FCA’s enforcement focus on individuals likely to increase the burden on firms

Written on 7 Feb 2017

The FCA’s extraction of large fines from co-operative financial services firms, without protracted litigation, may be replaced with a more difficult, expensive path of pursuing individuals.  The FCA’s new approach raises concerns for authorised individuals as the FCA pursues competing enforcement objectives to achieve its policy goals.

On 19 January 2017, the FCA’s Director of Enforcement and Market Oversight, Mark Steward, delivered a speech to the Practising Law Institute on ‘securities regulation in Europe’.  He used the opportunity to reinforce, in no uncertain terms, that the FCA intends to pursue an aggressive enforcement policy against authorised individuals under the controversial Senior Managers and Certification Regime (SMCR).

Mr Steward also identified a number of difficulties facing the FCA and competing policy objectives will likely increase the burden on firms and individuals responding to enforcement activity. This further emphasises the need for firms to have rigorous policies in place for the conduct of internal investigations.

A new regulatory landscape

Mr Steward noted that the volume and size of FCA fines have declined significantly in recent years.  In fact, only 23 fines, totalling £22m, were imposed in 2016, down from 40 fines totalling £905m in 2015, itself a significant drop from the £1.5 bn peak in 2014.  Whilst many in the market would attribute the 2014-15 numbers to the exceptional LIBOR and FX fines, Mr Steward instead highlighted the “unprecedented and remarkable” leverage the FCA had applied to convince firms to engage in early settlement negotiations.

The early settlement scheme, where acceptance of culpability is acknowledged by swift closure of the investigation and a financial discount on fines of up to 30%, has been a motivating factor for many financial services firms.  However, as focus shifts from firms to individuals, there is no guarantee that this approach can be sustained.  As Mr Steward accepted, there will need to be a significant change in the FCA’s approach to enforcement.

The “different dynamic” of the SMCR

Mr Steward emphasised that the decline in the volume of enforcement action and the size of the resulting fines did not indicate a return to ‘light touch’ regulation.  He, pointedly, noted that in most of these cases, no action had been taken against individuals or senior management.  With the introduction of the SMCR, it is likely that the FCA’s future enforcement achievements will be judged, not by the size of the fines, but its success in attributing personal responsibility for regulatory breaches.

The SMCR came into force on 7 March 2016 to encourage a stronger culture of responsibility.  Despite many changes prior to implementation (not least the welcome rejection of the proposed “reverse burden of proof”), there remain uncertainties and risk in the regime, not least as to how the FCA will approach enforcement.  There has been a troubling lack of guidance from the regulator.  For example, the new regime “doesn’t prescribe or define any particular misconduct”, Mr Steward reminds us, concluding that the FCA will simply hold senior management responsible “for what happens on his or her watch.

Despite, or perhaps because of, the ambitious scope of this approach, Mr Steward conceded that there were a number of difficulties the FCA will face in pursuing this new policy.

Hurdles to enforcement

First, the FCA doesn’t “expect senior managers to agree so readily to pay high fines to resolve cases.  We expect there will be more contest and more litigation“.  At the same time, Mr Steward highlighted the “very clear public interest” in pursuing a cost-effective enforcement policy, with cases resolved through agreement where possible.

The tension between these competing objectives will not easily be reconciled.  The FCA may attempt to share the burden by co-operation with other UK authorities, such as the SFO, or internationally, with the US DOJ, where appropriate.  It may become more common for the cost to be pushed back onto the authorised person, with the FCA requiring an investigation by an independent “skilled person” under s.166 FSMA, at the subject’s expense.

The historic approach – avoiding litigation by early settlement – will become less common.  The FCA accepts that “firms may well be reluctant to spend such high sums to resolve investigations [that] do not also resolve cases against senior managers who may also be in our cross-hairs“.  With individuals explicitly in the firing-line, it is not merely shareholders’ profits but personal reputations and careers on the line; it is unlikely that individuals will carry out a cold, pragmatic cost-benefit exercise when it comes to their livelihoods.

Prosecution of individuals also involves factually complex issues around their conduct as judged against what would be “reasonable”.  Under the previous rules, uncertainty arose as to the scope of what constituted “reasonable steps” by senior management to prevent misconduct as seen, for example, in the successful challenge against sanction before the Upper Tribunal by John Pottage, the CEO of UBS’s wealth management.  It is likely that similar difficulties, and the need for similar lengthy appeals, will arise under the new regime.

Unless there are further changes to encourage settlement, or the FCA finds additional resources to detect misconduct early, it is likely that investigations will be lengthy, disruptive and costly.

In the FCA’s Feedback Statement FS16/6 published in September 2016, it was reported that firms of all sizes were experiencing difficulties in implementing their mandated “Management Responsibilities Maps”, intended to ensure a comprehensive allocation of responsibility to appropriately senior individuals.  Whilst firms are no doubt working diligently to adapt to the new landscape, mere effort will be unlikely to satisfy the regulator.  It is critical that all firms take steps to implement and regularly review their systems and controls to avoid burdensome FCA investigations.

A cautious approach to internal investigations

In this regard, the most troubling pronouncement was, perhaps, the view that “there lurk latent tensions in the way in which firms may self-report misconduct or cooperate with the FCA”.  Mr Steward expressed concern about potential conflicts of interest between senior managers who may commission an investigation and also be its subject.  This approach assumes bad faith, and the dismissal of internal investigations is short-sighted.

Despite the “fundamental importance” of detecting serious misconduct early, Mr Steward pronounced that internal investigations are of “limited determinative value” to the FCA.  Whilst of course the FCA will always need to ensure that it sufficiently investigates issues to satisfy its statutory obligations, such statements are potentially counter-productive.

Nonetheless, firms must ensure they continue to comply with their regulatory obligations.  The rules require firms to have adequate systems and controls in place to identify and address potential misconduct, to report findings of misconduct, and to deal openly with the regulator.  In short, firms must conduct internal investigations and report their findings.

Even if the FCA is not prepared to accept such reports as determinative, they will still prove invaluable in getting ahead of the issues: understanding the available evidence, taking legal advice, and developing a strategy for negotiations with the regulator (or fighting unwarranted enforcement proceedings).

Recent legal rulings have confirmed the difficulties of conducting internal investigations in a protected environment, and protecting internal investigation work-product from potential third-party litigants, in particular (see, the Court decisions in PAG v RBS and The RBS Rights Issue Case). Internal investigations raise a host of legal and practical considerations and we would encourage all firms to take legal advice before commencing any investigations.  We can ensure that appropriate reporting structures and document management is put in place to maximise protection against potential disclosure applications and litigation risk.

A revised approach to settlement

One positive note from Mr Steward was the FCA’s nascent flexible approach to settlement options. The current approach is a binary ‘take it or leave it’; if matters cannot be resolved before referral to the independent Regulatory Decisions Committee (RDC) the incentive is lost, and there is no mechanism to narrow the scope of the dispute. The FCA proposes to allow a discount provided there is agreement that the salient facts and/or that circumstances amount to a breach of the rules.  The subject will be permitted to challenge the scope of the proposed sanction before the RDC without risk to the general availability of a discount for settling the facts. The FCA’s policy statement on these proposals was published on 1 February 2017.

Although a welcome first-step, as the FCA’s enforcement policy shifts, a more nuanced palette of enforcement tools will be required.

At its core, Mr Steward’s speech demonstrates that the FCA is committed to pursuing individuals and is prepared for a fight in doing so.  It is critical that senior management prepare for that fight with the financial backing of their firms, or their insurers, and arm themselves with prompt legal advice.