The UK FSA: Nobody does it better?
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Speech by Margaret Cole, Director of Enforcment, FSA
Fordham Law School, New York
17 October 2006
I am delighted to be here with you tonight and honoured to have been asked to deliver this, the Seventh Annual A.A. Sommer Jr. Lecture on Corporate, Securities and Financial Law with the title – "The UK FSA: Nobody Does it Better?" I was asked to suggest a catchy title for my remarks tonight. As you can see, following the philosophy of the FSA's Enforcement Division, I have been "Bold & Resolute" in my choice of theme. Standing in front of this distinguished audience another title comes to mind, perhaps "Fools Rush In." But I note with interest that I am the first overseas speaker to have addressed this gathering and hope that, as such, you will grant me some licence to depart from the British norm of understatement so that I can indulge in a bit of shameless, PR for the United Kingdom Financial Services Authority (FSA) and the way we go about our business.
My title does at least end with an interrogation mark and if this was a debate, as my title suggests, I would be standing up for the FSA and a long line of US regulators, including the SEC, The Federal Reserve Bank, CFTC, NASD, numerous regulators of insurance and others, would be on the other side of the table, opposing my motion.
Outnumbered yes, but solid in my convictions, I would be arguing many of the points I want to raise today, such as the benefits of having a unitary authority, how London’s philosophy of ‘light touch’ regulation has helped it in becoming the world’s leading centre for mobile capital, how the FSA is not an enforcement-led regulator, but one that uses supervision and on-going relationships with authorised firms as its front line means of regulation, and how the FSA is recognised in the international community of regulators as a thought leader, always seeking new approaches to better regulation demonstrated, for example, by our deliberate shift to more principles based regulation. We continue to have our aspiration of being the most admired and respected regulator globally.
I also want to mention some of the things that my opponents in this hypothetical debate would almost certainly raise. They might well say, for example, that there is a conspicuous absence of criminal prosecution of securities law violations in the UK, or that the FSA’s resources are widely stretched across its huge jurisdiction or that its strategic approach to enforcement sends out selective messages to the markets and allows some illicit activity to go unpunished.
In this debate, some such criticisms might fairly be argued, but I would still argue that our model in the UK is an innovative and highly effective one.
Ours may not be a perfect model of regulation but I do genuinely believe it is one that gets a lot of very important things right. I am also the first to recognise that there are many things that we can learn from you.
Now to some background about the FSA to give context to my proposition. The FSA is a body that is operationally independent of the UK government. We were set up in 1997 by the then incoming Labour administration, – the second thing they did after making the Bank of England independent in respect of monetary policy – the result of a merger of 10 predecessor regulators. We are now a one-stop regulatory shop for virtually all aspects of financial services regulation in the UK. We are financed by fees levied from the firms, large and small, that fall within our remit.
We have supervisory responsibility for Wholesale and Retail markets, equities and derivative trading, banking and insurance. The FSA also acts as the competent authority for listing in the UK. The scope of the activities we regulate was more recently increased to include mortgage business and general insurance activities. One fact you may find of topical interest – we do not authorise or regulate hedge funds – which is not to say that we aren't concerned about the risks they pose. I'll return to this in a moment.
We regulate an industry which employs more than 1 million people (the population of the UK has recently topped 60 million) and accounts for some 7% of GDP. We have 2,800 staff and a current budget of £276 million.
The corner-stone of our powers is the Financial Services and Markets Act 2000 (FSMA). FSMA gave us a wide range of rule-making, investigatory and enforcement powers and certain important responsibilities, including the ability to take action to prevent market abuse and to prosecute offenders for insider dealing.
FSMA gives us four statutory objectives:
- market confidence: maintaining confidence in the financial system;
- public awareness: promoting public understanding of the financial system;
- consumer protection: securing the appropriate degree of protection for consumers; and
- the reduction of financial crime: reducing the extent to which it is possible for a business to be used for a purpose connected with financial crime.
The objectives govern the way we carry out our general functions and help ensure that the FSA is accountable in political, public and legal terms: we have to report annually to Parliament on how successful we have been in meeting our objectives; and, when we interpret the objectives wrongly, or fail to consider them, we can be challenged in the courts.
So, we are a single regulator with a single aim and, at last count, 30,000 firms and 165,000 individuals to regulate.
Let me say something about our approach to regulation to deliver our objectives. Our clear preference is to encourage efficient markets. Our philosophy is that only after market solutions have been exhausted should regulatory initiatives be contemplated. A very good example of this was the work done, alongside the US Federal Reserve Bank as well as the Swiss and German authorities, to address concerns about growing operational risk associated with confirmations for credit risk derivatives. This problem could not be solved by any one regulator or any one firm and required collaboration between regulators in different countries – something which will be increasingly essential in the global landscape of financial services. Together we met with the industry, set out the problem and the industry came back with proposals which the regulators discussed. There was agreement on approaches and tracking of the improvements and, I am pleased to say, the results have been good.
There are numerous risks in the financial markets, so we adopt a disciplined process to identify the big ticket risks to our objectives. This "risk-based approach" is designed to align our finite resources with addressing the big risks that matter most. This means that we, and others, need to accept that some things can and will go wrong – what we refer to as a "non-zero failure" regime.
Our view is that, although the idea that regulation should seek to eliminate all failures may be appealing in theory, in practice it imposes prohibitive costs on the industry and consumers.
The FSA’s decision to be a risk-based regulator is a conscious and deliberate decision and we regularly review the amount of risk we are prepared to accept and focus our resources on the risks that we consider matter the most.
We are keen to ensure that our regulatory interventions always add to rather than detract from the positive impacts of market forces and really are justified in terms of the level of risk to our statutory objectives and consequent harm that would otherwise arise.
Consequently, even where empirical analysis shows there has been a market failure, we are not always convinced that regulatory intervention is the most efficient and cost-effective form of correction. Market failures can also be addressed using other mechanisms such as competition policy or the FSA using its considerable influence with market participants and their trade representatives to change firms' policies, processes and behaviours without reaching for the heavy handed tool of the Regulator's Rulebook.
The FSA is firmly of the view that regulators must be very wary of the damaging effects they can have on creativity, innovation and competition.
In support of our risk-based approach, the FSA is an advocate for principles-based regulation – that is where the focus is on the outcomes rather than the prescription of detailed rules. Targeting outcomes such as customers of financial firms being treated fairly, or firms holding financial resources sufficient for the risks they run, enables companies to focus on the substance of what is good for their business, their customers and for society around them.
The FSA's eleven high level principles for businesses have in fact been around since 2001 and set overarching requirements for all financial services firms. They are the regulatory equivalent of 'first principles' that articulate what action and behaviours we expect from firms.
We see real benefits for firms, markets and consumers, as well as our own people, in tipping the balance materially towards principles and away from prescription.
We believe that providing firms with the flexibility to decide more often for themselves what business processes and controls should operate will better align good regulation with good business practice. We also believe that firms who seriously commit to a set of outcome-based principles are in the best position to judge the detail of how best to deliver those outcomes in the marketplace.
By taking this approach, we are creating incentives for firms to focus on compliance in return for a regulatory dividend - that is less regulatory intervention.
We also think that a tick-box mentality towards rule compliance, at the expense of judgement and a real understanding of the business, de-skills the industry because good people, who like to exercise judgement, will leave that kind of environment. We want good people in all sectors of the UK financial services industry.
However, an approach along these lines is not always easy. Both regulators and regulated find a sense of safety and security in detailed rules as they define the scope of their legal exposure. But, while rules-based standards are authoritative and enforceable, they do not prevent dishonest practice.
The regulator and the regulated must be bold enough to accept some uncertainty and ambiguity and to manage any consequent legal risks for the good of markets and society as a whole.
So, for our part, when we ask questions of our firms, we have to accept that the answers will not always be precise and that there may be a range of judgement-based outcomes that are acceptable.
In short, it is a question of striking the right balance between simplicity and detail. As Einstein once said:
"Everything should be made as simple as possible, but not simpler"
The benefits of this light touch approach to regulation are borne out by the figures. By the end of September this year, companies had raised more capital on the main market of the London Stock Exchange (the LSE) ($26.7 bn) than the New York Stock Exchange (NYSE) and NASDAQ combined ($26.4 bn) – this did not include the $6.7bn raised on the LSE's Alternative Investment Market. The figures are even more stark when you look at international IPOs – so far this year the LSE has attracted 59 deals, worth $15.9bn while the NYSE and NASDAQ together have only attracted 17 deals at a value of $5.9bn.
I am not gloating about these figures and I do know that New York's performance of late, in comparison with London, has caused a great deal of concern in your corridors of power. I understand that Mayor Bloomberg has recently appointed a consultant to look at just this issue and that Treasury Secretary Paulson has mobilised a team of experts to look at the impact of the Sarbanes-Oxley legislation. However, I do believe, to use the words of a leading UK financial journalist (Damian Reece, The Daily Telegraph, 27/09/06), that "there is a regulatory dividend that London enjoys under the auspices of the Financial Services Authority" and that that dividend has bolstered London's status to establish itself as the world's leading centre for mobile capital.
The whole issue of our different regulatory approaches was thrown into stark relief recently when Ed Balls, Economic Secretary to the Treasury, announced a month ago that the FSA will be given powers to veto rule changes to exchanges that it considers to be too draconian and disproportionate in their impact. The Government was at pains to emphasise that this unprecedented move was not protectionist and was not aimed at deterring foreign buyers bidding for our exchanges. However, it seems clear that the possibility of a take-over of the LSE by NASDAQ (which already owns a 25% stake in the LSE and is no longer barred from increasing that stake) and anxiety at the prospect of rules driven by Sarbannes-Oxley regulating the LSE, played a major part.
The FSA welcomed this move by the Government to create a legal ring-fence and ensure that London continues to enjoy the competitive advantage it derives from domestic regulation. Equally, we welcome and are hugely encouraged by the SEC's pledge, at the end of last month, not to apply US rules to European exchanges that are taken over by American exchanges. This is testament to the open and constructive dialogue between the SEC and the FSA on matters of mutual interest.
Now at this stage, you might be forgiven for wondering when or whether I will get round to talking about enforcement. After all, I am the FSA's Director of Enforcement.
So, where does enforcement fit into this picture?
Well, a clue lies in the fact that my team of 280 represents just 8% of the total staff of the FSA. Contrast this with the SEC, whose Enforcement Division makes up just over half the SEC's total personnel nationwide.
The FSA is not an enforcement-led regulator. Enforcement is one of a range of tools available to deal with non-compliant behaviour but it is not the most widely used. It is used selectively and strategically as part of our overall risk-based supervisory strategy and in support of the FSA's objectives.
Consistent with this, the Enforcement Division does not have its own free-standing priorities. Our priorities are the same as those of the FSA as a whole and our work is driven by the needs of the rest of the organisation.
Two big priority areas for the FSA, and therefore for the Enforcement Division, are Market Abuse, on the wholesale side, and Treating Customers Fairly, on the retail side.
A key focus in the FSA's efforts to ensure the integrity of markets in the UK is to deter market abuse. Appropriate enforcement action that sends out strong messages is an important part of achieving deterrence, but we generally regard non-enforcement options, such as pro-active surveillance of likely 'hot spots', up-to-date transaction analysis systems and industry co-operation to ensure a steady flow of information, as more desirable. We take the view that prevention is better than cure.
An interesting dimension to this priority is the role played by hedge funds, a subject I flagged earlier which is of much topical interest. Indeed, it is not possible to open a newspaper, either in London or New York, without reading about the latest issue concerning hedge funds, be it in connection with regulation of hedge funds or the absence of it, the risk of the mis-use of inside information by hedge funds (witness the SEC's investigation in the Movie Gallery case which featured on the front page of yesterday's New York Times), the well publicised difficulties of Amaranth, or the risks posed by an industry that has become so dominant that it accounts for roughly half the trading on the New York and London Stock Exchanges. It is important to emphasise that the FSA does not and is not seeking to authorise and regulate the funds themselves which are outside our jurisdiction. Rather, we believe we can mitigate the risks through our existing authority over hedge fund managers and broker/dealers who provide prime brokerage services to the funds.
Of particular interest to us in Enforcement is the FSA's belief that some hedge funds may be testing the boundaries of acceptable practice with respect to insider trading and market manipulation. In addition, given their payment of significant commissions and close relations with counterparties, they may be creating incentives for others to commit market abuse. Characteristically, our main response has been on the surveillance side and we have recently devised metrics to measure the incidence of unusual price movements in order to see if this belief is correct. However, we have also used our enforcement powers against hedge funds acting improperly on our markets, most notably in the GLG case.
The FSA's initiative aimed at Treating Customers Fairly is a prime example of the FSA's strategic shift to more principles based regulation. This initiative is of great importance for retail financial markets in the UK and is directed at improving the outcomes for consumers in these markets.
Through this work, we hope the industry will move to a position where consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture. Although much of this work is done through supervision and education the TCF agenda is also keeping the Enforcement Division very busy.
As I hope is evident, in the UK Enforcement is a small part of the regulatory relationship. It is used strategically, for the most egregious cases and where necessary to protect the markets and consumers. We put great emphasis on the messages sent out to the markets through careful selection of cases and leverage off the publicity they generate.
However, the potential impact of Enforcement action is very significant and my Division generates more publicity (good and bad!) for the organisation than any other area. Our enforcement outcomes play a very significant role in educating the industry and consumers about issues of concern and the FSA's approach to them. They can also be a very powerful way of changing behaviour and achieving effective deterrence more generally, which is what Enforcement activity is all about.
So, what can the FSA do to enforce the provisions of FSMA (and certain other Acts), as well as the Principles and rules it issues under FSMA?
We are able to prosecute insider dealing and market abuse in the criminal courts as well as breaches of the "perimeter" (when people conduct regulated activies without authorisation). And we can bring cases in the civil courts to freeze assets and to restrain unauthorised behaviour, amongst other things.
But these types of cases are rare compared to the cases we bring through our own regulatory proceedings. Our own procedures enable us to impose unlimited fines, to alter or withdraw a person or a firm's ability to conduct regulated activities, or even to prohibit (ban) them from the industry altogether.
There are a variety of reasons for regulatory cases making up such a large majority of our cases, but I see the main reasons as being the greater scope they offer for establishing breaches, the lower evidential standards that apply and the consequent lower (but not low!) litigation risk they involve and the greater prospects of settlement they hold out.
The FSA actively looks for new ways to make sure its penalties bring about the deterrent effect the FSA wants to achieve. This means considering not only the types and levels of penalties the FSA imposes but making sure that the penalties impact upon the right people.
It also means acting with confidence and resolutely taking Enforcement action where appropriate to convince wrongdoers that there is a real risk that they will be caught and proceeded against. Sometimes it means taking important cases, recognising that they will be difficult to fight and that we may not win.
The Enforcement Division also supports the FSA's strategic shift to more principles based regulation. Where appropriate, the FSA can and does take Enforcement action on the basis of principles alone and this trend will grow.
I did promise at the beginning of this speech that I would acknowledge that there are some things we in the UK and we at the FSA might be considered to do less well and where we might learn from the way things are done here in the United States.
It is clear to me that the authorities in the US, particularly in recent years, have been very successful in prosecuting major corporate scandals and, in so doing, recognising that those at the heart of those scandals are criminals and deserve to be brought to justice. Eliott Spitzer's efforts here in New York are particularly well known, but they are only part of the picture. I know that the SEC and the DOJ have also obtained criminal convictions in a number of insider trading cases, some involving hedge funds. With the SEC's Head of Enforcement giving testimony before the Senate Committee on the Judiciary only a few weeks ago it is a subject that is very much in the spotlight.
In the UK we have the Serious Fraud Office, whose sole role is to investigate and prosecute serious and complex fraud and who conclude in the region of ten such trials a year.
As far as the FSA is concerned, we have successfully brought a number of prosecutions against people who have acted without appropriate authorisation, but we have only used our criminal powers against someone who has committed an offence on our markets once – that was last year when we successfully prosecuted Directors of the AIT Group, for 'criminal market abuse' (making false and misleading statements in violation of section 397 of FSMA).
However, while some notable victories have been achieved in the UK – for example, the City Slickers prosecution by the DTI and convictions arising from the Guinness trials - overall, successful prosecutions of so-called 'white-collar' criminals are sparse.
There are clearly some cultural and environmental differences between our two countries which perhaps, in part at least, explain our different appetite for prosecution of major corporate and financial scandals.
First, for the last ten years or so, after the scandals of the early 1990s most notably BCCI and the Maxwell Pensions Funds, we have been enjoying a relatively quiet time on this front, perhaps because the economy has generally been buoyant.
Second, looking across from my side of the Atlantic, there appears to be a greater public support in the US than in the UK for seeing alleged corporate fraudsters and financial wrong-doers prosecuted in the criminal courts and, indeed, a greater willingness of juries to convict.
Finally, plea bargaining and the giving of 'state's evidence' by accomplices – in the UK we call this giving 'Queen's evidence'. This is a practice that is explicitly recognised in US criminal legal practice and, as such, is a valuable tool for obtaining convictions of all manner of offenders. By contrast it is not a practice that is formally recognised in our system and is not one that, traditionally, the legal establishment has approved of. Over 350 years ago Chief Justice Hale, expressed his distaste for pleas of approvement (the term used at the time for granting immunity from prosecution to accomplices willing to give evidence for the Crown):
"The truth is that more mischief hath come to good men, by these kinds of approvements by false accusations of desperate villains than benefit to the public by the discovery and convicting of real offenders…"
How much sympathy would that view find in the US? Although I certainly agree that the potential benefits of using Queen's evidence must be weighed carefully, on a case-by-case basis, with the potential risks, I do not necessarily share Chief Justice Hale's distaste for the practice in principle.
But, as I said earlier, the FSA has very wide responsibilities and limited resources and we take a risk-based approach to applying our resources in enforcement cases. From a risk-based perspective we often feel it is a better use of our scarce enforcement resource to seek a quicker and less uncertain regulatory outcome. It is not as if the consequences of our own regulatory proceedings are not serious. As I have said we ban people from the industry, for life if necessary, and we have unlimited fining powers.
Nevertheless, the FSA has stated publicly that, despite the well documented difficulties of criminal prosecutions (some of which the SEC's Head of Enforcement outlined in her recent testimony on Capitol Hill) there are some cases where this route is the appropriate course and we expect to bring more criminal cases going forward.
Conclusion
So, to conclude, I propose to you, ladies and gentleman, that "Nobody does it better" (than the FSA).
I believe that our light-touch approach to regulation, with its growing emphasis on principles, backed up by bold and strategic enforcement action, is highly effective.
I would point to London's current success on the global stage as irrefutable evidence of this but we also know that we are not perfect. This is a competitive world and we don't intend to rest on our laurels.
Thankfully for me, as this is not a debate, I am relieved that my proposition will not be tested here tonight by a vote.