In this article, which first appeared in the September issue of Butterworths Journal of International Banking and Financial Law, Jon Ford considers how industry codes present risks to firms and how these risks can be mitigated.
What are industry codes?
An industry code is formulated by market participants or experts setting out guidance or good practice in a particular market. This is in order to develop and establish trust within the market and create an environment for a fair, effective and transparent market to flourish.
They can be useful for market participants in providing practical guidance in a principles-based regulatory environment, such as the FCA’s Principles for Businesses (Principles).1
However, industry codes can also present risks to firms, as they may be relied upon by litigants against a firm or by regulators investigating suspected misconduct in a market.
When considering enforcement action, the FCA will use industry codes to (among other things) help assess whether it could reasonably have been understood or predicted at the time that the conduct in question fell below the standards required by the Principles.
In particular, the existence of an industry code is likely to inform the FCA’s view on what constitutes proper standards of market practice for the purposes of determining whether, in its view, there has been a breach of Principle 5:
“A firm must observe proper standards of market conduct.”
This risk exists whether a firm has formally signed up to and adopted an industry code or not. The FCA’s PS18/8 Industry Codes of Conduct and Feedback on FCA Principle 5 notes that:
“Codes may be evidential and relied upon in determining what proper standards are, or were believed to be, at the relevant time when considering enforcement action.”2
These risks will be heightened where industry guidance has been recognised by the FCA in:
- regulated markets, a process known as “FCA confirmation”3; or
- in unregulated markets, a process known as “FCA recognition”.4
Industry codes can also pose a litigation risk. What sort of risk will depend on what (if anything) is said by the firm in relation to the relevant industry code in its contracts, marketing material or by virtue of it agreeing to adhere to the code.
If the firm has adopted the code and makes reference to the code in its contracts with its counterparties, there is a significant risk of a court finding that the code has been incorporated into the contract, either expressly or impliedly. An express reference and promise to adhere to certain industry codes in a contract will likely make such a code obligatory to that counterparty.5 A reference to an industry code could give rise to an implied term if it was necessary to give business efficacy to the contract. A lot will depend on the circumstances,6 but the general trend is for the courts to resist such implied terms.7
If the firm has adopted the code and makes reference to the code in its marketing materials only, the risk is likely to be a claim of misrepresentation or negligent misstatement. There is also the risk, depending on the content of the industry code, of the firm assuming responsibility of an “information” duty to its customers (ie lower than the duty arising in an advisory context, but higher than the common law duty not to mislead or misstate). Any such duty would be based on the content of the industry code requiring the firm, if asked about a product, to give the customer certain information8 and by signing up to the code, assuming responsibility to adhere to it.
If the firm has adopted the code, but makes no reference to it in its contracts or marketing material, the risks should be lower. However, depending on how the fact of the firm agreeing to the code is published and its content, there could be a risk of the firm assuming a responsibility to a claimant in relation to it.
How to mitigate such risks in practice
The litigation risks can be mitigated to some extent by the careful drafting of contractual obligations and the inclusion of disclaimers, basis clauses or other clauses seeking to exclude a duty of care from arising. There may, however, be a point where a firm cannot sign up to an industry code and successfully disclaim liability to anyone for adhering to it.
Therefore, the best way to mitigate the litigation and regulatory risks is to actually meet the standard in the industry code. In practice, firms seek to achieve this by:
- participating in industry bodies that produce such codes, to ensure they agree, support and can comply with their content;
- performing gap analysis against the requirements of industry codes and internal policies and procedures;
- implementing any necessary reconciliation projects, managed with an appropriate governance framework; and
- if it is not possible to meet the industry code standard, considering carefully the adequacy of the firm’s alternative approach and being in a position to explain it.
Such processes will need to adapt to the changing nature of markets and relevant requirements of regulation and industry codes.
For example, the FICC Markets Standard Board (FMSB) has recently highlighted the benefits and risks of machine learning in financial markets.9 Whilst existing regulation has requirements in relation to algorithmic trading, the FMSB has been able to detail the risks of machine learning – such as model drift, bias, and data quality issues – and publish relevant good practice. This should assist firms in assessing and benchmarking their own processes. As noted in this article, if they do not the risks are real.