The principle argument

The Financial Services Authority is changing its mode of regulation relying more on its 11 Principles of Business. But can such an approach be enforced? Peter Bibby reports

The Financial Services Authority (FSA) and its predecessors have historically relied on detailed rules to regulate the UK’s financial services industry. Accordingly, firms and the regulator have been clear about what is required and when. But recently the FSA has changed its approach, relying increasingly on general principles.

The FSA’s 11 high-level Principles for Business, in place since 2001, set out the essence of its expectations for firms. The principles cover issues from market and business integrity and the management of conflicts of interest through to the protection of client assets and fair behaviour in dealings with customers. The principles are, however, currently underpinned by a set of detailed, prescriptive rules supported by guidance.

The FSA is open about its intention to become a principles-led regulator. Principles-led regulation has, however, raised concerns about a period of regulatory uncertainty and increased risk: uncertainty could stifle innovation, while the risk is that a behaviour, when judged with the benefit of hindsight by the FSA (as is always the case in an enforcement situation) may be considered in breach of a principle.

When investing in business initiatives, firms are looking for reliability and predictability, and reliance on principles is an unstable foundation on which to make decisions. The key concepts on which the principles are based, such as integrity (principle one) and fairness (principle six), are not defined by the FSA, nor are the standards (‘adequate’, ‘proper’ and ‘appropriate’) against which firms’ behaviour will be measured.

What does this mean in practice?
Some difficulties can be highlighted by the recent experience of the FSA’s Treating Customers Fairly (TCF) work in the retail sector. TCF has its roots in principle six:”A firm must pay due regard to the interests of its customers and treat them fairly.”

‘Fairness’ is not a term defined by the FSA, or by English law in general. The FSA has not made prescriptive rules to underpin the principle in this area. Although the FSA has attempted to correlate fairness with established legal principles such as equity or natural justice, it has emphasised that its meaning is not the same. The FSA has offered examples of what may or may not constitute ‘fair’ treatment in specific circumstances, but suggests that fairness is a flexible, relative and subjective concept, capable of taking on different meanings in different contexts or points in time.

Few would disagree that the appropriate treatment of customers is important. However, many will be concerned that fines or business restrictions could be based on an allegation of a breach of a vague concept. Different supervisors may have different views of what amounts to fairness and this could create an unlevel playing field. Such uncertainty risks stifling innovations in product development or promotion. It has become increasingly risky for businesses to proceed without creating a fully documented risk analysis and a full record of decisions and the reasoning behind those decisions. This costly and time-consuming audit trail will be needed to defend after-the-event allegations of a breach of principle.

The FSA’s enforcement powers
It is an established principle that for consequences legitimately and fairly to attach to a breach of law, there should be sufficient certainty so that it is possible to predict, at the time the alleged breach is committed, that it would be a breach. Although the FSA suggests that it can “illuminate” the meaning or application of a principle and improve predictability by issuing guidance (whether formally or through the use of case studies), the regulator will need to take account of its own statutory rules structure. The Financial Services and Markets Act 2000 makes it clear that guidance does not have the status of a rule and does not create an enforceable requirement. General guidance does not even have evidential effect: there can be no presumption that departing from guidance is indicative of a breach of the relevant rule (or principle).

This makes both the prosecution and defence of principle-based FSA enforcement action problematic, and it will be interesting to see what the Regulatory Decisions Committee and Financial Services and Markets Tribunal make of this approach.

The success of the FSA’s principle-led approach depends entirely on FSA staff making sound, consistent judgments. FSA staff will need significant training and supervision to ensure that they are able to operate a principles-based system, giving clear and consistent interpretations of the principles and taking proportionate decisions in the context of the industries in which they operate and the products sold. Extreme care needs to be taken to ensure that, in pursuing its aim of flexibility, the FSA does not sacrifice appropriate levels of certainty and predictability and create a legal minefield.
Peter Bibby is a partner at Bingham McCutchen