In May 2014, George Osborne commissioned a review of the fairness and effectiveness of the regulatory enforcement process in the UK. The review was part of the wider governmental programme of strengthening accountability in financial services, the most pressing manifestation of which is, of course, the new Senior Managers and Certification regimes for banks, and the Senior Insurance Managers regime for insurers.
Just before Christmas last year, HMT produced its report following this review. The report contains 39 recommendations for change, the vast majority of which are unobjectionable, or even helpful. For example, HMT have recommended that: there should be more frequent communication between the regulator and the firm under investigation during the enforcement process; the regulator should make more senior individuals available to firms during the settlement negotiation process; and there should be prior notice to firms of the likely date of commencement of Stage 1. Nobody could argue with these recommendations, which make clear sense and will improve the fairness of the enforcement process for firms under investigation.
However, there is one recommendation that, in my view, is ill-thought through and has the potential to undo all of the improvements to the fairness of the enforcement process that are likely to be achieved by the remaining, helpful recommendations. It is this: HMT is recommending that the Executive Settlement procedure be varied so that there would no longer be discounts for early settlement beyond ‘Stage 1’. This is a hugely significant recommendation, because almost all enforcement cases are currently settled under the executive settlement process (only 7 substantive cases were heard by the Upper Tribunal last year, and a similarly small number reached the RDC stage).
Under the current executive settlement process, Stage 1 is a 28-day period which commences on the day that the firm under investigation receives a draft Warning Notice from the regulator, and ends 28 days later (save for exceptional circumstances that would justify an extension – we see such exceptions extremely rarely). During Stage 1, a firm stands to receive a 30% discount on the financial penalty that would otherwise be levied upon it if it reaches a settlement with executive decision-makers of the relevant regulator. If no settlement is reached during Stage 1, the firm retains the right to settle for a 20% discount during Stage 2 – we have seen this done in one insurance case which we advised upon, with the regulator agreeing to a significant concession only after the Stage 1 period had expired. Once stage 2 has ended (on the last day for making written representations to the regulator in response to a Warning Notice), the firm retains the chance of negotiating 10% off the financial penalty if it settles within Stage 3, which ends on the date that a Decision Notice is published.
In recommending that settlement discounts post-Stage 1 be abandoned, HMT focuses upon the fact that only 9 cases have been settled at Stage 2 or beyond over the past 3 years. As a result, they conclude that “a graduated discount scheme is unlikely to have a significant bearing on whether a case is contested”.
However, the question that interests firms is usually not whether to contest the case at all. The ‘no smoke without fire’ adage applies aptly to regulatory enforcement, and it is our experience that a case that reaches the draft Warning Notice stage is rarely without some foundation in fact. Rather, firms are interested in how to contest a case in order to reach an outcome that is fair in light of what has actually occurred. It is our experience that the regulators already use the time pressure that firms experience during the 28-day Stage 1 settlement window heavily to their advantage, and that they do not always do so fairly. For example, the FCA has been known to refuse to engage with firms on valid legal points, on the basis that it will not be possible to resolve the points within 28 days. In this way, the regulators are effectively able to cherry pick which defensive arguments that they are willing to consider within the executive settlement process. Firms, conscious of the weight of factors in favour of opting for a settlement as regulatory fines increase year on year, are powerless for all practical purposes to insist upon their legal rights.
So the playing field is already heavily skewed in favour of the FCA during the executive settlement period; we fear that abandoning the graduated discount scheme would skew this balance even more severely. This is because, rather than losing the right to achieve a 30% settlement discount and retaining the right to achieve a 20% discount (net loss: 10% discount), the firm would face losing the chance of achieving any discount on the financial penalty at all if settlement is not reached within the Stage 1 period. The pressure upon firms’ governing bodies from their shareholders to settle upon whatever terms the regulator is insisting upon will therefore become acute – even irresistible – even where the defence lawyers advise that there are problems with the FCA’s legal case. Effectively, the regulators will be able to operate outside the law, making the UK a dangerous and unpredictable place in which to do business, and potentially driving firms away from London. Ironically, this is exactly the scenario that the Government is seeking to avoid under its current insurance sector strategy. There is a great risk that this recommendation has consequences that neither the government, nor the regulated community, would want.
I understand from sources within the FCA policy division that a PRA/FCA consultation paper covering HMT’s recommendations will be issued during the course of this year. We feel very strongly that, if there is to be an executive settlement process at all, then the discount scheme needs to be graduated in order to guard against unfair outcomes for firms. We hope that you will join us in making the appropriate representations to the PRA and FCA when the time for consultation comes around.