United Kingdom

Author: | Published: 30 Sep 2004
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General framework and conduct of business

What legislation governs authorization and regulation of banking activities in your jurisdiction? What has been the most significant regulatory issue in your jurisdiction?

Authorization of banks, investment banks and other financial market participants is governed by the Financial Services and Markets Act 2000 (FSMA). The FSMA, which was implemented in 2001, provides for the establishment and operation of the Financial Services Authority (FSA), the unitary regulator of banking, securities, derivatives and insurance business in the UK. The FSA has four regulatory objectives: maintaining market confidence, promoting public awareness, securing the protection of consumers and the reduction of financial crime.

Key regulatory issues for the FSA have included:

  • restoring consumer confidence following reviews of the mis-selling of pensions, mortgage endowments, shares in investment trusts, and so-called precipice bonds;
  • enhancing the financial regulation of insurance companies; and
  • addressing conflicts of interest in relation to the production of research by analysts working within multi-function firms and the provision of research and other services in return for order flow (soft commission).

Preparing for implementation of directives flowing from the EU Financial Services Action Plan has also been a major feature of regulatory work, with directives on the distance marketing of financial services and the regulation of financial conglomerates about to be implemented. Consultation is also underway in relation to the implementation of the Market Abuse and Prospectus Directives and the Modernization of Accounts Directive for Lloyds' of London.

What are the key activities for which authorization is required in your jurisdiction?

Under the FSMA, the FSA took over responsibility for the regulation of a number of activities from various self-regulatory organizations. Its remit includes banking (deposit-taking), issuing electronic money, insurance, designated investment business (which includes dealing (as principal or agent), arranging deals in, managing, custody of, and advice in relation to, securities and derivatives), underwriting and membership at Lloyd's, and even the sale of rights under funeral plan contracts. The FSA's scope is shortly to be extended to cover regulation of residential mortgage lending, long-term care insurance and insurance mediation activities, and will be further extended to cover home reversion plans as soon as parliamentary time allows.

What sanctions are available to the regulator in your jurisdiction when taking action against regulated bodies?

The FSA is granted wide-ranging disciplinary powers under the FSMA against authorized companies and their employees, together with a detailed disciplinary process under the auspices of the Financial Services and Markets Tribunal. These range from informal statements of concern and private warnings (used for minor matters without the formal commencement of the FSA's disciplinary process), to statements of public censure and financial penalties. There is no limit on the amount of the financial penalty which FSA can levy on a firm for a breach of its rules. In addition, where the FSA has very serious concerns about a firm or the way in which its business is or has been operated it can seek to cancel a firm's permission and effectively revoke its authorization to carry on regulated activities.

The FSA also has a similar range of enforcement tools for disciplining of staff of authorized firms who are approved persons. Approved persons for these purposes include the chief executive, other directors, finance officer, compliance officer and individuals engaged in significant management functions and employees who deal with or for, or advise, customers.

The profile of the FSA's enforcement actions has risen in the past year as the amount of its penalties has increased substantially with fines of £1.25 million ($2.2 million) imposed in relation to money laundering control failings (August 2003 and January 2004) and £2.3 million for serious compliance failings (December 2003).

Another key area is the market abuse regime, which grants the FSA considerable power to levy fines on any person (whether authorized by and subject to the FSA's oversight or not) who has committed market abuse. For these purposes, market abuse is behaviour which occurs in relation to investments traded on a UK recognized investment exchange and is of one or more of the following three types, and which is likely to be regarded by a regular user of the market as a failure on the part of the person concerned to observe the standards reasonably expected of such a person in their position in relation to the market. The three types of abusive behaviour are:

  • misuse of information;
  • dissemination of information which is false or misleading; and
  • distorting the market.

Any action for market abuse is a civil action and the burden of proof is lower than that required to obtain a criminal conviction. In one recent action, the FSA imposed a fine of £17 million for market abuse and breach of the Listing Rules.

Does the regulatory regime for banking business in your jurisdiction include regulatory conduct of business rules governing the obligations of a bank to its customers?

The FSA's Conduct of Business Sourcebook provides for conduct of business obligations on banks and other regulated entities. These include requirements as to marketing (financial promotions), which apply to all activities including deposit-taking. The FSA also expects compliance with the Code of Conduct for the advertising of Interest Bearing Accounts issued by the British Bankers' Association and the Building Societies Association. This code recommends certain calculations for the quotation of various types of rates of interest.

In addition, the sourcebook contains a substantial amount of provisions relating to designated investment business but not to deposit-taking (other than where the deposit is a cash ISA), including requirements to classify and have written terms of business with customers, and various obligations in respect of disclosures to, advising and selling to, dealing and managing for, and reporting to customers, and the holding of client assets.

Supervisory requirements

Does the regulatory regime for banking business in your jurisdiction include regulatory capital requirements? If so, are these based on the Basel Accord and are there significant variations from the core Basel recommendations?

The regulatory capital regime for UK banks is set out in the Interim Prudential Sourcebook for Banks, which is a part of the FSA Handbook. The sourcebook implements the European Banking Consolidation Directive (2001/34/EC), which in turn implements the Basel Accord, as amended. It should be noted that the scope of the sourcebook is of wider application than the Accord, as it applies to all UK banks (as opposed to the Accord, which applies only to internationally active banks). The sourcebook is also superequivalent in a number of respects to the Directive.

What effect will Basel II have on banking transactions in your jurisdiction? Are financial institutions already taking account of its future effect?

The text of the revised Basel Capital Accord, known as Basel II, was published at the end of June 2004. It is intended that Basel II be implemented with effect from December 31 2006 but that the most advanced approaches to assessing regulatory capital will not be available until the end of 2007. Implementation in the UK will be via EU capital directives. In July the European Commission published a proposal for the recasting of the Capital Adequacy and Banking Consolidation Directives.

The two most significant changes are the introduction of an operational risk charge and the differentiation of capital requirements by reference to the sophistication of the internal systems of banks (reflected in the more favourable reduced capital requirements associated with the internal ratings-based approach to credit risk, and with the advanced measurement approach to the calculation of operational risk). These favour the larger and better resourced banks which can attain the high standards required to achieve the more favourable requirements.

Basel II provides for significant amendments to the calculation of credit risk on exposures to counterparties. The capital charge associated with any particular transaction is a considerable part of the cost of funds to the bank in lending to most counterparties. In terms of current practice, banks can seek to take account of the changes by backing off the risk of increased costs associated with the implementation of the new regime on borrowers. Banks are also beginning to devote considerable resources to putting in place the necessary systems and controls to obtain more favourable treatment under the new regime.

Does the regime in your jurisdiction include rules and operational and organizational requirements relating to internal controls and operational risk?

Around the time of the implementation of the FSMA, the FSA placed a great deal of emphasis on the importance of the maintenance of internal systems and controls. This is reflected in Principles for Businesses 3, which requires that authorized firms "take reasonable care to organize and control [their] affairs responsibly, with adequate risk management systems".

There are detailed rules elaborating on this Principle in FSA's Senior Management Arrangements, Systems and Controls Sourcebook (SYSC). The core rules of SYSC are that every authorized firm must take reasonable care to maintain a clear and appropriate apportionment of significant responsibilities among its directors and senior managers in such a way that it is clear who has those responsibilities, and its business and affairs can be adequately monitored and controlled by the directors, relevant senior managers and governing body of the firm. A firm must also take reasonable care to establish and maintain such systems and controls as are appropriate to its business.

The forthcoming integrated Prudential Sourcebook, which will reflect Basel II and related EU legislation, will include a chapter on operational risk that will apply to banks and other higher risk firms.

Do you believe that Sarbanes-Oxley will have a material impact in your jurisdiction?

The Sarbanes-Oxley Act covers a range of issues associated with listed companies whose shares are publicly traded, independence of auditors, corporate governance and conflicts of interest in investment research. Particular areas that are attracting attention in the UK are investment research and conflicts of interest with the introduction of a requirement for firms to publish a conflicts management policy addressing matters such as:

  • dissociating analysts' remuneration from investment banking transactions;
  • not using an investment analyst in a marketing capacity;
  • imposition of systems to withstand pressure from subject companies; and
  • greater disclosure by firms as to their interest(s) in subject companies.

In its review of the Listing Rules, the FSA rejected a mandatory requirement for issuers to accept codes of conduct but expressed the view that the Financial Reporting Council should consider in any future development of the Combined Code whether issuers should be required to publish and maintain a code of conduct as a matter of good corporate governance.

A consultation document seeking views on various aspects of the governance of mutual life offices has recently been launched. It also explores some wider issues, arising from Lord Penrose's report on Equitable Life, relating to the role of non-executive directors in complex businesses.

Does the regime in your jurisdiction include a requirement for controllers and major shareholders of regulated banking institutions to be approved by the supervisory authorities?

The FSMA introduced a statutory regime for the approval of controllers and major shareholders of authorized firms, including banks. This implements the relevant provisions in the Banking Consolidation and Investment Services Directives. Part XII of the FSMA broadly requires a person proposing to acquire control (or to increase control between certain thresholds) of a company authorized by FSA to obtain FSA's approval before doing so. A direct or indirect shareholding in excess of 10% or a right to exercise significant influence over the management of the authorized company or its parent will constitute control.

Failure to obtain such approval before taking control is a criminal offence. The FSA must consider whether the proposed controller is a fit and proper person to have control of an authorized company. FSA has up to three months to consider whether to approve the change in control.

The FSA may serve a warning notice and then a notice of objection unless it is satisfied that the person concerned is a fit and proper person and that the interests of consumers would not be threatened by the acquirer's control.

If, in breach of the provisions of the FSMA (which carry criminal sanctions), a person becomes a controller in contravention of a notice of objection FSA can serve a restriction notice and can apply to the court for the sale of the shares.

Investor protection

Have there been any recent significant changes to insolvency legislation in your jurisdiction, or are any such changes proposed? Have they made/will they make the regime more or less borrower friendly?

The Enterprise Act 2002 received Royal Assent on November 7 2002, and the provisions of Part 10 (Insolvency) make significant changes to the law of corporate insolvency and the insolvency of individuals.

The provisions dealing with corporate insolvency and Section 251 (abolition of Crown preference) came into force on September 15 2003; the remaining provisions came into force on April 1 2004.

The aim of the corporate insolvency reforms in the Act is to promote the rescue of a company as a going concern, and to this end administration replaces administrative receivership as the primary means of enforcing full fixed and floating security. There is a new out-of-court route into administration available to both the company and a secured creditor with a full security package. The secured creditor has first choice as to who is appointed. Unless an exception applies, a lender with security is no longer able to appoint an administrative receiver and is not able to prevent the appointment of an administrator. The purpose for which an administrator can be appointed has changed to give priority to the rescue of the company, with the enforcement of security being subordinated to this.

The main change for a secured creditor is likely to be one of control. A secured creditor is only entitled to vote on the administrator's proposals as to how the purpose of the administration will be achieved, to the extent that there is a shortfall in the value of the secured assets. However, the administrator's proposals may not include any action that affects the right of a secured creditor to enforce without that secured creditor's consent. In practice this may mean that the administrator will need the consent of secured lenders before putting his proposal to the unsecured creditors. Once appointed, the administrator's duty will be to all creditors. A ring-fencing mechanism has been introduced whereby a certain percentage of all floating charge realizations is made available to the unsecured creditors, although the administrator may not have to make a distribution from these funds if the costs of doing so outweigh the benefits. Overall, the changes improve the position of unsecured creditors with regard to secured creditors.

The changes in relation to the bankruptcy of individuals are intended to encourage enterprise by reducing the stigma of failure in honest cases while providing for robust and effective remedies against the small minority who act recklessly or dishonestly. An automatic discharge of the bankrupt takes place, in most cases, after a maximum of 12 months, and the restrictions that were previously automatically imposed on undischarged bankrupts (for example disqualification from holding certain offices) are reduced. However, a new court-based regime involving bankruptcy restriction orders is introduced for bankrupts whose conduct before or during bankruptcy the court has found to be culpable, or who fail to cooperate with the Official Receiver or bankruptcy trustee. These restrictions will run for a minimum period of two years and a maximum of 15 years. In contrast to the corporate insolvency reforms, the purpose of the changes relating to individuals is to make the system more debtor friendly to encourage continued entrepreneurship among those who have previously tried and failed in business without dishonesty.

Regulations have been made to implement in the UK the Directive on the reorganization and winding up of credit institutions (2001/24/EC). These provide for the exercise of EEA liquidators of their function in the UK and make changes to UK insolvency law in relation to notifications of various matters. The Regulations also make provision for application to credit institutions whose head office is outside the UK and the EEA.

Does your jurisdiction operate a deposit protection or guarantee scheme protecting retail depositors from loss in the event of insolvency of an authorized bank?

Part XV of the FSMA is concerned with the Financial Services Compensation Scheme. The Scheme provides for a body corporate, Financial Services Compensation Scheme Ltd, and a scheme manager to administer the Scheme and protects certain deposits and other investments made with UK authorized persons and UK offices of non-EEA authorized institutions against the insolvency of such institutions.

All institutions are liable to make contributions to the Scheme. There are two types of levy, the management expenses levy and the compensation costs levy. The management expenses levy includes: base costs (the amount required for the running of the Scheme); specific costs (required for the running of the Scheme in a particular year); and establishment costs (costs imposed for the first three years of the Scheme and applied to the expenses of setting up the Scheme). Base Costs and establishment costs are payable by all participating firms. Specific costs are payable depending on the contribution group to which a defaulting firm belongs and contribution groups are dependent on the range of permissions that a firm has. Each contribution group has a separate tariff, which varies from year to year. The management expenses levy is part of the regulatory costs that are payable to FSA from year to year. The compensation costs levy is also payable by every firm, depending on its contribution group, as are the costs incurred in paying compensation.

The Scheme is available for eligible claimants, who are primarily consumers and some small businesses. The maximum level of protection for deposits is set at £31,700. The UK scheme now applies to deposits not only in sterling but also in euro for UK institutions with offices in the EEA. A UK institution can apply for offices in other EEA states to be covered by the local deposit protection schemes in those states instead of the UK scheme if the local scheme offers greater protection, and similarly, an EEA institution can apply for its UK offices to be covered by the UK scheme instead of the home scheme of the EEA state where the institution is established if the UK scheme offers greater protection. A non-EEA institution can apply for its UK offices to be covered by its home state scheme, instead of the UK scheme, if the home state scheme offers the same level of protection to UK depositors.

In recent years there have been relatively few bank failures leading to calls on the predecessor to the present scheme, the Deposit Protection Scheme.

Does your jurisdiction have an ombudsman scheme, arbitration scheme or similar scheme for the resolution of disputes between a bank and its retail customers other than through formal legal proceedings?

Part XVI of the FSMA provides for the establishment of an ombudsman entitled the Financial Ombudsman Service Limited. This is a company limited by guarantee with statutory powers to administer an ombudsman scheme, which is funded by a combination of a general levy on firms subject to the compulsory jurisdiction of the ombudsman, and case fees charged to individual firms who are the subject of a complaint. The rules governing the ombudsman are set out by FSA in the Dispute Resolution: Complaints Sourcebook. The scope of the ombudsman scheme and jurisdiction of the ombudsman covers activities with most retail banking customers (broadly individuals and businesses, charities, and trusts with a net worth under £1 million).

Complaints that are not satisfactorily resolved within eight weeks of the customer's complaint are handled via an adjudicator, whose role is to manage the complaint and who may institute conciliation to settle the complaint or investigate it. Determinations of the ombudsman are binding on authorized firms (although not on complainants).

Author biography

Bob Penn

Allen & Overy

Bob Penn is a senior associate in Allen & Overy LLP's Regulatory Funds and Financial Markets Group, and is also a member of the firm's Investment Structures Group. Bob advises on a range of financial services regulatory matters, including capital adequacy, custody, asset management (including funds), brokerage, and the regulation of market infrastructure providers, including exchanges, alternative trading systems, and clearing and settlement systems.



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