The Financial Services Authority (FSA) has consulted on proposals to extend the scope of the approved persons regime, focusing on holding senior management to personal account for incompetence. The final rules will be published later this year and compliance departments need to start preparing for them. The key points are:
- the FSA will now consider the competence of significant influence function holders, as well as considering cases of dishonesty or lack of integrity; and
- the proposal widens the application of the regime to individuals such as directors, non-executive directors and senior managers of a parent undertaking or holding company.
Following the internal audit review of lessons learned from the supervision of Northern Rock, and as part of the new supervisory enhancement programme, the Financial Services Authority (FSA) has identified the following as a key aim for the future: holding senior management to account on a personal basis, not only for misconduct, but also incompetence. To this end, consultation ended on 31 March 2009 on proposals to extend the scope of the current approved persons regime – The approved persons regime: significant influence function review (CP08/25). Publication of the final rules by way of a policy statement is expected during the second quarter of 2009. Compliance departments are gearing up for a busy summer 2009 in ensuring the necessary applications are processed as required under the new regime.
The consultation paper outlines the FSA’s approach, focusing the spotlight on the competence of senior management and referring to recent steps taken in this regard. It then outlines five proposals to strengthen the current regime.
What is an approved person?
An approved person is someone who is approved to perform a controlled function for an authorised firm or an appointed representative firm. To be approved to perform a controlled function, an individual must:
- satisfy and maintain the criteria for approval (the fit and proper test) – the most important considerations are: (i) honesty, integrity and reputation; (ii) competence and capability; and (iii) financial soundness; and
- perform the controlled function in accordance with a set of standards (the Statements of Principle and Code of Practice for Approved Persons).
If an approved person does not comply with the FSA regulatory requirements, the FSA may issue a fine or public reprimand or withdraw approved status.
For individuals holding significant influence controlled functions, in the past the FSA has focused on cases of dishonesty or lack of integrity, where prohibition or withdrawal of approval was the most appropriate outcome. The FSA says that in the future, it will also consider the competence of significant influence function holders and will not shy away from pursuing cases against individuals who breach the Principles and the Code of Practice for Approved Persons, where fines may be more appropriate. A strategic decision has been made to investigate more individuals to achieve credible deterrence.
Demonstrating its increased scrutiny of significant influence controlled functions, from October 2008, the FSA has started interviewing more of those applying to become significant influence function holders at the largest firms and has amended Form A (application for a controlled function) requiring provision of information about the candidate’s competence and capability.
When the FSA investigates an employee for misconduct, the process is fairly straightforward to manage from an employment law standpoint. Immediate suspension while an internal investigatory process is conducted would in most cases be appropriate, which may lead to immediate dismissal on grounds of gross misconduct. Difficult issues arise if the FSA decides to investigate a senior employee for incompetence. Suspension and immediate dismissal are not generally options open to an employer in cases of suspected incompetence. Since the FSA is now arguably treating incompetence of senior managers similarly to misconduct, it is advisable for employers to ensure that these employees’ contracts expressly provide for the ability to suspend should the employee be subject to investigation by the FSA for incompetence and for the ability to dismiss immediately should such an investigation be upheld.
The concept of an employee being fined for incompetence is also of great importance because approved persons are prohibited from being protected by an indemnity from the firm or by insurance against regulated fines or criminal penalties. However, they may be protected in relation to the costs of representation in regulatory proceedings. Employers may well face increased defence costs as a result of increased FSA scrutiny.
The five proposals outlined in the consultation paper are as follows.
Proposal one: extending the definition of the existing CF1 (director) and CF2 (non-executive director) to include those individuals who exercise significant influence on a regulated firm from a parent undertaking or holding company within its group
The proposal widens the application of the regime to individuals such as directors, non-executive directors and senior managers of a parent undertaking or holding company whose decisions, opinions or actions are regularly taken into account by the governing body of the authorised firm. Current definitions do not necessarily catch such individuals.
Whether individuals within a group company structure fall within this widened net is a question of fact for the firm itself to determine.
The proposal would cover regulated and unregulated UK and non-European Economic Area (EEA) parent undertakings and holding companies and EEA unregulated parent undertakings and holding companies. It would not cover UK branches of an EEA regulated company, nor UK incorporated authorised firms with an EEA regulated parent company.
A transitional period of six months from the date of publication of the new rules would apply, during which firms would need to identify whether any individuals within a group company on which they rely in respect of governance arrangements fall within this wider ambit and arrange for necessary approvals. To ensure applications are determined in time, firms would need to submit applications no later than three months before the end of the transitional period. No action would be required if such persons already hold a CF1 or CF2.
The FSA anticipates receiving up to 200 initial new applications on this basis and then approximately 200 applications per year thereafter.
The proposal directly links, for the first time, governance of a subsidiary company with that of its holding company. However, given the existence of shadow directors in the current regime, group directors in accordance with whose directions and instructions the director of the authorised subsidiary is accustomed to act are already within scope. The proposal formally broadens the scope of the regulatory regime to group senior management and by strengthening the test from ‘accustomed to act in accordance with directions’ to ‘instructions to be regularly taken into account’.
Proposal two: clarifying the role of non-executive directors within the Code of Practice for Approved Persons
The FSA intends to clarify expectations for non-executive directors of regulated companies, rather than impose any new requirements on them. However, it is clear that it has increased expectations of non-executive directors. The intention is to issue guidance based on industry codes, namely the Higgs Report: Review of the role and effectiveness of non-executive directors (January 2003) and The Combined Code on Corporate Governance (June 2008). The FSA expects non-executive directors to be capable of asking challenging questions to understand (and, if necessary, positively influence) the business model and inherent risks within the firm. It makes it clear that in the future it will be more likely to hold nonexecutive directors accountable if there is evidence of incompetence or lack of integrity. In the past it has said that it would not discipline non-executives if they have acted in accordance with their roles and responsibilities when things go wrong. Now, it makes clear that it will look at non-executives more closely if it believes that they should have intervened where executives are making sustained poor decisions.
The increased scrutiny of the FSA over the actions of non-executives may deter many able candidates from performing this role. It is also questionable whether those non-executive directors without a formal financial services compliance background would be able to meet the proposed expected standards.
Proposal three: extending the definition of the CF29 controlled function to include appropriate proprietary traders with the expectation that this will capture all proprietary traders
The proposal is to include all proprietary traders (not only those who are senior managers, as is the current position) if it is likely that function will enable them to exercise a significant influence on the firm. This proposal is aimed at addressing some of the current market problems, where proprietary traders have demonstrated potential to cause substantial harm to firms. The FSA says that the risk of personal enforcement action being taken against proprietary traders may assist in deterring both senior and junior proprietary traders from undertaking activity for short-term advantage that is unauthorised, exposes the firm to risk of financial failure or jeopardises confidence in UK markets. The prospect of a fine for lower-paid employees may well affect their risk-taking activities.
Proposal four: amending the application of the approved persons regime to UK branches of overseas firms based outside the EE A so that all the controlled functions may apply
Most notably, CF1 and CF2 do not currently apply to UK branches of non-EEA firms. It is proposed that this limitation be removed to better reflect current corporate governance arrangements and to ensure regulatory consistency between non-EEA firms that form subsidiaries in the UK and non-EEA firms that branch into the UK. The FSA expects that many individuals who perform CF1 and CF2 will be domiciled overseas rather than based in the UK branch itself, but do not see that fact being problematic.
Proposal five: extending the rule obliging firms to provide references on request for applicants of the CF30 (customer function) to all controlled functions
This proposal seems a fairly sensible development. However, such references are typically extremely brief and would not in most cases lead to improved supervision.
This article was first published in the Butterworths Journal of International Banking and Financial Law, volume 24, May 2009, No. 5.