“In the context of the PBR debate, the phrase “regulatory creep” does not mean that you should toady up to the FSA at every opportunity – although there are a vast number of situations in which this would be a very well-advised strategy...” Martyn Hopper, speech to the Securities & Investments Institute, November 2007

The FSA’s recent amplification of its guidance on the extent to which cooperation by firms under investigation will be recognised and rewarded should formal enforcement proceedings become necessary, provides a limited amount of reassurance to firms that they may be able to reassert somemeasure of control over their fate should the dreaded Warning Notice appear. But how far does a firm have to go to demonstrate that it deserves a lesser penalty or a smaller fine – and does the FSA’s approach to co-operation work against the backdrop of principles-based regulation?

Extent of Co-operation required

The problem firms face is that when one looks back to the FSA’s eleven Principles for Businesses, Principle 11 already requires firms “to deal with [the FSA] in an open and cooperative way” and to “disclose to the FSA appropriately anything…of which the FSA would reasonably expect notice”. This obligation is both fundamental and ongoing. Principle 4 of the FSA’s Statements of Principle and Code of Practice for Approved Persons extends the same level of obligation to individuals. And it is an offence under s.177 of FSMA 2000 “knowingly or recklessly to supply to the FSA information which is false and misleading in amaterial particular”. There will have to be something more in the way that a firm deals with the enforcement division once a potential problem is uncovered. The FSA is clear that it will not give any credit for firms whomerely react to the proceedings in which they find themselves embroiled: the key is for there to be “evidence of proactive cooperation”. The FSA is candid about the policy reasons behind this stance: it has long sought to distance itself from suggestions that it is an enforcement-led regulator and indeed makes the point that its enforcement resources are limited, occupying just 8% of the headcount and that its enforcement division tracks the FSA’s overall strategic goals rather than pursuing an independent agenda. Indeed, the FSA is instead a risk-based regulator which is all too aware that it cannot police every firm and individual and hope to pick up every regulatory infraction. And regulated firms are the best placed to know their businesses and adopt monitoring programmes to guard against regulatory risks2; if a regulatory breach does occur they are equally best able to design and implement an appropriate remedial programme.

The rewards for co-operating with the FSA are considerable – particularly given the FSA’s repeated signalling of its intention to impose higher fines for regulatory breaches. Although the FSA has refused to be drawn formally on the level of discount which might be available to firms who are able to convince the FSA of the value of their cooperation, counsel for the FSA in the Legal & General reference to the Financial Services and Markets Tribunal suggested that the discount could range from 10 – 45%. This is in addition to the up to 30%discount available to firms which use the early settlement procedures which were brought in by the Enforcement Process Review in July 2005, which has resulted in the early settlement of a very high proportion of the enforcement actions brought by the FSA.

Guidance on co-operation

Pointers as to the behaviours which will qualify for a reduced penalty can be drawn, as is usual in this age of principles based regulation and proliferation of soft guidance, from a number of sources. Having revised and reissued the Enforcement Sourcebook as the Decision Procedure and PenaltiesManual, DEPP, and the Enforcement Guide, EG, the FSA has consolidated the factors which it may take into consideration in determining: 

  • whether to take enforcement action at all; 
  • whether to issue a public censure rather than a financial penalty; or 
  • the level of penalty to be levied.

A full review of the ranking of these factors in terms of effectiveness at reducing penalty is beyond the scope of this article but as the following analysis will show the way that a firm conducts itself to the FSA will have a significant effect on the outcome of the enforcement proceedings in question.

Whether to refer to enforcement:

The guidance at DEPP 6.2.1 G states that each case will be considered according to its own circumstances, and then goes on to list a series of factors affecting the decision whether to employ its enforcement tools by pressing for a financial penalty or public censure. Of relevance here is the firm or individual’s conduct once the breach has come to light, which may include the following:

a) how quickly, effectively and completely the breach was reported to the FSA;

(b) the degree of co-operation the person showed during the investigation of the breach;

(c) any remedial steps the person has taken in respect of the breach.

The “soft” guidance on the FSA website has recently been amended to give fewer, but more detailed, examples of cases in which the FSA decided not to take formal enforcement action but instead to either give a private warning or to pursue no enforcement action at all. The two cases studies have differing factual bases (one relates to a partialmisreporting of transaction data which omitted underlying client data; the other deals with concerns over account monitoring and potentially suspicious transactions) but the common factors emerging are that firms which: 

  • discover the problemthemselves; 
  • report the problem quickly and voluntarily; and 
  • take remedial action.

may stand a greater chance of avoiding public enforcement action – although this will of course depend on the seriousness of the original breach.

Whether to issue a public censure instead of a fine:

Although the FSA notes that theremay be circumstances in which the regulatory breach was so serious that no level of mitigating conduct would justify a decision not to bring any regulatory action at all, there is still significant scope to minimise the penalty levied through active co-operation, and to persuade the FSA to impose the lesser (in financial terms at least) penalty of a public censure. This is so even where the original breach was itself of Principle 11. In the final notice issued against The Underwriter Insurance Company Limited and its former CEO, Keith John Rutter, for deliberately contravening premiumincome limits and failing to notify the FSA of this, the FSA expressly recognised the co-operation offered by the company’s (admittedly new) senior management and by Mr Rutter in issuing lesser penalties (in Mr Rutter’s case, a lower fine).

The factors weighing in favour of a decision to issue the lesser penalty of a public censure are set out in DEPP 6.4.2 G. Bringing the breach to the attention of the FSA of one’s own volition (rather than waiting for the FSA to discover it during an ARROW visit or thematic study)may prompt a public censure only, as might admitting the breach and providing “full and immediate” co-operation to the FSA. Ensuring that those who have suffered loss due to the breach are fully compensated for those losses appears to be a particularly significant factor - although the FSA would probably argue that it should be taken as read that this should happen in any event. The way in which compensation is assessed, allocated and paid out, rather than the fact that this is done at all, is likely to be of more relevance here - firms would do well to read across the requirements of the TCF programme in this regard, in particular the final TCF “outcome”, to ensure that customers are given prompt and fair access to redress.

Turning to the relevant final notices, however, the occasions on which penalties have been downgraded to public censures on the basis of adequate co-operation are relatively rare. Public censures were imposed in lieu of financial penalties on two motor dealerships in relation to their sales of PPI in connection with vehicle finance agreements.

Having investigated Cathedral Motor Company, whose failings came to light as a result of an FSA thematic visit, the FSA concluded that the number of PPI policies sold by Cathedral was low (257 in 16 months) and was impressed by the decision by Cathedral voluntarily to suspend PPI sales after the FSA’s visit while it satisfied itself that future PPI sales would be compliant. Cathedral’s progress in improving its systems and controls, record keeping and training and monitoring arrangements and its commitment to carry out an appropriate customer contact exercise were also taken into account.

Another motor dealership, EasternWesternMotor Group, also escaped a fine for PPI mis-selling: again, the number of PPI policies sold was low and the firmhad sought independent compliance advice prior to the FSA taking a supervisory interest. EWMG cooperated fully with the FSA and in the relevant period, only one complaint was received in relation to its PPI cover. However it was the scale of the misselling which saved EasternWestern: but for the limited number of PPI policies actually sold, a financial penalty would have been proposed.

Berkeley Independent Advisors was able to escape a £425,000 fine which would have been imposed upon it for the mis-selling to over 3,800 customers of Whole of Life Policies or Regular Savings Plans. However, shortly after the commencement of the FSA’s investigation, BIA voluntarily suspended sales of Whole of Life policies and Regular Savings Plans and committed itself to undertaking a past business review to review advised sales of Whole of Life policies and Regular Savings Plans, which would include assessing any consumer loss and paying appropriate redress where unsuitable advice has led to any loss. These factors helped to persuade the FSA that it should instead impose a public censure, together with the firm’s “very close” co-operation with the FSA to bring the investigation to a timely conclusion and the introduction of a new senior management team. It is clear however that acting promptly to put in place a systemfor channelling compensatory payments to customers may help firms avoid a double financial hit.

Reducing the level of financial penalty imposed:

The most common “reward” for a sufficient level of cooperation with the FSA is the receipt of a reduced fine. Amongst the series of factors which may be considered by the FSA in DEPP 6.5.2 G in determining the appropriate level of financial penalty to be imposed are the firmor individual’s conduct in bringing (or failing to bring) the regulatory breach to the FSA’s attention “quickly, effectively and completely”; the degree of co-operation during the investigation of the breach by the FSA; any remedial steps taken since the breach was identified, and whether these were taken on the person’s own initiative or that of the FSA (for example, identifying whether consumers or investors or othermarket users suffered loss and compensating them where they have; correcting anymisleading statement or impression; or taking disciplinary action against staff involved (if appropriate); and taking steps to ensure that similar problems cannot arise in the future.

The FSA’s revised guidance on co-operation gives a number of specific examples of co-operation leading to reduced fines by quoting fromthe press releases which usually accompany the issue of final notices. FSA policy is to stress the benefits of co-operation by stating within the press release itself that co-operation has been received, but what is lacking is any real quantitative feel for where along the 10 – 45% spectrum the co-operation discount has been calculated. The website “guidance” gives four examples of co-operation reducing the level of financial policy by quoting fromfour (anonymised) relevant press releases froma broad spectrum of cases: 

In March 2003 Royal & SunAlliance was fined £950,000 for mortgage endowment mis-selling and systems and controls failures between 1997 and 1999. Despite its chequered regulatory history, the penalty on R&SA was reduced because the FSA “recognised that the failings have beenmitigated by the firm”, which: 

  • warned its policyholders between 1994 and 1997 of the risk that insufficient funds might be generated to pay off their mortgages – this was independent to the industrywide reprojection exercise led by the FSA; 
  • set aside £11million for redress to policyholders missold mortgage endowments; 
  • proactively identified, using its own internal procedures, an associated compliance issue relating to the sale of short term mortgage endowment contracts and offered an additional £5.6million in redress to affected customers; and 
  • “readily agreed” to offer redress to qualifying cases identified during a sample post business review.

Also in March 2003 DBS Financial Management plc was fined £100,000 for approving a misleading direct offer advertisement and for failing to improve its advertising approval procedures. The fine imposed “would have been much higher if DBS had not fully co-operated with us by overhauling its existing approval procedures and offering the 455 investors who responded to the advertisement their money back.” However, whilst a great deal of the credit given for co-operation referred to DBS’ “proactivity” in reviewing its internal procedures, identifying investors who may have been misled and arranging for refunds, the FSA does make the somewhat pointed comment that the firm’s co-operation was “largely in response to the regulator’s actions and instigation”, which suggests that there might have been yet further room for manoeuvre.

Small firms also have the opportunity to claim credit for cooperation: when Kings, a small IFA, was fined £60,000 in November 2005 for approving misleading financial promotions, its agreement to appoint an independent third party to review its financial promotions approval procedures and its willingness to appoint a full-time compliance officer was sufficient to earn it a discount: the press release concluded: “Without this positive action, the penalty would have been higher”.

The paradigmof co-operation to date is the third example given on the FSA’s website: Scottish Amicable, despite being fined £750,000 in March 2003 for mortgage endowment misselling, and despite the contravention having been discovered by the FSA, was given “considerable credit” for their subsequent conduct. The FSA summarises the actions taken by Scottish Amicable in its soft guidance piece on co-operation to include: 

  • a “positive response” from, and the “active involvement” of, senior management;
  • combining its compliance arrangements with those of its parent; 
  • immediately instigating a full review of its compliance policies;
  • commissioning an independent review of a sample of its sales to establish whether there had been mis-selling and if so the extent of any customer detriment;
  • extending that review to its compliance function and management reporting systems; 
  • accepting the findings of the review; 
  • ensuring that redress would be paid where due; 
  • in the event of any doubt as to whether a customer was mis-sold, erring on the side of the customer.

The FSA concludes its website guidance by defining the “outcome” of Scottish Amicable’s actions: ensuring that consumers were offered redressmore efficiently and quickly than if it had not co-operated with the investigation. According to the press release on the Scottish Amicable final notice the steps taken represent “a model of the type of co-operation and acceptance of responsibility by senior management which is desired by the FSA, and which consumers deserve”: it can only be concluded that the discount attracted must have been towards the upper end of the range.

Supervisory co-operation

But it is not just co-operation with enforcement which will tend to steer the FSA away from using its enforcement sanctions. Yet further guidance can be found in the Enforcement Guide. At paragraph 2.33 EG highlights the nature of a firm’s overall relationship with the FSA as a relevant consideration when determining whether, against that background, the use of enforcement tools is likely to further the FSA’s aims and objectives. If a firm has invested the time and effort into building up a strong track record of taking its senior management responsibilities seriously and being “open and communicative”, these may be factors which will mitigate the penalty. And even where enforcement action is decided against, the FSA will still expect to see “prompt” action to implement the measures agreed upon by it with its supervisors if the threat of enforcement action is not to be revived.

Co-operation and principles-based regulation

The high degree of co-operation expected by the FSA is all very well if the parties are able to agree on what the correct way forward should be, but principles-based regulation is intended to encourage “creative compliance” in the noblest sense. There is a danger that in seeking to persuade its supervisors that its way of doing business is a perfectly valid, if novel, way of complying with the Principles (and/or that it has its own ideas as to how best to remedy regulatory breaches) a firm may not only fail but deprive itself of any “cooperation premium”.

During the Enforcement Process review, one of the cooperation factors set out in the FSA’s website guidance - ‘Did the firm or individual quickly agree the facts and actively seek to agree a basis on which enforcement action could be concluded?’ - was criticised as potentially blurring the distinction between general co-operation and the early settlement process that the express discount scheme is designed to cover. The Review pointed out that a firm or individual could in theory contest a case (even as far as the Tribunal) but nevertheless receive credit for co-operation. It suggested that there should be credit for narrowing the issues in dispute, even if settlement is not reached. It was therefore proposed that the co-operation factor be recast as ‘Did the firm or individual actively narrow the issues and seek to resolve these at an early stage?’ This amendment was not carried over in terms either into DEPP or EG, or when the website guidance was revised (without consultation or notice, as is the normwith “soft” FSA guidance) and reissued in September 2007.

Nevertheless, the distinction between co-operation and early settlement is preserved within the structure of DEPP, and it may be, therefore, that a broader view of what “cooperation” means may have to be adapted to demonstrate to firms that the potential benefits of PBR do not outweigh the risks. If PBR is to work then it will be necessary for both compliance staff and senior management to walk a fine line between a robust defence of an innovative compliance practice on the one hand, and the risk that failing to share the supervisory view of what is required will condemn the firmor individual as being “unco-operative” on the other. Equally, supervision and enforcement will have to accept that PBR demands a greater degree of give and take in their relationships with and understanding of their regulatees and that a firmwhich pushes back on its supervisor’s view of the acceptable way to comply (which will inevitably be informed and – to an extent – constrained - by historic practice and guidance) should not be deprived of a co-operation discount if it has attempted to persuade the FSA of the validity of its approach and the FSA has nevertheless determined that it is not compliant. As has been recognised in the context of voluntary versus compulsory interviews, in EG 4.9 – 4.11, the FSA is not looking for unquestioning obedience in all circumstances: but there is a risk that unless this is made explicit in the cooperation context, firms will prefer to herd around existing standards rather than strike out on their own and seek to defend their position constructively. Such fear would be the enemy of the innovation and creativity that PBR seeks to promote.