Speech by Michael Lord, Head of Investments Department, Small Firms Division, Retail Markets
10 June 2005

Introduction

Good morning ladies and gentlemen. As head of the Investments Department in our Small Firms Division, I am pleased to be part of this year's PIMS event. The organisers have put together an excellent programme that reflects the many important issues facing the retail financial advice market.

One issue that has been a priority for us at the FSA, is phoenix firms. I am well aware that this is a shared concern of mine as a regulator and yourselves as practitioners, and so I would like to let you know what we have been doing to address this problem; to set out what we expect of firms; and what we will do if firms and individuals do not do what we expect of them.
The main points I'd like to make should not sound new to you. We have made it clear on other occasions – most recently by Clive Briault at Money Marketing Live last month that:

  1. We expect the directors of firms who move their business to another legal entity to treat their customers fairly by ensuring there is adequate provision to deal with complaints and any resulting claims in relation to their former business;
  2. We will intervene to ensure this happens where directors do not make adequate provision;
  3. Where directors are found to have disadvantaged customers in the transfer or refuse to co-operate with the FSA in making adequate provisions, then the FSA will consider Enforcement action– if necessary we'll act to keep them out of the industry.

And some of you may have been through our Authorisations process and seen in action what I'm going to talk about.
Today I'd like to build on this further with some examples of the action the FSA has taken to prevent firms from phoenixing. As you will be aware, I am restricted with the amount of detail I can give, but I can still provide a flavour of the action we have taken. By doing this and by working together, with you, to identify phoenixing, I believe we can make further strides to eradicate this type of activity from our market, and to help customers who want to pursue a complaint against a firm that may have phoenixed.

What is 'Phoenixing'?

Let me begin by explaining what I mean by a 'phoenix firm'.
This is only an issue for incorporated entities (including Limited Liability Partnerships). It is where the assets of one Limited Company are moved to another legal entity, sometimes at price below its true market value, and without moving the liabilities. In a phoenix firm, some or all of the directors will be the same in both entities. So the directors are seeking to take the benefits of their business by avoiding the liabilities. For simplicity, I will refer to the predecessor firm as 'Ash Co' and the new firm as 'Phoenix Co'.

Why do firms do it?

We have found that primarily the directors of the original firm, Ash Co, want to continue trading in a similar capacity having absolved themselves of significant financial liabilities. These liabilities could have already become apparent or they might be likely to do so in the future. A good example of this is where a firm has been unable or unwilling to meet all of the compensation owed to their customers. They have set up another firm, Phoenix Co, (transferring assets such as the client base) to enable them to continue trading after allowing the firm to go into insolvency. This new firm was probably set up at or before these consumer liabilities became apparent.

An example

Let me give you an actual example.

Three directors of a firm 'ABC1' were applying for authorisation of a new firm. A pension review visit highlighted serious concerns about the way the firm was conducting its review. A second visit a couple of years later showed the firm had not implemented many of the recommendations from the previous visit and had not committed sufficient resources to the review.

Around this time the directors discovered that the insurer providing their PII was refusing to pay out on claims as ABC1 had made incorrect notifications to them. Despite the fact that the directors had extracted over £2,000,000 from the firm, they had failed to make any provision for liabilities. They then estimated the potential liability to be £1million and so on the advice, they say, of liquidators, they went into liquidation.

A second firm ABC2 was incorporated in the middle of this period with a similar name but lay dormant. ABC2 subsequently bought the client bank and renewal commissions of ABC1 from the liquidator.
To date the Financial Services Compensation Scheme (FSCS) has paid over £600,000 in compensation to ABC1's customers, and is still dealing with open cases. I gather total compensation could reach over £1 million. Some consumers were owed redress greater than the FSCS £48,000 threshold, and so have lost money. And of course as the FSCS paid, it is in effect you who are paying for the compensation.

In summary, by setting up ABC2 and then putting ABC1 into liquidation, the directors have been able to draw a line under their liabilities, and then buy back the assets at a discount and continue trading as before. But this is not the final part of this example; I'll come back to this a little later

Our Approach

We have devised an approach to identify and deal with potential phoenix firm situations.
The primary focus of our approach is to ensure that any justified claims are dealt with appropriately. By that I mean customers are not unfairly treated. We have established an internal group of experts to help support our staff. This group has developed a strategy for a variety of potential phoenix firm scenarios; this strategy makes maximum use of our rules and powers.

So far, 18 potential phoenix firm situations have been looked at by the group, with each situation either working towards or already having achieved a successful outcome. These then form examples to be used on other similar situations as they arise.

Investigating a phoenix firm

Most of the phoenix firms we have investigated have been identified during our authorisation process.
There several common issues we look for:

  • Clients being transferred from Ash Co and if so, what value (if any) is being paid for them? We generally expect a sum of money to be paid for the client base as these are often assets of the existing firm, including the renewal and trail commission.
  • We look at how this sum of money has been calculated. Is it "fair"?
  • We will look into why the firm is closing down and why a new one is being formed. There is not an easy solution to this tricky situation, but we will always seek to take action against those we find who are serially phoenixing.

Regulatory action against a phoenix firm

To date, we have taken the following action against phoenixing firms we have identified:

  • A regulatory undertaking to be signed by the directors of Phoenix Co in respect of the liabilities of Ash Co so that consumers get paid.
  • Requesting an independent fair value report on the transfer value of the business.
  • Requesting that Phoenix Co obtain Professional Indemnity Insurance (PII) for the past business of Ash Co – it can be done.
  • Helping liquidators investigate the conduct of directors – which may lead to us taking action or the liquidator making an adverse report to the Department of Trade and Industry (DTI) (leading to the directors being banned as directors). This is an area that needs more work – we know that liquidators need more encouragement to do this.
  • Agreeing to the segregation of assets by Ash Co or Phoenix Co, possibly in trust, for a set period to meet any liabilities of Ash Co ('ring fencing').
  • Insisting that Phoenix Co purchase the assets and liabilities in their entirety.
  • Stopping the phoenix, by recommending the refusal of the authorisation application of Phoenix Co.

Going back to my earlier example, the regulatory action we took was to stop the sale of ABC1 by refusing the application to become authorised as ABC2. Quite often we will use a combination of these actions.

However, some firms that at first appear to be phoenixing are genuine. We see a number of firms applying for authorisation because of changing circumstances with an existing authorised firm. These circumstances can be wide and varied ranging from a change of legal entity, or a restructure due to retirement or commercial reasons. We have seen firms facing difficulty obtaining PII cover. These can all be valid reasons and as long as appropriate arrangements are made for consumers, we will allow the transfer.

I'd like to say a little more on some of the key regulatory actions we have taken to date:

Regulatory undertakings

My colleagues in our authorisations department see the first indications of potential phoenix situations. Someone planning to phoenix would want Phoenix Co authorised and able to receive the transfer of business and the individuals prior to cancelling the permissions of Ash Co.

With a change of legal entity, the transfer of business undertaking included in the Change of Entity application pack may be signed by the directors or partners of the applicant firm. This is a regulatory undertaking designed to ensure that the directors fulfil their obligations to their customers, those of Ash Co.

In one recent case, a firm closed down because of a disagreement among the directors. Two new firms were created. During the acrimonious split, the client base was loosely shared out to each director. However, the process was not well managed and some clients were not allocated to a director. One of these 'orphaned' clients then wanted to make a claim for compensation but was advised by both firms that the other firm was liable for their claim. This was flagged to the FSA. We invited the directors in, and they completed a regulatory undertaking which allocated the liability of each client of the old firm to one of the directors.

Sometimes the change of entity undertaking may not be appropriate. If directors or partners don't want to sign the undertaking, we don't assume their reasons are invalid. It is purely that such cases may present additional consumer risk that needs further consideration before we can properly evaluate the application.

Ring fencing funds

Our overriding concern in these cases is to make sure that firms treat their customers fairly. So applicants have to put forward suitable arrangements which provide adequate and continuing protection for their customers particularly in relation to any complaints or claims made.

For instance, Ash Co or Phoenix Co can ring fence funds to cover potential future claims. In one example, we required a firm to protect consumers in this way. The firm wrote to the customers advising that the firm was closing and that they should correspond with an appointed contact if they had any future claims. The contact was a solicitor who was given a fund to cover any future compensation.

In cases like these we like to check that the funds are still there. That the levels of claims made on the funds are within the original expectations and that any signed regulatory undertakings still exist and are being adhered to.

Fair valuation of transferred assets

Within a limited company, client banks are essentially a corporate asset (often the only real corporate asset of value). If they are bought by a new firm, we expect to see fair value paid to Ash Co.

When we are dealing with applicant firms looking to take value out of an authorised firm, our principal concern from an Approved Persons perspective is that of the suitability of those in governing functions: namely the directors. This applies both to their role in the existing firm and how that might affect their suitability in their new role with the applicant.

After taking into account all factors, a decision has to be made about the application. If we think the applicant has acted properly in purchasing the ongoing business of an existing authorised firm, or, in cases where a straight sale / purchase is not appropriate, has allowed for suitable provisions to be made in dealing with complaints and claims against the existing authorised firm then we will grant approval for authorisation.

If we decide that suitable arrangements have not been made and think the application has been contrived to allow assets to be stripped out, or has been structured in a way that liabilities are evaded or consumers disadvantaged, we will take the view that the directors in question have failed to demonstrate the integrity expected of an Approved Person and if the applicant is applying for them to be Approved Persons, we will recommend that their approvals are refused. We will keep out those directors.

Asset stripping

My final example arose while we were investigating a firm. We discovered that the directors had been buying small firms, stripping out the assets, and moving the advisers. This left a dormant entity with substantial liabilities and no way of meeting these liabilities. The firm is now being investigated by my colleagues in Enforcement.

Scope of FSA action

There are limits as to what FSA can do to address these situations. We cannot do anything about directors of a firm who legitimately withdraw capital from the business either because they didn't want to re-invest in their business, or reasonably concluded that they had no potential liabilities.

In some cases a firm subsequently becomes insolvent when unforeseen liabilities materialise. If, at this point, the directors decide to 'walk away' from the industry, there is very little that we can do. But if they were to apply to return to the industry we would look at their conduct carefully and if we find they have acted in appropriately, we will keep them out.

It is worth reminding you that many aspects of phoenixing are governed by corporate and insolvency law. In themselves, they do not fall under our remit. However, we will discuss issues that arise with the DTI and other relevant authorities, particularly if there is a blatant disregard for legal standards. In extreme circumstances, we can take action through the courts ourselves. But our main aim here is to deal with those directors that do try to avoid their responsibility to treat their customers fairly.

A new area that we are alert to is the potential for transferring liabilities to the Pension Protection Scheme. This is a matter for The Pension Regulator. However we will work with them where we identify matters that fall within their jurisdiction.

As I mentioned at the beginning, I believe that this is a shared issue for us all. If we are to be more effective in tackling phoenixing, then we need you to help us spot it. You can do this by informing us at the Firm Contact Centre or whistle blowing number – details of which I'll give at the end of this presentation.

You could also help us to advise customers who have been victim to phoenixing. Our Consumer Contact Centre deals with consumers who wish to make a claim for compensation but have been advised that the firm no longer exists. If the consumer suspects that the firm or individuals are still operating under a new identity, then our message is 'don't give up'. Please help us advise these consumers not to be put off by firms that claim they are not responsible for their complaint when the firm is a phoenix for example it's the same advisors, working from the same offices under a slightly different name. If the firm continues to fob off the customer then they should contact the Financial Ombudsman Service who will advise them on their next steps.

Conclusion

In conclusion I hope you can see that we expect the directors of firms who move their business to another legal entity to treat their customers fairly by ensuring there is adequate provision to deal with complaints and any resulting claims. If this doesn't happen we will intervene, and if necessary take enforcement action. We'll look to keep those directors out of the industry.
Hopefully you can see we have taken action and you understand a little more about the standards we expect of firms and the individuals who govern them.

There will be situations that we can not respond to. But make no mistake, where we find evidence of deliberate actions taken to avoid liabilities or refusal to cooperate with us; we will seek to take the strongest action available. As we, (and I am sure you) find this kind of behaviour wholly unacceptable.

To those directors who are contemplating moving themselves or their business to a new firm I have a clear message: take responsibility for your previous actions. Take responsibility for complaints or we'll act to remove you from the industry.
I hope this doesn't prove necessary in all cases. The measures we have put in place are producing significant benefits and ensure that customers are treated fairly.

Ladies and Gentleman, thank you for your time. Here are the contact numbers I mentioned and web-links to further information. Are their any questions in respect of the presentation I have just made?

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