Over the past few years the Financial Services Authority (FSA) has repeatedly stated that it takes senior management responsibility very seriously and that it expects senior management not only to design and implement appropriate systems and controls but also to deal effectively with any problems that do occur. With an increased emphasis on principles-based regulation, the FSA has indicated the need for greater senior management responsibility in ensuring that appropriate systems and controls are in place to achieve outcomes consistent with its Principles for Businesses.

In a speech on 29 June 2007, Margaret Cole stated, ‘We expect senior management to engage proactively in the risks they face and the challenge of making regulation appropriate to their business and risk profile… This means that we expect senior management to take responsibility for ensuring that their business identifies and properly considers the risks that it faces, has due regard to the operation of financial markets as a whole and develops appropriate systems and controls to manage those risks.’

The FSA has also indicated that senior management must also deal with problem situations. As Margaret Cole put it:

‘It is also important that senior management deal appropriately with wrongdoers and self report if they suspect their own staff have been involved in misconduct. If you do this and can also demonstrate that you have, and are complying with, robust systems and controls, then you have nothing to fear.’

However, with very few exceptions (such as Mr Whistance’s fine over the systems and controls failings within Williams de Broë), the FSA has not taken action against management, even if it has determined that there have been significant breakdowns in the control infrastructure in a financial institution that have resulted either in retail mis-selling or ‘rogue trader’-type situations causing losses to the institutions themselves.

The recent government bail-out of banks, the comments made by political leaders and the FSA’s increased focus on executive pay and remuneration make it clear that if there are failures in systems and procedures the role of management may be looked at with increased vigour. Moreover, if it can be shown that the compensation policy may have been a factor influencing or leading to the misconduct of individuals, questions may be asked not only of the firm but of individual members of management responsible for setting remuneration policies.

The need to set remuneration policies that manage appropriately the tension between regulatory compliance and the profit-making incentives given to employees is a feature of the FSA’s guidance on appropriate systems and controls for a regulated firm (FSA Handbook, SYSC 3.2.18G). However, the ‘Dear CEO’ letter published by the FSA on Monday this week has given greater importance to this issue. It is clear from the letter that the FSA is expecting firms to use remuneration policies to create an incentive for employees to act in accordance with FSA rules and principles and with good risk management procedures rather than incentives to maximise profits alone. An annex to the FSA’s letter contains examples of good and bad practice in setting remuneration policies, which should be considered by regulated firms in reviewing their current remuneration policies. Although this does not amount to formal guidance, in any action based upon a failure to have appropriate systems in place to deal with remuneration, it is to be expected that the FSA will focus on these issues.

In practical terms, we expect regulated firms to come under greater pressure to demonstrate a clear link between the annual appraisal process and setting performance-related pay. It may be necessary to reevaluate the weighting given to various performance indicators used to determine annual incentives (and possibly the appropriateness of these indicators) and to re-assess the proportion of remuneration that is deferred.

Equally, the design of deferred bonus arrangements may also need to be revisited given the FSA’s initial recommendation that the effect on long-term profits of performance in the base year needs to be assessed. Many listed financial institutions will already have implemented long-term incentive arrangements that reward executives through shares or options rather than just in cash. These are usually subject to performance targets closely aligned to building shareholder value over a number of years. At least for UK listed firms, such arrangements have tended to follow, for the most part, the guidelines issued by the Association of British Insurers (ABI) and the National Association of Pension Funds (NAPF) in this area. Non-UK issuers and unlisted firms may need to consider the conditions attached to pay-outs under their deferred bonus arrangements. This is especially the case for cash-based schemes linked only to remaining in employment until the end of the deferral period.

Members of management will therefore need to consider and, equally important, be able to demonstrate by way of documentary evidence that they have considered such issues. Otherwise, particularly, if any of its employees who have received large bonuses not based upon the above criteria are found to have committed serious regulatory breaches, the managers may find themselves under investigation.

Firms will also need to take care in considering the appropriateness of any compensation arrangements for those leaving the firm in connection with, or as a result of, a regulatory or disciplinary investigation. If individuals may have employment claims relating to their dismissal or other conduct by their employers, such claims are often released by a compromise agreement. These arrangements are likely to come under increased scrutiny from the FSA. Again, this may raise difficult questions for management faced with the invidious position of balancing regulatory pressures and legal claims by employees.

UK listed firms are already subject to a requirement to disclose the terms of any departing director’s compensation arrangements in their annual reports. Public disclosure has led to such compensation arrangements coming under fire and the development of ABI and NAPF guidelines guarding against ‘rewards for failure’. Regulated firms need to bear in mind similar principles when setting the terms of any individual’s departure.

In the light of this, firms will need to reassess: ??

  • their remuneration policies as part of their general systems and controls; 
  • how they deal with regulatory problems, particularly if there is no obvious customer detriment;
  • what action they take against individuals within the firm who may have been responsible and, in particular, whether they dismiss them; and
  • whether, if they do dismiss such individuals, they will be able to compromise possible employment claims.

In each of these areas, relevant senior management will want to be able to demonstrate that they have taken appropriate action. Otherwise, there is likely to be more enforcement activity from the FSA, which has already indicated that it is going to be increasing the level of its fines to create ‘credible deterrents’.

As Margaret Cole has stated:

‘We recognise that enforcement activity is right at the forefront of the drive to achieve credible deterrence. So we have to be ready, willing and able to do enough cases of the right sort to get the right outcomes, to get the message out to firms and individuals that they will suffer meaningful consequences if they fail to raise their game and improve standards of behaviour.’

In conclusion, in the current environment, the area of systems and controls is likely to be a focus for FSA enforcement activity in the near future and setting a remuneration policy will need to be a more significant consideration in a firm’s systems and controls review1.