SquareMile’s failings came to light as a result of ongoing thematic visits by the FSA to assess the practices of small firms when selling higher risk shares.The FSA investigated 55 transactions carried out by SquareMile betweenMarch andMay 2006 and uncovered a series of fundamental regulatory failings. The seriousness of the shortcomings is illustrated by the fact that the FSA originally sought a penalty of £1.5million, but this was reduced due to a combination of factors. SquareMile settled at an early stage, it was in financial difficulties, and will now have to fund the independent approval of its transactions and new account openings. SquareMile has also agreed to appoint a Skilled Person to assess its sale practices and to assesswhat level of customer compensation will be appropriate, as well as making changes to its seniormanagement and writing to its customers advising themof the FSA’s findings.
There are a variety of lessons to be learned fromthis case. Margaret Cole, Director of Enforcement, hasmade it clear that “the FSA will not tolerate any regulated firmcoercing customers into buying financial products or services they do not want or can’t afford”. The Final Notice sent to SquareMile amounts to a litany of failings – in effect, setting out how not to run a stockbroking firm– and provides significant insights into the FSA’s views. Finally, there is an important lesson for firms which find themselves in a similar situation to Square Mile: If under investigation by the FSA, firms should consider carefully the benefits of proactive remedial steps as regards customers who have suffered detriment, and co-operation with the FSA (see Resistance is futile: co-operation, enforcement and principles-based regulation in our last e-bulletin).
Nevertheless, considering the seriousness of the breaches by SquareMile, the fact that the firmwas already in financial difficulties, the findings of breaches of Principle 1 (integrity) and the FSA’s focus on seniormanagement responsibility, it is somewhat surprising that there have been no formal enforcement proceedings against individualmembers of SquareMile’smanagement team.
SquareMile offers derivatives and deals in securities admitted (or intended to be admitted) on the AIMor PLUS Market. It usedmail shots, purporting to offer free research, to attract customers.
The FSA found that SquareMile failed to conduct its business with integrity (in breach of Principle 1), pay due regard to the interest of its customers and treat themfairly (in breach of Principle 6), pay due regard to the information needs of its clients, and communicate information to themin a way which is clear, fair andmotmisleading (in breach of Principle 7), take reasonable care to ensure the suitability of its advice and discretionary decisions (in breach of principle 9) and take reasonable care to organise and control its affairs responsibly and effectively (in breach of Principle 3).
In addition, SquareMile breached Conduct of Business rules 5.2.5R and 5.4.3R (whichwere in force during the relevant time).
Breach of Principle 1
SquareMile established a businessmodel in which it recommended high risk securities, knowing customers would rely on its advice,without undertaking independent research. Instead it relied on the research conducted by the supplier of the security. SquareMilewas not able to demonstrate to the FSA that it understood the risks involved in the securities it was selling (in particular it did not consider the specific risks involvedwith small cap securities). By doing so it exposed its customers to the risk of being treated unfairly and of receiving recommendationswhichwere unsuitable. SquareMile created an environment through its bonus structure which encouraged its advisers to adopt adopted high pressure sales tactics. Themanagement at SquareMile not only knew that its advisers used these strategies, it actively discouraged advisers frominforming customers about the associated risk of the securities.
For instance, advisers pressurised customers tomake immediate investment decisions by using phrases such as “the allocation [of securities]will be gone fairly soon” or “a very limited allocation but [the adviserwas] pretty confident this is going to be a good one.” In all the cases examined it was unnecessary to put pressure on customers as Square Mile had been selling the securities for some time before, and continued to do so after, the sale. Customers were also led to believe they were one of a restricted group of customers to whoma number of limited securitieswas being offered.
In seven of the 55 transactions investigated sales people recorded purchases of securities for customers without having the customers’ consent. This conductwas labelled “dishonest” and lacking integrity by the FSA. After the purchase customers received contract notes requiring payments. In one case an 89 year old customer had £75,000 charged to his account, fromfive transactions to which he had not consented and, although he had an agreed risk capital limit of only £25,000 SquareMile sold him£395,000 worth of securities. Through this conduct the FSA concluded that SquareMile exposed its customers to the risk of being charged for securities they did not want to buy.
Breach of Principle 6
SquareMile established a remuneration systemthat led advisers to put its own interests before customers’ interests. Advisers were paid a low base salary and commission of 5% to 10%of the value of the securities they sold. Sales of less established companies or those that traded on PLUS received the highest commission. Adviserswere also expected to sell a certain amount of securities each day. The FSA considered the system“a serious failing” because it was likely to encourage advisers to attempt tomeet the required figures without regard to the fair treatment of customers.
Breach of Principle 7 and COB 5.4.3R
During the relevant period advisers were required by the COB rules to provide a risk warning to clients,which Square Mile failed to provide in 47 out of the 55 cases reviewed. The firmfurther failed to pay due regard to the information needs of its customers and communicate information in a way which is clear, fair and notmisleading in accordancewith Principle 7. Inmany cases the risk warning was cursory and material risks were disregarded.Often advisers failed to explain that the securitieswere long terminvestments. In other cases investors were provided with incorrect information about the issuing company. For instance, customers were told that one issuing companywas an established and profitable business,when in fact it was a “cash shell” company. Advisers also communicated exaggerated and unsupported information about the future performance of securities and persistently exaggerated their skill and experience as well as the professional service offered by SquareMile.One customer was told that Square Mile spent £6.8million on research when it only spent £25,000. Another customer was told that SquareMile employs 20 analysts, when in fact it employed none.
Breach of Principle 9 and COB 5.2.5R
SquareMile failed to seek up to date information about its customers’ financial situation and risk appetite. Inmany cases advisers recommended small cap securities to customers, although, the adviser knew only very little about the customer. A 68 year old customer told an adviser that he is a “completely new investor”, that “he does not understand themarket” and that “he did not havemuchmoney.”
Nevertheless, the adviser convinced himto sell securities in a LSE listed company and buy high risk securities listed on PLUS. Only after customers agreed provisionally to buy the securities, were inquires about the customer’s financial statusmade. SquareMile neither provided its adviserswith information about a customer’s agreed risk capital level nor their trading or cash payment history. Advisers alsomade recommendations to buy high risk securities despite customers indicating that they were risk averse, and they disregarded customers’ ability to pay for the securities.
Breach of Principle 3
SquareMile failed tomaintain any clear apportionment of significant responsibilities amongst seniormanagement such that its business could be adequately controlled. It was not even aware until after a visit by the FSA that it did not have the required Apportionment and OversightOfficer. Therewas no ongoing risk assessment in the firmnor were there adequate compliance procedures.Generally, SquareMile’s compliance teamhad very little input in the running of the firm and because of its inadequate systems and controls Square Mile was not able to properlymonitor andmanage the risk in its small cap securities business.
The FSA found that the breacheswere particularly serious because they were the result of systematicweaknesses in SquareMile’s controlsmechanisms. The FSA further found that that SquareMile acted recklessly because its business presented a high risk to customers and it failed to implement the necessary controls. SquareMile’s seniormanagement knew that its advisers engaged in doubtful sales practices but failed to take reasonable steps to remedy the problem. The FSA also took into account that SquareMile earned £947,307 as commission fromsecurities sales during the relevant period.
Despite this the FSA took into consideration the specific financial circumstances of SquareMile, considering it a mitigating factor, for the purpose of the size of the fine, that the firmmade a loss of £445,069 in 2006. However, the FSA also “recognised…measures taken by SquareMilewhich mitigate the seriousness of the failings”, which included:
i) engaging an independent consultant to reviewits operations and to produce a report on the implementation of revised compliance arrangements: the reportwasmade available to the FSA;
ii) undertaking changes to its seniormanagement;
iii) engaging a Skilled Person (appointed under section 166 FSMA) to conduct a reviewof its controls and sales practices, whose recommendationswill be binding on
SquareMile and whose report will be sent to the FSA;
iv)writing to all its customers informing themabout the findings of the FSA and advising themhow they canmake a complaint; and
v) voluntarily varying its permission, granted pursuant to Part IV of FSMA, to impose requirements upon it to obtain independent approval of all transactions and the opening of new client accounts and to restrict sales of securities to amaximumof £48,000 per individual customer.
Despite SquareMile’s recourse to executive settlement procedures the Final Notice remains litteredwith unflattering adjectives: the FSA repeatedly found SquareMile to have been “careless”, “inattentive”, “reckless”, “dishonest”, “misleading” and “unfair”. Given that SquareMile earned over £947,000 in commissions fromrecommending sales of securities during the period under investigation, it seems surprising that an initial fine of £1.5million should be reduced to just £250,000 and that SquareMile should be given the opportunity to pay in instalments, particularly as the FSA makes the point that there is no evidence to suggest that, despite operating losses of over £445,000, it is unable to pay the fine imposed. In the face of such flagrant and fundamental breaches it is also difficult to understandwhy the FSA has apparently decided against formal enforcement proceedings against SquareMile’s seniormanagement – or even to consider withdrawing its authorisation (although a “voluntary” variation of SquareMile’s Part IV permission has been agreed).Whilst section 206(2) of FSMA 2000 precludes the FSA fromboth fining a company and withdrawing its authorisation itmight have been open to the FSA either to consider, on the basis of SquareMile’s financial position, withdrawing its authorisation on the grounds of inadequate reserves or alternatively to opt for a cancellation of Square Mile’s Part IV Permission on its own initiative, under section 45(1)(c) of FSMA 2000 in order to protect consumers or potential consumers. The outcome in this extreme case suggests that, for the present, the practice of fining (in increasing amounts, if recent FSA pronouncements are to be believed) in preference to cancelling authorisation seems likely to continue, even for themost egregious of regulatory failings.