An odd decision was published in a recent FSA Final Notice that found a firm and one of its individual accountants acted without integrity but not dishonestly. This intellectual wordplay raises novel and significant issues for the insurance of defence costs associated with regulatory investigations into regulated firms and individuals.


The FSA issued its Final Notice in respect of accountancy firm Sedley Richard Laurence Voulters (SRLV) and one of its junior partners on 13 December 2010 (see press release here).

The firm of chartered accountants is an “authorised professional firm” under the Financial Services & Markets Act, authorised to the extent that it carries out regulated activities. The junior partner (who had no managerial responsibilities) was an approved person, performing the CF30 (customer) controlled function. The firm was found to have acted without integrity by its involvement in the promotion, offer for sale and sale of shares in a company known as NSL by various unauthorised overseas entities which the FSA believes to be share fraud operators (commonly known as ‘boiler rooms’). The firm should have known that the promotion and sale of the shares were being carried out by such entities in breach of the Act and that share fraud operators were involved and therefore that it could be handling the proceeds of crime. It should also have known that its involvement might have reassured potential investors about the legitimacy of the shares despite the warning signs of possible financial crime available to the firm and the junior partner in particular. The firm failed to act or respond appropriately. Rather than accepting its own responsibility to counter the risk of financial crime, it recklessly, through the junior partner, sought to place those responsibilities on the fraud operators. The FSA found the firm to have breached principle 1 by acting recklessly and thereby failing to act with integrity. However it expressly stated that “The FSA does not allege that SRLV acted dishonestly …”

The final notice against the junior partner states that he was “knowingly concerned in the contravention by the firm of Principle 1…” in that he managed the firm’s relationship with the boiler room fraud operators. His conduct “demonstrated a lack of readiness and willingness to abide by legal and professional standards” and on that basis he had fallen below the minimum standards required in terms of integrity by acting recklessly and therefore was found not to be a fit and proper person to perform any function in relation to any regulated activity. However, the FSA did not allege that he acted dishonestly.

The FSA imposed on the junior partner a prohibition order and a fine of £105k and fined the firm itself £163,140.

Defence Costs

Insurers of Directors & Officers and Professional Indemnity Policies are now well familiar with the heavy burden of defence costs placed on their insureds by regulatory investigations, particularly by the FSA. As noted in our press release of 20 December (see here) the total amount of fines levied by the FSA in 2010 increased by over 150% to £88.4m, but this represents the tip of the iceberg. As Jonathan Davies noted, “The vast majority of firms never get fined by the FSA but there is a huge cost for many of them in defending investigations by the FSA. … unlike in formal legal proceedings, there is no possibility of firms recovering the costs of defending themselves successfully when they are investigated by the FSA … Whilst fines cannot be covered by insurance, legal defence costs are regularly insured. The increased number and complexity of investigations increases the bill for insurers.”

With a new policy of increased fines for firms and individuals, and the spectre of two potentially competing regulators on the horizon, insurers can expect the regulatory investigation defence costs bill only to increase. As noted by Simon Goldring in our Financial Services Update of December 2010 (see here), the creation of additional significant influence and oversight functions (for those exercising influence over a firm from within a parent entity, those responsible for CASS operational oversight and complaints handling) means that senior managers and their insurers are increasingly exposed to regulatory action. Personal responsibilities are being assigned to new areas within regulated businesses and their parent entities. The ever increasing encroachment of FSA regulation into the boardroom and the heightened intensity with which individual directors are likely to want to defend enforcement action when facing personal fines or prohibition only add to the costs.

D&O Coverage

An FSA investigation involving allegations of involvement in a boiler room share scam is likely to prompt insurers upon receipt of a notification to reserve their rights. But defence costs are likely to be payable until such time as the policy is avoided for nondisclosure of a moral hazard or cover declined by application of a dishonesty exclusion or until the policy limit is exhausted – whichever happens first. Most D&O dishonesty exclusions only bite upon final adjudication by a court or similar tribunal, confirming the insured’s dishonesty.

Increasingly, policy sub-limits for regulatory investigation defence costs are spent entirely on FSA investigations, regardless of their outcome, and even substantial full policy limits can be exhausted on defence costs alone. In a case like that involving SRLV, insurers would probably find no means of applying a dishonesty exclusion where the express finding states that no dishonesty was alleged, let alone found. Insurers are always free to try to prove dishonesty1 and would not be bound by an FSA decision (such as that in the SRLV case); however, the burden of proof is a notoriously heavy one. Until dishonesty or fraud is proved, insurers must pay.

The insurers might have a case that the finding of a lack of integrity and that an individual is not a fit and proper person could ground a case for avoiding the policy for non-disclosure of such a moral hazard but that would depend entirely on the facts of the case and the evidence available. Faced with an express finding of no dishonesty, the insurers are more likely to be obliged to provide cover.

PI coverage

The costs of defending regulatory investigations into firms may be covered by their PI insurance if the policy carries an extension for matters under investigation which, in the insurers’ opinion, are likely to give rise to civil claims or, as is increasingly common, the policy has a specific extension of cover for regulatory investigation defence costs. Again, in the absence of a finding of dishonesty, PI insurers would be unlikely to be able to rely on any dishonesty exclusion and, even if they had evidence of an undisclosed moral hazard surrounding one of a number of partners within a firm, it is unlikely that the knowledge of that one partner’s guilty conduct would be attributed to the insured firm or company as a whole. The FSA Final Notice in respect of SRLV expressly stated that the junior partner did not have a managerial role which, whether by coincidence or design, would serve to assist the firm to pursue a claim under its insurances for defence costs and any civil liability incurred to investors because his was not the guiding mind of the firm. With its consumer protection focus, the FSA, like savvy claimants, may be aware of the insurance issues that arise when alleging dishonesty.

A tenuous distinction?

With so much riding on the terminology used by the FSA in its investigation and Final Notices, we must presume that the FSA considers there to be a substantial difference between a lack of integrity and dishonesty. In practice, we suspect the difference is far from clear cut. The FSA does not define ‘integrity’ even though it is the first of the high level principles and the first of the Statements of Principles for Approved Persons. The dictionary defines it as “the quality of having strong moral principles”. The definition of ‘dishonesty’ has kept lawyers busy for generations but can be summarised as acts or omissions that the person knew or ought to have known that a right minded person would consider dishonest. The FSA’s explanation of the first Statement of Principles for Approved Persons (set out at APER4.1) describes a number of types of conduct which would show a lack of integrity, including: deliberately misleading a client, firm or the FSA; falsifying documents; providing false or inaccurate documentation or information; destroying documents; deliberately recommending an unsuitable investment; misusing assets or confidential information, including unjustified trading on a client’s account; misappropriating client’s assets or wrongly using one client’s funds to settle margin calls or to cover trading losses on another client’s account; designing transactions to disguise breaches and/or deliberately failing to disclose the existence of a conflict of interest. The deliberate element of most of these examples tends to suggest that lacking integrity usually involves what most would consider dishonesty For the purposes of its fit and proper person test, the FSA states in rule FIT2.1 that “In determining a person’s honesty, integrity and reputation, the FSA will have regard to all relevant matters including, but not limited to, those set out in FIT2.1.3G …” Those matters are a typical list including whether the person has been convicted of a criminal offence or subject to an adverse finding in civil proceedings or subject of, or interviewed in the course of, investigation or disciplinary proceedings. By treating the three concepts of honesty, integrity and reputation together, the FSA blurs the distinction between each, providing no helpful guidance as to its understanding of the concept of honesty.

Appeal – and yet more costs?

In another case decided by the Upper Tribunal in November 20102, the managing director of a stockbroking firm failed in his challenge of an FSA Decision Notice imposing a prohibition order, preventing him from working in the financial services industry for life. He was found by the FSA and Tribunal to have been knowingly involved in a share ramping scheme. His knowledge and involvement constituted breaches of the market abuse offences described at section 118 of FSMA. Notwithstanding a finding of “lack of integrity … and … deliberate involvement in the share ramping scheme”, the Tribunal made no finding of dishonesty or fraud. The insurers of the regulatory costs in such a case may therefore have found no grounds for avoidance or to decline cover. Had such insurers been required to continue paying for defence costs through the appeal stage, it is likely the costs would have doubled.

Given that D&O policies are designed to protect individuals whose very livelihoods are threatened, they often contain no ‘claim control’ provisions by which insurers can call an end to attempts to clear a Director’s name. If the definition of the ‘defence costs’ covered includes (or does not exclude) appeals, insurers are likely to be obliged to continue to fund the case. Even if insurers were to object to an appeal, if the policy contains a ‘QC clause’ by which any dispute is determined by a jointly appointed Queen’s Counsel, a Director facing a prohibition order or crippling fine would have good prospects of persuading the QC that the fight should continue, even if the prospects would not warrant further litigation in the commercial sphere.

RPC’s comments

Semantics aside, these recent cases raise a significant issue for the insurers of regulatory investigation costs. In the absence of a clear finding of dishonesty, it will likely prove hard for insurers independently to prove actionable dishonesty such as might entitle them to avoid a policy or apply a dishonesty exclusion. One simple answer might be to alter the wording of the dishonesty exclusion to incorporate a finding of breach of Principle 1 and/or a lack of integrity. Otherwise, insurers will simply have to carry on paying, even if that means funding an appeal too.