Five Lessons for Lawyers

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Howard Davies
Chairman, Financial Services Authority
LSE LAWYERS GROUP OF ALUMNI
LONDON SCHOOL OF ECONOMICS – 3 JULY 2003

I have to admit to being somewhat intimidated by the prospect of talking to an audience of LSE lawyers. I am well aware of the strong legal tradition at the School, which is indeed chaired by a distinguished Silk, Lord Grabiner. And I am conscious of the fact that the intellectual foundations of financial regulation in the United Kingdom were established here. It remains true that the single clearest expression of the intellectual justification for our approach to regulation was contained in Professor Gower’s review of investor protection in 1981. And Jim Gower, I understand, was a Professor at the LSE in the 1930s.

There are, too, more recent connections between the School and financial regulation. My General Counsel, Andrew Whittaker, spoke at a seminar organised by the LSE a few months back looking at the implicit regulation involved in contract law, and its impact on the development of regulatory policy. He (I hope) is competent to do battle with the legal fraternity at the School, whether students, lecturers or alumni. I, by contrast, am strictly an amateur in these complex matters. When it comes to the law I don’t know much about it, though I do know what I don’t like.

So speaking from a determinedly amateur perspective this evening I would like to offer a few reflections on lessons I have learned from 6 years in charge of financial regulation in London, points which I hope will be of some interest to lawyers. And when I say "a few" I mean precisely five. Giving you this certainty about the scale of my presentation will, I hope, ease the nervousness which is bound to be felt by those of you who are programmed to calculate the opportunity cost of billings foregone as you listen.

However, before I launch into my 5-points, just a few words about the FSA and its construction. Its birth was announced by Gordon Brown in 1997, as the other side of the coin of Bank of England independence. The old SIB was used as a takeover vehicle, renamed in the autumn of 1997. The organisation came together on 1 June 1998, so we are five years old. The draft Financial Services and Markets Bill was published in July 1998, but not enacted until June 2000 and not implemented until December 2001 – N2. So we have only 18 months experience of the new regime in all its glory. And indeed there are elements still to come. We will be taking on mortgage and general insurance regulation in October 2004 and January 2005 respectively.

However, although the experience of a new system is short, it is not too early to offer some observations about how it is working. Which brings me to my first point, which is that in my view the unusually protracted parliamentary process left us with a good quality piece of legislation.

1. The Parliamentary Process

The Financial Services and Markets Act is innovative in a number of respects. In the first place, as my brief timetable illustrated, it took a long time to go through its parliamentary stages. That was because it was subject to a number of interesting constitutional innovations. Not all of them were absolutely new, but some were, and the combination certainly was.

In the first place, the Bill was published in draft for consultation. The consultation process was lengthy and intense. There were times when I could have wished it otherwise. But it certainly meant that a large number of issues were aired at an early stage, and by the end of the process I believe it is true to say that everyone felt they had had their say. The result is that legislation which was highly controversial when first drafted, has been much less controversial in its operation. That, I believe, is the right way round.

A second related innovation was that the Act was one of the first pieces of public law to be carried over from one parliamentary session to another, following the recommendations of the Modernisation of Parliament Committee in 1998. Carry over depends on the approval of the opposition, which was forthcoming in this case, though not without some horsetrading. There is clearly a risk that the Government is obliged to make undesirable concessions as a result, but in this case there were no concessions which fundamentally damaged the legislation, so I would count the carry-over process to be a success. It avoided the hasty, hectic law-making which often arises as the end of session deadline approaches.

The legislation was also subject to review by a Joint Committee of both Houses of Parliament chaired by Lord Burns, a former Permanent Secretary to the Treasury. That pre-legislative scrutiny certainly added value, and teased out a number of complex issues which would have otherwise detained Parliament, and would have been more difficult to deal with in the traditional confrontational style of Westminster. The issue of regulatory statutory immunity was dealt with by the Burns Committee, for example. In my view, and I believe Lord Burns himself shares it, the Committee could have been even more useful had it been given more time to operate. Some uncertainties about the Committee’s composition and procedures delayed its start. But I am convinced that this was also a useful constitutional innovation, and I am pleased to see that it is being followed, most recently in Lord Flynn’s committee on the draft anti-corruption bill.

Another innovative element, which caused some difficulties at the time, was the need for certification by Ministers that the legislation was compatible with the European Convention on Human Rights, which they had very recently ‘brought home’ by incorporating it into our domestic legal system. Ours was the first major piece of legislation to require certification in this sense. There are those who still believe that our procedures could be subject to challenge on this score, though I note that no challenge has yet been forthcoming. And, indeed, a couple of challenges on human rights grounds to the procedures of one of the previous regulators have not been sustained. However, we are not complacent on this score. One of our French opposite numbers lost all of their current disciplinary cases as a result of a challenge on human rights grounds. We are well protected against the particular challenge which overturned the French procedures, but I am sure that inventive legal minds – if that is not an oxymoron – are even now thinking of ways to raise the issue again.

Lastly, in terms of legislative innovation, the Act is, unlike the regulatory statutes it replaced, purposive in nature. It begins with a set of four statutory objectives which the FSA is obliged to pursue, which are themselves conditioned by a series of principles of good regulation. The objectives include maintaining confidence in financial markets, and protecting consumers of financial services. The principles include proportionality, the need to meet a cost-benefit test, the need to avoid unnecessarily damaging competition and innovation etc. We have found this framework of objectives and principles most helpful. Indeed we have built the corporate strategy of the institution, and our operating procedures, around them – something which I think is relatively unusual.

So my conclusion is that the new legislation looks good, so far. We have found relatively few problems in operating it – certainly no insuperable technical obstacles. There are those who believe that it overconstrains the regulator in terms of publicising enforcement actions – certainly we are more constrained than many of our overseas counterparts. That is an issue which may be reviewed when the Government carries out a 3,000 mile service of the Act around the end of this year. But I would be surprised if a strong case were to be mounted for fundamental revision of the statute.

Indeed we have seen suggestions that elements of the system might with benefit be adapted elsewhere. Ann Abraham, when Legal Services Ombudsman, suggested that the regulation of legal services should be reformed, and noted that the FSA provided "an obvious model against which to benchmark the current regulatory maze".

2. The Interface with European Law

However, and this is my second point, the Financial Services and Markets Act is not the only influence on the development of financial regulation in the UK. Indeed possibly a more fundamental influence at present is the European Commission’s Financial Sector Action Plan – a programme of some 42 directives and regulations agreed in principle by Heads of Government at the European Summit in Lisbon 3 years or so ago.

It is not my intention this evening either to question the overall aim of the FSAP, or to discuss individual measures within it. I am quite happy with the notion of a single European capital market, with enhanced opportunities for investors, and better access to capital by companies. My concern is twofold. First, the programme does not emerge in a simple and coherent way and, second, in some respects it cuts across the disciplines built into our own legislation.

To be scrupulously fair, I ought to amplify the first point a little. The Financial Sector Action Plan itself is planned in a broadly coherent and systematic way by DG Markt in the Commission. Unfortunately, other legislative initiatives which affect financial markets also emerge from other parts of the Commission. For example, the E-Commerce Directive affects the marketing of financial products and services, along with others. The proposed duty not to trade unfairly would similarly affect financial markets, and could cut across some of the provisions in our law to protect investors, under the Investment Services Directive. The Distance Marketing Directive is another which was conceived elsewhere in the Commission, yet which affects financial markets. And the Consumer Credit Directive, which you might have thought was part of the Financial Sector Action Plan, is in fact a separate initiative emerging from the Consumer Protection Directorate in Brussels. Se we have a series of overlapping and cross-cutting directives which can produce a less than clear legal environment for financial services.

Also, the constraints which apply to our regulation under the Financial Services and Market Act, embedded in the principles of good regulation, are not incorporated into the European processes. The so-called Lamfalussy Group which reported a couple of years ago recommended similar principles for adoption in the EU, but they have not been taken up actively by the Commission. So, on a number of occasions we have found ourselves required to implement directives in London which would not pass a cost-benefit test, or which would not in our view meet our proportionality requirement. Understandably, the industry here find it difficult to distinguish clearly between regulatory requirements which emerge from the FSA under the FSM Act and those which emerge from the FSA under the FSAP. Of course any City lawyer worth her salt would immediately spot the difference, but I have to tell you there are other less fortunate folk who struggle.

The consequence is that our regime is not so tidy or so easily justifiable as it would be if it depended only on the FSM Act. We must all hope that the trumpeted benefits of the single financial market are sufficiently large as to dominate this disadvantage. But since there is no cost-benefit analysis attached to the Financial Sector Action Plan, we cannot prove the point, one way or another.

3. Consultation

My third point is of a slightly different nature.

One problem we have run into recently is some resistance in the market to our outflow of consultation papers. Perhaps we have not helped ourselves by our rigid numbering system, which tells you that we are now up to CP188. A species of consultation fatigue has set in.

We do our best to minimise the volume and complexity, but consultation is built into the Financial Services and Markets Act and, on balance, it certainly adds value.

But my point this evening is not about the volume, but about the care we need to take in interpreting the responses. Two general points strike me about responses we receive. These may seem blatantly obvious, but they are rarely made.

First, we only receive responses from firms who exist.

In some cases, that does not matter. But if we take, for example, our current consultation on soft commissions, payment for research and the way in which brokers generally are remunerated, the responses have all come from firms currently in the market. They argue that the result of the proposed changes might be a significant diminution in their ability to fund research, and that investors would thereby be disadvantaged. Yet one consequence of unbundling of payments for transactions and for research might well be that investors chose to buy research elsewhere, and find much better value and greater independence as a result. So new research firms may emerge if the market is liberalised in the way suggested in our consultation paper. By definition, we do not receive responses from these as yet non-existent firms.

A second, and related source of potential structural bias in the evolution of a consultation-based system is the imbalance of resources between financial firms and investors. During the legislative consultation, in particular, the weight of representations from financial firms, by comparison with investor groups, was enormous. And those financial firms could typically afford to commission the major City law firms to work on the legislation on their behalf. That is similarly true in relation to some of our rule consultations at present.

Of course we do not discount these responses, and I can assure we read them carefully. But we do need to recognise the imbalance of resources when we assess the totality of the consultation response and determine the right way forward.

4. Lawyers in Regulation

In making these assessments we are able to draw on a significant body of legal advice within the FSA. We employ around 100 legally qualified people in the Authority, though some – quite understandably – prefer not to admit it openly. But the important point about our in-house lawyers is not so much their number, as the way in which they are used.

The role of lawyers in the predecessor organisations was very different from one to another. No lawyers were directly involved in insurance regulation, though the regulators drew on the central legal services of the DTI. The Bank of England had grown a very small cadre of lawyers to support the banking supervisors in response to Lord Bingham’s recommendation, while, by contrast, in the investment regulators they played a much more central role. Though even in our investment regulation lawyers were never so dominant in the staffing mix as they are in the SEC, or indeed in Continental European securities regulators, most of whose staff are legally qualified.

In constructing the FSA we needed to make some decisions about how our legal support would be structured and more importantly how it would be integrated with other disciplines.

In practice most, though not all, of our legally qualified staff are either in the Enforcement Division, or in the General Counsel’s area. We staff our enforcement teams with a mixture of legally qualified and other staff, notably forensic accountants. Much of the investigative work we undertake can benefit significantly from that kind of discipline.

The General Counsel’s Division are typically not directly engaged in enforcement activity. Their roles are to interpret and apply the legislation, to help develop new regulations under the FSM Act, and ensure the legal integrity of our Handbook of Rules and Guidance, and to support supervisors in their day to day work. Our experience is that we get best value from our legal resource if we ensure a lively interaction between lawyers and those from other disciplines, notably economics, accountancy and other types of financial qualification. If that interaction is to work well it requires lawyers who are innovative, and activists. One important lesson we have learned from our assessment of the old regulatory regime is that if legal powers are not used, they can ossify. Yet in many cases supervisors can be reluctant to invoke legal powers in their day to day business. So we have explicitly tasked our General Counsel’s Division with an assessment of how best to use the legislative provisions in the Act – which were put there by Parliament for a purpose after all – and to ensure that supervisors are aware of the full potential of the legal toolkit at their disposal.

We think, therefore, that we have found an interesting new approach to integrating legal thinking with the other disciplines which make up the regulatory cocktail. Only time will tell whether this is the best solution, though we are encouraged so far.

5. Legal Risk

And one particular aspect of the contribution lawyers can make leads me to my fifth and last point.

The overall philosophy of the FSA is founded on a risk-based approach to regulation. We aim to identify those risks which can threaten our statutory objectives, and at the level of the firm that typically means risks which threaten its financial stability.

In articulating this new approach to risk we have looked at the causes of failure in firms in the past, and indeed the causes of unexpected losses.

It is fair to say that the most significant and life-threatening risk for most firms remains credit risk, a very traditional source of failure. But in an increasing number of instances we have identified legal risk as an important contributing factor in financial crises of varying kinds.

One thinks, for example, of the Hammersmith and Fulham swaps affair. This case, in which I was intimately involved as Controller of the Audit Commission, was precipitated by a House of Lords ruling that interest rate swap contracts carried out by local authorities were ultra vires. The Equitable Life closure was also precipitated by a House of Lords ruling on the treatment of their guaranteed annuity policies. A third and even more topical international example is the litigation flowing from the Enron debacle where banks and insurers are contesting the validity of a variety of bond and reinsurance contracts.

An interesting dimension of these cases is the cultural clash between the typical approach taken by banks in the event of disputes – pay now, sue later – and the traditional attitude of insurers which, let me put it delicately, is to seek legal certainty before writing a cheque.

There are many other cases I could cite, but the point I draw from them is one of general application, which does not relate specifically to the circumstances of any of the cases I have quoted. It is that firms should explicitly consider legal risk as one of the risks which they should actively manage, and for which they should seek mitigation. We are regularly surprised by firms who are operating on the basis of an implicit assumption about the legal position of the contracts to which they are a party, without seeking to clarify the position. Of course we understand that not every contract can be litigated to the House of Lords, as a theoretical matter, before it is signed. But firms seem surprisingly willing to proceed without the benefit of Counsel’s opinion, even in what is known to be heavily contested territory.

I am uncomfortably aware, as I say this, that I may be accused of encouraging the practice of opinion shopping, and giving an unjustified boost to the turnover of London’s legal industry. But my motives are pure. They are to reduce the volume of litigation, normally a more lucrative source of business for the legal profession – and also to reduce the risk of financial failure.

Conclusion

These five points do not lend themselves to a neat summary conclusion. Except, perhaps, to say that at the FSA we have benefited from the intensive interaction we have had with the London legal community over the last five years – even those parts of it which, unlike you, did not benefit from an LSE education.

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