Investigations and enforcement column: March 2016


Regulatory penalties: time for review?

One of the first things I am usually asked when advising a firm under an FCA enforcement investigation, is: what sort of penalty are we looking at should we be found in breach? While I can give my best estimate based on my experience and knowledge of other cases, the lack of more precise answer based on clear rationale can be pretty frustrating for the firms involved. While the FCA made much of the transparency of its penalty setting framework when it was introduced for breaches post March 2010, in reality other than significantly increasing the level of fines it did little in terms of improving transparency or predictability. The end of 2014 saw the FCA announce at its enforcement conference that it would be reviewing its penalty framework in 2015, but there has to date been no further public announcement.

Increasing fines and the credible deterrent

Huge fines, as we saw most notably in the LIBOR and FX cases (with Barclays' fine of £284 million for FX failings in May last year, being the current record) certainly attract attention both from the media and the public. There is no doubt that fines at these sorts of levels create headlines and have reputational consequences and so go some way to achieving the "credible deterrent" the FCA is looking for. There can certainly be few in the regulated sector that would regard a regulatory fine "as the cost of doing business" as others have suggested in the past under the previous regulatory regime - although I did not see much evidence of this being a commonly held view even then. Of course, while high fines satisfy public and political pressure they are also often just the tip of the iceberg for the firms themselves as they can be dwarfed by the enormous spend in management time, personnel change, systems enhancement, and compensation which can be a multiple of the fine.

The FCA itself recognises ever increasing fines does not necessarily change behaviour and, short of another scandal in the vein of FX and LIBOR, these sorts of fines are likely to represent the high water mark. Consequently, we have seen more emphasis by the regulator of the importance of early intervention, personal accountability and taking action against senior management, as well as making more use of the other disciplinary tool it has at its disposal. In my November 2015 column, I considered what the new statutory "duty of responsibility" requiring senior managers to take reasonable steps to prevent regulatory breaches in their area of responsibility means in practice, and what it signals in terms of regulatory enforcement for the future.

Use of restrictions as disciplinary sanctions

The FCA has previously indicated it would look at using its other disciplinary powers, highlighting the commercial impact for firms and therefore the deterrent effect this may have on incentivising poor behaviour. In October 2015, Tracey McDermott, FCA Acting Chief Executive, referred at a Treasury Select Committee hearing to making more frequent use of the powers to impose restrictions on a firm's business(under DEPP 6A), having used it twice previously in imposing a recruitment ban on the Financial Group, and a restriction on the Bank of Beirut from acquiring new customers, for 126 days in each case.

Last month saw the FCA use this power for a third time in the case of WH Ireland, in which the FCA, having found market abuse failings, not only fined the firm, but also imposed a 72 day restriction on taking on new clients in its corporate broking division. Hidden within the wording of the final notice setting out the details of the penalties imposed is also a statement that the FCA is signalling to the market that, where a firm operates with a weak market abuse environment, the FCA will take disciplinary action to suspend or restrict the firm's activities. Undoubtedly, restrictions on a firm's business can have a significant commercial impact and act as a deterrent to poor behaviour. However, so far, their use and the level of restriction imposed has been limited and applied against smaller firms. There are clearly challenges to imposing these sorts of restrictions on more complex larger businesses and, equally, in ensuring they are proportionate to the misconduct. While I can see their public perception attraction as a sanction to regulators and those that call them to account, in practice I think it will be difficult to justify their use, at least in terms of restrictions that would have any meaningful impact on a firm's business, and so are likely to be little more than window dressing.

The need for improved transparency

Certainly, a review of the effectiveness of regulatory penalties and how these are set is now overdue. Currently, DEPP 6 sets out a five step framework by which penalties are determined by the FCA. I understand the need for any framework to include an element of discretion and flexibility to tailor the penalty to the individual facts and circumstances. I also recognise that, very often, a crude measure basing the penalty purely on a percentage of relevant income or some other set benchmark does not produce the fair or right outcome. However, the balance between discretion and a consistent approach to penalty setting needs to be achieved. Too often a firm is left feeling that the punishment does not fit the crime when judged against other cases and is unable to obtain a clear explanation from the regulator to justify the figure imposed, beyond the simple application of how the figure has been increased or decreased under the five step process. This is all the more important now that the FCA settlement process allows very little challenge on the level of proposed penalty or its rationale. The message being that this is the figure FCA senior management consider appropriate based on the case put to them by the enforcement investigation team and it is not open for discussion. As a result, firms feel they have little choice but to accept it, rather than fight the case through the full administrative process, losing the 30% early settlement discount and incurring significant costs and management time.

For those of us advising firms in this situation, there is very often a feeling that FCA management has picked a figure and then worked backwards through the framework applying the various adjustments for deterrence, mitigating or aggravating factors and level of seriousness to justify it. It is often difficult to see why there has been an uplift in one case but not in another. Given that most precedents are set through the early settlement, there is a justified concern that insufficient scrutiny and rigour is being applied to the penalties that are imposed leading to a concern over overall fairness and consistency of treatment.

The lack of real transparency is most evident in those cases where the FCA finds that the relevant revenue from the firm's business is not an appropriate starting point and therefore identifies a different figure, usually without reference to any benchmark. So, for example, in those cases where a Principle 11 breach is found, the FCA simply picks the starting point based on its view of the seriousness of the breach and, other than citing the reasons the breach is serious, does little to say how it reached the figure itself. For instance, when it imposed a fine on Deutsche Bank for LIBOR failings and for misleading the regulator, the FCA, when assessing the level of penalty for the Principle 11 breach, identified it as level 4 seriousness and decided this merited a starting point of £150 million (later reduced through the later steps in the framework for co-operation and settlement).

The FCA's arbitrary fining model destroys confidence in a process where the regulator holds most of the cards. There are a number of examples of the FCA departing from the framework where it sees fit. For instance, the fine imposed in the Clydesdale mortgage case where, having found relevant income was not an appropriate measure, the FCA used the capital shortfall on the mortgage accounts and then replaced its seriousness tariff with a new tariff using different multipliers just for the occasion. There is nothing in the framework that prevents the FCA from doing this and the relevant sections of the Handbook (DEPP 6.5A.2G(13)) expressly permit it.

It is clearly important that the public and the regulated community have confidence that penalties are set consistently and fairly and that they work and achieve the regulatory objective of a credible deterrent. This should not simply mean ensuring the regulators can continue to increase the level of fines, and I hope that the FCA review will go beyond that narrow focus, despite that being behind the initial recommendation for the review. It was the Parliamentary Commission on Banking Standards' report on "Changing banking for good" that first recommended both regulators should be prepared to review their penalty setting frameworks in future to allow for a further substantial increase in fines. The FCA, having stated in its response to the report that it would do this when the time was right, subsequently agreed with the government that this review would begin in early 2015. It will be interesting to see what the long-awaited review finds or proposes. It is clear that the current framework does allow for very substantial fines and the evidence of the fines imposed by the FCA in the two years plus since the publication of the PCBS report (including those imposed outside of LIBOR and FX) are likely to have addressed this concern. Whether that difficult balance between discretion and flexibility on the one hand, and consistency and transparency on the other, can be achieved is more difficult and perhaps not an issue high on the FCA's agenda.