Towards Fairer outcomes for consumers through principles-based regulation
Speech by Katherine Webster, Manager of the Unfair Contracts Team, FSA
at The Building Societies' Association Legal Forum
11 May 2007
Many thanks for inviting me to join you here today. I am going to speak to you about our move towards more principles-based regulation and how we are shifting our focus from regulating processes to achieving improved outcomes for consumers. I will then talk about an example of more principles-based regulation in practice – our treating customers fairly initiative. I will also talk about how we work with stakeholders through, for example, the work of my team on unfair contract terms and give some examples of how we take that forward in practice referring specifically to Mortgage Exit Admin Fees and Payment Protection Insurance refunds. Finally I will talk about how a more principles-based approach to regulation affects our approach to enforcement action. I hope there will be time for questions at the end, but if you want to stop me at any point for an elaboration of any of the points I make, then please do.
More principles-based approach to regulation
To begin, let me explain why we are moving to a more principles-based approach to regulation. There are two main reasons for this.
Firstly, we want a stronger focus on the outcomes that really matter – by that I mean better outcomes for consumers, better outcomes for investors and better outcomes for markets. This will achieve better outcomes against our four statutory objectives. It is important to stress here that we are not changing our Principles and other high level requirements – the move to a more principles-based approach is absolutely not about any lowering of the standards we are seeking to achieve, it is about a new approach to achieve higher standards of behaviour.
Secondly, we believe that a more principles-based approach should deliver these outcomes more effectively, in particular by emphasising the responsibility of the senior management of firms to engage with the Principles and to ensure that their firms deliver outcomes that meet these high level requirements.
Principles and detailed rules
You will all be familiar with the FSA's 11 Principles for Businesses. They have been in place since 2001, and they have their origins further back in the rules of our predecessor regulators.
Our Principles are themselves rules. As lawyers, this might seem obvious to you, but we have found some misunderstanding over their status. Some have suggested that these are ideals or aspirations – well they are not – they are rules. They articulate the outcomes we require firms to deliver.
We currently have, and will continue to have, a hybrid approach that combines both high level requirements and detailed rules. But, where possible, we will move towards fewer detailed rules. Lawyers have tended to be the most sceptical of our shift towards principles-based regulation. As a lawyer myself I understand some of the concerns raised so perhaps I can explain some of the limitations of relying on detailed rules.
Detailed rules have not always delivered the outcomes they were supposed to achieve. This is because detailed rules cannot cover all circumstances and eventualities. We cannot hope to devise a set of detailed rules to cover all types of business and all types of firm; and we cannot expect detailed rules to be responsive to market innovations and structural changes. A rule-based system will always be trying to catch up with the marketplace. Too often regulators are drawn into tackling problems by shutting the stable door after the horse has bolted – writing yet more detailed rules to address yesterday's problems.
Detailed rules also tend to address processes, not outcomes. This can encourage a narrow approach to compliance – a focus on the letter of the rule not the spirit.
For example, detailed rules have not been successful in preventing major mis-selling episodes in the UK such as personal pensions, mortgage endowments, split capital investment trusts and ‘precipice bonds’. We have consistently seen examples of firms giving poor quality advice; selling complex, opaque products to consumers without fully identifying or explaining the associated risks; and providing unclear product information.
So our approach is to tackle the root causes. That is why we want to shift the balance more towards high level requirements and away from detailed rules. And we want to make this shift not only in terms of regulatory architecture, but also – and more importantly – in the way that both we, and firms, behave. As such, a more principles-based approach challenges both firms and regulators to focus on the outcomes that really matter.
We will not move completely away from detailed rules. In some cases detailed rules are, and will continue to be, the best way of delivering a regulatory outcome. For example, consumers may benefit from us requiring firms to prescribe the way in which firms provide key information to them. And we must consider the impact of the European policy agenda. Much of our policy work is driven by the requirement to implement European Directives, which are often highly detailed and prescriptive.
So we will retain a mixture of high level requirements and detailed rules.
An example of using high level requirements and detailed rules in practice
A good example of this approach in practice comes from my own team, the Unfair Contract Terms team. My team deals with contract terms – an area which, as lawyers, you will doubtless feel at home with! The FSA is not a 'contract approval authority', however, it will take action when unfair terms come to light – and this may be through dealing with individual consumer complaints, through the work of FSA supervisors or through thematic work in relation to a particular product, such as early repayment charges; or a particular type of contract clause, such as variation clauses.
The team has a range of means available to it, of dealing with unfair terms. Principally, we exercise the FSA's powers under the Unfair Terms in Consumer Contracts Regulations 1999. The Regulations give us the power to seek an undertaking from a firm. The firm will undertake to operate an unfair term in any existing contract in a way which is fair and to amend the drafting of future contracts so that they are fair. If necessary, the FSA can seek an injunction against the firm to prevent that firm relying on an unfair term. We have never felt it appropriate to use our injunctive powers to date.
We don't expect firms to focus solely on the strict letter of the law, we also want them to embrace the spirit of it. As lawyers, it is tempting to get caught up in detailed legalistic arguments, for example about the interpretation of the paragraphs of schedule 2 to the Regulations, and lose sight of achieving fair outcomes for consumers. Schedule 2 to the Regulations sets out an indicative and non-exhaustive list of terms which may be regarded as unfair. Just because a term may not offend any of the terms listed in schedule 2 to the Regulations, does not in itself remove the risk of unfairness. Firms need to assess whether terms are unfair using the Regulations as a whole and in the context of the particular product or service. Regulation 5 provides the overarching test of fairness in the Regulations. In addition, there are other fairness measures in place and the team can and does draw upon these. They include the 11 Principles for Businesses and, looking to the future, we have the forthcoming legislation pursuant to the Unfair Commercial Practices Directive which will prohibit unfair practices by businesses in their dealings with consumers.
More principles-based approach – senior management responsibility
The primary responsibility for delivering a more principles-based approach rests with each firm's senior management. We expect senior management to focus on the Principles and the outcomes we want them to deliver, and determine how to apply them in practice, in the particular circumstances of their particular firm, consistent with their commercial objectives. This has to be a dynamic approach – as firms and their business models change, so too do the implications of the Principles for the day-to-day behaviour of firms. Firms should have the scope to compete and innovate while meeting our requirements; and the scope to compete by exceeding our minimum requirements.
So, what do we expect of senior management in firms? Senior management – including the board of directors need to:
- Understand and engage with our desired regulatory outcomes, to determine how to exercise the flexibility offered to them under a more principles-based approach, and to set the direction and culture of their firms accordingly. We expect to see firms making use of the increased freedom provided by principles-based regulation, while still delivering proper standards of conduct.
- Ensure that any changes needed to ensure the shift to consistent delivery of outcomes are embedded throughout the organisation.
- And satisfy themselves that they are delivering at least the minimum standards required by our Principles and other high level rules. Measurement and effective management information are central to this. It is essential that senior management are confident that their aspirations and objectives are being delivered in practice throughout the organisation. If this delivery is important to the firm – and it certainly ought to be – then it would be very surprising and worrying if a firm was not measuring this.
Each of you, as commercial legal advisers to your firm's senior management, can advise them on how best to achieve this within the particular circumstances and particular business model of your firm.
Treating Customers Fairly
An example of our principles-based approach is our Treating Customers Fairly initiative, or TCF as it has become colloquially known. This is a key element of our strategy to make retail markets work more effectively and thus to deliver benefits to consumers.
The requirement that firms treat their customers fairly is of course enshrined in the sixth of our Principles, which states that 'A firm must pay due regard to the interests of its customers and treat them fairly.'
Notwithstanding this obligation, our work in the retail market has consistently found that some firms do not treat their customers fairly. As mentioned earlier, my team reviews contract terms that are referred to it and, through its work, sees many examples of deficiencies in firms' standard form consumer contracts. We see this as an example of how the FSA's Treating Customers Fairly initiative has failed to take hold in a specific area. It is worth remembering that a contract defines the relationship between firm and consumer and fairness of terms in consumer contracts is an important part of treating customers fairly throughout the whole product life cycle.
To address such failings, and given the limitations of detailed rules, we decided four years ago to focus more on the Principle – Principle 6 – itself; to highlight the areas where customers were vulnerable to unfair treatment; to encourage firms to challenge themselves to ensure that they do treat their customers fairly; and to stress the responsibility of the senior management of firms to deliver this.
We therefore challenged firms to identify any shortfalls against meeting our high level requirements in this area; to draw up and to implement plans to address any shortfalls; to embed the necessary changes throughout their business; and to measure the outcomes.
Our overall goal is to ensure that all firms treat their customers fairly in all parts of their business and throughout what we call the 'product life-cycle' – product design, marketing and promotion, sales and advice, after sales information, and complaints handling. We want to see a real and measurable change in the behaviour of firms towards their customers. And this in turn should lead to real and identifiable benefits for consumers.
The focus of our TCF initiative – which mirrors our overall move to a more principles-based approach – is that it is outcome focused. We are determined that firms focus on the things that really matter for consumers. Last July we articulated six consumer outcomes, built around the product life-cycle, which explain what we are trying to achieve through the Treating Customers Fairly (TCF) initiative and the behaviours we wish to see exhibited by firms. These are:
- Consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture.
TCF is a cultural issue. As such, we expect it to be driven from the top, and from all firms we expect demonstrable commitment from senior management. Putting consumers at the centre of the corporate culture means that rather than simply being about process, TCF should translate into practical outputs in the shape of fair outcomes for consumers. - Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly.
Products and services need to be designed with the intended market in mind. Equally, it is important they are targeted appropriately, to minimise the risks that the marketing might lead those for whom they are unsuitable to buy them. - Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale.
Clear communication is a key component of a firm's approach to TCF as well as to Principle 7 – paying due regard to the information needs of consumers and communicating information to them in a way which is clear, fair and not misleading. I feel it is about time I mentioned the law again – as you will be aware that there are legal obligations in this area. For example, there is common law which seeks to protect against particularly onerous clauses being hidden in the body of a contract without attention being drawn to them. - Where consumers receive advice, the advice is suitable and takes account of their circumstances. Delivering suitable advice – where a firm has chosen to offer it – is a key component of TCF as well as Principle 9: ‘A firm must take reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely upon its judgement’. Where consumers have obtained a recommendation, the advice must reflect their needs, priorities and circumstances.
- Consumers are provided with products that perform as firms have led them to expect and the associated service is both of an acceptable standard and as they have been led to expect.
We want firms to be clear about what product or service is being provided and the range of possible results and experience for the consumer. Consumers can be fairly treated even if the product they purchase performs poorly, but there can be fairness issues where the consumer is misled about possible performance or is led to expect a different standard of service to what is received. - Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint. Post-sale barriers can be cultural, contractual or competitive. The consumer ought to be able to switch providers without incurring excessive penalty. Similarly firms should not make it unnecessarily difficult for consumers to make claims or make a complaint.
Whilst we have seen some progress, some firms have failed to respond to the challenge presented by our Treating Customers Fairly initiative. There is some way to go before the senior management commitment seen and the work invested in the Treating Customers Fairly initiative overall fully reaches the front line and is translated into significant improvements across the full range of outcomes for consumers. We will be making an assessment of how far firms are performing against these outcomes in autumn this year.
Increased range of regulatory materials
To assist firms, for example in making further TCF progress, and generally as we move to having fewer detailed rules, we are developing a range of regulatory materials to supplement the Principles and other high level requirements. We want to help firms and their senior management understand the outcomes we are seeking to achieve, and to make this predictable. So we are providing examples of good and poor practice, case studies and other materials to illustrate ways in which firms have successfully met our requirements.
We see these materials as a means of helping the senior management of firms, with you advising them, to think for themselves about how best to meet our requirements within the specific circumstances of their own activities and business models. And, by publishing real life examples of practice on either side of a minimum standard, firms can see how to draw the line between what is, and is not, acceptable.
One source of material is the undertakings that we publish under the Unfair Terms in Consumer Contract Regulations. We – the FSA – have a duty to notify the Office of Fair Trading (OFT), the lead enforcer under the Regulations, of the undertakings we receive. In turn, the OFT has a duty to publish details of these undertakings, which it does on its Consumer Regulation Website. Our policy is to also publish any undertaking and its details on our website. Both publications will name the firm and identify the specific term and the part of the Regulations which relate to the term’s fairness. Guidance at 20.5 of the Enforcement Chapter of our Handbook requires firms to remain alert to undertakings or court decisions concerning other firms since these will be of potential value in indicating the likely attitude of the Courts, the FSA, the OFT and other qualifying bodies under the Regulations to similar terms or terms with similar effects. To date, we have published 19 undertakings and I would encourage you, as legal advisers to your firm's senior management, to review them against your own firm's contracts.
We are also looking to encourage and facilitate greater use of industry codes and guidance, both to help firms to consider how to meet our regulatory requirements and to provide firms with some assurance and predictability that if they follow such codes and guidance then they will meet our minimum standards in that specific area. There are significant challenges here and we issued a Discussion Paper back in November last year to invite comment and debate around them. The paper outlined that we do not intend simply to replace our rules with codes and guidance issued by trade bodies. Nor are we 'outsourcing' the setting of minimum standards to industry – the minimum standards remain as stated in our own high level requirements and detailed rules. However, we do see appropriately formulated industry codes and guidance as a means to help firms understand how to comply with our high level principles. I should pay tribute here to the work of the Building Societies Association (BSA), as I know that there are working groups, seminars and workshops run frequently to share good practice, indeed inviting me to speak to you today is itself an indication of how engaged the BSA is.
The move from detailed rules to a range of different regulatory materials is challenging and we accept that interpreting how our Principles and other high level requirements apply in particular situations is not always easy. A number of questions have arisen in this context.
What is the status of our various materials? Should we formally consult on them and undertake a cost benefit analysis? How do we determine the right amount of materials to publish, given the requests for more detail from some firms, while others would prefer us to 'leave it to them'? And, within this, how should we determine the best approach among guidance, case studies, illustrations of preferred outcomes or statements of good and poor practice?
We will work closely with trade bodies, and with other stakeholders, to develop clear and helpful answers to these questions. And we need to be careful here to focus on helping firms to meet the minimum standards contained in our high level requirements, not to suggest that all firms should be striving to meet much higher standards, and not to publish 'proprietorial' good practice that firms have developed to give themselves a competitive advantage.
More principles-based approach – working with stakeholders
Taking a more principles-based approach will lead to us working even more closely with stakeholders. We need to have 'grown-up' conversations with firms, trade and consumer associations, public bodies and other stakeholders to reach pragmatic solutions across the industry. You will be well aware of the work we did on Mortgage Exit Administration fees (MEAFs). This is a good example of our approach.
MEAFs
We responded to concerns that these MEAFs had been increased unfairly, so consumers were being charged higher MEAFs than they hade expected to pay.
We took the view that if a MEAF term is drafted to enable the lender to recover the cost of the administrative services which a lender provides when a customer exits the mortgage, the lender should ensure that the MEAF represents in fact the costs of the lender's administration services. Also, an increase to a MEAF based on an increase to such costs will only be fair if it is demonstrably in proportion to the increase in those costs. If a lender cannot show this, then it is possible that any increase to the MEAF on this basis would be in breach of contract. Furthermore, the MEAF must be expressed in plain and intelligible language.
Resolving this issue individually with each lender would have had significant timing and resource implications. Instead, we worked with the Council of Mortgage Lenders to reach a practical solution which formed the Statement of Good Practice on MEAFs, which we published in January of this year. Thanks also to the Building Society Association who, although not involved in drafting, did follow progress as the Statement and the solutions it set out were formed.
In the Statement, we broke customers down into three categories – past, present and future.
For current customers, we said we would be unlikely to investigate further any lender that reasonably adopted and implemented one of the outcomes which would lead to a MEAF that is equal to or less than the original MEAF by the end of February. The original MEAF will usually be the MEAF that was disclosed to the customer when they entered into the original contract, took out a further advance or changed their mortgage product. As a result, more than 95% of lenders have chosen to charge current customers a MEAF that is equal to or lower than the original MEAF. And, as we indicated we would in the Statement, the FSA has asked lenders that have opted to charge current customers more than the original MEAF to justify their position. We are currently reviewing lenders' responses to this and, where lenders are unable to justify their position, will take further regulatory action.
We expect any lender that receives a complaint from a past customer to treat that customer in the same way they would treat a current customer in the same situation. While we did not have the power under the Regulations to require lenders to pay compensation to customers, past customers may choose to complain to the lender and to seek compensation. So for example, if a lender opts to charge its current customers their original MEAF, then if a past customer who has paid a higher MEAF to exit complains he or she can expect a refund of the difference between the actual MEAF paid on exit and the original MEAF. The FSA requires lenders to deal with complaints from customers in connection with MEAFs in line with the relevant rules and guidance set out in the Dispute Resolution: Complaints (DISP) manual of the FSA Handbook (where they apply) and with the principles set out in the Statement. The FSA has liaised with the Council of Mortgage Lenders about this and the CML placed text on its Website for its members to remind them of this.
For future customers we said in the Statement that we would be less likely to take action against a lender who has decided whether it will be amending its MEAF terms and MEAF amounts in light of the principles contained in the Statement (and if so how) by 31 July 2007, and has applied these terms and amounts (if applicable) by then.
PPI
Another example of where my team has worked closely with the industry is on the work on refunds of single premium payment protection insurance. We were particularly concerned with terms that prevented consumers from receiving any refund of the premium if they wanted to cancel the PPI policy for any reason. For example, if they repay the associated loan early, are no longer able to claim under the insurance, or simply do not want to have the cover any more. We called these types of terms 'nil refund terms'. We were also concerned with the fairness and transparency of refund terms.
By working with the relevant trade bodies and focusing on treating customers fairly, we were able to agree a series of measures using a range of regulatory tools. The measures included firms amending nil refund terms in new contracts and not relying on nil refund terms in existing contracts, to meet the requirements of the Unfair Contract Terms Regulations. The measures also covered firms contacting existing customers with contracts that contain nil refund terms to inform them of how the firm will apply the term in the future. Further, if firms need to reissue the associated loan because their systems don't allow them to cancel the PPI on its own, it was agreed that firms should treat their customers fairly when considering what terms they reissue the loan on.
And, we were particularly encouraged at the extent to which they are engaging with TCF when the trade bodies themselves proposed that the transparency of refund terms could be improved by stating examples of the refunds in the contract. But for some firms, stating examples of refunds that consumers will be given has implications for the amount of capital required by the firm to cover our capital adequacy rules on provisioning. In order to help firms achieve this transparency, we worked with the industry to set up a waiver by consent so that firms (who meet certain requirements) can include examples of refund amounts or provide a table of refunds in their contracts without being adversely affected by our rules. We view this as a good example of how working closely and collaboratively with relevant stakeholders and taking a pragmatic, more principles based approach, we can achieve 'real-world' outcomes.
Relationship with OFT/FOS
We also work closely with the Office of Fair Trading on issues connected with unfair contract terms and other areas where there are shared interests. We estimate that there are 19,000 firms which are regulated by the OFT and ourselves. The fact that the FSA and the OFT operate under different pieces of legislation which have different objectives and detailed provisions makes it inevitable that there will not be a common approach on all issues, however we do engage in close collaboration to ensure that policy and rules in areas of overlap are consistent and complementary and cost-effective for jointly regulated firms.
Some observers have asked for more clarification on how arrangements for the Financial Ombudsman Service (FOS) relate to our TCF work and whether it would be for the FSA or the FOS to determine whether a firm has acted fairly. FOS was established in line with our duties under FSMA. While the detailed arrangements under which the FOS operates are set out in rules we made, FSMA provisions specify certain terms. In particular, the FOS must determine a complaint by referring to what is fair and reasonable in all the circumstances of the case. That is a judgement for the FOS, but our rules clarify that in reaching a judgement in a particular case, the FOS should take into account relevant regulations, regulators’ rules and guidance and standards.
As we have noted, our TCF work focuses mostly on the culture of a firm and its systems and controls for delivering fair treatment for customers in general. The FOS applies a different test, and is concerned specifically with the question of resolving whether an individual consumer has been treated fairly in the context of a specific transaction. An adverse finding by the FOS in a particular case may not be definitive proof of a breach of an FSA rule. It could reflect an isolated incident, error, or oversight, by the firm, rather than a wider TCF failing. In a non-zero failure regime, mistakes can be made and the FOS is there to ensure that such mistakes are corrected and appropriate remedies are given.
More principles-based approach – effect on enforcement
Turning now to enforcement and how principles-based regulation will affect our approach.
Firms have expressed concerns that enforcement action based on breach of a Principle exposes them to the danger that a more principles-based approach will lead to more enforcement against minor failures to meet our Principles. We are not looking to take more enforcement actions for their own sake, and we are absolutely not looking to catch firms out by finding some aspect of their behaviour that falls slightly short of meeting our requirements. Where we find that a firm is failing to meet a Principle, we will consider the most suitable course of action. In many cases, we will agree with the firm a means of addressing any shortfall. But where a firm has not responded to indications of a problem, has failed to identify shortcomings and to develop a strategy to remedy them, and has committed a serious breach of a Principle, then we will certainly consider taking enforcement action. But we do not expect to take enforcement action if we see that firms have made a genuine attempt to deliver on what our Principles mean for them and there has not been significant risk or actual detriment against our statutory objectives.
Secondly, it has been suggested that enforcement action might be based on an interpretation made long after an event which imposes a standard of behaviour which was not current at the time of the event. The fear of retrospective imposition of standards is not a new issue. We recognise that firms need to be able to know, at the time when they take an action, whether that action could expose them to the prospect of enforcement action because it is a breach of our rules: in short, we need to establish a condition of predictability. Adherence to our own or appropriate industry materials can provide a 'sturdy breakwater' for firms' protection. But when that condition of predictability has been established, it will be entirely legitimate for a breach of a Principle to entail consequences, including enforcement action, for the firm or individual committing the breach, even when no detailed rule has been broken.
Conclusion
In conclusion, while we don't expect principles-based regulation to result in more enforcement action, we also don't expect it to result in any less. We expect firms to 'grasp the nettle' of moving towards more principles-based regulation and for senior management to take responsibility for ensuring it flows throughout the firm, resulting in the outcomes for consumers I have outlined today. We very much look forward to working with you as stakeholders in the future. Thank you for inviting me to speak and for your time in listening to me today.