Enforcement in a principles-based environment: shield or sword?

Jul 04 2007 Peter Elstob

The Financial Services Authority's approach to enforcement will be central to the success of its more principles-based regulation project. A key industry concern, from the beginning of the MPBR process, has been how the FSA would carry out enforcement when what banks and firms are required to comply with are both detailed rules and high-level principles of conduct. Complinet asked the distinguished practitioners who make up our editorial board to say what they thought enforcement in a MPBR environment should be, and what it may turn out to mean. The following article is a distillation of their views.

At the end of this month the FSA is expected to publish a policy statement on its new Decision Procedure and Penalties Manual and its Enforcement Guide, following the review it consulted on in CP07/2.

In that paper, the FSA proposed deleting its existing enforcement and decision making manuals, replacing them with the new DEPP module, together with EG as a new regulatory guide outside the Handbook. Specific changes to the FSA's decision-making process are also proposed, including the separation of the regulatory decisions committee and the team gathering evidence. EG will also seek to provide greater clarity on the imposition of penalties and the conduct of interviews by the RDC.

In its April paper entitled "Principles-Based Regulation - Focussing on the Outcomes that Matter", the FSA stated in detail the reasoning behind its move towards MPBR. A key element of MPBR is that the FSA is seeking to shift responsibility for firms' key regulatory and compliance decisions up the business, to more senior levels of management. As FSA chief executive John Tiner stressed at the conference to launch the MRBR paper: "Greater manoeuvrability for firms in deciding how to comply will mean key decisions move further up the organisational hierarchy."

Firms want to know how far the FSA intends to implement a "shield not sword" policy. An example of this would be a clear indication by the FSA that the "soft" statements it makes, outside the Handbook, will signpost ways to achieve compliance ("shield"), rather than be grounds for prosecution ("sword"). In this context, members of the editorial board found comments that Tiner made at the April conference encouraging:

"We will be making more guidance material available, not always or even primarily in the form of guidance text in our Handbook but in case studies, 'Dear CEO' letters and industry guidance that we confirm as reliable for compliance … of course, materials such as these do not create obligations on firms, but where firms choose to apply them to a relevant business process they will be able to rely on them in deciding how to satisfy their regulatory obligations." [emphasis added]
So, in the coming MPBR environment there will be a range of reasonable views on how to achieve compliance with a principle that specifies requirements in general terms. It follows from this that the FSA should recognise that enforcement action would not be taken against a firm that:

Had taken a reasonable, well-considered approach to engaging with the principles.
Had undertaken a careful analysis of how to deliver those principles within the context of its own business.

This should be the case even if the FSA judged that the compliance steps the firm actually took were insufficient. The regulator should give appropriate credit to firms that notify it of issues it has identified, and that seek, where appropriate, to remedy problems at the earliest opportunity. The question is: will the FSA use DEPP/EG to confirm that this will indeed be its approach?

Offering support

There are also questions concerning what support the FSA will be prepared to offer firms. When firms go to the supervisor to discuss the regulatory adequacy of a particular business model, will they receive a constructive response? Will the response include (where relevant) confirmation that the firm's approach, if implemented appropriately, would be sufficient to meet the regulatory requirements? What would the position be if a firm's proposals differed from the regulator's preferred approach?

Another issue is the "precedental impact" of early settled cases in an MPBR regime. It is not yet clear how much final notices in early settled cases — often the product of intense negotiation — will be considered to cast light on what the principles entail.

The readiness of FSA staff below those who make speeches and statements is another concern. The industry accepts that it must be prepared to embrace the brave new MPBR world, taking to heart the shift from observing rules to achieving outcomes. It also expects that the entire staff of the FSA's enforcement division is equal to the task. As one editorial board member put it: "Just as some firms will feel nervous at the prospect of losing the security of black and white rules and the challenging assessments which principles-based regulation will require, equally, FSA enforcement must be prepared to step up to the plate."

As its Handbook becomes more streamlined, the FSA should increasingly be prepared to make difficult judgement calls. It will need to decide whether there is sufficient evidence to prove a breach of principles alone. If the regulator is unable to demonstrate that it has the teeth to enforce principles-based regulation, critics may well characterise MPBR not as "light touch" so much as a "soft touch". Moreover, principles-based enforcement decisions would be tested in the Financial Services and Markets Tribunal. Without the tribunal's support, MPBR could be undermined.

As one editorial board member said: "Enforcement in a principles-based environment will only be fair and equitable to all market users if sufficiently detailed information, underlying guidance and non-exhaustive examples are provided to the market."

The views and the opinions expressed in 'hot topics' are that of the individual authors and not necessarily those of the Securities & Investment Institute.