Joint Committee on Financial Services Minutes of Evidence



Examination of witnesses (Questions 240 - 260)

THURSDAY 25 MARCH 1999

MR KIT FARROW, MR DAVID MAYHEW, MR CHRIS BATES, MR PHILIP TELFORD, MR ALAN WHITING and MR GUY MORTON

Mr Loughton

  240.  Can we go on to the thorny subject of the European Convention and obviously stemming from the role of FSA as judge, prosecutor, jury, executioner and the beneficiary of the executed to take it to extreme there as well bearing in mind that there are probably two main areas where the Bill may get a conflict within the European Convention in relation to the FSA and competition on the one hand and the claims by investors against practitioners in financial services as well. Could we have potted versions of what the Economic Secretary referred to last week as "room for disagreement amongst lawyers", to put it mildly? Bearing in mind that nobody here is notching up bills of about £350 an hour for their views, could we have potted versions of where we think there are discrepancies that may lead to problems with the European Convention which need to be sorted out before this Bill becomes law as stated earlier on?
  (Mr Morton)  There are two main areas of potential discrepancy. The first is, as David Mayhew referred to earlier, the classification of market abuse and disciplinary measures as to whether they constitute criminal or civil proceedings for the purposes of the Convention. That is significant because criminal proceedings under the Convention have an additional set of extra protections which include in particular the privilege against self-incrimination and therefore classification as criminal carries with it the consequence that the current provisions which entitle the FSA to use in evidence material which has been compulsorily obtained would fall away as being contrary to the Convention. That is the first issue. The second issue relates to Article 7 of the Convention, which deals with the principle of certainty. There is a fear that some of the provisions, in particular the prohibition on market abuse which we talked about earlier, are insufficiently precise to meet the standard required by that and, therefore, there is doubt about their enforceability should they be challenged under the Convention. Those are the two main areas where there are points at issue.

  241.  Your views as to how they can be resolved?
  (Mr Morton)  In the first case I do not see that there is much scope for resolving them other than by admitting that it is not possible to use evidence compulsorily obtained by putting it in evidence before the proceedings in question. As David Mayhew referred to earlier that probably is not such a dramatic change as you might suppose because it is still possible for the prosecutors to have the evidence in deciding how to present the case. In relation to the question of legal certainty then I think the remedy is clear, that if the provisions are too uncertain then they have to be reworded so they are more certain.

Chairman

  242.  Mr Morton, is your conclusion as far as the general question of enforcement is concerned, other than market abuse, that your view is that this is now all right and that your uncertainty relates to market abuse, or do you have some questions also about the more general area of enforcement?
  (Mr Morton)  There is one particular issue outstanding on the general area which is this question of whether evidence which is compulsorily obtained can be used.

  243.  Right.
  (Mr Morton)  My view would be that it cannot be used because jurisdiction is properly classified as criminal under the Convention.
  (Mr Mayhew)  Effectively Clause 104 subclause 5 should be extended to include all enforcement proceedings. The reason for that is that the enforcement proceedings are directed to achieve punishment and deterrence with quite severe fines. In a sense this comes back to an earlier point made in relation to the question "Well, we all know what is misconduct, we all know what is good or bad conduct". That was fine when regulators were about regulating a profession and not allowing people to practise for the protection of the community who were not fit and proper. If that is what the regulatory system is about you do not have to worry about the criminal nature of the process because it can be dealt with in the civil system but having introduced, as has happened over the last few years, substantial fines and substantial punishment that is what has brought the criminal element into play.
  (Mr Farrow)  If I understood Mr Morton correctly, the problem of an uncertainty would apply to enforcement proceedings for breach of principles?
  (Mr Morton)  Correct.

  244.  Do you want to say anything at this stage, Mr Whittaker? You do not have to.
  (Mr Whittaker)  Why not carry on.

Mr Beard

  245.  There is no test of intent in the legislation as so far proposed for market abuse. The Government have said this is because unintentional behaviour would still undermine the proper work of the market and confidence in it. Mr Howard Davies when he was here said that he agreed with that but, on the other hand, they have no intention of prosecuting people for accidental offences. The Minister, Ms Hewitt, told us that the degree of intent might affect the penalty but not the character of the offence. Do you find the Government's arguments are persuasive on this question of including or not including intent?
  (Mr Bates)  Shall I start because no-one else wishes to take this point. I do not think we are convinced that one can ignore the issue of intent altogether. The point which we would make is that if you have very broadly defined offences then in order to decide whether it is culpable or not culpable you have to introduce an element of intent or some sort of mental element. If you have narrowly, specifically focussed offences where the conduct is clearly prescribed then it is much easier to abandon the test of any form of mental element or intention. The parking ticket example where it does not matter that you drove the car and left it on a double yellow line—it is your car, you are liable, you can be fined—that is a very clearly defined act. At the other extreme you can have very broadly defined offences but you find that, generally speaking, to make them workable and to make them fair to people you have to introduce the mental element to make them effective. I think the danger here, particularly with the statutory test—and remembering that the statutory test can be relied on supposedly on its own without any guidance from a code of conduct—the statutory test is both a broad test—we are very unclear what the conduct is precisely proscribed—and no mental element is attached to it either, so you end up with the worst of all worlds on both counts. Even when one moves to the codes, the codes of conduct, I think you find that the FSA have found drafting it that they have had to introduce some sorts of mental elements into the definitions—and they say so themselves—but what they have done in some cases is reduce those mental elements to a very limited extent: for example, and this shows the width of the quasi legislative power being given to the FSA, to criminalise negligent mistakes, which as far as I know is an entirely novel concept, that a fine can be levied on someone for a mistaken false statement, careless or whatever but false. Firstly, that demonstrates the width of the power being given, going back to the delegated powers point, but also demonstrates that even in the context of the Code the FSA has found that it has had to have some mental element. We think that ought to be directed.

Chairman

  246.  How do you tell? Unless somebody says "Fair cop", how do you show intent other than by looking for other corroborative evidence about what it is that they have been doing? I ask this in a very naive way. If you rely on intent can you ever catch anyone?
  (Mr Bates)  Can I just make the point that it is not the case in the States. The States is different and yet the American legislation 10b-5, on which most enforcement action is based, is firmly based around the idea of intent or recklessness, that is the test of scienter. The idea is that somehow we have English regulators who need to do away with the intent test because in other jurisdictions they do not have it either, but I do not think that is really truly the case. It is possible to prove intent by inference.

  247.  Yes, but that is back to evidence.
  (Mr Bates)  It is back to evidence, that is the point. Let us call a spade a spade: being fined £1 million is a conviction whether you label it civil or not and you should be convicted on the basis of evidence not on the basis of a vague assertion.
  (Mr Whiting)  Could I just make a personal comment. The LME does not have a formal policy on this; it does not actually need one because it does not really affect it. If we are frank, regulators hate the concept of intent because it is virtually impossible to prove. I cannot recall a single case where anyone has been able to prove intent. On the other hand, firms, quite rightly, not just because they do not want to be found guilty when they have committed offences, do not like the absence of intent because it does lay them open to the possibility of being disciplined for things which they did not intend to do. I think there is a way through this. If we can introduce certainty in what market abuse is then I think the issue of intent falls away.
  (Mr Farrow)  My Lord Chairman, I think you were present at the FSA Conference a couple of weeks ago. I thought the SEC judge, who addressed the conference and who said he had managed to be satisfied as to intent several hundred times in cases in front of him on the basis of inferring it from behaviour, was not dismissing it. Intent is quite substantial in US law he was saying, he was recognising that the test of intent in the law had to be satisfied but you could reasonably see intent without actually having the man on tape saying "I meant to do it". It seems to me we risk making this a yes/no insoluble problem whereas in a more pragmatic way the US system seems to have found a way of coping with it.
  (Mr Mayhew)  I think it is important, to follow on from what Kit Farrow said, that we understand clearly that the concept of intent in law is different from how you might use it in everyday parlance. It is not a question of motive or desire that the court will look for in this sort of area but should you have a knowledge of the natural consequences of your actions. This is where the flaw in the Government's position comes in because if the aim of this provision is to deter abusive behaviour, by definition you cannot be deterred if you did not have a knowledge of what you were about to cause. I may not desire it, I may not have had that as my purpose, but if I know what is going to happen then that is sufficient for knowledge.

  248.  Or you suspect that it might happen?
  (Mr Mayhew)  Then it is a question of degree. That is a matter of evidence again. If I know the consequences of my actions the court will hold me as having intended those actions, even though that was not my desired outcome.
  (Mr Whittaker)  On this occasion I would like to agree with one point that Kit Farrow made which is to agree that this is not something where there is necessarily a yes/no answer as between intent and non-intent. I would agree that the correct classification of the issue is what, if at all, should be the mental element for different aspects of market abuse. I would emphasise that the market abuse definition covers a wide variety of different forms of behaviour and it is quite conceivable that you might want to have a different mental element as between different forms of behaviour covered in the Code of Conduct. We are certainly looking at the Code of Conduct again to see whether there is more scope to introduce a mental element into different parts of it without making it completely impossible to be able to take any enforcement action over market abuse as a result. All that said, I think that Howard made clear when he gave evidence to you that we are not seeking to take action where someone has taken all reasonable steps to avoid committing market abuse. I think there are cases where someone may well not have intended to abuse the market but where they should be expected to take reasonable steps to secure that their conduct does not do so.

  249.  This is the margin between recklessness and intent?
  (Mr Whittaker)  It may well be that if there is any sort of general solution it is in that area.

Mr Kidney

  250.  Could I ask the lawyers about fines. Mr Morton, would you like to start. It is proposed that the FSA can fine authorised persons for regulatory breaches and that the FSA can fine authorised persons and unauthorised persons for market abuse. Do you see those as two limbs of one administrative regime or is the first one an administrative one and the second one a civil regime?
  (Mr Morton)  I certainly see them as separate regimes. The market abuse regime is there for a significantly different purpose which to my mind is more closely akin to what in layman's terms we would call a criminal regime. I think one can spend an awful lot of time debating academically whether it is administrative or civil or criminal but I would see them as two quite distinct functions. Having said that, I do not see why the power of fining in principle is not appropriate for each of them.

  251.  Is it a worry that under the proposed scheme fines could be unlimited?
  (Mr Morton)  I think that is a worry but a greater worry is the need to ensure a reasonable degree of clarity about the probable scale of fines. There are provisions in the Bill, as you know, requiring the FSA to publish, and it has published some material already, the scale of the fines. I would be very concerned to try and ensure that there is as much clarity as possible about the likely level of the fines for what particular kinds of behaviour so that the tariff, using the word loosely, is apparent to people and therefore the deterrent effect which Chris Bates referred to before is maximized.

  252.  Presumably in due course the tribunal and the civil courts will have a track record of fines themselves?
  (Mr Morton)  Presumably so because they will have possibly appeals against the level of fines and, therefore, a track record will emerge.

  253.  Lastly, is it a worry that the FSA is going to keep all the fine income?
  (Mr Morton)  I think that is a worry. There seem to be differing levels of concern expressed about this but I do think that it gives rise to clear conflicts of interest and it increases the risk that the eye will stray from the ball a little bit in fixing the fine on the basis of the case rather than on the basis of extraneous factors like budget and the performance indicators.

Chairman

  254.  I assume that those who worry about this do not actually wish the income to come to the Government! It would be extremely unusual for a group to volunteer that it should be handed to the Government. Is it not therefore an issue of trying to find a way of ensuring that in terms of recycling the money it influences the behaviour of the prosecuting body as little as possible?
  (Mr Morton)  I think that is a fair point.
  (Mr Farrow)  It is not altogether separate from the question of how should prosecution costs be funded. At the moment the proposal is that in any case where somebody has been found guilty in the enforcement process, all the prosecution costs should be charged against him. One can easily envisage in a case which turns out to be a difficult case to investigate and much argument and expense for witnesses that at the end of the day you are found guilty for something for which the appropriate tariff fine is £10,000 but you are fined £10,000 with £200,000 costs. That seems to be quite an inappropriate way of setting about things. I have no simple solution to offer this afternoon but I think this question that you raised about where do the proceeds go needs to be looked at alongside where do the prosecution costs come from.

  255.  I think we have probably kept you all long enough. I have one last question and short answers would be preferred. Besides the rules and processes many of the things that in practice are going to matter here are going to be the people who apply them. We wonder what advice you would like to give Howard Davies as he builds his teams and committees as to how we are going to get the people to do the job?
  (Mr Telford)  Once point particularly is that we focus a lot on the punishments of people who do wrong. One of the greatest things in the minds of those people must be the chance of being caught, the deterrent effect is partly whether you are going to be caught as much as what the fine will be. We are quite clear that there must be effective monitoring and a proactive regime. I think Howard Davies has already sent out a message in a variety of ways saying: "I am on your case, I am looking for potential problems before they become very expensive, very long term problems." I think the message would be "Look at the monitoring as much as much as look at the penalties and the powers in the enforcement regime".

  256.  Preventing things, getting into this process which we are discussing this afternoon.
  (Mr Farrow)  Not quite answering your question, I am afraid, but to the extent that the FSA is going to be taking prosecution decisions and perhaps settlements on the basis of very market judgments like what is proper market behaviour, I am conscious of the considerable efforts that the FSA has made to recruit people with market experience and that it is far from easy. But, nevertheless, it remains absolutely essential that they are found because without some experience of what is market behaviour you cannot be an arbiter of market behaviour.

  257.  Mr Whiting?
  (Mr Whiting)  I think that the hope must be, and I think it is a realistic hope, that when the FSA becomes established and develops its reputation it will attract extremely good people. I should say there are already extremely good people. The LME on the regulation side has had no difficulty at all finding over the last year extremely capable people. Some times we have taken them from the FSA I am afraid to say although they are probably more valuable within the LME than they are there. This is the experience in the United States where it is perceived to be an extremely good thing indeed to have done two, three, four years in the CFTC or the SEC and then they go back into private practice and sometimes come back into the regulatory body. This can have mutual benefits for all sides.

Viscount Trenchard:  Could I ask the panel whether they think that the FSA should have some separation of the powers of chairman and chief executive? We hear a lot nowadays about corporate governance, companies increasingly requiring the functions to be separate. The FSA has very extensive powers and it can be said to be in part legislator, prosecutor, judge, jury and enforcer all within one body, although admittedly it is said that there will be separation of functions within the body. Are the panel satisfied that the powers of chairman and chief executive should be combined in one person?

Chairman

  258.  If you do not wish to answer, fine, I understand if it is incriminating!
  (Mr Bates)  My own view, if I might express one, is that the corporate model is inappropriate because this is not really a public company. It may be clothed in corporate form but it is not a company in the traditional sense of the word. Therefore the governance models adopted for corporate companies, I do not think necessarily can be thrown straight on to what is essentially a regulatory body or regulatory agency where it is not that uncommon to combine the roles. I would not express a view one way or the other about the appropriate governance model on that particular point but I do not think you can necessarily say that it is a company, therefore we ought to separate the two roles.

Viscount Trenchard

  259.  You do not think it should be a company?
  (Mr Bates)  On that point I think that the question of whether it is a company or not is not of particular importance. I understand that there are reasons why it is, not least because the SIB was in that form and therefore continuity was possible. What is important is the role that it has, the powers it has, and the accountability controls that the Bill provides for which the Government has gone a long way in its recent statements to strengthen and enhance in line with and in response to comments made by the industry.
  (Mr Farrow)  In our very early submissions when the concept of the FSA was first announced we addressed this by saying that the majority of the board should be non executives and should be independent of the FSA. The Government has agreed with that proposal. I think bearing in mind what Chris has said that is a reasonable way of dealing with the need for both control and supervision.

Chairman

  260.  There is of course the position of the senior non-executive in particular. I think it is probably fair that we should not ask Mr Whittaker about that. Mr Telford I am aware that on much of what we have been doing today the detail has not been your concern, but do you have any final comments you want to make?
  (Mr Telford)  I think just to emphasise some of my earlier remarks. Of course we support any fairness and transparency in the system, we think that should be pushed as far as it can be. We are aware that in a fast moving market the regulator does need to be flexible. One thing certainly, in a way we are disappointed to hear, as we have been told for many years by people in wholesale and retail markets that they really wish the regulator would just establish clear principles and let them get on with running their business as they know how to run it, are comments that in fact detailed rules are what are required at every turn to give certainty, putting aside the legal argument about certainty in that context. We have been receptive to those views and said, yes, principles are very important and firms should be left to run their businesses as they see fit. We still support that principle and we would rather the regulator was not caught up at every turn at having to go into the detail of every single eventuality. Just one final point I would make is about companies paying for regulators, they have consumers and consumers generally also pay for regulation. Our understanding of where funds go is to reduce the cost of regulation which is to consumers and also to firms. So long as that is transparent and we do not see the regulator issuing large fines to make the budget better then we will be happy with that. Yes, clarity and transparency but also a strong regulator with teeth will give consumers confidence in the market place right across the board. Although you are right to say wholesale markets may seem one step removed from consumers, what happens in those markets, the fact they are not corrupt and they are working efficiently does impact on consumers on the range of investments and institutions they wish to trust. We do have those concerns.

Chairman:  Thank you all very much. It has been a very interesting session.


 
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