Financial Services and Markets Appendices to the Minutes of Evidence


Supplementary Memorandum by the Financial Services Authority


  1. The Committee has raised with the FSA two issues which have arisen in the course of the oral evidence which it has taken over recent weeks. In addition, the FSA wishes to take this opportunity to comment on some other aspects of evidence given and to amplify its own earlier evidence in specific areas. This note therefore covers the following topics:

    —  Market abuse (paragraphs 2-18).

    —  Destination and treatment of fine income (paragraphs 19-21).

    —  Enforcement of FSA Principles (paragraphs 22-27).

    —  Involvement of practitioners in FSA's decision-making (paragraph 28).

    —  The Consumer Panel's budget (paragraph 29).

    —  Protection of employees (paragraph 30).

    —  FSA staffing issues (paragraphs 31-46).

  The FSA's latest thinking on its internal decision making on disciplinary cases is set out in a separate note.



  2. The FSA's view is that the need for a new civil framework to tackle market abuse, complementing the existing criminal offences, is clear. There is behaviour which is capable of damaging the integrity and efficiency of markets which does not constitute either insider dealing or market manipulation under the existing criminal regime, but which it would be inappropriate to criminalise. Such behaviour may be the subject of regulatory sanctions when engaged in by the authorised community, but that community does not embrace the full range of market participants. There is thus a gap in the ability of the existing regime to protect UK financial markets and those who use them. The new regime makes clear that all those who take advantage of the organised investment markets recognised in the UK will be required to comply with the same standards of behaviour to safeguard the markets' integrity and efficiency.


  3. We believe that it is essential that the market abuse regime established under the new legislation should strike the correct balance between, on the one hand, providing flexible arrangements which can adapt to fast-changing markets and, on the other, giving market participants adequate guidance as to whether conduct is likely to fall foul of the regime. Getting this balance right is vital. That is why we have embarked on a lengthy consultation process with market participants.


  4. A number of concerns have been expressed over the uncertainty that arises from the status of the Code of Market Conduct ("the Code"). As an "evidential" Code, compliance with, or breach of, its provisions will not be conclusive of compliance with, or breach of, the statutory provisions. In principle, we would have no difficulty with a provision that made clear that the FSA could not take action to impose a civil fine for market abuse where conduct is in compliance with the Code. The effect would be to ensure that those who abided by the provisions of the Code could not be the subject of enforcement action under the general provisions of clause 56.

  5. In the same way, the FSA would favour statutory provisions that made clear that breach of the Code would amount to market abuse. A primary provision such as that in clause 56 would then become an enabling provision setting the outer limits of an FSA rule-making power in relation to market abuse. The Code would take the form of a binding code setting out the standards of market conduct. We appreciate that this would be a wide-ranging rule-making power for the FSA to have, especially as the provisions will apply to unauthorised persons. Nevertheless we think that giving the FSA's Code full, binding force would address many of the concerns that have been expressed regarding lack of certainty in the new regime.

  6. We continue to believe that it is possible to devise a Code which sets out with clarity the standards of conduct which are to be expected of all those persons who take advantage of the organised investment markets recognised in the UK. We have previously set out for the Committee the extensive consultations in which we are currently engaged with a view to revising the provisions of the Code. This process will, we believe, result in a clearer and more precise text which market participants will find it easier to apply in practice. This is the purpose of the consultative process. We believe that the Code will give Authorised Firms considerably more guidance than is currently available from the regulators as to what constitutes acceptable standards of market conduct.


  7. There has been a great deal of debate about whether the FSA should be required to prove intent before imposing a sanction for market abuse. Considerable confusion exists as to precisely what "intent" means in this context; it is a term which means different things to different people. We set out below a range of different tests which may be adopted in any rule or legislative provision and describe them in a way which may assist the Committee in understanding our approach to the Code:

    —  "Strict liability"—here liability or sanctions are imposed wherever a person commits certain acts, regardless of his state of mind at the time. Such provisions are generally used where preventing the conduct in question is considered so important in the public interest that it should be sanctioned on a "no fault" basis;

    —  Negligence—a negligence test is one which requires persons concerned to take reasonable steps to avoid particular acts or events occurring. What are "reasonable steps" is judged on an objective basis according to the standards of a reasonable person in the position of the defendant. On this test, liability or sanctions may be imposed where a person "knew or ought to have known" that his conduct would have the unwanted consequence or where the person failed to take reasonable care. Such a standard is appropriate where it is desirable to provide an incentive to persons to take reasonable care not to behave in a manner that will have the undesirable effect in question;

    —  Recklessness—unlike the objective negligence standard, a recklessness test requires an examination of what was in the mind of the person concerned. In order to show recklessness it is necessary to show that the person concerned acted without caring whether his conduct would have the undesirable consequences that it did. A person may be negligent but not reckless in that he may have failed to take reasonable care when judged by the standards of reasonable persons, but he may have genuinely (but unreasonably) believed that his conduct would not have the consequences that it did;

    —  Intent—like recklessness, this term may be used to describe an entirely subjective test which requires proof that a person intended the consequences of his actions, i.e., that he actually knew or believed they would occur. While intention is often inferred from circumstantial evidence as to what the natural consequences of a person's action would be, the tribunal of fact must still satisfy itself that this is what was in the mind of the person concerned. A genuine belief or ignorance (no matter how unreasonable it may be) may defeat an allegation of intent. Intent and recklessness are tests which are generally reserved for criminal offences which carry the threat of imprisonment because they denote serious moral culpability.

  8. It has never been the FSA's intention that the market abuse regime should be capable of being used to punish conduct on a "no fault" or strict liability basis. We do not consider that to be the effect of the draft Code and will be working to ensure that this is made clearer in future drafts of the Code. However, we do not accept, as a general proposition, that conduct that damages the economic integrity and efficiency of the UK's organised investment markets should be capable of being pursued only where recklessness or intent (as described above) can be shown. In order to prevent significant damage to the efficient operation of our investment markets we consider that it is right to expect those who take advantage of those markets to take reasonable care to ensure that they do not act in ways that undermine those markets and damage the interests of all market participants. We therefore consider that, in principle, the adoption of a negligence standard is appropriate in relation to certain types of conduct.

  9. The precise degree of fault that should have to be shown on the part of any person accused of abusing the market needs to be considered carefully in the context of each of the different types of conduct that the Code seeks to address. We will be seeking to address this in a more transparent way in future drafts of the Code. We are not convinced that a provision in the primary legislation requiring the proof of intent to commit market abuse would be beneficial, although we do consider that in certain circumstances some form of "due diligence" defence may be appropriate. We will be examining the Code in some detail from that perspective.

Relationship between market abuse and Exchange rules

  10. We are concerned to ensure that the market abuse regime interacts in a transparent and coherent way with the rules of the Recognised Investment Exchanges (RIEs). Clearly, however, it would not be appropriate to provide a "safe harbour" for conduct which did not breach the rules of an RIE unless those rules themselves adequately address the various types of misconduct at which the market abuse regime is directed. A detailed examination of the rules and practices of each Exchange is under way. It is important that the legislation does not provide a loophole for market misconduct which cannot be said to breach the rules of any one individual RIE but which nevertheless falls short of the standards set out in the Code. Such loopholes may well exist given that the Code will cover transactions undertaken off-exchange as well as on-exchange.

  11. For this reason an attempt to provide a blanket safe harbour in this area in the primary legislation would, in our view, be fraught with difficulty. Instead, we think that the overarching provision in the Bill should place beyond doubt the FSA's ability to include such "safe harbours" in the Code.

Guidance and "pre-clearance"

  12. There has been much interest in relation to the new provisions on market abuse in the scope for individual guidance (whether in the form of interpretative letters, no-action letters, or pre-clearances) to be obtained from the FSA. As stated in our memorandum to the Committee of 12 March, it has always been the FSA's intention to issue guidance to supplement the Code, but it is clearly not possible for regulators to provide no action letters unless they are given very specific details of the transactions envisaged. Such clearance procedures might not always be very rapid, except at significant cost for regulated firms.

  13. There is still detailed work to be done to elaborate the FSA's policies and arrangements for giving guidance to individual firms under the new legislation, particularly with respect to the Code, and to develop guidelines on the status of guidance. The FSA will carry that work forward in consultation with interested parties.


  14. One of the objectives of the FSA's proposed disciplinary decision-making process is to keep to a minimum the cost incurred by the firms and individuals concerned and by the FSA itself. Accordingly, the FSA's proposed internal procedures provide the opportunity for a firm or individual to reach an agreed outcome in a disciplinary case rather than refer the case to the statutory tribunal. The respondent firm or individual will have the option to enter into settlement negotiations and to go to mediation. We hope this will lead to a greater number of settlements.

  15. We recognise that significant costs may be incurred, particularly when a case reaches the tribunal stage. The draft Bill provides that the tribunal may order a party to the proceedings to pay to another party to the proceedings the whole or part of the costs or expenses incurred by the other party in connection with the proceedings. This is consistent with the normal practice in civil litigation that "costs follow the event". The draft Bill confers on the Tribunal a broad discretion in relation to costs; the Tribunal is not required to order that all or indeed any of the costs be paid to the successful party.

  16. Concerns have been expressed that this provision could lead to an unsuccessful respondent bearing the whole cost of the proceedings, and that this would deter individuals in particular from exercising their right to contest the FSA's findings. On this basis, it has been contended that it is unfair to expect an individual to face the uncertainty of possibly being required to contribute to the FSA's costs. It is said to be a particular disincentive where a person believes that they may have a good answer to the charges in most respects, but that they may still lose some minor aspect of the case.

  17. The FSA as a regulatory authority is charged with enforcing regulatory requirements in the public interest, and should not, it can be argued, be deterred from reasonably bringing cases in pursuance of its statutory objectives, even where it is ultimately unsuccessful. In general, the FSA should not be required to pay the costs of a respondent, except where it acted unreasonably in bringing the proceedings.

  18. One alternative would be for each party to be responsible for bearing its own costs, whatever the outcome. This would give the parties a greater degree of control over their financial exposure. However, it would have the disadvantage that a party who has been exonerated by the Tribunal would be unable to recover its costs from the FSA. Similarly, the FSA would be unable to recover costs from parties which had been found by the Tribunal to have breached regulatory requirements. The FSA's costs would then fall to be paid by compliant firms through the FSA's fees.


  19. A number of witnesses have given evidence to the Committee on the question of the destination, and the treatment in the FSA's hands, of fine income. The Chairman of the FSA touched on this subject in oral evidence on 16 March. We hope it will be helpful to the Committee if we set out our views in a little more detail, picking up specific concerns raised by other witnesses in the meantime.

  20. The FSA will have power to impose a range of disciplinary sanctions, of which levying a fine is only one. Not every case of misconduct leading to enforcement action will warrant a financial penalty. The FSA believes that it is appropriate for fine income to be used to reduce the direct regulatory costs for the majority of firms which are not fined by the FSA. Alternative approaches, envisaging that fine income would pass to some other destination, would mean that "good" firms would subsidise the costs of investigating and disciplining the "bad"; we do not find that an attractive proposition. The FSA's preferred approach is supported by a number of trade associations and senior industry figures. In response to concerns that such an approach exposes the FSA to real or perceived conflicts of interest, the FSA would make the following points:

    —  the new legislation will require the FSA to consult on, publish and adhere to transparent procedures and processes for its enforcement work. This will include our policy on fining; in this context we expect to list the factors which we will take into account in determining the level of a fine. External stakeholders will therefore in future be able to assess whether—in specific cases, and more generally—the FSA is acting in accordance with its stated policy in this area. This process of consultancy by FSA is already under way, through the publication of CP17 in November 1998;

    —  firms or individuals who wish to challenge the imposition or the quantum of a fine which the FSA's Enforcement Committee is minded to impose have the right to have their case considered afresh by the independent Tribunal;

    —  in accordance with our responsibility under the new legislation to use our resources in the most efficient and economic way (to be monitored and reported on by the non-executive Committee), we have put in place a financial management and reporting framework which we believe provides a clear and robust mechanism to ensure transparency as to the FSA's expenditure. This will ensure that income from fines is not used to mask higher than budgeted expenditure;

    —  specifically, we identify in our published Plan and Budget for the coming year a "control total" covering our mainstream regulatory costs, including in-house enforcement costs, but excluding external enforcement costs (for example, hiring investigating accountants and instructing outside lawyers on particular cases) which are subject to substantial fluctuations year-on-year. The actual and budgeted "control total" expenditure will therefore not be affected by the incidence of fines. (The alternative approach—budgeting for enforcement costs and taking fines "above the line"—would result in a more volatile "control total".);

    —  any excess of fine income over external enforcement costs will reduce fees to the regulated industry;

    —  in our Annual Report and Accounts we will report against this framework; this will have the advantage that external stakeholders can track the FSA's expenditure year-on-year on a like-for-like basis.

  21. We believe that these mechanisms provide proper safeguards against any possible misuse by the FSA of fine income and preserves the advantage, outlined above, of enabling such income to flow back to the regulated industry in reduced fees.


  22. It has been suggested that the FSA should not have power to take enforcement action for breaches of FSA Principles alone.

  23. The use of Principles has been a feature of the regulatory regime for investment business for the last decade. The introduction in 1989 of a power to make broad statements of principle followed severe criticism from the regulated industry of the compliance costs associated with applying a large body of highly detailed and prescriptive rules.

  24. The use of statements of principle enables the regulator to avoid detailed prescription in certain areas. Principles can provide regulated firms with flexibility in determining how they should comply with regulatory standards. They are capable of being applied to new and changing circumstances and help to prevent "creative compliance" or the exploitation of technical loopholes in more detailed rules. The FSA Principles would not continue to serve their intended purposes if they could not be effectively enforced.

  25. We recognise that the practical application of the Principles needs to be reasonably predictable for those to whom they apply. We will therefore amplify the Principles through a combination of rules, evidential provisions and guidance. The FSA Principles should not therefore be viewed in isolation, but in the broader regulatory context.

  26. Disciplinary action for breach of a Principle may be appropriate where there has been a breach of related detailed rules, evidential provision or guidance. This reflects current SRO practice, where breaches of principles and rules are often pursued together. However, as happens in some cases now, there may also be circumstances in which it will be proper to take disciplinary action, based exclusively on a breach of one or more of the Principles.

  27. If the Principles are to achieve their purpose, it is important the FSA should be able to take action to enforce them where:

    —  it is clear that the conduct in question violates the Principles, regardless of whether any detailed rule, code or evidential provision has strictly been breached;

    —  the behaviour in question breaches the Principles because it is closely analogous to behaviour which would constitute a breach of a detailed rule, and would breach the spirit, though not the letter, of the rule. For example, rules may prohibit an authorised entity from holding certain kinds of investment, and a deliberate attempt is made to circumvent the rules by interposing intermediate companies, so that the investments are held indirectly;

    —  there is evidence of systematic and repeated breach of detailed rules. For example, repeated breaches of rules about recommending suitable products may indicate wider problems, such as a lack of due skill, care and diligence, breaching Principle 2.


  28. In response to the Committee's letter of 1 April on the involvement of practitioners in the FSA's decision-making, the position is as follows:

    —  the FSA Board, appointed by the Treasury, includes a number of industry practitioners as non-executive directors. All directors are, however, appointed in the public interest, and the whole Board is, of course, responsible for the FSA's overall strategic direction and in particular for the exercise of its legislative functions;

    —  under the FSA's current proposals, the Enforcement Committee (whose members will be appointed by the Board, and will be accountable to the Board) will include practitioner and non-practitioner public interest representatives. An overwhelming number of the responses to CP17 favoured both groups having voting powers in relation to their involvement in the FSA's enforcement process;

    —  beyond that, as we said in "The Open Approach to Regulation", the FSA will involve practitioners in an advisory capacity through a wide range of groups, such as the Practitioner Forum, the Small Business Practitioner Panel, the Handbook Advisory Group and the Market Conduct Group. Such practitioners do not take decisions on behalf of the FSA.


  29. The FSA would take this opportunity to clarify an answer given by Howard Davies in oral evidence on 16 March. The budget of £420,000 for the Consumer Panel is wholly available for the Panel's own use; it does not include the salary and overhead costs of the FSA staff who service and assist the Panel in its work. It is also important to note that the Consumer Panel's own budget is part of a larger effort to understand consumer views, and inform consumers, carried out by our directorate of Consumer Affairs.


  30. We have seen HM Treasury's note to the Committee on the protection of employees where disciplinary action is being taken against a regulated firm, and have nothing to add.


  31. The Committee asked a number of questions in its letter of 24 March about FSA staffing issues. Staffing the new Authority with the right mix and quality of staff has been challenging. Inevitably, we suffered from staff losses in the first few months of our existence. Immediately post merger our turnover rate was unsustainably high, peaking at 19 per cent in the first three months after the merger. As the organisation has settled down post transition we have seen turnover fall to more acceptable levels—turnover (three month rate annualised) is currently running at seven per cent. Since we were established we have been pleased with our record in being able to attract high calibre individuals into the Authority—we have attracted some 360 staff since 1 June. As the Authority becomes established we expect to find it easier to "sell" a period of employment in the regulatory body as a worthwhile career option.

  32. We support our new recruits with a comprehensive training programme, which includes induction and, for our regulatory staff, technical training which encompasses the individual technical training programmes provided in the prior organisations. We supplement our in-house training by sending staff on external courses and to conferences to ensure that they remain up to speed with market developments.

What salaries is the FSA able to offer?

  33. The FSA aims to be competitive in offering a remuneration package which attracts and retains the right mix of staff. We pitch our base pay against median or second-quartile pay levels in the relevant sectors of the financial services market. In benchmarking our pay, we generally compare our salaries to those in the market which we regulate, taking account of the sectors from which we recruit people, and to which we lose them—that is, financial services sector companies and professional services firms. By the "financial services sector" we mean retail banks, investment banks and insurance firms.

  34. Different sectors within the financial services industry can offer very different salary levels, so the pay of our staff is not uniform across the organisation. We accommodate these variances by having very broad indicative pay ranges which are used to manage pay levels across the organisation. The table below sets out the pay ranges for our staff and the number of staff employed at each level:
FSA Employees: Data as at January 1999

GradeNo. StaffPay Range

Administrator/Secretary578 £12-£30k
Head of Department44 Up to £110k
Director15Individual Salaries


  35. In recruiting staff with specialist skills which are crucial to our work and where we are particularly vulnerable to the external market we are prepared to pay individual salaries, sometimes in excess of the indicative pay ranges that we set.

  36. We do not try to compete with the external market in making bonus payments. In this first year we have operated a Performance Reward Plan which has paid out, on average, non-pensionable awards of six per cent of salary.

  37. In feedback from employees who have resigned from the FSA, pay has rarely featured as the dominant reason for leaving.

What proportion of your senior staff have market experience?

  38. Our objective is to recruit from a range of different sources, balancing the need for an understanding of the market with specialist policy making and other skills. As at the end of March 1999, 29 per cent of our senior staff (defined as Heads of Department or above) engaged in front line regulatory work have private sector market experience. A further 16 per cent have experience of operating in a market environment through work in the Bank of England markets (i.e., gilts, money markets and foreign exchange operations) and banking functions. By virtue of our history, a significant number of our senior staff have a public sector background. (The Treasury, Bank of England, Building Societies Commission, Registry of Friendly Societies, Friendly Societies Commission, all recruited primarily from university, and staff were moved in and out of regulatory functions.)

  39. Going forward, as a private sector organisation we are and will increasingly be recruiting from the private sector and our experience profile will change accordingly. By way of example, 55 per cent of the management team (including middle managers) in the supervisory areas of our Investment Businesses Division have market experience; of which one quarter of that experience was in the compliance field. We expect this profile to be more typical of the experience of our managers in the future. Since the FSA was established in June last year we have recruited to around 200 front line regulatory posts, for the vast majority of which we have found excellent recruits from the firms that we regulate. At senior levels, we have recently recruited two Heads of Department, one for our Complex Groups Division and the other for the Markets and Exchanges Division. The former comes with considerable compliance experience direct in a major international bank. The latter has been a Director of two major trade associations in the derivatives and investment banking fields.

  40. In the parts of the Authority where senior staff typically have less market experience, the prior organisations (in particular the Bank of England and the Insurance Division of the Treasury) recruited "grey panthers" to work directly with the banking and insurance supervisors. These are former senior managers drawn from the industry to work as internal consultants with front line regulatory staff. Collectively they have a wealth of experience drawn from years of specialising in different parts of the financial services industry. Some are employed on a formal consultancy basis to enable them to pursue other external roles (e.g., sitting on industry advisory committees) which maintains their external perspective.

  41. In addition, we resource a number of key posts in the regulatory areas of the organisation with inward secondees. We currently have 38 inward secondees, 16 per cent from banking firms and over 60 per cent from professional services firms (law and accountancy firms); together they bring considerable experience from working directly with our regulated firms.

  42. On the issue of outward secondments, the Bank of England, which recruited many regulatory staff direct from university, introduced an initiative to improve exposure to the external market by introducing six month placements in regulated institutions. At the FSA we intend to continue to use this approach to enhance the market knowledge base of our existing staff. We also second staff to other regulators (e.g., in Hong Kong) and to other relevant bodies (e.g. DGXV of the European Commission).

What proportion of your senior staff have a regulation or compliance background?

  43. Virtually all our senior staff have previous regulatory experience—the majority were appointed from a prior regulatory organisation. Very few have a compliance background in firms. In recruiting senior staff since 1 June we have brought in a number of key players with industry experience who have not previously worked in regulation e.g., Director of Markets and Exchanges; Director, Investment Businesses.

What proportion of your senior staff are lawyers?

  44. Given the range of statutory powers which the FSA will exercise, we regard it as important to have access to high quality, prompt legal advice. In addition to the five lawyers at senior level in the General Counsel's Division, 15 per cent of our front line regulatory senior staff are lawyers.

What is the turnover rate of senior staff?

  45. Turnover of senior staff since 1 June is 7.9 per cent on an annualised basis.

How far below complement are you?

  46. At the end of the 1998-99 budget year we were 85 below complement. Our new budget for 1999-2000 provides for an increase in headcount of 105 reflecting an increase in the volume of our underlying business, the resources required to update the regulatory rulebooks and meeting our new consumer objectives. We are now actively recruiting for a number of these posts. Recruitment will be activated for the others during the course of the year.

13 April 1999

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