The FSA

A cornerstone in the architecture of the proposed financial services regime has been published in the form of a consultation paper on a set of Principles,1 to apply to all the activities for which the Financial Services Authority (FSA) will have regulatory responsibility.2 This is complemented by a consultation paper on how the FSA plans to enforce the new regulatory regime.3 Taken together, these papers provide important indications on how the new regulatory framework will be applied to banking, insurance and investment business.

The Principles (set out at the end of this briefing) consist of high-level precepts imposing fundamental obligations on regulated businesses. They will apply in varying degrees to investment firms, banks, insurance companies and building societies, as well as to the conduct of business of certain "passported" European firms. The Principles will replace the existing Statements of Principle4 for investment firms, and the minimum fitness and properness requirements for banks, insurance companies and building societies.5

Broadly, the new Principles are similar in scope to the current Statements of Principle. We highlight below the most important changes. Our main concern is that the Principles will be used as a basis for enforcement action in their own right, without the FSA having to show that there has been a breach of underlying and more detailed rules. Given that the Principles are couched in very broad terms, this could give rise to considerable difficulties and uncertainty for regulated firms.

The proposed Principles will only apply to authorised persons, rather than to their employees (unlike the current Statements of Principle). A separate set of Principles and code of practice applying specifically to approved individuals will be published for consultation later in the year.

Investment firms

The Principles will apply in full to all UK investment firms (but not registered individuals) and to the conduct of business by incoming European firms. Although most of the Principles are similar to the current Statements of Principle, there are a few important changes, such as the emphasis on senior management responsibility, and although they have been reduced from ten to eight in number, they still more than match the existing Principles in scope.

Banks

The Principles will replace the minimum fitness and properness criteria for banks under Schedule 3 to the Banking Act 1987. Schedule 3 imposes minimum authorisation criteria, which include requirements for internal organisation, skill and integrity and capital adequacy. However, the FSA’s Principles are wider (although their application to banks’ conduct of business is limited (see below)). The FSA requirements relating to responsibilities of senior management (Principle 3) continue a trend initiated by the Bank of England for increasing managerial responsibility (see for example senior directors’ responsibility for accuracy of information contained in prudential returns6).

The FSA has confirmed that it will proceed only as a prudential supervisor when applying the Principles to banks. To that extent, it is limiting itself to the general application of the criteria in Schedule 3 which are currently used to assess the fitness and properness of a deposit-taker. The FSA will not apply the Principles to a deposit-taking conduct of business issue, unless it amounts to a serious or persistent violation which has implications for the fitness and properness of a deposit-taker or for confidence in that sector. Similarly for building societies, the FSA will apply the Principles to their prudential requirements, and not to deposit-taking conduct of business. In practice, however, the likely change in enforcement "culture" may mean that deposit-taking institutions will face enforcement action in respect of matters which previously would have been considered to be merely a supervisory issue.

Insurance companies: long term insurance

HM Treasury’s Insurance Directorate is currently responsible for prudential supervision of companies carrying on long term insurance business and these companies are presently subject to the fit and proper criteria under Schedule 2A to the Insurance Companies Act 1982. Their conduct of business is generally regulated by the PIA. Although long term insurers will be familiar with the current Statements of Principle, since they apply to their conduct of business, they will find the new regime different in that the new Principles will apply both to the prudential and conduct of business aspects of their activities.

Insurance companies: general insurance

At present, general insurance companies in the United Kingdom are supervised by HM Treasury’s Insurance Directorate. When the FSA formally takes over this role, it will apply the Principles to general insurance companies in the same way as to deposit-takers, namely, by imposing fitness and properness requirements on the companies. The FSA will not apply the Principles to conduct of business matters.

Lloyd’s of London

The Principles will apply to the Society of Lloyd’s, managing agents, members’ agents and Lloyd’s advisers. The application of a set of overriding Principles will be new to all of these entities, and it will be interesting to see how the FSA lives up to its commitment to ensure that they are appropriate to the Lloyd’s market. For example, will the FSA necessarily accept that a managing agent has observed proper standards of market conduct simply by adhering to normal practice within the Lloyd’s market? There must be a danger, especially if the FSA does not fully understand how this particular market operates, that a Lloyd’s regulated firm will be censured and fined even though it has not breached a Lloyd’s regulation or market practice.

Group companies

The Principles will generally apply only to those members of a group which are authorised by the FSA, but there are exceptions to this in relation to Principle 4 (prudence) and Principle 8 (relations with regulators). So far as Principle 4 requires a firm to maintain adequate financial resources, the FSA will take into account other members of a group. Similarly, when considering what information to provide to the FSA, Principle 8 will require a regulated firm to consider the activities of other members of its group.

Insurance companies and deposit-takers are already subject to minimum fitness and properness requirements7, and the FSA has said that it has drawn heavily on these existing models in formulating the new Principles. However, by far the closest model for the new Principles is clearly the current Statements of Principle for investment firms. The deposit-taking and long-term insurance industries will be inheriting largely unchanged the Principles which have represented for a number of years the regulatory philosophy of the FSA/SIB and the SROs.

The new Principles will be enforced across the full spectrum of regulated businesses. Although clearly there will be a need to consider the nature of the different regulated activities, we are likely to see a growing convergence of supervisory and enforcement activity. Although, initially at least, firms will still be supervised by many of the same individuals as before, these individuals will now be representing the FSA, whose culture, particularly in respect of discipline and enforcement, could be very different from the style to which deposit-takers and insurance companies have grown accustomed. The changes may even start before the new regime is in place - although statutory responsibility has not yet shifted to the FSA (except in respect of banking supervision), it already operates as the employer of the staff of the existing regulators who are now based in the one building in Canary Wharf.

We can also expect to see increased focus on customer service and consumer protection. The FSA’s consumer education drive is designed to promote public understanding of the products available and to put the consumer in a position to demand better quality of service from authorised firms where this is warranted. The regulator will also be focusing on the quality of information provided by firms in their marketing material, so that customers have a clear understanding of products on offer and are able to compare product performance. It should always be remembered that the prime stated motivation for overhaul of the financial services system is the need to improve consumer protection. We shall be following closely how these FSA initiatives will affect firms in practice.

The FSA’s armoury of enforcement powers is extremely broad, and will include powers of intervention and investigation, a power to fine, a power of public censure and, for the first time for breach of a Principle, a power to secure restitution for customers.

The FSA will consider taking action for breach of a Principle where there has been a breach of related rules, evidential provisions, codes of conduct and/or guidance. Of potentially greater concern is that the FSA may also take action based exclusively on a breach of one or more Principle. This may arise where:

• it is clear that the conduct in question violates the Principles, regardless of whether any detailed rule, code or evidential provision has strictly been breached;

• the behaviour in question is closely analogous to behaviour which would constitute a breach of a detailed rule, code or evidential provision; or

• there is evidence of systematic and repeated breach of detailed rules.

Although the FSA has stated that it will not use the Principles as a basis for arbitrary or unpredictable disciplinary action, there is a concern that the FSA may succumb too readily to the temptation of using its powers under the Principles to discipline firms without having to prove breach of any specific rule. There is clearly the potential for "lazy regulation" - if the FSA resorts to exclusive use of the Principles for disciplinary action too frequently, this could show either a lazy approach to enforcement or serious failings in the underlying conduct of business rules.

While it is acknowledged that the Principles have to be expressed at a high level of generality to be of any use, the extreme generality of some of the concepts has prompted criticism of the FSA’s power to take enforcement action for a breach. Some of the Principles are so vague that a firm would have great difficulty in ensuring that it (and, where relevant, members of its group) was fulfilling its obligations at all times (see specific comments on the Principles, below).

Prompted by the above concerns, critics are urging that the FSA’s enforcement powers under the Principles be curbed. Their suggestions include:

• only disciplining breaches of Principle which relate to fitness and properness;

• only using the Principles as a last resort, where conduct of business rules do not cover the behaviour in question, as for example, where a new issue has arisen from development of a new product not contemplated by the existing rules; and

• providing explicit safe harbours for firms which have complied with conduct of business rules or relevant codes of conduct, so that these firms can be confident that they will not be open to action by the FSA under the Principles.

Principle 3: Management and control

Principle 3 relates to the firm’s obligations in respect of its senior management. The responsibilities of such individuals will be the subject of a new set of Principles to be published for consultation later in the year. There has recently been increasing emphasis on the responsibilities of senior management by the FSA, and by the SROs and Bank of England before it. This initiative is clearly going to continue under the new regime and will affect all regulated businesses. The FSA’s determination to clarify the responsibilities and increase the accountability of senior management is evident in the explanatory commentary to Principle 3.

Principle 3 also requires a firm to operate robust arrangements for guarding against involvement in market abuse or financial crime, and singles out the detection and prevention of money laundering. The potential vagueness of the requirement to have in place "robust arrangements" for the prevention and detection of money laundering is an area of concern. To what extent will firms be required to upgrade their current systems and controls? What does "robust" actually mean? Does it imply a degree of strict liability? If money laundering was detected, would a firm have failed in the first limb of the obligation for failing to have implemented sufficiently "robust" arrangements to prevent the crime in the first place? Earlier in the explanatory commentary the FSA refers to the need for "adequate arrangements" for making sure employees are suitable - but it is not clear whether the FSA sees a difference between adequate and robust arrangements. These points may be semantic, but they may also illustrate a wider uncertainty about the role of the Principles themselves.

Principle 6: Customers - general

Principle 6 requires firms to pay due regard to the interests of their customers and to treat them fairly. This will include paying due regard to their information needs. Although unobjectionable in theory, the concept of treating customers fairly and paying due regard to their information needs may be too vague for practical application, particularly as "customer" is likely to include a potential customer. How can a firm satisfy itself that it has treated a customer "fairly"? Even if it performed its obligations under its agreement with the customer, it could still be in breach of this Principle if it is judged not to have acted with "fairness".

Principle 7: Customers - relationships of trust

Under Principle 7 a firm must "keep faith" with any customer who is entitled to rely on its judgement. Vagueness strikes again in the ambiguity of the term "keep faith". The commentary explains that this will include taking reasonable care to ensure the suitability of advice and discretionary decisions but it is not clear whether this will extend the existing fiduciary obligations of firms.

Principles 6 and 7 are clearly aimed at customer protection. In a recent discussion paper8 the FSA said that the customer-orientated Principles 6 and 7 will be "of limited relevance to dealings between professional counterparties ...", but it does not clarify (and it is very difficult to see) where they may be relevant to inter-professional dealings at all.

Principle 8: Relations with regulators

Principle 8 is very similar to the current Statement of Principle 10 and to Section 94(3) of the Banking Act 1987. It requires a firm to tell the FSA promptly anything about the firm which the FSA would reasonably expect to be told This requirement covers not only the regulated firm, but also information about the activities of members of the firm’s group. To some extent, firms may have to second guess what the FSA would like to know.

The proposed Principles for Business will be an important cornerstone in the FSA’s new architecture. Their impact should be of particular concern to their new areas of application, because of both the additional requirements they impose and the culture change they herald. If you would like to discuss any of these matters, whether from a compliance or other perspective, please contact your usual Norton Rose contact, or Elizabeth Cramb (0171 444 3404), who is responsible for co-ordinating the Norton Rose response to the regulatory reforms.

This Briefing is intended only as an outline of the main legal considerations. It does not try to cover every detail and should not be used as a substitute for professional advice on the circumstances of any individual case. Norton Rose takes no responsibility for the contents of this document. Readers who require any further advice should in the first instance contact Norton Rose.

ENDNOTES

1. The FSA Principles for Businesses, Consultation Paper 13, September 1998.

2. The FSA will assume its new powers and responsibilities under the Financial Services and Markets Act. The Financial Services and Markets Bill is to be introduced into this session of Parliament and is expected to come into force around mid-2000.

3. Financial Services Regulation: Enforcing the new regime, Consultation Paper 17, December 1998.

4. Issued by the Securities and Investments Board (predecessor to the FSA) on 15 March 1990 under Section 47A of the Financial Services Act 1987.

5. Schedule 3 to the Banking Act 1987, Schedule 2A to the Insurance Companies Act 1982 and Section 45 of the Building Societies Act 1986.

6. FSA Guide to Banking Supervisory Policy, Volume 2, AR: Annual Accounts and Prudential Returns 1.7(a).

7. See Footnote 5 above.

8. Differentiated regulatory approaches: Future of regulation of inter-professional business, October 1998

THE FSA PRINCIPLES

1. Integrity

A firm must conduct its business with integrity.

2. Skill, care and diligence

A firm must conduct its business and organise its affairs with due skill, care and diligence.

This will include arranging adequate protection for customers’ assets when responsible for them.

3. Management and control

• their individual responsibilities are clear; and

• the business and affairs of the firm are adequately monitored and controlled at senior management and board level;

1. keeping adequate and orderly records of its business and internal organisation.

1. Prudence

1. maintaining adequate risk management systems.

1. Market conduct

A firm must observe proper standards of market conduct

2. Customers: general

1. managing conflicts of interest fairly.

1. Customers: relationships of trust

A firm must keep faith with any customer who is entitled to rely upon its judgment.

This will include taking reasonable care to ensure the suitability of its advice and discretionary decisions.

2. Relations with regulators