Briefing Note BN006/2005
20 June 2005 (updated 14 December 2005)

The Financial Services Authority (FSA) was asked to review, under the 'wider implications' process1, a recent case under consideration by the Financial Ombudsman Service (FOS), where Mr Hart, the former managing director of an FSA-regulated firm, fraudulently diverted into his own account cheques made out by his firm’s clients to a bank or building society.

The FSA examined whether the case raised wider implication issues, e.g. in respect of the banking practice of allowing cheques payable to a bank or building society to be paid into a third party's account, and whether a regulatory solution would be more appropriate than the FOS deciding individual cases2.

The FSA concluded that, although the case does raise a new wider implications issue, regulatory intervention by the FSA would not be more appropriate than the FOS deciding individual cases. However the FSA continues to be willing to facilitate discussions between the firms involved on a common agreement on compensation, and the FSA held discussions with the British Bankers' Association and the Building Societies Association with the aim of reaching an appropriate industry-led solution on improvements to banking practice in the light of the new issues raised by this case.

Does the case raise wider implications?

The wider implications process considers whether the issue is a new one that affects:

  • A large number of customers;
  • A large number of firms;
  • The financial integrity of a firm;
  • Interpretation of FSA rules or guidance; or
  • A common industry practice.

The FSA accepts that the case does raise a new wider implications issue. Although frauds such as the Hart case appear to be rare and the case itself affected only a limited number of customers, the banking practice of allowing cheques made payable to a bank or building society to be paid into a third party's account is said to be widespread; and it potentially affects a large number of customers and a large number of firms. Frauds involving this practice could damage the financial integrity of a firm.

This is a matter primarily of civil law and industry practice rather than interpretation of FSA rules or guidance, as the FSA does not generally make rules or guidance about matters of banking practice. Firms’ conduct is also governed by the FSA’s high-level systems and controls rules, although the FSA generally looks to the industry to develop and improve banking practice in the light of new issues that arise.

Should the FSA become involved?

The FSA considered whether a regulatory solution would be more appropriate than the FOS deciding individual cases; and if not, whether it wishes to offer material for consideration in individual cases being decided by an ombudsman.

In deciding whether to become involved, the FSA normally takes into account whether:

  • It needs to comment on the interpretation or application of its rules;
  • It considers the case raises material issues about existing FSA policy that require new rules or guidance;
  • It considers there has been a clear breach of a regulatory requirement, where it intends to use its powers to secure redress for consumers (including through enforcement proceedings), and where this is likely to be more advantageous for consumers for whom redress is or may be due;
  • Its powers to investigate matters that are the subject of a complaint are likely to be more effective and timely than those available to the FOS; or
  • It is appropriate to ask the Treasury to authorise an industry-wide review under section 404 of the Financial Services and Markets Act 2000.
    Having considered some of the complaints which have been made in relation to the Hart fraud, the FSA does not think that regulatory action by the FSA is more appropriate than the FOS deciding individual cases. The FSA has not taken enforcement action against any authorised firm for regulatory breaches in connection with the conduct of Hart.

Firstly, the issue does not relate primarily to the interpretation or application of FSA rules or existing FSA policy. The potential financial exposure or liability of the banks and building societies turns partly on the implications of civil law and banking practice and partly on the particular circumstances of each transaction. There is no question of asking the Treasury to authorise an industry-wide review under section 404 of FSMA.

Secondly, it is not clear that there would be any advantage in resolving the issue through the use of the FSA’s restitution powers, having regard to the criteria for such use set out in the FSA Handbook (see section ENF 9.6). There is a limited number of persons affected, the FOS is available to consider their specific complaints, and in cases where redress is payable the firms concerned have the ability to sort out their respective liabilities between them.

Equally, there is no material (e.g. on the interpretation and application of FSA rules or existing policy) that the FSA would wish to offer to the firms involved or the FOS to help resolve individual complaints.

In summary, the FSA believes it does not need to become involved at present under the wider implications procedure, because there are other more appropriate means of resolving the cases for the benefit of the customers concerned, and for considering possible improvements to banking practice which, rather than being a matter for FSA rules, is an area where the FSA would look for an industry-led solution.

Resolution of the Hart cases

The FSA fully recognises the concern of all the customers involved about the loss of their funds, and also the concern of the banking industry that FOS decisions might have potential implications for banking practice ahead of the conclusion of the industry's own consideration of such implications. As the quickest route to resolving these concerns, the FSA therefore sees good grounds for all the firms involved to get together and come to a common agreement to resolve the issues fairly for all parties. The FSA has indicated its willingness to facilitate such discussions and continues to do so, but there would need to be sufficient appetite from the firms for such a solution. Unless or until there is a demonstrably realistic prospect that the parties can come to such an agreement, the FSA believes there is no sensible alternative to the FOS considering the complaints now before it on an individual basis.

The FSA will of course continue to take a keen interest in the outcome of these complaints, the level of awareness relating to the FOS of the customers, and whether, in dealing with further complaints, the firms concerned are complying with their obligations for the handling of complaints as set out in the FSA Handbook (eg see DISP 1.2.22R). Firms can expect the FSA to take regulatory action if at any stage it becomes clear that they are not handling complaints fairly, consistently and promptly, taking account of any settlements or FOS decisions made.

Consideration of banking practice

The Hart case does raise concerns about the current banking practice of allowing cheques made to a bank or building society to be paid into the account of a third party not mentioned on the cheque. As explained above, the FSA generally looks to the industry to develop and improve banking practice in the light of new issues raised, and is keen to work with the industry to reach a collective solution on this issue.

The FSA has therefore raised the issue with the BBA and the BSA to obtain an understanding of the risks involved and how these can best be mitigated.

In November 2005, the FSA reached an agreement with the BBA and BSA to phase out the acceptance of cheques made out simply to a bank or building society and paid into the account of a third party in most situations by October 2006, thus reducing the scope for fraud. The FSA will continue to work with the BBA and BSA to ensure that consumers have the right information to protect themselves from this type of fraud.

 

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Footnotes

1 Wider implications cases can be those where there is a widespread issue or issues which could give rise to significant consumer detriment. The Financial Ombudsman Service (FOS) is in a unique position to see such an issue arising across a number of firms, although it may also consider the implications in any one case to be of sufficient importance that the FSA’s attention should be drawn to it. Equally, the implications could indicate a possible materially detrimental effect on the financial resources of firms, or on the market in general.

2 Where a potential wider implications case is identified, the FSA can consider whether a regulatory solution would be preferable to the FOS deciding individual cases. The FSA may (for example) take supervisory or enforcement action or offer an interpretation of existing rules. More generally, the FSA may consider the need for new rules, or guidance to clarify existing ones. The FOS may suspend or terminate handling relevant complaints, depending on the stages they have reached, whilst the regulatory action is carried out. This might be done, for example, where the FSA is taking action that might result in redress being paid to consumers

The arrangements for consideration of wider implications issues were updated in March 2005 and are set out in Chapter 6 of the joint FSA and FOS consultation paper CP05/04 (FSMA 2 year review: Financial Ombudsman Service).