FSA gets tough with proposals to impose higher fines

The proposals will make changes to the Handbook (DEPP) and the Enforcement Guide. The period for consultation ends on 21 October 2009 and the changes are expected to come into force in the first quarter of 2010.

The proposals, if implemented, will certainly lead to significantly higher fines for firms and particularly for individuals and those found guilty of market abuse. Whilst regulatory fines have been rising as FSA has sought to show its teeth, this new framework would allow FSA to justify substantial increases on a tariff directly linked to income – for firms the level of penalty could be up to 20% of the firm’s relevant income and for individuals the fine could be up to 40% of the individual’s income or, for market abuse cases, £100,000 (whichever is the greater). Not only would fines of this magnitude dwarf recent penalties imposed, the framework also provides for the fine to be further increased where there are aggravating factors or for deterrent purposes.

This article explains the key aspects of the proposals and comments on what this will mean in practice.

New framework

Currently, there is very limited transparency in how FSA determines the level of the fines it imposes. There is no tariff, but just a series of factors that FSA says it takes into account in arriving at a figure which is then usually subject to considerable negotiation between the offender and FSA. FSA believes that the introduction of this new framework will not only add greater transparency to the process but also help it to achieve consistency.

The framework is made up of five steps based on three key objectives.

The key objectives are:

• Disgorgement – a person should not benefit from any breach.
• Discipline – a firm or individual should be penalised for wrongdoing.
• Deterrence – the financial penalty should be sufficient to deter the person from committing further breaches and to deter others from committing similar breaches.

The five step framework process can be summarised as follows:

Step 1

: Disgorgement – in cases where FSA identifies a benefit derived from the breach, either by a profit made or loss avoided, it will seek to deprive the person of that benefit.

Step 2

: A figure will be determined based on a tariff that reflects the nature, impact and seriousness of the breach (see below for further details).

Step 3

: Adjustment for mitigating and aggravating factors, which could include the conduct of the person in bringing the breach to FSA’s attention, the degree of cooperation provided during the investigation and the previous disciplinary record and compliance history.

Step 4

: Adjustment for deterrence. FSA is committed to achieving credible deterrence and this step seeks to ensure that it meets this goal such as where the penalty arrived at is too small or where previous FSA action has so far failed to improve industry standards. FSA has stressed that this might be a factor even where the previous action may have been in relation to different types of products.

Step 5

: A discount for settled cases. FSA already operates a settlement discount scheme and it is proposing that this will continue to apply to encourage early settlement.

Step 2 – the base figure

Step 2 is the most significant change because it introduces a method for calculation of the base figure which is directly referable to the firm or the individual’s income. For firms, it will be calculated by taking a percentage of firm’s “relevant income” – that is the pre-tax income derived by a firm for the period of the breach from the business area to which the breach relates. Dependent on the nature, impact, and seriousness of breach this will be set at a figure of 0%, 5%, 10%, 15% or 20% of income. FSA believes that the upper level of 20% is significant enough to focus senior management’s attention. There will be a non-exhaustive list of factors which will be relevant in determining which level of penalty the breach merits. This methodology, which is analogous to EU competition fines based on a firm’s turnover, is FSA’s first significant attempt at calibrating a penalty to the underlying business.

FSA recognises that for certain cases, such as those concerning a breach of the listing rules, there may be more appropriate ways than using income to calculate the penalty such as market capitalisation. In those cases it will still follow the five step process but will use an alternative method of arriving at a figure for step 2.

For individuals, the figure will be calculated on the percentage of the individual’s “relevant income” – that is the pre-tax amount of all benefits including bonuses, share options and pension contributions received by an individual from the employment in connection with which the breach occurred and for the period of the breach. The five fixed levels set for individuals are more stringent than those set for firms to reflect FSA’s increasing focus on individuals and range from 0% to 40% of income. In addition, relevant income for individuals, unlike for firms, will be for total employment benefits regardless of whether the individual’s role also encompasses non-regulated activities or activities not related to the breach. Factors which FSA has said might be present in a serious case justifying a 40% penalty would include where the breach was a deliberate breach of employer procedures or where the individual sought to conceal the misconduct. This is a neat way of bringing home to an individual the amount that is at stake in the event of personal misconduct.

For market abuse, FSA is continuing in its determination to be more resolute in tackling these types of offences and so for an individual found guilty of market abuse the minimum starting point is whichever is the greater of:

(a) £100,000; or

(b) 40% of relevant income (where the misconduct is referable to the employment) or twice the profit made or loss avoided (where the conduct is not referable to the employment).

Financial hardship

Currently, FSA takes account of serious financial hardship in determining the level of penalty. FSA wants to change this approach so that if this factor is considered at all it is only taken into account once the amount of the penalty has been determined.

The paper puts forward two options for dealing with serious financial hardship. In both options for firms, FSA is proposing that where the penalty threatens the firm’s solvency it will (as today) take into consideration its regulatory objectives including the potential impact on consumers in deciding whether or not it is appropriate to reduce the penalty so that, for example, the firm is able to pay redress to customers.

For individuals, FSA’s first option is that there will be no reduction in the penalty on the grounds of serious financial hardship, even if it forces individuals into bankruptcy. The second option proposes using a threshold for individuals where if as a result of a fine the individual’s income falls below £14,000 and capital below £16,000 it will consider agreeing to payment by instalments or reducing the penalty.

Conclusion

At one level this is a further example of FSA flexing its muscles and putting its recent warnings into action. It wants firms, and particularly senior management, to sit up and take notice, and the FSA is now convinced that higher fines act as a deterrent especially when imposed on individuals. The proposals can be viewed as going further than this in that they represent a well thought-out strategy for linking the penalty to a quasi-objective measurement of the wrongdoing. For the first time a fine will be expressly linked to turnover or salary rather than being based on analogous – and sometimes not so analogous – past cases with a mark-up to ensure that the latest fine is not eclipsed for some weeks if not months.

Nonetheless, although the framework will give more transparency and structure to the process it still allows FSA a considerable degree of latitude over where it places an offender on the scale and then what mitigating or aggravating factors it applies. It is therefore likely that there will continue to be considerable negotiation over penalties as part of the settlement process. Firms in particular are likely to challenge FSA’s view of the level of relevant income which is derived from any product or business area.

However, notwithstanding these challenges and potential grey areas, there is no doubt that fines are set to increase substantially with individuals and senior management firmly in the firing line as well as firms which fail to meet the required standards facing the particularly damaging publicity and reputational damage that record fines bring.