Sanctioning directors of failed banks

On 3 July, HM Treasury published for consultation its proposals on "Sanctions for the directors of failed banks", requesting responses by 30 September 2012. 

The consultation paper seeks comments on whether the Financial Services Bill should introduce a “rebuttable presumption” that the director of a failed bank was not suitable to be approved by the regulator to hold a position as a senior executive in a bank.  The paper does not attempt to define the situations in which a bank would be considered to have "failed".  The Government also asks whether there should be criminal sanctions for serious misconduct in the management of a bank, whether through the imposition of strict liability, or through new offences of recklessness, negligence or incompetence.    

The Joint Committee, which carried out pre-legislative scrutiny of the draft Financial Services Bill, had recommended [para 225] that the Government consider whether there was a need to strike a different balance between risk and return for the senior executives and managers of banks, so as to take into account the wider impacts to which failings by such individuals can give rise.  

The implications of this consultation, which is the Government's response to that recommendation, are of significance to the Boards and senior executives of banks and the proposals merit careful scrutiny.

Existing powers

The consultation paper reviews what is - initially - acknowledged to be a wide range of existing powers which can be used to hold directors and senior managers of financial institutions to account:

• the approved persons regime;
• prohibitions;
• disqualification of directors;
• deferral of remuneration; and
• cancellation of unpaid deferred remuneration in the event that performance conditions are met.

The consultation does not canvas the additional remuneration restrictions which are likely to be imposed at European level in the CRD IV regulation - including proposals for a 1:1 restriction on the ratio between fixed and variable salary, which would serve to address part of the Joint Committee's recommendation. 

The case for new measures

The consultation paper then moves seamlessly on from the suite of existing civil and regulatory sanctions, and bank directors' responsibilities under company law and FSA rules, to the conclusion that the existing measures need to be extended.

The case for new measures is alluded to earlier in the paper, and is founded on the FSA Board's analysis of mistakes made by the regulator and by the management of RBS, which led to the bank's failure.  In that case, the FSA's Enforcement lawyers had concluded that although errors of judgment and execution may have been made by the bank's Board and senior management, there was insufficient evidence to bring enforcement actions that had a reasonable chance of success in Tribunal or court proceedings.  The FSA's Chairman therefore suggested in the foreword that:

"... there is a strong argument for new rules which ensure bank executives and Boards place greater weight on avoiding downside risks.  The options for achieving this merit careful debate."

The "fundamental limitations" on holding individuals to account under the existing powers are said to be:

• the need to prove that the actions of particular individuals were incompetent, dishonest or demonstrated a lack of integrity;
• the facts that errors of commercial judgment are not sanctionable unless either
• there are clear deficiencies in processes and controls which governed the way these judgments were reached; or
• the judgments are clearly outside the bounds of what may be considered reasonable.

It is welcome that, notwithstanding the tide of public opinion and emotions generated by recent events, HM Treasury, in considering these proposals (and in particular the proposals for new criminal offences), is mindful of the fact that - when brought down to brass tacks - that complaint is really that English (and European) law starts from the premise that a person is presumed innocent until proven guilty. 

New measures under consideration

Approved person status: through Financial Services Bill or under existing powers

• A rebuttable presumption that a director of a failed bank is not suitable to be approved by the regulator as someone who could hold a position as a senior executive in a bank - to be included in the Bill; or
• Making the fact that an applicant for approval had previously been a director in failed bank a (more?) material factor in approval applications through regulatory guidance.

In practice, the second option is not really "new": the FSA is already able to take a person's success or failure in previous roles into account in its approval decisions.  In late 2008, the FSA began to introduce in-depth interviews as part of its process for assessing the competence and capability of certain candidates seeking approval to carry out Significant Influence Functions (SIFs) in authorised firms.  In April 2012, Hector Sants reported that over the last 2 years the FSA had determined 653 applications, following one or more SIF interviews.  Of those applications, 48 of those applications were withdrawn rather than pursued - according to Mr Sants, 39 of the withdrawals were "demonstrably" due to serious concerns identified by the FSA interview panel. 

The consultation paper suggests that this second option is "less satisfactory" as the onus of proof would remain on the regulator to make its case.  As the statistics cited by Mr Sants suggest, the reality is that a sponsoring firm will be reluctant to damage its credibility with the regulator or attract adverse publicity by persisting with an approval application about which the regulator has expressed "serious concerns", with the risk of an adverse decision on the approval of a SIF candidate (and particularly an external candidate).

The first option is somewhat more controversial, because although the presumption is rebuttable, the individual's right to challenge the regulator's finding would be limited under the Bill in that the Upper Tribunal would not be able to substitute its decision for the regulator's, but would be required to refer the matter back to the regulator. 

Viewed as a protective measure rather than a sanction, however, the approach finds some echoes in the provisions that exclude undischarged bankrupts and those who have failed to make a payment under a county court administration order from becoming company directors (save by court order), and also in the imposition of a duty on the court to disqualify unfit directors of insolvent companies (although in the latter case, it is still necessary to establish that the individual's conduct makes him unfit to be concerned in the management of a company).  

Some jurisdictions provide for automatic disqualification of directors (for example, Australia and Singapore, where the director has been convicted of an offence involving dishonesty).   Although HM Treasury considers the possibility of automatically disqualifying directors of failed banks from holding senior executive positions in a bank, it acknowledges that the need to provide safeguards for individuals and to ensure that requirements of fairness and natural justice are met would remove most of the advantages of an automatic approach. 

The consultation has not attempted to put forward any text for the provisions.  It is perhaps worth noting that section 6 of the Companies Directors Disqualification Act could not have been applied in respect of the rescued banks because the definition of "insolvency" does not cover the position where an insolvent company is bailed-out rather than allowed to "fail".  This highlights the importance of defining the situations in which a bank will be said to have "failed". 

There would also need to be some clarity about the kinds of positions or roles intended to be covered by the concept of  "senior executive in a bank", given the variance in size, complexity and management structures in the various banks. 

An additional issue that would need to be addressed in the creation of a rebuttable presumption is the difficulty that it could cause in terms of maintaining continuity of essential functions within a "failed" bank which was in the course of being resolved.  If the fact of a bank's failure is the trigger for the presumption, then the regulator arguably should not allow a director to continue to perform controlled functions, even at the direction of the liquidator or administrator.   Yet in most cases, some high-level continuity will be required during resolution of banks, even if proposals to parachute in an interim Board do ultimately receive regulatory endorsement.

Clarifying management responsibilities: under existing powers

• Clearer regulatory requirements regarding the responsibilities and standards required of individuals for certain key roles; or
• A requirement that the firm and the individual produce a detailed written statement of the duties and responsibilities of each role.

As HM Treasury acknowledges, the difficulty in more prescriptive rule-making which specifies responsibilities and standards for key roles is the need to cater for variations in the way firms structure themselves and allocate responsibilities.  It is for this reason that the second option - the firm-led approach - is preferred. 

The second option is not a wholly new suggestion.  In 1997, the Securities and Investments Board had suggested in its Consultative Paper 109 that firms should be required to compile and keep up to date a statement on their management structure (the requisite detail being dependent on the complexity of the organisation), providing details about the individual responsibilities of a firm's directors and senior managers.  The consultation paper had also proposed that each director and senior manager would have to acknowledge formally that he was aware of and understood his or her responsibilities.  

This requirement has already found expression in SYSC 2.2 and SYSC 4.4.3 in the FSA's Handbook.  The perceived advantage of further clarifying management responsibilities would be to make it easier for the regulator to establish causation and responsibility.

The problem for larger firms will be the difficulty of ensuring, firstly, that these statements are maintained, and kept up to date as individuals move or are promoted and, secondly, that performance is monitored and assessed against the agreed standards.  The challenge for the regulator will be how to review these statements regularly (and meaningfully), given resource constraints.  It would be disappointing if additional requirements were to be imposed solely to enable backward-looking enforcement rather than for facilitating more proactive regulatory engagement.

Change to the regulatory duties of bank directors: under existing powers

• Explicitly requiring banks to run their affairs in a prudent manner; and
• Requiring Boards to notify the regulator when they become aware that there is a significant risk of the bank being unable to meet the threshold conditions.

The FSA already has power to sanction individuals for breach of the FSA's Statements of Principle and Code of Practice for Approved Persons (APER) and can impose unlimited fines.  It is not entirely clear that what is envisaged is qualitatively very different from the duties that already apply to approved persons - and in particular SIFs - under APER:  

• Statement of Principle 2 already requires approved persons to act with due skill, care and diligence in carrying out their controlled functions'
• Statement of Principle 6 requires approved persons performing significant influence functions to exercise due skill, care and diligence in managing the business of the firm for which they are responsible in their controlled functions;
• Statement of Principle  7 requires approved persons performing significant influence functions to take reasonable steps to ensure that the business of the firm for which they are responsible in their controlled functions complies with the relevant requirements and standards of the regulatory system; and
• Statement of Principle 4 required approved persons to disclose appropriately any information of which the FSA would reasonably expect notice.

It is possible that prudence is intended to carry a rather different connotation than care (importing some notion of safety and soundness?) and that greater articulation of the regulator's expectations by way of formal guidance could be helpful for Boards - again, changes should be aimed at genuine clarification and effecting positive forward-looking improvements rather than solely at making backward-looking apportionment of blame more efficient.

Criminal sanctions: in fresh legislation

In a speech in March this year, former SFO head Richard Alderman canvassed the question of possible prosecutions of senior executives and others in the financial institutions involved in the financial crisis, suggesting that current criminal offences do not provide the necessary tools (although he did not provide any further explanation).  He appeared to be advocating the introduction of a criminal offence of recklessly running a financial institution; in an earlier interview he also appeared to suggest that the FSA was unable to bring proceedings against directors who recklessly mislead investors (although section 397 of FSMA largely covers this issue).

In this consultation, HM Treasury has canvassed a number of possibilities:

• A strict liability offence of being a director of a failed bank at the relevant time

The consultation paper acknowledges the very significant difficulties in introducing a criminal offence which involved strict liability for bank failure.  Where the prosecution is not required to prove some form of failure to meet clearly defined standards of conduct, there is a risk of imposing severe criminal penalties on individuals who were not at fault, whether because a decision, taken conscientiously and with the best of intentions, is later shown, with the benefit of 20:20 hindsight, to have been wrong, or the failure was the result of unforeseeable external events. 

HM Treasury also notes that there could be a risk that a director brought in to rescue a bank already in difficulties was unsuccessful, and therefore strictly liable, whilst a director, who was responsible for the problems, left the bank prior to failure and thus escaped liability.  In addition, the introduction of criminal sanctions - particularly on a strict liability basis - carries a significant risk of deterring the already relatively small pool of individuals eligible and willing to take board appointments in banks from considering appointments where a bank might be heading towards rescue or recovery.  For these reasons, the Government does not favour the imposition of strict liability.

• An offence of negligence - failure in a duty of care leading to a reasonably foreseeable outcome; and
• An offence of incompetence - failure to act in accordance with professional standards or practice

Although HM Treasury suggests that introducing such criminal offences would send a further message that incompetent or negligent conduct is unacceptable, it concedes that the regulator already has the ability to take action against individuals (and their firms) in such cases,  and that civil action can also be taken against individuals by the firm (or its liquidator), or by a shareholder where their negligence or incompetence causes loss.  HM Treasury remains unpersuaded that there would be any compelling advantage in additional criminal offences covering this ground, particularly since they are usually more difficult to prosecute. 

• An offence of recklessness - failing to have sufficient regard for the dangers (or the possibility of such dangers) posed to the safety and soundness of the firm in question

This is the option which the Government considers the most appropriate, as reckless misconduct involves a greater degree of fault which has been subject to extensive judicial consideration in case law.  The Government believes the introduction of such an offence would send a very clear signal and might encourage boards to give decisions more extensive consideration and possibly to obtain legal advice about whether the conduct could be considered reckless.  Even so, difficulties remain in defining what, in banking business that inherently involves risk-taking and the exercise of judgments about future developments, would amount to the taking of excessive and unreasonable risks.

More generally, however, it is clear that the Government is alive to the practical hurdles involved in prosecuting criminal offences of this kind: the complexities involved in establishing causation, particularly over a lengthy period, the need to identify those individuals connected with the failure who should be prosecuted, and potentially to extradite defendants who have left the jurisdiction, the volume of material which would need to be analysed, the prosecution's duties to disclose unused material, and the sheer time and costs involved in any criminal investigation and prosecution, let alone one involving a substantial financial collapse.  Laws - even criminal laws - ultimately have little deterrent effect if they are not enforced and seen to be enforced.

If the proposal to introduce some form of criminal offence is taken forward, the Government will not seek to shoe-horn the proposals into the Financial Services Bill, but would propose to introduce a separate Bill in the present Parliament.

Whatever proposals are put forward, it will be important to ensure that the impact of proactive interventions by the new regulators in banks' business judgments, which, it is openly acknowledged, may result in outcomes that are at "variance" to the regulator's mandate or objectives, are properly taken into account in any proposed action to sanction directors for such outcomes.