High anxiety: how the new financial regulatory regime will affect lawyers

Nerves are mounting over the ‘twin peaks’ financial regulation regime which could see accountants grabbing top-end advice work

Students slogging through law school two decades ago spent far more time than their lecturers would have liked glued to the TV phenomenon of the era – David Lynch’s Twin Peaks.

Those who still managed to qualify and then move into financial services regulation practice will have been experiencing a Lynchian dose of deja vu in the past few days as a groundbreaking regime fell into place.

‘Twin peaks’ regulation has arrived in the UK, with the combined affects of the still-reverberating financial crisis and a litany of homegrown retail disasters delivering a coup de grace to Gordon Brown’s baby, the Financial Services Authority (FSA). And the two-headed beast replacing it may pose far more of a threat to law firms’ bottom lines than its predecessor – with forecasts that only the big four accountancy practices will be able to tame the monster on behalf of increasingly vulnerable and beleaguered banks and other financial institutions.


Bean-count on it

Specialist lawyers fear that splitting conduct from prudential regulation will drive the big players needing to manage high-risk so-called ‘bet the farm’ issues into the arms of accountants.

As one specialist lawyer commented when the new regime kicked into gear at the beginning of this month: “Almost all law firms are going to struggle because there are so many accountancy issues involved.”

Others suggest the restructuring of UK financial services regulation – borne out of a wide acknowledgment that the FSA dropped the ball in its last few years – will trigger a profound realignment of specialist departments within firms. And some maintain that a whole raft of mid-tier City players will have to refocus their practices or bail out of the field all together.

Amid this uncertainty over the impact on specialist legal practice there are profound concerns over the impact on clients. Critics claim that the much-touted regime is a muddy soup of overlapping rules that will do little more than create a self-perpetuating regulatory bureaucracy, funded by increased costs for a struggling financial services sector.

Corporate bodies are not the only clients viewing the regime with trepidation – individual City high-fliers should also be concerned. Lawyers maintain that now ministers have got the twin peaks system in place – which itself reinforces the trend for increased fines on individual executives deemed to have crossed the regulatory line – they will ramp up their efforts to legislate for criminal sanctions on Square Mile bad boys and girls. Indeed, the prospect of jail time for what used to be the red-braced sons and daughters of Thatcher may not be far off.

Third party

What are the twin peaks on the new regulatory topographical map? Well, before answering that question it is worth pointing out that specialist lawyers say the issue is confused right off the bat by what is actually a three-peak regime.

The two frontline regulators – the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA) (see box) – are overseen by a third peak that has had far less publicity, the Financial Policy Committee. But that body will not interact directly with financial services businesses and their lawyers, as it will focus more on macro-prudential issues in the market.

So it is the FCA and the PRA – given life by the Financial Services Act 2012 – that are preoccupying minds in the days after implementation. Put simply, the FCA will regulate the conduct of retail and consumer businesses, aiming to prevent another payment protection mis-selling fiasco, while the PRA is a subsidiary of the Bank of England, tasked with regulating the big beasts and, arguably, preventing another Northern Rock or HBOS.

While law firm specialist departments have a multiplicity of concerns about the practicalities of the new regime for their clients, they are also concentrating on the impact on themselves. An initial, short-term benefit is welcomed, as implementation has translated into increased instructions. Firms catering to large corporate clients as well as individual financial sector executives say instructions have been flowing through the door regularly in the run-up to implementation.

“Our job is about change,” says Roger Tym, a retail financial services partner at Hogan Lovells. “If things never changed there wouldn’t be much for us to do. In relation to this, there has been work around the ‘what might happen’ phase, the ‘what will happen’ phase, and the ‘it’s happening so we’d better do something’ phase.”

At the other end of the spectrum is Harvey Knight, a contentious financial services partner at Withers. Before joining the City, private client specialist Knight spent a decade at the FSA’s general counsel division. He points out that even before twin peaks emerged, the regulatory focus was moving towards holding individual executives to account. Of the new regime, he forecasts simply, “At both an individual and corporate level, more legal advice is going to be required.”

Divide and conquer

While the fees are now rolling through the doors of large City players and more niche practices, there are concerns over the longer term implications for department structures. It is anticipated that some specialist firms will split their existing across-the-board financial services teams to mirror the regulators’ split between conduct and prudential issues.

Comments one top-tier specialist practitioner: “There’ll be people who work on a lot of products, distribution and alliances – the outward-looking side. Then others who focus on capital and systems of control – the internal side. So whereas in the past they all worked on FSA work, now they might realign informally as FCA and PRA.”

Tym maintains that top-10 firms will not be forced to change their departmental design to reflect that split, but the mid-tier practices – which currently do some regulatory work but do not have large specialist teams – could face hard choices.

“The impact on them could be either to grow their teams to be able to advise across the board or to go the other way and be more niche, focusing exclusively on one side or the other,” he adds.

Alternatively, say some commentators, the mid-tier firms may be forced to bail out of the practice area entirely. Predictably, lawyers at those mid-tier firms disagree.

“I don’t envisage separate departments by regulator,” comments Richard Everett, a financial regulation partner at Lawrence Graham, who is also a former FSA in-houser, having been a senior legal adviser to the authority’s regulatory decisions committee. “Rather, any specialism beyond regulatory issues is likely to focus on banks or insurers, much as happens now.”

Nonetheless, others claim mid-tier departments could struggle. Exacerbating the issue is an anticipated push by the global accountancy behemoths to lure the big banks and other financial institutions away from law firms, promoting the argument that prudential issues are all about numbers – and lawyers can’t count.

“Prudential issues tend to be matters at the front of the minds of large accountancy firms,” comments Knight. “So the large financial services businesses might soon start thinking about getting into bed or closer to one of the Big Four or other large practices.”

He goes on to predict that mid-sized law firms will hope to continue to pick up work from the big banks further down the food chain, “but they won’t be on the bet-the-farm issues”.

And Knight says that the PRA has not got a monopoly on those make-or-break issues, as the FCA will deal with areas such as the ruckus over PPI schemes, which ultimately was not so much ‘bet the farm’ as ‘the farm just burst into flames’.

“Firms will continue to try advising across the board,” says Knight, “but with major prudential issues, almost any law firm will struggle because there are so many accountancy issues involved. Ultimately, all this is good news for the Big Four accountancy practices – the prudential issues require that sort of mind.”

A right mess

Nonetheless, lawyers are applying their minds to FCA and PRA issues. They fear the regime will be a quagmire of confusion for clients.

Risk of duplication between the regulators ranks high on the list of concerns, next to worries that the two bodies will not be able to co-ordinate their activities. Lawyers maintain that ministers need to focus on areas of potential overlap and the interface between the organisations to ensure co-ordination.

“Otherwise,” adds Angela Hayes, a regulatory partner at the London office of Mayer Brown, “the regime is going to be ridiculously burdensome for the average bank if it’s answering the same questions for two sets of regulators.”

Hayes says the main problem is that the politicians who designed the structure “absolutely want to make sure that each regulator has the freedom to develop its own policy in the direction it wants to go”.

Ministers and senior regulators point to a memorandum of understanding between the FCA and PRA as a means of dealing with those concerns. But, as Tym explains, this is simplistic at best.

“It basically says we should co-operate,” says Tym.

A general lack of clarity over the ambit of responsibility of the PRA and FCA sparks specific practical concerns. For example, in the event of another mis-selling incident, lawyers say there is confusion over which of the bodies will be responsible for establishing whether a board-level executive failed – in other words, whether there was a firmwide structural failure at the highest level.

“That is a conduct issue and it all ought properly to be the role of the FCA,” argues Hayes. “But what if the FCA wants to take enforcement proceedings against a director of Barclays when that will also affect the reputation and standing of the bank? There are artificial divisions in many scenarios that can arise. Both regulators have avoided engaging on those questions.”

A failure to clarify these points is going to hit clients squarely in their profit margins, warn lawyers.

“Inevitably, for those businesses in the scope of two regulators there will be increased costs,” says Julian Burling, a financial services specialist barrister at Serle Court. “There will be two teams of people – they will talk to each other, but it’s not the same as dealing with just one team. And both the regulators have been saying that they’re going to be more forward-looking by studying people’s business models much more closely. The process will be much more intrusive – that will require more management time and therefore be more expensive.”

One of the trickiest areas of legal advice centres on financial services sector entrants aiming to engage in principal dealing. There are plenty of legal bear traps en route to answering the crucial and vexed question of whether they need to worry about the PRA as well as the FCA.

As Everett puts it: “For banks and insurers the point is clear, but for principal dealers it is less clear. They have to make a judgment call”.

Everett also flags up issues around the new regime’s approach to business model suitability and product invention. He describes both as being “novel and coming into play at a time when the political driver is for the FCA to get involved at an earlier stage on a judgement basis. The previous regime was more rules-orientated, while this one will be less predictable for businesses and their advisers.”

Personal injuries

If nothing else, the financial crisis has thrown up a rogues’ gallery – at least in the public perception – of financial services villains, from the demise in 2008 of Fred ‘The Shred’ Goodwin at RBS, to the coruscating dressing-down issued to three HBOS senior executives only a fortnight ago. Individuals are in the regulatory cross-hairs like never before.

For Knight, the most damaging aspect of a regulatory investigation of a senior executive is the attendant publicity. And under the new regime, that media circus is set to be triggered much earlier in the process.

Under the previous system – governed by the Financial Services and Markets Act 2001 – individuals in the regulatory spotlight were issued with a warning notice and then afforded the right to make written representations before a decision notice was handed out. If that second notice was issued, the business or individual could refer it to an external adjudicator for a further hearing before a final notice was delivered. Only at the point of a final notice would the FSA publicise the matter.

The twin peaks regime throws that process to the wind, allowing publicity at the warning notice stage – in other words, when the regulator proposes action, but well before the individual or firm has an opportunity to defend itself.

“From an individual’s point of view,” says Knight, “that is a big change – and not for the better.”

But perhaps more worrying are potential six-figure fines for executives and the looming possibility of criminal sanctions. The former have been on the cards for some time at the FSA, says Hayes.

“We’ve already seen the FSA seeking to impose ever-higher fines on individual directors if they can be held to account for regulatory breaches,” she says. “That trend will certainly be accelerated under the FCA because as a matter of policy it has spelled out that is the intended direction of travel.”

In addition, the Government has already embarked on a consultation about whether criminal offences should be introduced for financial services directors who fail in their duties – and the appetite in Whitehall to bang up wayward directors is thought to be increasing now twin peaks has launched.

Agents of change

Has it all been worth the effort, and past and future cost? Specialist lawyers have serious doubts despite acknowledging that the Government faced intense pressure to overhaul the regulatory system in light of dramatic financial sector disasters.

“On a cost-benefit analysis, I’m not wholly convinced,” ponders Everett.

His counterpart at Mayer Brown is more certain.

“The time, effort and expense put into the new regime has not been worth the candle,” asserts Hayes. “Any positive practical benefits could easily have been achieved by minor adjustments to the existing FSA structure.”

On the other hand, Everett says twin peaks is more than a simple rearranging of deck chairs.

“Staff won’t be doing exactly what they used to do,” he adds. “How long they will do things differently – such as the focus on early intervention, the focus on how much liquidity and capital banks have, the degree to which remuneration requirements need to be applied beyond banks – will be interesting to see. Those issues are quite overtly political. While we remain in a difficult economic environment it is difficult to see the political drivers changing. But if they do change, how much more likely are we to return to a format we were used to in the early 2000s? At the moment, regulation is as political as it’s ever been.”

An equally political issue is Britain’s relationship with the EU, and financial regulation is core to that debate.

“UK regulators still seem to have their heads in the sand about the fact that if things carry on the way they are, they are going to become toothless because of the amount of direct-affect legislation coming out of Brussels,” says Hayes. “British regulators will increasingly become a postbox that dares not opine on any issue because it will be written in an EU Directive over which they have no jurisdiction.

“It’s really unfortunate that for the sake of political ends we’ve been put through this huge turmoil for the UK regulatory structure when the reality is that the traffic is all going to be directed by Brussels.”

In the meantime, those in the financial services sector and their legal advisers will be anxiously awaiting a call from the UK regulators’ equivalent of Special Agent Dale Cooper and hoping he isn’t quite so obtuse as the Lynch original.

PRA and FCA: what the two peaks are supposed to do

By the Financial Services Authority’s own admission, the old regulator was asleep at the wheel during the global economic meltdown and subsequent British banking and mis-selling crises. Still, it has its legal profession defenders.

“The FSA has been scapegoated in a very shoddy way,” says one City lawyer. “Ok, it didn’t cover itself in glory, but it wasn’t designed in a way that would enable it to do what people thought it should do.”

Regardless, the FSA is yesterday’s breakfast and ‘twin peaks’ is the latest entry to the financial regulation lexicon. So what do the two peaks do?

Prudential Regulation Authority A subsidiary of the Bank of England, the PRA does what it says on the tin, with its raison d’être being to focus on prudential regulation and ensuring the big beasts prowling the financial jungle – banks, insurance companies and large, complex financial groups – have sufficient capital.

Its core role is to ensure that the risks those businesses are running – whether involving principal trading or carrying insurance claims – have the liquidity, capital, governance structures, systems and controls to do so.

Financial Conduct Authority Again, the clue is in the name – the FCA focuses on conduct of business. Lawyers maintain it is effectively the same as the old FSA and will focus on the integrity of the market rather than the stability of the financial system.

The FCA will investigate abuse and look at consumer protection, including client money and issues around retail sales techniques. It also aims to ensure there is adequate competition.