On 1 March 2010, the FSA published its Enforcement financial penalties Policy Statement (10/4), and amendments to the guidance in the Decision Procedure and Penalties manual (DEPP), following a consultation period between June and October 2009. The new guidance will apply to misconduct which takes place on or after 6 March 2010. Where misconduct straddles that date, the new guidance will apply to conduct from 6 March 2010 and the existing guidance will apply to conduct before that date.
The aims of the proposals outlined in the FSA’s consultation paper were threefold:
- to achieve more transparency regarding the manner in which penalties are set;
- to improve consistency in the penalties levied; and
- to increase the level of penalties in order to achieve credible deterrence (with the effect of doubling or trebling enforcement fines).
This briefing note outlines the key changes that will be made to the determination of financial penalties and considers whether these aims are likely to be achieved.
The key changes that the FSA has made to DEPP are:
- to apply a five step approach to determining the penalty for: (i) individuals; (ii) firms; and (iii) market abuse cases, as outlined in broad terms below; and
- to explain the circumstances in which the FSA will consider reducing the proposed penalty to take account of serious financial hardship.
Five steps to setting a penalty
Step 1 (disgorgement)
Where the FSA is able to identify the benefit derived from the breach, in the form of profit made or loss avoided, and the benefit can be quantified, the person will be deprived of that benefit.
The amount of interest applied, together with the date from which it will apply, will be determined on a case-by-case basis, having regard to the interest rates applied by the Financial Ombudsman Service and the civil courts.
Step 2 (discipline)
The starting point will be to set the penalty based on a percentage of a minimum of a year’s revenue (for firms) or income (for individuals), or where the conduct continues for longer that a year, for the period of the breach. In the case of a one-off event, the relevant revenue or income will be that derived during the twelve months preceding the end of the breach. The percentage used will depend on the seriousness, nature and impact of the misconduct, adopting a sliding scale from levels 1 to 5 on the basis that the more serious the misconduct, the higher the percentage applied. Amongst the factors which are likely to be considered to be more serious and so fall within level 4 or 5, is whether the conduct is intentional or reckless, whereas negligent or unintentional conduct is likely to fall within levels 1-3.
In the case of firms, the percentage of “relevant revenue” for a particular product or business area will range between 0-20%, at fixed levels of level 1 - 0%, level 2 - 5%, level 3 - 10%, level 4 -15% and level 5 - 20%. Relevant revenue is not intended to be a ‘term of art’ or to reflect a precise accounting definition and will depend on the facts of each case. Where revenue is not an appropriate indicator of the harm caused (e.g. in information security cases), the FSA will us an “appropriate alternative”.
In the case of individuals, the percentage of gross income and benefits (including salary, bonus, pension contributions, share options and share schemes) will range between 0-40%, at fixed levels of level 1 - 0%, level 2 - 10%, level 3 - 20%, level 4 - 30% and level 5 - 40%.
In respect of market abuse cases referable to the individual’s employment, the FSA will select the greater of: (i) 0-40% of income (as above); (ii) a multiple of the profit made or loss avoided for the individual’s benefit or the benefit of others arising as a direct result of market abuse (zero to four times); and (iii) in the most serious cases (levels 4 or 5), £100,000.
In respect of market abuse cases which are not referable to the individual’s employment, the FSA will select the greater of: (i) a multiple of the profit made or loss avoided for the individual’s benefit or the benefit of others arising as a direct result of market abuse (zero to four times); and (ii) in the most serious cases (levels 4 or 5), £100,000.
Step 3 (mitigating or aggravating circumstances)
The FSA may increase or decrease the amount derived from Step 2 as a result of any aggravating and mitigating factors. For example, if a person has arranged his resources in such a way as to avoid disgorgement or payment of a financial penalty this would be an aggravating factor which may justify an increase in the penalty.
Step 4 (deterrence)
The FSA may increase the amount arrived at from Step 3 if it considers it to be insufficient to deter the person who committed the breach and others from committing further breaches. For example, an increase may be necessary where previous FSA action in respect of similar breaches has failed to improve industry standards.
Step 5 (settlement discount)
As is currently the case, the FSA will then apply a discount to the penalty if a settlement occurs within prescribed “stages” (see DEPP 6.7).
Serious financial hardship
The FSA will only consider whether to reduce the penalty for serious financial hardship if: (i) verifiable evidence is provided; and (ii) the person provides full, frank and timely disclosure of the evidence and co-operates fully with the FSA’s questioning about his financial position. An individual will only suffer serious financial hardship, in the FSA’s view, if his net annual income will fall below £14,000 or his capital will fall below £16,000 as a result of paying the penalty.
In the case of an individual’s income, the FSA has indicated that an individual with an annual net income of £50,000 should be able to pay £36,000 of his income for each of the following three years without suffering serious financial hardship. The FSA will take into account the impact of a prohibition order or withdrawal of approval where this reduces an individual’s earning potential.
In considering capital, FSA will normally include the equity in an individual’s home. However, the FSA will consider representations, for example as to the exceptionally severe impact of a sale on other occupants of the property or the impracticability of re-mortgaging or selling the property within a reasonable period.
In the case of a firm, the FSA will consider reducing the penalty where that penalty would threaten the firm’s solvency or render it insolvent.
Whether the FSA will allow the penalty to be paid in instalments will depend on the facts of each case. Notwithstanding representations regarding serious financial hardship, the FSA has the discretion to disregard them.
We set out below some of the more significant issues that are raised by the FSA’s new approach to setting penalties.
- Whilst increased transparency and consistency are to be welcomed, it is questionable to what extent these objectives will be achieved as the FSA will retain a high level of discretion in determining penalties, particularly in Steps 2, 3 and 4. If the FSA considers the penalty is too low (or too high), it can change it. The factors that will be taken into account in determining the amount by which the penalty should be increased or decreased in these circumstances are highly subjective. This lack of certainty already exists in the current regime, particularly in relation to cases involving conduct which has previously been the subject of disciplinary action but where the FSA considers that penalties need to be increased to provide an additional deterrent effect. However, it is far from clear how the new guidance will improve matters.
- The application of so many factors at Steps 2 and 3 followed by the overall discretionary adjustment at Step 4 means that it will be difficult in practice to isolate particular factors so as to determine to what extent the penalty was influenced by each factor and, therefore, to predict the level at which future penalties that share similar factors will be set.
- The absence of a definition of "relevant revenue" and the lack of clarity as to the meaning and application of an "appropriate alternative" indicator of harm (where revenue is not an appropriate measure upon which to base the Step 2 calculation), will make it difficult to compare cases involving similar conduct, achieve consistently calculated penalties, and predict the level of future penalties accordingly. This is particularly so where commercially sensitive material relating to the calculation of “relevant revenue” may, as envisaged by the Policy Statement, be omitted from a final notice. Similarly, at Step 1, inconsistencies may arise in the calculation of the "financial benefit" derived directly from the breach for the purposes of achieving disgorgement.
- The FSA's insistence on basing the Step 2 calculation on a minimum of 12 months’ income, even where the breach lasted for less than 12 months or was a one-off event, means that there is a risk that the penalty for a breach lasting one week will be broadly the same as the penalty for a breach lasting a year.
- When agreeing the terms of a settlement, the FSA recognises the importance of sending clear, consistent messages and is committed to settling only where the agreed terms of the decision result in acceptable regulatory outcomes. However, it remains to be seen whether other “litigation risk” factors (on both sides) act to distort some penalties which are the product of extensive negotiation or mediation. Moreover, if more cases proceed to the RDC as a result of the imposition of higher penalties, there appears to be an increased risk of inconsistencies arising between settled and RDC cases, if the FSA and RDC take different views as to the weight to be applied to the various factors. This will present an even greater liaison challenge to Margaret Cole (Enforcement) and Tim Herrington (the RDC).
Higher financial penalties
- The FSA remains committed to the view that increasing penalties should increase compliance with its rules. Time will tell if this view is correct. However, regulatory penalties in the US have tended to be significantly more than those imposed in the UK and yet there does not appear to be substantially less misconduct in the US. Conversely, penalties tend to be lower on the Continent and it would not appear that there is significantly more misconduct there than in the UK.
- Indeed, reputable financial institutions expend considerable resources in seeking to comply with their regulatory obligations. They do so for a variety of reasons other than the size of any financial penalty. It is doubtful that the risk of a substantially increased penalty will cause such institutions to act any differently.
- The FSA has dismissed concerns that substantially increased penalties on approved persons will act as a deterrent to individuals becoming approved persons but no reasons are given for rejecting the concern.
- It is possible that the introduction of a more prescribed framework for the calculation of financial penalties will mean that there is less scope for negotiated settlement. In particular, there is likely to be a lack of flexibility regarding the starting figure for negotiations once the “relevant revenue” and level of conduct have been determined by the FSA. Further, in the past, some firms and individuals have been willing to reach a settlement with the FSA which has resulted in an increased financial penalty but on the basis that the firm or individual is not found in breach of a particular FSA Principle or rule. It is possible that the new framework will mean that the scope for reaching this sort of agreement is reduced.
- Currently, most cases against authorised firms settle at an early stage. It is likely that, with significantly higher penalties, more firms (and even more individuals) will decide to challenge the FSA, particularly in the light of the very high threshold for serious financial hardship. This may result in significant FSA resources being tied up in challenging cases before the RDC and the Tribunal and, in the long run, prove counter-productive for the FSA’s desire to establish credible deterrence.
The FSA considers that the amendments to DEPP strike the right balance between providing sufficient guidance to achieve transparency and consistency and the necessary flexibility to deal with all types of regulatory misconduct. Although there are no plans to review the new process following implementation, the Policy Statement indicates that the FSA will welcome comments from stakeholders. Stakeholders should bear in mind the need to highlight any inconsistencies or lack of transparency as we enter the new regime so that regulatory attention can be swiftly drawn to any resulting practical difficulties.