FSA issues guidance on accounting for windfalls when paying compensation

Although the FSA was not a party to the Needler case, the judgement has implications for Pensions Review and FSAVC Review compensation cases, where relevant guidance on accounting for cash or share windfall benefits has been in place since May 1997. The main change from this guidance as a result of Needler is that firms are no longer allowed to deduct the value of windfalls paid as top-ups from any compensation payable. It also affects mortgage endowment complaint cases, where no previous guidance was in place.

Under the updated guidance, firms should use the principle in Needler to work out whether a benefit from a corporate event is a windfall benefit. A windfall benefit arises where:

• a special event (such as a demutualisation) takes place in a life office; and

• the benefit given to customers was more than that needed to meet policyholders reasonable expectations at the point of sale.

Very rarely, firms may be able to say that the special event was expected at the time the customer was advised to buy the product, and that the adviser expressly recommended that the product be bought for this purpose. If this is the case, then the firm does not have to give credit for the benefit the customer got, so it will pay less compensation. To protect customers, the firm has to prove, using its records from the time of the sale, that it is justified in doing this. To calculate the value of a windfall, the guidance is that:

• Windfalls paid as shares will be valued at the issue price, not the market price at the time that the compensation is calculated;

• Windfalls paid as cash will be valued as the amount received;

• Windfalls paid as policy top-ups will be valued in line with principles set out in the Policy Statement. If a firm cannot work out the value accurately using these principles, then it can use a simplified or proxy approach;

• To protect customers, a firm should have its appointed actuary certify that the windfall benefit has been valued in line with the principles in the guidance.

Following the Needler judgement, the FSA required firms to stop calculating cases affected by windfalls paid by policy top-up until updated guidance could be issued. The new guidance will come into force on 1st August 2002. Outstanding FSAVC cases will then need to be completed by 31 December 2002 and Pensions Review cases by 31 March 2003. Cases that were completed before the concession was granted will not be re-opened to take into account the Needler judgement. Similarly, completed cases that are re-opened for other reasons will not be required to take Needler into account.

Notes for editors

1. In July 2001, judgement was handed down in the case of Needler Financial Services and Taber. The case had been brought under the Personal Investment Authority (PIA) Ombudsman Bureaus test case procedure. The case aimed to get a decision on whether windfall benefits derived from a life office demutualisation should be brought into account when calculating financial loss and redress.

2. The Court identified two relevant propositions:

   "First, the relevant question is whether the negligence which caused the loss also caused the profit in the sense that the latter was part of a continuous transaction of which the former was the inception. Second, that question is primarily one of fact."

3. The Court found that:

   "The profit in this case is the holding of demutualisation shares issued to Mr Taber, but it might just as easily have taken the form of a cash payment or an additional bonus. I can see no reason for drawing any distinction based on the form in which the benefit was received. The benefit was derived from the demutualisation. The demutualisation was not caused by the negligence of Needler. It arose from the desire of the directors of the Society to have the corporate structure best suited to competing in the new markets for financial products they perceived to have arisen in the mid 1990s. The underlying reasons are explained in detail on chapter 3 of the Report of the Independent Actuary. They have no connection with the breaches of duty of all or any of the financial advisers which led policy holders to transfer to a mutual society.

   It is true that but for the negligence of Needler Mr Taber would not have taken out the PPP. It is also true that but for the PPP Mr Taber would not have received any demutualisation benefit. Even allowing for these factors the demutualisation benefit was not caused by and did not flow, as part of a continuous transaction, from the negligence. In causation terms the breach of duty gave rise to the opportunity to receive the profit, but did not cause it."

4. The Court concluded, on the facts of the case, that:

   "the common law principles for the assessment of damages do not require the value of the benefit of the demutualisation shares issued to Mr Taber to be brought into account in diminution of the compensation to be awarded to him for Needlers breach of duty...."

5. Before the test case, the PIA had included an article in Regulatory Update 33 (published in May 1997) entitled Pensions Review and Demutualisation Shares giving guidance on the treatment of windfall benefits for the pensions review. The PIA confirmed that it regarded the share value purely as the price paid by the demutualising entity for the exchange of membership rights in favour of shareholder rights. The PIA also confirmed that firms should ignore the financial impact of demutualisation when calculating financial loss or redress. This covered the situation of windfall benefits received as shares. Although not directly stated, the same principle was applied by imputation to cash windfalls. However, Regulatory Update 33 was silent about windfall benefits received as policy augmentations.

6. To view Policy statement 126 ('The treatment of windfall benefits for the Personal Pensions Review, the FSAVC Review and mortgage endowment complaints - Feedback on CP126 and 'made' text') to go http://www.fsa.gov.uk/pubs/policy/

7. The FSA is the principal regulator of the UK financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; the protection of consumers; and fighting financial crime.

8. The FSA aims to maintain efficient, orderly and clean financial markets and help retail consumers achieve a fair deal.