reasonably expected to have known that to be the case.214

3.10.4 Disciplinary procedure The disciplinary procedure provisions of FSMA 2000 attracted considerable attention during the committee stages in Parliament as debate focused on their compatibility with the Human Rights Act 1998.215 The main issue was the compatibility of the procedures with article 6 of the European Convention on Human Rights (ECHR) which provides for the right to a fair trial. Potential contraventions were identified by reference to the following:216 (a) the extent to which the disciplinary procedure and the role of the FSA pro-

213

See the FSMA 2000 (Transitional Provisions and Savings) (Civil Remedies, Discipline, Criminal

Offences) (No 2) Order 2001, SI 2001/3083, art 9.
214

S63A FSMA 2000, inserted by s11 of FSA 2010. The Act gives effect in the United Kingdom to the European Convention on Human Rights. See the

215

First (H of L 50 I-II; H of C HC328 I-II) and Second (H of L 66; H of C HC465) Reports of the Joint Parliamentary Committee on Financial Services and Markets. Para 147 of the First Report notes: According to the Progress Report [on the Bill] ‘The main focus of comment on the draft Bill has been on the disciplinary process. There has been a perception that the FSA internal procedures may lack fairness and transparency, or be unduly costly and burdensome, and that the FSA will be able to act as prosecutor judge and jury.’

216

See Annexes C and D to the Joint Committee First Report on the draft Bill (above n215).

vided for a fair trial; (b) the absence of legal assistance to secure representation for persons appearing before the Financial Services Tribunal217; (c) the standard of proof to be required in hearings before the Financial Services Tribunal; (d) the use of compelled evidence in disciplinary proceedings; and (e) the absence of legal certainty in the definition of market abuse. The disciplinary framework ultimately adopted by the Act took account of these concerns. The relevant powers of the FSA are spread across various provisions of the Act and in the relevant part of the FSA Handbook (designated DEPP). The key points are as follows: (a) The first stage in the disciplinary process is the issue of a ‘warning notice’ to a firm or individual. This gives reasons for the proposed action and allows a period of time during which representations may be made to the FSA. (b) The Regulatory Decisions Committee (RDC) is responsible for reaching decisions on disciplinary matters raised in a warning notice. The members of this Committee are independent of the FSA.218 When making decisions the RDC meets in private and is required to adopt procedures that will result in the case before it being dealt with fairly. (c) Following intimation of the RDC’s conclusions to the FSA, either a decision notice or discontinuance notice will be issued to the firm or person concerned. 219 A decision notice must set out the action that the FSA proposes to take and, if relevant, draw attention to any right of appeal to the Upper Tribunal and any right of access to material relevant to the decision. If there is no referral to the Upper Tribunal, a final notice will be issued before the relevant action is taken. If there is a referral to the Upper Tribunal (or a subsequent appeal to the court), the Authority must give the relevant person a final notice before taking action in accordance with the direction of the Upper Tribunal or court. (d) The Upper Tribunal has a wide-ranging jurisdiction over many of the FSA’s decisions,

217 218

This was replaced by the Upper Tribunal with effect from April 2010. This gives effect to the requirement of s 395 FSMA 2000 that such decisions must be made by persons

independent of those who investigated the matter.
219

The FSA 2010 amended s 391 of FSMA 2000 so as to permit the FSA to publicise a decision notice.

including those of a disciplinary nature.220 It is not an ‘appeals’ tribunal in the strict sense as it determines matters de novo and is able to consider fresh evidence that was not available to the RDC. The Tribunal must determine what (if any) is the appropriate action for the FSA to take. Decisions of the Tribunal can no longer be appealed to the courts on a point of law. 221 (e) The Act makes provision for persons to whom notices are issued to have access to material that the Authority relied on in making the decision regarding issue of the notice.222 The objective is to give effect to the right to a fair trial (article 6 ECHR), which includes the right to have knowledge of and comment on evidence relied on in the proceedings. (f ) In respect only of market abuse cases that are referred to the Upper Tribunal, there is a legal assistance (or ‘legal aid’) scheme.223 3.10.4 Consumer redress schemes In cases of widespread regulatory failure the FSA is authorised to establish a consumer redress scheme.224 The purpose of such a scheme is to require relevant firms to investigate potential regulatory contraventions and to provide redress to consumers225 where loss or damage has been caused to them. While the provision in its original form required the Treasury’s approval for a scheme to be established, the amendments introduced by FSA 2010 authorise the FSA to establish a scheme

220

The tribunal hears appeals against FSA decision notices concerning authorisation and permission,

market abuse, disciplinary matters and official listing.
221

FSMA 2000 s137 (which permitted appeals on a point of law) was repealed by the Transfer of Tribunal

Functions Order 2010, SI 2010/22 Sch 2 para 46 with effect from 6 April 2010.
222

FSMA 2000 s 394. This reflected advice given to the government during the passage of the bill through Parliament that

223

the market abuse regime could be considered ‘criminal’ rather than ‘civil’ for the purposes of human rights law. Categorisation as ‘criminal’ would increase the likelihood of triggering the requirement of article 6(3)(c ) ECHR that legal assistance be provided ‘when the interests of justice so require’.
224 225

FSMA 2000, s404. Consumers includes for this purpose business and professional customers: s404E FSMA 2000. It also

includes customers who have not complained to the relevant firm: see FSA Policy Statement 10/12 ‘The assessment and redress of Payment Protection Insurance complaints’.

on its own initiative.226 It was argued by the British Bankers Association in a test case relating to payment protection insurance227 that since s404 FSMA 2000 prescribed a specific statutory procedure for dealing with widespread cases of regulatory failure by firms, it ‘occupied the field’ and precluded the use of other regulatory powers to achieve similar objectives .That argument was rejected by the High Court and therefore leaves open the possibility for the FSA to deal with widespread regulatory failure through other powers such as rule-making, guidance and open letters.

3.10.5 Prosecution of criminal offences There are a number of criminal offences created by FSMA 2000. They include: • breach of the general prohibition against carrying on regulated activity without authorisation228 • the making of false claims to being an authorised or exempt person229 • the use of misleading statements and practices to induce another person to enter into an investment agreement230 • engaging in market manipulation231 • misleading the Authority.232 In England and Wales, prosecutions in respect of offences under FSMA 2000 may be instituted by the FSA, the Secretary of State (Department of Business, Innovation and Skills233) or by or with the consent of the Director of Public Prosecutions. The FSA is also empowered to bring prosecutions
226

The amended version of s404 FSMA 2000 applies to regulatory failures that occurred before that

provision took effect (on October 12, 2010).
227

R (British Bankers Association) v FSA [2011] EWHC 999 (Admin). See Ch 3.6 for more details about

the case.
228

FSMA 2000 s 23 FSMA 2000 s 24 FSMA 2000 s 397. FSMA 2000 s 397(3). FSMA 2000 s 398.

229

230 231 232 233

Formerly known as BERR (Department for Business, Enterprise and Regulatory Reform) and the Department of Trade and Industry (DTI).

under other statutes.234 In exercising its powers, the FSA must comply with any conditions or restrictions imposed by the Treasury. In Scotland, prosecutions for offences under FSMA 2000 remain the responsibility of the Crown Office.235 A contravention that is a criminal offence may or may not be pursued through the criminal courts. A decision on whether to prosecute or take disciplinary action will depend on a range of factors, including: (1) whether, in the FSA's opinion, the taking of civil or regulatory action might unfairly prejudice the prosecution, or proposed prosecution, of criminal offences; (2) whether, in the FSA's opinion, the taking of civil or regulatory action might unfairly prejudice the defendants in the criminal proceedings in the conduct of their defence; and (3) whether it is appropriate to take civil or regulatory action, having regard to the scope of the criminal proceedings and the powers available to the criminal courts. 236 The FSA has made clear that prosecution will not normally be pursued alongside disciplinary measures. FSMA 2000 also provides for personal criminal liability on the part of certain individuals in circumstances in which an offence is committed by an organisation with the consent or connivance or as a result of the negligence of that individual. The provision237 applies to officers of a company238, partners in a partnership and officers or members of the governing body of an unincorporated association. The Treasury has power to extend this section to bodies established outside the United Kingdom.

234

It was held in R v Rollins [2010] UKSC 39 that the Authority had the power of a private individual to

bring any prosecution which fell within its memorandum and articles of association and was not precluded by the terms of the relevant statute. Sections 401 and 402 did not define exhaustively the FSA’s prosecutorial powers and accordingly the FSA had power to prosecute money laundering offences under ss 327 and 328 of the Proceeds of Crime Act 2002.
235 236 237 238

The same applies to those offences which fall within the remit of the SFO in England. See FSA Enforcement Guide (EG) para 12. FSMA 2000 s 400. The term includes controllers (large shareholders) who are individuals, and members of a Limited

Liability Partnership (see SI 2001/1090).

Under the Criminal Justice Act 1987 the Director of the Serious Fraud Office (SFO) may investigate any suspected offence which appears on reasonable grounds to involve serious or complex fraud and may also conduct, or take over the conduct of, the prosecution of any such offence. The SFO may investigate in conjunction with any other person with whom the Director thinks it is proper to do so; that includes a police force, the FSA or any other regulator.

3.10.6 Civil action for damages A contravention of FSMA 2000 or a regulatory rule made under the Act239 opens up the possibility of an action in damages at the suit of a private person.240 A private person includes any individual, unless he suffers the loss in the course of carrying on any regulated activity and any person who is not an individual (eg a company) unless he suffers the loss in question in the course of carrying on a business of any kind.241 Non-private persons can take action in three circumstances only: (a) where the rule that has been contravened prohibits an authorised person from seeking to make provision excluding or restricting any duty or liability; (b) where the rule that has been contravened concerns the misuse of unpublished information for the purposes of effecting transactions (ie criminal or regulatory forms of insider dealing and market abuse242); or (c) where the action can only be brought in a fiduciary capacity by a nonprivate person on behalf of the private person. 243 The basis of an action under section 150 is that the contravention represents a breach of statutory duty which has caused loss to the investor. As it is of most direct relevance to private investors, the

239 240 241 242 243

Not all rules are actionable: see Ch 6.5. FSMA 2000 s 150. Art 3 of the FSMA 2000 (Rights of Action) Regulations 2001, SI 2001/2256. See Ch 13.2. Art 6 of SI 2001/2256.

requirements for a successful action are discussed in Chapter 6.244 The equivalent provision in FSA 1986 was little used and this has remained so under FSMA 2000, largely as a result of the possibility of cases being referred to the Financial Ombudsman Service or through bulk settlements negotiated by the FSA on behalf of private investors.

244

See Ch 6.5.