Financial Services Lawyers Association

This year's AGM took place in Old Hall, Lincoln's Inn. As well as the AGM's formal business including the relection of the officers and executive committee, Hector Sants, the FSA's Chief Executive Officer, set out for members his views on the role of lawyers in outcomes-focussed regulation. You can read Hector's speech by clicking 'read more'.

Speech to the Financial Services Lawyers Association 5th May 2009 by Hector Sants

Good evening.

Thank you for the opportunity to speak at your AGM. I know the Association’s members are lawyers representing a broad cross section of the financial services industry, from those carrying out pure advisory work for the FSA, government, firms, individuals and exchanges to litigators involved in both sides of current enforcement cases.

In all these areas lawyers have a vital role in defining, explaining and challenging regulation.

This evening I intend to comment on how our regulatory approach has been modified in the light of the financial crisis and to seek to give you a flavour of how we expect lawyers to assist in ensuring our approach of ‘outcomes focused’ regulation is effective.

I’ll be very happy to take questions or discuss other issues you might want to raise afterwards.

Let me start by commenting on the nature of the changes required.  Nearly two years since the onset of the financial crisis the dust is still settling on the events which have continued to shake financial markets since then. In my view, there were seven fundamental structural failures that led to the crisis:

• A set of macro economic conditions such as global imbalances and low interest rates;
• A prevailing mindset throughout society promoting the benefits of credit and asset inflation, notably in housing;
• A flawed global regulatory architecture which in particular lacked adequate macro prudential oversight and had a series of gaps with regard to the oversight of some financial institutions, particularly shadow banks, such as structured investment vehicles;
• A flawed set of prudential rules particularly for capital and liquidity.  Basel II is an improvement on Basel I but still has large elements of procyclicality;
• A failure of the market to self-correct.  A failure to recognise the overriding influence of the herd instinct; 
• A pro-cyclical interaction between the accounting regime and market sentiment; and
• A lack of responsible governance by market participants, in particular bank management themselves.

This analysis of the principle drivers of what went wrong is now commonly shared.  There is also an emerging consensus, at least at the high level, of how the regulatory architecture should be altered.  We have already seen a variety of reports and proposals covering various aspects of the future agenda.  I would, of course, commend to you the Tuner Review as the most comprehensive but I am sure you will agree it is broadly aligned with other such publications: the De Larosiere Report and the G20 Communiqué. 

There is also a general agreement as to those matters which should be determined at the national or international level.  Key amongst those changes which need to be global is capital and liquidity regulation.  As you would expect, the FSA together with other UK bodies will be closely involved in that process.

Such a fundamental change will of course need a long and detailed process of consultation with the industry of which the recent Turner Review Discussion Paper was just the beginning. Following on from the G20 and the Turner Review, the FSA has identified many areas for policy review. I won’t list them all now but these include work on the need for a higher quantity and quality of capital, more granular disclosure for high risk asset classes and a fundamental review of trading book requirements.

If past form is anything to go by, industry lawyers will often be central to this process in putting forward responses to these consultations for their clients or in putting forward views that have been formed through acting for a range of clients on very specific issues.

It is highly probable that many policies we will be considering in the months ahead will not have been tried and tested in the UK but many respondents to the consultation will have come across variations of these policies for clients in other jurisdictions or have opinions on their effectiveness based on a deep understanding of the technical aspects of the matter. I would hope that those lawyers here who are involved in the consultation process will bring the full extent of their knowledge to the issues to ensure that we get the right regulatory outcomes.

The next stage is the implementation. Here again lawyers are central to ensuring that the right outcomes are arrived at.  You can do this both by giving sound advice and by furthering your clients understanding of the FSA’s regulatory approach.

In advising your clients on how their business proposals comply with their regulatory obligations I would ask that you do one thing at all times. This is to look beyond the legal technicalities that might seem to allow a firm to ‘get away’ with something – to a question of what the outcomes of the business are likely to be for consumers, the market and the wider economy.

This focus on the outcomes of a firm’s business, rather than box-ticking, is what our supervisors will be looking at when they visit firms so it is right that a firm’s legal advice reflects and adapts to this approach. I am determined that in future no-one who has ever been the subject of a supervisory visit will choose to suggest that the FSA is only looking for firms to tick the right boxes. Nothing will be further from the truth.

Turning to the educative remit, I do believe that lawyers have a key role to play in assisting their clients to understand what our approach to outcomes focused regulation means for them.

I spoke recently about the FSA’s new ‘intensive’ supervisory approach and how we intend, by the end of 2009, to have increased the number of front line staff by 30%. To support these supervisors we are also increasing the number of lawyers in the General Counsel’s Division and our Enforcement staff. It is my intention for this resource to be deployed where they will have the most impact on outcomes for consumers and market participants.

Your clients may experience this outcomes focused approach and increased supervisory resource in two ways.

First, the FSA will no longer be prepared to take comfort from the fact that a particular business model has been considered and approved by a firm’s senior management. We are now starting to regulate firms based on our own judgements about the likely consequences of a proposed course of action rather than stepping in only when things begin to go wrong.

You will appreciate this is a key change. Senior managers will need to get used to the idea that their decisions may be challenged when we believe that their plans lead to unacceptable levels of risk to consumers or the market. In doing this, the FSA will not be trying to second guess shareholders or managers but will be seeking to act as a backstop to ensure that the decisions senior managers take to benefit shareholders are not damaging to consumers or the market. In practice this system will work best if firms are completely open with supervisors about their proposals and the potential risks.

Second, supervisors will also be focusing on what is actually happening on the ground to identify the gaps between what senior managers think their firms are doing and what is actually happening to consumers in the market. This conduct risk assessment is aimed at dealing with problems such as PPI or mortgage endowment mis-selling before they become widespread. If supervisors believe there is actual consumer detriment, senior managers will be expected to identify the problems and put the necessary changes in place to redress them.

In assessing business models and conduct risk, the FSA will be much more ready to use our powers to require a firm to change direction or stop an activity if we believe that problems which were not apparent previously are now likely to arise. Getting the right balance between intervention and innovation will not be easy or always obvious but that doesn’t mean we shouldn’t try.

One thing that I would stress however is that just because the FSA’s supervisors will be more involved in assessing the outcome of an activity does not in any way mean that a firm’s management can abdicate responsibility.  Senior managers will need to understand at all times the circumstances under which their firm might fail and they must be happy with the level of risk mitigation they have.

At this point I should mention a couple of things that this new approach to supervision does not mean. First, just because senior management and the FSA have agreed a course of action is appropriate does not mean that compliance with our rules becomes optional.

Neither does it mean that we have moved away from principles-based regulation. We will continue to rely on rules and principles as appropriate to ensure that firms are in compliance with our requirements. The principles serve as a high level articulation of what we expect from a firm. In this way they allow a firm’s senior managers to think through the appropriateness of planned or current actions. In my view lawyers have an extremely important role in taking management through this thinking process both before a business strategy gets underway and in ensuring that management continue to keep the principles in mind when the business gets going.

Having, I hope, given you a good flavour of what we are looking for from both management and their advisors let me now turn to the issue of delivering the required deterrence for those who deliberately seek to transgress.   

The message for these individuals is that the risk of FSA enforcement action and subsequent penalties is real and more likely now than ever before.

When referring cases to Enforcement our supervisors are encouraged to consider whether the referral should be of a firm, a firm and certain individuals or simply the relevant individuals. We have not, and will continue to not, shy away from taking cases against individuals who breach our Principles and the Code of Practice for Approved Persons.

This focus on individuals is part of our credible deterrence strategy which has achieved some notable results over the past 12 months.

I should stress that the strategy isn’t just about improving standards of behaviour where supervisory steps fail to achieve the desired results it also extends to deterring market abuse (both criminal and civil), unauthorised business fraud and share fraud. Our intention is for anyone considering these activities to know that the possibility of the FSA taking action against them is real.

In the last year we’ve taken steps to prohibit over 40 individuals from the regulated sector and have cancelled the permissions of over 100 firms. We’ve imposed financial penalties on eight individuals and 1 firm for market abuse. We are also planning to consult on proposals to implement a new framework for penalty setting.  One rationale behind this is a perception that financial penalties have not been sufficiently large to deter wrongdoing in large institutions. The full details of these proposals will be public in the summer.

2009 will also be a year where our determination to establish our credible deterrence philosophy is self-evident. We’ve already had our first successful criminal prosecution in an insider dealing case and we have a number more in the pipeline including three that have been publicised already. Our ability to prosecute market abuse has also been enhanced – we’ve developed our transaction surveillance capacity and we’ve recruited experienced criminal solicitors and investigators.

We welcome the proposal, as set out in the Coroners & Justice Bill, to give us the power to grant statutory immunity. This will incentivise less culpable parties to come forward and give evidence against those who have a greater part in wrongdoing. Those of you who advise clients in enforcement cases will have a lot to think about how these capabilities change things.

We are also doubling the size of our unauthorised business team. This is to deal with our concerns about the number of individuals who are carrying on regulated activities without permission. And we have opened five share fraud investigations in the last few months. Where we find share fraud taking place we will use the full extent of our civil and criminal powers to freeze assets, restrain activities, make individuals bankrupt and prosecute.

This willingness to tackle the most serious breaches of our rules through the civil and criminal courts is a world away from the types of activity that the vast majority of those working in the financial sector are involved in. But we need to realise that the knock on effects of the activities of the few have financial and market confidence related consequences for many.

So, to conclude, I ask the following:

• First, please involve yourselves in and bring your expertise to the consultation processes we will be undertaking over the next year or so.  This I am sure will be a once in a life time opportunity to bring about change in the financial services sector. We have a real opportunity to get in place policies that deliver the right outcomes for the economy and society.
• Second, please continue to question and encourage your clients to question what the outcomes of their plans will be. Firms should no longer feel comfortable relying on technicalities if that results in non-compliance with our high level standards.  We will not hesitate to require firms change direction if we are unhappy with the risks their business brings.
• Third, I would ask you to work with your clients to help them understand our new supervisory approach and how it will change the nature of their dealings with the regulator.
• Fourth, I would ask that you work with us to ensure that your clients understand our determination to deliver effective credible deterrence.

Finally, I would like to acknowledge the work you do in interpreting our requirements for your clients within the sector and to ask that you continue to work in partnership with the FSA to help us regulate better.