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CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 606-xxiv
HOUSE OF COMMONS
HOUSE OF LORDS
TAKEN BEFORE THE
PARLIAMENTARY COMMISSION ON BANKING STANDARDS
THURSDAY 17 JANUARY 2013
PROFESSOR JULIA BLACK, PROFESSOR DAVID KERSHAW and GREGORY MITCHELL QC
Evidence heard in Public
Questions 2626 - 2691
USE OF THE TRANSCRIPT
This is a corrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.
The transcript is an approved formal record of these proceedings. It will be printed in due course.
Taken before the Parliamentary Commission on Banking Standards
on Thursday 17 January 2013
Mr Andrew Tyrie (Chair)
Lord Lawson of Blaby
Mr Andrew Love
Mr Pat McFadden
Lord McFall of Alcluith
Examination of Witnesses
Witnesses: Professor Julia Black, London School of Economics and Political Science, Professor David Kershaw, London School of Economics and Political Science, and Gregory Mitchell QC, Three Verulam Buildings, examined.
Q2626 Chair: Thank you very much for coming to give evidence this morning. We have quite a full session to get through.
I would like to begin by asking a straightforward but rather difficult question to all of you, starting with Professor Black. Despite the financial crisis and the spate of mis-selling scandals, we still have not seen anybody sent to jail. Is that because nobody ought to go to jail, or because there is a fundamental failure in the sanctions regime or the legal system in the UK?
Professor Black: Starting with the easy questions, I think there is a clear public frustration as to why nobody seems to be in the dock. There are two issues: why no individuals have had actions taken against them; and why no firms have had enforcement action taken against them.
In relation to individuals, if you look, for example, at the FSA Handbook and theApproved Persons code, most of the things you think should be there in relation to the duties and responsibilities of senior management-to act with due skill and care, to be competent, to arrange their organisations in such a way that they can be effectively managed and so on-would seem to be in place. If you were writing what you would want from scratch, a lot of the material does seem to be covered in APER. It seems that you have the rules in place.
As for sanctions, the FSA has a decent range of sanctions. It can fine and it can ban somebody from working in the industry, which probably has a much bigger impact than a fine because it has a long-term impact on the ability to earn a living in a very well remunerated business.
The failings must come down to the ability to show personal culpability in the context of managing a large and complex organisation, and of collective decision making. There have been two actions brought: there is the Pottage case and the Cummings case-they are quite different in terms of their facts. For the FSA to bring a case under APER they have to be able to pinpoint whether you were the person who made this particular decision and were responsible for this particular line of business over probably quite a period of time.
In the context of organisations where jobs move and people change roles quite frequently, and where you may be not just responsible for the UK and compliance there, but for Europe or a wider sector, obviously, it is difficult trying to pin down that personal culpability. As to why it is nobody has had action taken against them in those individual banks, that is really a question for the FSA, without wanting to bat it off. You need to know the facts. If you look, for example, at the Pottage or the Cummings cases, the detail that you go into is who was at which meeting, who did what, who did this and who did that. The absolute detail you need to know about the facts is quite difficult to establish.
I am more surprised that the FSA did not bring action against the banks themselves for breach of the principles for business-for that you do not need to show personal culpability, but you just need to show they breached the principles for business, that they did not act with due skill, care and diligence, and that there was failure in their systems and controls.
Q2627 Chair: Do either of the others want to add anything at this stage?
Gregory Mitchell: The question was why nobody has been sent to prison. The wrongdoing that one has seen in the various reports to what led up to the crisis appears to be largely a failure on the part of people who should have known better to exercise a greater degree of care and skill, so the culpability essentially appears to be that of negligence. In our system, people do not generally get sent to prison for negligence. There has to be some deliberate wrongdoing, such as fraud, before those severe criminal sanctions are imposed on people.
Q2628 Chair: Is that always true of gross negligence and recklessness-doing something silly when knowing it is silly?
Gregory Mitchell: You are absolutely right. There are some serious offences for which the mens rea is recklessness, but recklessness is quite a tricky, legal concept that tends to be quite difficult for juries to apply. There is quite a lot of case law on exactly how the concept of recklessness is to be applied, and how judges are to explain that concept to juries.
Q2629 Chair: None the less, less tricky than fraud.
Gregory Mitchell: Fraud requires deliberate wrongdoing. It requires somebody actually knowing that they are doing something wrong and misleading somebody.
Professor Kershaw: I have a couple of additional points. I agree with Julia very much that most of the rules and standards that you would want to have, are in place. There are a couple of possible adjustments to that position for me, particularly when you look at the requirement to take due care and to exercise the requisite degree of skill. When you think about the application of that standard to any company, including banks, you need to think about what it is that you are asking directors to do and in whose interests you are asking them to act on behalf of, because that is the way you assess whether they have taken reasonable skill and care in pursuing that objective.
In the context of financial services and banking, when we look at it from society’s perspective, we would say that you have not taken the requisite degree of skill and care given the effects that your actions have had. But the problem is that directors of banks are asked to act in the interests of their shareholders. It may indeed be reasonable in some contexts to do things that are in the interests of your shareholders, but are not in the interests of society at large. That is one possible problem with the rules.
A second problem with the rules that may account for some of the failings to bring actions for lack of care against individuals is that in some instances the rules-particularly in APER-are just too detailed and they over-focus on context and complexity, and taking account of all the circumstances in the case. As if directing the regulator to be too reasonable. I think that is one concern.
Secondly, on the enforcement side-why actions haven’t been brought-the FSA is the only body that can really answer that question. We would, I think, have some legitimate doubts about whether the right judgment has been exercised in relation to some cases, particularly RBS, where it seems pretty clear, at least on the publicly available information and the information produced by the FSA in its report, that you could make a case for having not taken the requisite degree of care. Given the context of RBS-the effects of the failure of RBS-you could obviously therefore make a case that, in that instance, you should pursue the case and see whether or not you would be successful, granted that, if you look at the costs and benefits of that particular case, you might say, "Well, it’s not clear that we would be successful."
Q2630 Mark Garnier: Professors Black and Kershaw, in your submission you talk about the culture in the financial services industry being an "eat what you kill" and "eat your own young" type of culture, which, having worked in that industry myself, I recognise entirely. One of the things we are trying to wrestle with in this Commission is trying to establish good standards and good culture and then, having done that, how we uphold those good standards and culture. What role do you think sanctions play in upholding standards?
Professor Black: In any regulatory regime, you need carrots and sticks, so you need some incentives. You need to pay attention to incentive structures that are in place, both in terms of remuneration and in terms of the micro level things that affect how people will do their day-to-day job. For the regulator, as well, it needs to be able to give firms some incentives to behave ethically. But you also need a range of sanctions, and the important thing is that it is a range, because you will have ranges and degrees of culpability. At the moment, you have tiers and fines that can be variable, and public censure, but what we do not have is the criminal sanctions that you were arguing about before. I think we were clear in our submission that, if there is a role for that, the standard should be one of recklessness, rather than negligence as Gregory was saying.
There is a hefty Law Commission report, published just a couple of years ago, which reviewed all regulatory sanctions in all different regulatory regimes and came to the conclusion that while criminal sanctions could have an important deterrent effect, deterrent should not be the only justification for imposing a criminal liability on an individual; there should be some degree of moral wrongdoing exhibited, at least in the standard of recklessness. The question would be: what impact would that have?
The old adage is that, as a regulator, you have to walk softly and carry a big stick, but for that big stick to be effective with your soft speaking, it has to be credible that it is going to be used-and used successfully. Sanctions are good and necessary, but they have to be credible. For that, as we set out, as an individual, if your behaviour is going to be deterred, you need to believe: first, that if you do somebody wrong, somebody is going to find out about it; secondly, that if they do find out about it, they are going to do something about it; thirdly, that if they do try and take enforcement action against you, they are going to be able to prove it; and, finally, that if they have gone through all those stages, the sanction is going to be something that you cannot just put down as a cost of doing business-it actually has to mean something.
So sanctions do have a role, but they have to be quite carefully crafted and you need a tier and a ranging up, because the greater the deterrent message from the criminal sanction, it sends out a powerful message-and it may have an initial shock and awe effect on behaviour-but at the same time it is a higher standard of proof. If enforcement action has not been taken because of concerns that you will not be able to prove the lower standard of civil liability, those concerns are only going to be magnified in relation to a higher standard of proof.
Q2631 Mark Garnier: You raise a couple of interesting points, one of which is this high standard of proof regarding sanctions. The other is, actually, what are moral and ethical standards and how do you define them? It seems to be that when you have something like a "treating customers fairly" regime, actually you can observe the letter of the rules or guidance without necessarily observing what most of us in society would regard as treating with respect and dignity. That then comes to the question of professional bodies and professional organisations. Of course, you have the Law Society to uphold yours, but in the banking industry there are a number of organisations, but there is no requirement to be a member of those organisations. Do you think that these potential professional bodies are something that, in the broadest sense, can drive standards, but can also be used as part of the regulatory regime, where you are required to be a member of a professional body and that professional body can take on the role of driving the standards?
Professor Kershaw: My immediate reaction to that is a sceptical one, I think. There is obviously a concern that there may be some actors in the financial industry that are not subject to an ethical code. A significant majority of actors will be subject to an ethical code-either directly through the approved persons regime, or through membership of a body that has an ethical code-but there could be some individuals who fall through the loops. The question then is how to reach those individuals, and what is the best way of doing that. You could do that through the FCA itself, or you could have a separate independent professional body. You needto make sure that all those individuals are covered by an ethical regime, but what is the benefit of doing it through a separate and new independent professional body? It is very unclear to me what the benefit of that would be.
Q2632 Mark Garnier: Might I make a suggestion? There is a certain pride among individuals, one would hope, in having a few letters after their names. The ultimate sanction of losing that, and therefore losing your ability to be a practitioner, could be one of the sanctions.
Professor Kershaw: We already see that so, for example, the CFA designation, particularly in the United States is a very important designation for operating in the financial services industry and getting another job, etc. You are subject to an ethical code as a result of it, and if you misbehave, you run the risk of losing your CFA designation, which would have an effect. It is incredibly rare-exceptionally rare-for anyone to lose their CFA designation. So in theory that makes sense, but in practice, how would a professional body make a difference? The difference that it would have to make is that such a professional body is somehow much better at enforcing those standards than a body such as the FCA. It is unclear to me why that would be the case, because the body would have to be extremely well resourced in order to be a better enforcer. If you are to resource such a body, why would you resource that body and not simply resource the FCA to cover everyone in the industry more effectively?
Q2633 Mark Garnier: So we come back to the big stick question and the Chartered Banker Institute, which defended vehemently its reputation by not throwing out Fred Goodwin last week-that kind of illustrates that point.
May I turn to something slightly different? I do not know if you had a chance to look at the evidence session with the UBS bankers who came in last week. There was one particular element of this to which I gave a bit of thought afterwards, and I am very interested in your thoughts. The people running UBS at the time the crisis was unfolding knew nothing about it until they read it in the newspaper a month ago, which is remarkable. Tracey McDermott of the enforcement department of the Financial Services Authority made a very good point when I asked her why she had not interviewed the manager or senior executives: she said that the trail petered out. Therefore if you follow the line of inquiry and the trail peters out, there is no reason why you should necessarily always go forward all the way up to the managers. Taking this to a conclusion-I am curious to know if you think this is the right conclusion, or one of many right conclusions-the message that we were getting from those senior executives was, "This may have happened on my watch, but I was not watching, so therefore I am not responsible for it." It occurred to me that if you take this to a conclusion, what this means is that if you are running one of these organisations, far from setting the tone from the top, actually what you want to do is to put up an accountability firewall between you and what is going on in the organisation. Do you think that is a fair assessment?
Professor Black: It clearly is in those cases-but if the regulator lets them get away with it. Again, I would not want to say that the FSA should or should not have done something in any particular circumstances, because I do not know all the facts, but I know from talking to other regulators around the world, which I do in relation to different supervisory activities, that speaking to senior management, even if the trail has petered out, is regarded in other regulatory organisations as something that you have to do, because otherwise the message goes out-either implicitly or explicitly-that all you need to do is make sure that you do not know anything, as then you are liable only for what you know. The onus should be on you to find out. I would hope that senior management are up in front of the FCA and the PRA on a very regular basis. I totally agree that, at the moment, the message seems to be that what you need to do internally is manage your bank, and as long as you set that up appropriately, you can get away with it. If you want organisational change to occur, and if you want to change culture, it has to come from the top. If the top is able to say, "I can shield myself from the implications of not actually putting that in place," that is not a clear signal that the top needs to change.
Q2634 Mark Garnier: I do not want necessarily to push you into making a judgment on the way in which the FSA covered the UBS scandal, but do you not find it profoundly significant that it did not interview the people running the business at the top, even just as a matter of course, in its investigations?
Professor Black: Yes.
Professor Kershaw: I am afraid that I have not read the testimony. Listening to it now, as you present it, it does sound problematic. When you look at APER and the requirements for taking the requisite degree of care, they are very detailed. They are very detailed also about supervision, monitoring-
Q2635 Mark Garnier: The FSA?
Professor Kershaw: The FSA rules, yes. And putting the right system of controls in place. You are right, it is possible informally to build those sorts of accountability walls to protect yourself. The FSA clearly has the requisite standards in place to pull down those walls. The question then arises as to whether or not it investigated these things appropriately with the standards and tools it already has in place.
Professor Black: To add to that, as legislators, you have one tool-legislation. It is a very big tool, but it is quite a blunt tool. Just as it is difficult to try to change the culture of banks through legislation, it is quite difficult to change the culture of a regulator through legislation. When people ask me what a regulator should be, I say that they should be three things: they should not be captured; they should not be conned; and they should not be cowed. A lot of what we are trying to drive at here is possibly not so much, "If we change the sanctions regime, what kind of impact will that have?" but driving the tougher, more credible, and less cowed approach to very powerful individuals who are very successful and very used to getting their own way. Those culture changes to the FSA and its staff-the FCA and the PRA-are coming through, and I think they are probably very much on board with that, given the criticism they have had since the crisis. In fact, the abolition of the FSA is your ultimate accountability. So, coming back to the question of interrogation, yes, interrogation of senior management is a key part of effective regulation.
Q2636 Lord Lawson of Blaby: As I understand it, when the Chairman asked Professor Black why individuals had not gone to jail, the main burden of your response was the difficulties of the burden of proof and all that. Lying behind that is the fact that the whole corpus of law affects every citizen in the land, which has to be seen as part of this, although we are focusing just on banks. There is one sanction that applies just to banks: the approved persons regime. As you said, it is quite a significant sanction if you cannot earn your own living. Is it not the case that the burden of proof required for somebody to be struck off the approved persons regime is not as onerous as that required for a criminal prosecution? Can you confirm that? If so, why is it that the FSA, which had this power, has struck virtually nobody off the approved persons regime? In fact, everything is kept terribly quiet and they just go to the head hunter, who places them somewhere else so that they can infect the culture of the next bank as badly as the one that they came from.
Professor Black: It is a sorry state of affairs. To be honest, I am going to be second-guessing here, in terms of the FSA’s decisions-
Q2637 Lord Lawson of Blaby: But it is connected to the burden of proof.
Professor Black: The burden of proof is lower.
Q2638 Chair: Who on the panel is not second-guessing? Does anyone have a good feel for this? I did not want to interrupt, but we are pressed for time and we are coming towards the conclusion that Nigel has articulated. If you think that there is something that we need to know, please say so.
Professor Black: The standard of proof is lower. Why they have not proceeded is for them.
Chair: It is a matter for them. That was what I thought you would say.
Q2639 Lord McFall of Alcluith: The Treasury came out with a document last year called Sanctions for the directors of failed banks. We are interested in changing, or getting recommendations to change, the culture in the industry, so it seems as if just looking at directors of failed banks is a limited focus, because if we are going to change the culture, as you said, it is at the top. Should this document have a wider remit? Would it be beneficial if it was called "Sanctions for approved persons within the financial services industry"?
Gregory Mitchell: Yes, I can see how, were that implemented, it could be extended throughout the financial services industry. I can see the rationale.
Q2640 Lord McFall of Alcluith: Could it pick up the PPI cases? PPI was first highlighted in the press in 1995-96. At a Treasury Committee hearing in November 2005, the then chief executive and the chairman of the FSA were asked to look at the matter urgently. Since then, we have had a slow trail, and the problem, in the regulator’s eyes, could be sorted out next year, but it will not be sorted out in terms of compensation. We are talking about a situation that will have been going on for 20 years. How can we bring an appropriate legal framework and accountability to such a situation so that we do not have a repeat of this?
Gregory Mitchell: One additional sanction is the fact that directors of companies owe fiduciary duties. Those duties are set out in case law and in the Companies Act. If a director is in breach of fiduciary duty, they are personably liable for the loss that has been caused. To date, there have been few-if any-such claims in relation to the various scandals about which we have heard. It seems that that is one area that should be looked at further, because that is a very effective sanction, because if one thinks about it, it means that if proceedings are brought against a director who has been in breach of fiduciary duty, he stands to be held liable for the full amount of the loss, together with the costs of the action. That could be a very effective sanction.
Q2641 Lord McFall of Alcluith: When you ask the FSA what they have been doing, they usually answer in the way that Tracey McDermott answered Mark when she said that the trail petered out. Now, it seems that either there is something wrong within the FSA-whether they are captured, cowed or conned, as you said Julia-or they have insufficient sanctions to exercise on companies. Maybe I am asking you to guess, but do they have a sufficient legal framework in your opinion, or is there something missing? For example, the trail petered out. To me, it seems obvious that the FSA should ask companies for a chain of command, identifying who is responsible for certain things, so that if something goes wrong early on, such as with PPI, the individual who designed the product could be up straight away. That doesn’t happen. We get a cluster saying, "We’re all responsible. Nobody is individually responsible." Therefore, the circus goes on for 20 years.
Professor Kershaw: It is extremely difficult to prove wrongdoing in the context of supervision and monitoring, for the reasons that you describe. One thing to focus on is an example of possible poor behaviour where the directors and senior management are clearly on the hook, such as the ABN AMRO decision in the context of RBS. There a decision was taken that, in hindsight, looks highly problematic. Clearly, those directors were involved in making that decision. To go to your question, Lord McFall: are the standards in place that we can rely on to hold individual directors and managers to account? Yes, they clearly are. There is no question about that.
The question then becomes: why haven’t they been deployed in relation to that particular example that, on the publicly available facts, looks highly problematic? The answer to that question is that it is still very difficult to prove that someone has not taken the requisite degree of care in making a decision of that magnitude. It is also clear from the public record that you could make such a case. That leads directly to the question: why did the FSA elect not to make that case?
Professor Black: I think we are back to where we were before, aren’t we?
Q2642 Lord McFall of Alcluith: We mentioned the Treasury document that suggested four possible standards covering managerial misconduct: strict liability, negligence, incompetence and recklessness. What are your views on extending criminal sanctions to cover managerial misconduct? New Zealand imposes a standard of strict liability in certain cases. Would that be appropriate for the UK?
Gregory Mitchell: I think not, because strict liability offences tend to be regulatory offences, minor offences, punishable with a fine. For example, if a company fails to file accounts, directors are strictly liable and they have to pay a fine. I do not know of any strict liability offences that carry a serious sentence, so I doubt if that would be an effective sanction. It seems wrong in principle to impose a serious sentence on somebody for mere negligence.
Q2643 Lord McFall of Alcluith: In the case of PPI, would the existence of criminal liability in the context of mismanagement have ensured that some individuals were held to account before this time for the falling standards?
Gregory Mitchell: I don’t know; that is a difficult one.
Professor Black: It is difficult. There is an interesting analogy to be drawn from the Health and Safety at Work etc., Act, where there is liability for directors for failure to ensure that appropriately safe systems of work are put in place. So you do have a liability on directors, but it is not a strict liability standard. It is nudging towards a recklessness standard. There is a clear analogy in terms of responsibilities for supervisory arrangements to be put in place across large complex organisations and so on.
The other interesting idea that operates in the health and safety context that could be explored is that it is for the firm to show that there is a safe system of work. In other words, the onus is on the firm to demonstrate that this is a safe system of work, not for the regulator to prove that it is unsafe. You do, to that extent, have a reversal of the onus of proof, if you like, or in this case of safe systems and competence. We are trying to grist something, aren’t we? We are trying to force some kind of action to satisfy the clear public demand that something needs to be done about this. It is an area to explore. It is not a sanction but it is a reversal of onus.
Professor Kershaw: If you are going to have a criminal offence for serious misconduct by senior management, you need also to think about the unintended consequences of having that standard. If you have a standard that is too weak - like a strict liability standard or even a negligence standard that will deter many people from serving on the boards of banks and acting as senior managers. The question is: who are you going to deter? The people you are going to deter are those who are more risk averse and more careful. The people who will take the jobs are going to be the more risk-friendly individuals. If you have a criminal offence and the standard is too weak-if it is a negligence or strict liability standard-your boards will become more populated with risk-taking individuals.
Q2644 Mr McFadden: Professor Black, you talked a second ago about the public demand. There is a public demand, but I think it is almost more serious than that. This is not just a populist cry. In your joint submission you said that the "criminal law is in some sense unjust because it criminalises smaller scale misconduct but does not hold powerful businessmen responsible for the economic destruction wrought by the financial crisis." It is not just a popular desire, although it certainly is that. It the sense that when it comes to the question of direct responsibility for actions, there is a very clear standard if you park your car in the wrong place, or something on a small scale like that, but when it comes to big money, it is a bit like trying to nail jelly to the wall.
I just want to try to explore some of the gaps that people have referred to in the questions. If we take PPI, here we have something where selling it is probably not a straight fraud. You were sold a product, you may have been unwise to buy it and you may have been badly advised-we were advised last week that the profit margins on some of these policies were 87%-so in other words what you were sold was an insurance policy with very little chance of it ever paying out to you, because of the exclusions and so on. That is the territory we are in. In a legal sense, where should culpability for that kind of thing lie? It is not straight fraud in the sense that I have not delivered the goods, or something like that. You have bought something, but it is the wrong thing and the information balance has been clearly unfair. How could that legal gap be filled so that someone could be held responsible for that scale of mis-selling?
Professor Black: You also have to remember that banks are large organisations and they have a lot of very straightforward people working for them on fairly normal salaries, particularly when you come down to the sales end of the market. I would be very cautious about the possibility of any salesman who was found to have mis-sold PPI being subject to a strict liability criminal offence.
Mr McFadden: The salespeople were just doing what they were told.
Professor Black: Exactly. They are doing what they are told, and those sales are what they get commission and performance reviews on, so that would be very invidious. One of the difficulties about strict liability regulatory offences is that you have collateral damage. You have people who are under a strict liability and it is an offence, for example, in a case I happen to know about, because they transported a banned medicinal product or veterinary product but they did not know it was in the back; they were just the driver.
If you are going to have sanctions, you have to put them on those who have power, and power to act. Power comes with responsibility. What that means is that it goes further up the management chain, and it has to go to those who write and shape the products. That is where TCF, the treating customers fairly regime, has the right idea in terms of tracing. That means tracing right back to source how this could have happened in the first place. We come back, do we not, as ever to senior management systems and controls? We are identifying a gap in terms of the potential sanctions to which they are subject, in that there is not a criminal standard there. There are two separate things we have been talking about, and which we reflect in our joint submission.
If you have the signalling effect by imposing a criminal sanction, you have parity, as it were, in terms of potential liability, because a criminal sanction is in place. However, the other thing we go on to say is, how much difference would this make? That comes back to the issue we opened up by saying that it really depends on the likelihood of prosecution; if prosecuted, the likelihood of proof; and, if found, the likelihood that the sanction is something somebody is going to take notice of.
Q2645 Mr McFadden: I really want to understand this. You are saying there is a gap around the design and senior management in terms of selling products like this. I completely agree: the front-line sales staff are just doing what they are told. What would a remedy that addressed that gap look like?
Professor Black: The thing that is on the table now is the question of whether there should be a criminal sanction. The answer we have given quite clearly is that you have a raft of regulatory sanctions that are good, subject to one caveat, which I will talk about in just a minute. The question is then, do you increase to criminal, to which we have said, "Yes, there is clearly a gap there. Yes, it would have a sort of signalling effect. Yes, it might have a behavioural effect." But, for all the very good reasons that have been mentioned-I do not need to go into them here-that standard should not be one of strict liability or of negligence, but of recklessness, because of the severity.
Q2646 Mr McFadden: That would be the charge: you are designing and selling in a reckless way? So the charge for someone at a senior level is that they have designed, and authorised, or pushed, the selling of this product in a reckless way. Do you think that is a change we should be making?
Professor Kershaw: I think our submission says that we need to be very clear that we do not think this would have a profound future effect on how people behave, but there may be good reasons do it. If you are going to have such an offence, the standard should be one of recklessness-reckless indifference to the interests of the customer. There are very good reasons not to have any other standard.
Q2647 Mr McFadden: On the menu in the Treasury’s paper, they talk about strict liability, negligence, incompetence and recklessness. Of those concepts, you think the one that it is most useful to focus on, despite the caveat you have just given, is recklessness?
Professor Kershaw: That is right, but the way the document has been drafted is not very clear; the way in which recklessness has been articulated in that document sounds more to me like a form of negligence standard. To be honest with you, I do not think those four options have been very clearly drafted. Option No. 4 uses the term "recklessness", but when I read the rest of it, it is not a standard I really recognise as recklessness. A recklessness standard involves deliberate disregard for, or total indifference to, the interests of a particular community.
Q2648 Mr McFadden: We may not have time today, but we would be interested to hear your alternative definition of recklessness.
Mr Mitchell, can I turn to you on the question of gaps? You talked about a gap in the PPI mis-selling context. The other gap I am interested in relates to the point Mark Garnier raised about constructive ignorance. As long as I can, as a senior manager, make sure I do not know what is going on in my business, I will be in the clear when the regulators come calling. That is clearly a perverse incentive, isn’t it?
Gregory Mitchell: It is absolutely wrong; it should not happen. A director who did not know what was going on may well find himself in breach of fiduciary duty, because it is his duty to know what is going on.
Q2649 Mr McFadden: You are placing a lot of weight on this existing fiduciary duty-it is not a new thing, you are saying; it is already on the books-but it has so far proven to be useless or unused in the situations we are talking about. Are you saying to us, "Actually, there’s a perfectly good tool there that the regulators could be using for directors who profess ignorance. You don’t need any change. The tools are already there"? Is that basically what you are saying?
Gregory Mitchell: Yes, but it is not a matter for the regulators, because the claim would be a claim in the company which had suffered a loss. It would normally be the company which would bring a claim against its ex-directors-
Q2650 Mr McFadden: Given the public mood described by Professors Black and Kershaw in their note, which I completely agree with, I am sceptical of your telling us that there is no problem here; that there is something there, it is just that nobody has picked it up and used it yet. I find that a bit counter-intuitive.
Gregory Mitchell: I am not saying that there is no problem-there clearly is a major problem-but there is an existing remedy: there is a lot of case law defining what directors should and should not do, and there is also the Act. There is a lot of learning in relation to the fiduciary duties of directors, and the civil courts are well used to dealing with those kinds of claims. As I see it, the problem is that nobody has brought such a claim. Why? I do not know whether claims by failed banks have been investigated and rejected.
Q2651 Mr McFadden: So you think that, on the face of it, it is within the FSA’s powers to bring an action on a breach of fiduciary duty to directors who said that, no matter what was going on with LIBOR or other fraudulent activity in their bank, because they did not know about it, you cannot come after them? Do you think that, without any of the remedies proposed by the Treasury in their paper, that could happen at the moment?
Gregory Mitchell: There would be a case for investigation. Obviously, I cannot predict the outcome of the case, but there would certainly be something that would require serious investigation, and there might well be a civil claim for damages.
Q2652 Chair: We want to know something a bit stronger than that: whether there is a serious likelihood that it would be successful, because this question is right on the money. Why have these cases not been brought? The logical implication must be that it is very difficult to make them stick.
Gregory Mitchell: Certainly the claimant is the company itself. There are circumstances where a shareholder can bring what is called a derivative claim if the board is unwilling to bring a claim, but, in relation to the more extreme mistakes which have been made in the course of this crisis-certainly from what I have read about it in documents in the public domain-there would seem, at least, to be a case to answer. I am surprised that nobody has brought a claim, but I do not think that I can go beyond that.
Q2653 Mr McFadden: But it would be civil damages, you said, it would not be something stronger. Yet civil damages seems to be a bit light for constructive ignorance of what could be criminal activity within the company that you run.
Gregory Mitchell: The consequence for a director found liable for a breach of fiduciary duty is pretty serious, because there would be a judgment for a large amount of money and there would also be an order for costs. I think that it would probably be a fairly severe sanction if a director were to be found liable.
Q2654 Chair: You seem to be telling us that companies, or institutional shareholders and others, have been asleep on the job or badly advised by lawyers, systemically. Otherwise, these powers would have been used, wouldn’t they?
Gregory Mitchell: I am not suggesting that they have been badly advised by lawyers-I do not know what advice they have taken.
Q2655 Chair: We began this session, just before you came in, with a decision to have a non-aggression pact, so I withdraw that slur in my question-
Professor Black: We are academics, by the way.
Chair: What is the answer to the question, none the less?
Gregory Mitchell: I do not know.
Professor Kershaw: Gregory is absolutely right that there is this standard in place and there are several means of bringing it: the company itself could bring the action itself; the shareholders, which are the Government, could pass a resolution in a general meeting which directs the directors to bring an action; or an individual shareholder could bring an action derivatively. Now, one of the reasons why they have not been brought, I suspect, is because there are significant costs in bringing an action: both direct costs and, for an individual shareholder-say, an institutional shareholder-significant opportunity costs as it takes a lot of time and effort, and the probability of success is not completely clear. You could make a case for having breached a standard that you have not taken reasonable care in putting in place the correct structures for monitoring and control, but, as we see from the Pottage case, these things are difficult to clearly establish and it is difficult to be successful when the other side has in place a set of effective lawyers.
Q2656 Chair: That implies that we need to tweak the cost-benefit analysis of an action with some measure. Correct?
Professor Kershaw: Yes, clearly you could tweak the cost-benefits. If you had had contingency fees for derivative actions whereby the lawyers could take a significant part of the pot, we would have seen actions brought against those directors. There is no question of that.
Chair: We know that the lawyers will be very active.
Q2657 Lord Lawson of Blaby: Just to take one particular scandal, the one in the wake of which this Commission was set up-LIBOR-it will become apparent, as it hasn’t yet fully, that pretty well every bank was in that scandal. Are you saying, therefore, that every director at every bank could be sued for breach of fiduciary duty?
Gregory Mitchell: No, I couldn’t possibly go that far.
Q2658 Lord Lawson of Blaby: Then I am not sure what you are saying.
Gregory Mitchell: Each particular case would have to be looked at on its merits in order to determine to what extent any particular director had been in breach of his fiduciary duty and had caused loss. That would certainly depend on the individual circumstances of each case.
Q2659 Lord Turnbull: One of the main propositions on the table is the rebuttable presumption. As I read it, the two professors are not particularly enthusiastic about that because they don’t think it would change behaviour very much. I think you, Mr Mitchell, would probably go rather further in your criticism by saying that it is unfair because, if you are going to be denied the ability to ply your trade, there has to be some proof of wrongdoing. Do you think we should not be supporting that proposal? The proposal has a different status in this document-it is almost as if it is what the Government want to do-but should we be recommending it?
Professor Black: Our view is that, by analogy with the medical principle, financial regulation should do no harm, the rebuttable presumption would do no harm, but would it signify a big change? We did not think so, because we thought it was largely regulatory practice anyway. Given the increased intensity of scrutiny by the regulators of those being appointed to SIFs-significant influence functions-if you have been a director of a failed bank, it seems that within the interview process that the regulators now go through, it is for you to show that you are still capable. Putting the rebuttable presumption in the regulatory requirements puts down a marker to say that this is a fixed point in regulatory practices that cannot move, whereas what we are saying is that current practice may well change, as practices can. The rebuttable presumption would seem to be encouraging what occurs already, rather than introducing radical change. That on its own, however, is not to say that it should not be done.
Q2660 Lord Turnbull: I think you, Mr Mitchell, are saying something different, which is that the rebuttable presumption could do harm, because the outcome could be determined by the depth of the FSA’s pockets. The FSA could strike someone off, and the individual, who is much less well resourced, unless they are backed by an organisation, would not be able to fight it. I suspect the difference between the Pottage case and the Cummings case is that Pottage’s employer supported him through the tribunal, and in the Cummings case the employer did not, but that is by the bye.
Is there a conflict in that company law, in effect, says that a board has a degree of collective responsibility, which clashes directly with the political demand that heads of named individuals must roll? Is it actually quite difficult to use company law to tackle individual directors, provided that they can demonstrate that they all discussed this, they all had the same information and they took the decision together?
Gregory Mitchell: If a board as a whole had taken a decision that was negligent, and as a result had fallen below the standard of care, they would all be liable.
Q2661 Lord Turnbull: But you would then have to take on the whole board; you could not pick out the CEO or the chair.
Professor Kershaw: I think you could. The various duties already apply to all directors, but they are applied according to the nature of what they do, their role and function on the board. If you are a senior executive manager and also a director, the duties adjust to take account of the fact that your role is different.
Q2662 Lord Turnbull: I cannot remember in which of your submissions you introduced the concept of due diligence. Surely one of the defences would be "With due diligence, I shared this and took advice from all my colleagues; I took legal advice; I took advice from outside the company." It seems to me that the criminal sanction is still quite difficult to pin on an individual who takes care to make sure that every step in this process is shared with colleagues.
Professor Kershaw: That’s right. In relation to any director, you would take account of the context in which they made a decision: reliance on legal advice, the opinions of your fellow colleagues, the executive management etc. That would all be taken into account in assessing whether you had breached the standard.
Q2663 Lord Turnbull: If you’re going to believe the banks are different- and there is a case that they are different, which is that they can damage the public interest more and in a wider sense than other companies-do you think that dealing with the exceptionalism of banks, if that is what you want, is better done through having criminal offences which apply only to banks, or that, if we are going to target banks, that should be done through the regulatory system?
Professor Kershaw: I think there are things you can do with corporate law along those lines, going to the point I made at the beginning, which is that banks are different. You ask the question "What are the duties of directors?" A director’s duty is to act with reasonable skill, care and diligence. "But to do what?": to generate shareholder value. Banks are different from other companies. Their pursuit of shareholder value, if you are a too-big-too-fail bank, is at odds with the interests of society.So if you are asking directors to pursue shareholder value and to do so reasonably, then they are not in breach of their duties if they do things, which, provided that they are lawful, actually have negative consequences for the rest of us. So corporate law can respond by altering those duties, which, as you see in our submission, we think should be taken very seriously.
Q2664Lord Turnbull: Do you mean to say that this higher test of recklessness could be applied only to them, and not to drugs companies, or aviation companies?
Professor Kershaw: Banks are different precisely because creditors in too-big-to-fail banks benefit from a state guarantee, whereas a drugs company or an oil company does not, and therefore we can distinguish them.
Q2665Lord Turnbull: But nobody benefits from that because the state decided, wrongly, in my view, not to enforce it.
Professor Kershaw: If the state feels it has no choice but to keep the payments system in place, then banks are different, and because they are different company law has to be different. The requirement to act in shareholders’ interest for banks is nonsensical, in my view, and there you can alter the incentives of directors to act-
Q2666Lord Turnbull: Are they the only companies of which that is true?
Professor Kershaw: I haven’t thought about every other industry, but it is a clear example in which, when there is a too-big-to-fail subsidy, promoting shareholder value-doing what you are supposed to do-can generate problems for the rest of society. It is a clear example of that.
Professor Black: On your question about how far you should extend this, regulation has a habit of going on a case-by-case basis, and one of the reasons we stepped back from extending your proposal across the board was just in terms of the need to think about the consequences of this; but again I go to health and safety as an analogy, where, you have directors’ liability, criminal liability, for failure to put in place a safe system of work. So I think there is just a priority in terms of a work flow, really, you can’t just say-"Okay, put it in place." It is easier within the financial regime, perhaps, to see the consequences there, and we would argue for reordering the priorities in relation to whom you owe your duties as a director.
On any extension beyond that to other areas, look at the other regulatory regimes in place to which those companies are already subject, see what happens there and, on a project management basis, really, have a proper review. Do that if you really want to extend it out into other areas of law, simply because it’s a crowded space already.
Q2667 Lord Turnbull: It is normally good practice that there should be a separation between people who investigate and gather evidence, people who decide whether a prosecution should be brought, and people who make the judgment. My final question is: do you think the enforcement arm of the FSA/FCA fully meets that separation?
Professor Black: To be honest here I have to go back to the Act. I had trouble with the way it was formulated in the Bill, but I have not gone back to the Act to see whether the separation has been enforced between investigation and the decision whether to take enforcement action. The Regulatory Decisions Committee had to recraft itself on the back of a tribunal decision.
Q2668 Lord Turnbull: The RDC is surely part of the judgment element.
Professor Black: Yes, but it used not to be. There was not the clearest separation so the FSA had to recraft it in that way. Yes, as a matter of principle there should be a very clear separation between those investigating and those determining.
Q2669 Lord Turnbull: The separation I was suggesting was between those investigating and those deciding to put a case to the RDC.
Professor Black: There could be a number of reasons why you might want to do that. One might be in relation to prejudicing and making sure that your evidence is not somehow distorted and you have not corrupted the investigation process. Would that be it?
Q2670 Lord Turnbull: A separation was made for the police and the Crown Prosecution Service. Thirty years ago that was not made, but we have not made it for the enforcement processes of the FSA. Do you have any thoughts on it? Perhaps ponder on it and let us know.
Professor Black: Okay, that’s fine.
Q2671 Baroness Kramer: In the House of Lords, virtually every Member who spoke on these issues was utterly shocked that in the case of LIBOR misrepresentation-the provision of inaccurate and misleading information to the LIBOR setting system-there appeared to be no mechanism for either the regulator or the Serious Fraud Office to call any individual to account, even though individuals were knowingly providing information that was inaccurate, for the benefit of their particular institution. Looking through the various recommendations that you have made, and the comments you have just made, on recklessness, are there any features that would capture that? I know there is new legislation now that specifically goes after that area, but given that we have to assume that, in a constantly changing world of financial services and bank services, we cannot possibly in every instance look at every new product area or activity area and set up specific regulations for that, would any of the things that you have come forward with capture issues like that, or will they fall between the stools of a very specific statute?
Professor Kershaw: With the recklessness standard, you would think you would have a good chance of capturing that sort of behaviour.
Q2672 Baroness Kramer: That is the one, is it?
Professor Kershaw: For the reasons we have given, we think the recklessness standard is the right one. You can have a higher standard and it makes it easier to hold people to account, but because of the negative consequences we have talked about, we don’t think that is appropriate. Even with the recklessness standard, taking LIBOR as an example, if senior management were deliberately to do what has been suggested and put up an accountability wall-if you effectively said, "I don’t want to know about that. Hopefully that is going on, but I don’t want to know about that."-that would appear to be reckless of the interests of the constituencies affected by that action. So I would have thought that in the context you describe, even a tough-to-prove recklessness standard could be deployed to capture behaviour of senior management that encourages, but does not direct, that sort of behaviour.
Professor Black: Another thing that can be done, or which is already going through, is this: under the approved persons regime you have to act with integrity in carrying out your control functions, so what you have to pin action in relation to LIBOR on would be not acting with integrity. A way to do it under the regulatory regime, leaving the criminal regime on one side, would be to do one of two things. One is to extend the scope of responsibility for those who are already within APER, which is already happening. It would be to say if you have no systems and controls in place that make sure that the integrity standard is adhered to, not just when you are acting your control function, but more generally, that is a breach of APER. It would also be to extend the population, the number of people to whom APER applies. I have to look, but to the extent that those who were submitting the LIBOR figures for the compilation of the index-it would apply to anybody else who was submitting figures for the compilation of all sorts of other different indices-the responsibility would be on those individuals to be subject to something like an APER regime.
We go back to the extension of ethical standards, do we not, across different axes within the financial services company. If those individuals are subject themselves to an APER provision, which says that you must act with integrity, that would capture lying about figures when putting up figures to an index, because you are corrupting the integrity of the market. If you did craft the extension that way, you would be able to have a regulatory sanction against them and not just have to rely on the criminal law.
It is like a risk-control mechanism. You have your front stop, your back stop and your further back stop. You want your regulatory sanctions to be fair, but relatively straightforward, quick to apply and subject to duties of fairness-the fact that you might have the wrong person etc. One way that you can focus on the LIBOR-type issues is in relation to the senior management by extending APER beyond their control functions, which is already under consideration.
The second, which would be a matter for the FCA and the PRA, would be to look closely at different groups of actors within the financial services companies, and saying, "Okay, who needs to be subject to these types of principles, as well?" As we said in our submission, you cannot do that on a blanket base across the entire company because you have the employees in the office canteen etc. It is the key workers that matter, so it can be the key traders, those submitting to indices or those performing other functions where you think the ethical standards should be brought to bite.
Q2673 Baroness Kramer: The tool is the approved persons regime, both expanding it and taking it down through the organisation. That is really helpful.
One of the issues that you raised earlier was that there are, in fact, a wide range of sanctions available to the regulator. One of the interesting questions is whether they were really used and used to their full capacity. I think you suggested that the culture is changing. Obviously, our concern is for a regime that will last well into the future, even in those eras when good times mean that regulators find it harder to be tough. Are there are any additional underpinnings that could reinforce and provide a permanent basis for the very different cultural approach that you have tried to define? It seems to exist frankly in the United States, but not necessarily here.
Professor Black: I am very wary of analogies with the SEC. I do not know whether you have read the SEC report into the Madoff investigation, but although the SEC does have a strong litigious approach, at the same time, the SEC was seriously asleep on the job in relation to Madoff, and it does not make very good reading for how you want to run a regulatory organisation. In fact, when I talk to regulators about how to regulate, the SEC report is one that I make them read. It is a lesson in what not to do.
How do you keep regulators on the ball all the time? It depends on where you are in the institution or firm. It is very difficult to do on a legislative basis. You cannot do crude metrics-you need to bring x number of enforcement actions a year. You do have other ways to keep them on track, and that is through the accountability function that Parliament serves and has been serving, I have to say, very effectively, and is what the TSC has been doing all the way through the crisis. Now you will have the back-up of the NAO, which you did not have before because it did not scrutinise the FSA. The National Audit Office has a very good role, as it has proved in a number of different areas, for doing very good forensic information gathering, providing evidence base on which others and parliamentary Select Committees can perform their accountability functions. Harrying-you cannot legislate for it, but you can harry them and harangue them.
Q2674 Baroness Kramer: Nagging. That is certainly something that middle-age women understand. Can I ask one last question? I was very interested in the point raised by Mr Mitchell in the earlier discussion about how the institution itself could chase down various directors for failures to meet their fiduciary responsibilities. I can imagine that that is antithetical to the culture of many boards and how they tend to operate, where there is a sort of professional courtesy to others who serve on boards. Is there a way to give that scope and ability to other stakeholders? You said that shareholders could bring an action, but there are some issues there. Is there any reason why customers and depositors should not have the capacity to bring actions? As a customer, you are surely in some fiduciary relationship with the organisation and its board of directors. Is there anything worth exploring in that direction?
Gregory Mitchell: A customer would certainly be able to bring a claim against a bank, for example in relation to a mis-sold product or LIBOR. There are certain claims that have already been brought.
Q2675 Baroness Kramer: But not specifically against the directors for a failure in fiduciary responsibility?
Gregory Mitchell: No. I do not think that under English law, unless the circumstances were truly exceptional, the directors would owe a duty to a customer. Obviously, if a director commits a fraud against a customer, there could be a claim, but that is because the fraud is that of the director. Ordinarily, the claim would be a contractual one, as between the customer and the institution-not the director.
Professor Kershaw: There is no reason in theory why you could not give the right to bring an action on behalf of the company to another constituency, but when you think about the incentives to bring an action, shareholders have some degree of incentive to bring an action, because if they hold the person to account, they indirectly benefit from any compensation paid to the company as shareholders. If a customer or an employee was to force an obligation over to the company, it would only be the company that would benefit. Those customers or employees would get no indirect benefit whatsoever. Even if you gave them the right to bring those actions, it is very unlikely that they would actually use it.
Q2676 Mr Love: May I come on to civil liability and, in particular, the duty of care owed by bank directors? I want to talk about the changes that we might make to the duty of care, but perhaps I can start by asking whether there are any reasons why we could not extend that duty of care to senior officials within a bank. It is a rather false differentiation between directors and senior managers, who may well be taking some of the decisions on whether a duty of care is required to protect the public.
Professor Kershaw: The duties apply to directors, and that covers directors who have been formally appointed and anyone else who may not be formally appointed but acts as a director or who may be a shadow director, pulling the strings from behind. If you are neither formally appointed, nor a de facto director or a shadow director, those duties do not apply to you-you are absolutely right. Formally speaking, there is no reason why you could not expand the application of those duties to other individuals. That would be a great leap forward, but if you did that through the Companies Act, it would raise a whole pile of issues, because you would be regulating all companies. There is a big question as to whether that would be an appropriate step forward.
Q2677 Mr Love: Let me come on to that, because in your submission you recommended that any changes should be restricted to the financial services sector. Will you go on to explain why you felt that we ought not to include the whole of the companies sector?
Professor Kershaw: I think we went even further than that, to be honest with you. There has long been a huge debate in the UK about in whose interest directors should act-their duties are owed to the company, but this is about theose interests-when they exercise corporate power. That debate was had in the 1990s and did not result in any significant changes to the Companies Act. Why do we want to restrict it just to the financial services industry and, further, just to ring-fenced banks? The reason for that is the effects that having that explicit stake guarantee have on shareholder incentives. It generates incentives to take excessive risk and to act in ways that are detrimental to society, because of their peculiar nature. That, for us, is a strong justification for treating ring-fenced banks, in particular, differently, because we need those ring-fenced banks not just to pursue shareholder value at the expense of society, but to act in the interests of all groups, particularly depositors.
Q2678 Mr Love: Let me come on to that point, because you made it earlier and you made it in your submission. You suggest that we ought not to look, as always with company law, to shareholders and protecting their interests and that we ought to extend that to depositors and give them equal, if you like, priority. How would you change the duty of care to recognise that?
Professor Kershaw: Formally speaking, it would not be the duty of care that you would change. You would alter another duty in the Companies Act, which is the duty to promote the success of the company. That duty currently says that it is the duty of directors to promote the success of the company for the benefit of its members , ie., itsshareholders. That is a duty that you can alter in the Companies’ articles. So there are other means of altering that duty for particular banks without having to change company law, were it to be decided that ring-fenced banks should be different. You would do that by altering that duty to say that it is the duty to promote the success of the company for the benefit of members, depositors, employees or whomever you decide to include within the framework. Clearly, however, you would want to include depositors. The point would be that the interests of those other groups would be of equal priority to shareholders, or you could go further and say that depositors’ interests should come first and that shareholder interest should be second. There is a debate to be had around that. It is that duty, which is in section 172 of the Companies Act, that you would change.
Q2679 Mr Love: You are changing an almost fundamental principle about the role of shareholders in a company by suggesting that.
Professor Kershaw: Absolutely.
Q2680 Mr Love: You are right about there probably being a need for debate here.
Professor Black, you have been involved in this submission. What difference would this all make to standards and cultures in those ring-fenced banks? Would it have a greater impact, for example, than treating customers fairly?
Professor Black: I think that it would bring some of the regulatory expectations in line with the duties to which directors are held, because under the treating customers fairly regime some of the reactions were, first, that customers are always treated fairly and, secondly, that banks always have to maximise profit. So it is fairness with an eye to profits. We limited the proposal to the ring-fenced banks for the reasons we set out. What you would be doing there is clearly saying, "Actually, do you know what? We are reordering the priorities. We are reordering your priorities for public interest reasons and to bring them in line with the goals that we hope the rest of the regulatory regime, to which you are subject, is pursuing."
Q2681 Mr Love: Would that change open the possibility-I come back to what I think Baroness Kramer might have been hinting at-of collective redress? In other words, I mean depositors, or others that are equally ranked, getting together and making a claim against the company.
Professor Kershaw: In most other jurisdictions, the duties that companies owe are typically to all constituencies. That is true of many states in the US. It is true of Germany. In those constituencies, however, the only party that is given a right to bring an action to enforce the duty that is owed to the company is the shareholders. It is not for any other constituency to enforce that right.
Just going back to the point that I made in relation to Baroness Kramer’s question, you need to think about the incentives. If you give that right to someone else, you need to think about their incentives for using it, and the incentives for them to use it would be poor, because you are enforcing an obligation owed to the company and therefore they would not benefit indirectly from that obligation being enforced. They are therefore very unlikely to deploy the time and effort actually to bring such an action.
Q2682 Mr Love: The reason I raise this point is that we have been talking about PPI all morning. There were of course many problems with PPI, but one of the most serious was that the delays inside the system meant that it got completely out of hand. If those affected by PPI, who would not take an action individually because of the small amounts involved, had the ability-some consumer organisations have been very prominent in arguing this case-to act collectively, we could have nipped PPI in the bud at a much earlier stage. The argument then is, should that sort of collective redress procedure be introduced?
Professor Kershaw: On the assumption of a breach of duty owed to the company that affects consumers in that way, what you are suggesting, Mr Love, is that you would have a consumer organisation that could bring an action. In fact, they could do that now anyway. In order to bring an action, as a derivative action under the Companies Act, you just have to buy one share. You can buy that share after the events that you are questioning have taken place and you can bring an action. So, if you want to do that as a consumer organisation in order to highlight these problems and nip it in the bud at an early stage, in theory, that is wholly available by just purchasing that one share and bringing an action.
Q2683 Mr Love: I can see Mr Mitchell aching to get in. Would there not be an enormous risk involved in a consumer organisation taking a collective action on that basis? Would it not be better to introduce a system that allowed that to happen as an influence on ring-fenced banks and others to act responsibly, if they knew that that sort of collective action could be taken?
Professor Black: There are a number of issues going on here in the debate. First, there is the issue of who you are trying to bring liability against. We have talked about the directors, on one hand, and then you have the company itself. You then have the "so what" question if you do bring the action-in other words, who gets any recompense? If you have the action within the company, the benefits go back to the company. In the PPI, however, what you are talking about actually is wanting compensation for consumers, so that is a very different type, and you want that from the company, as you do not want it from directors because their pockets are not deep enough. It is a different type of action-do you see what I mean? The collective action for consumer redress is actually against the company for compensation to those individuals for economic loss, for the mis-sold product.
You have a range of possibilities. You have the empowered litigant model, which we have in consumer law and competition law, whereby someone like Which? is empowered to bring a form of representative action on behalf of consumers. The point there is that they are the ones with the information. They are the ones who can get sufficiently well organised. You do not have the difficulties of trying to corral an appropriate group, etc., and the idea of having them there is to act, exactly as you were saying, as a supplement to the regulator, if the regulator is not doing their job. The idea is that public enforcement action, if it is lacking, can be supplemented by private enforcement action. So you have this representative model, which I think would be an interesting one to introduce or extend, because there is a precedent for it.
Then you have the class action model. Again, it is a wheel that has been partially invented before. You had a detailed study of this back in 2009 from the Civil Justice Commission, and then it got in the crossfire of another issue that comes in relation to costs. There was another hefty review there, the Jackson review, as to what exactly you do in relation to costs of civil litigation. But we went some way down the track in terms of designing that collective action provision. It would have a role, but depending, as in all these things, on exactly how it was designed and therefore, how easy it was to bring, both in terms of costs and therefore the incentive, and also technical issues relating to opt-in and opt-out-who is the class who brings the action? Do you wait until the judgment and then everybody piles in, in which case the company is subject to unlimited liability, in the sense that it is very difficult for it to foresee who this potential class is going to be? Do they have to opt in right at the beginning of the action? That is quite narrow. They might not know about it. You may therefore be excluding a group of potential claimants, so there are technical issues. They are sortable, but there are technical issues that just have to be addressed in terms of how you would design that action. It got part way, but it could be revived.
Q2684 Mr Love: Mr Mitchell, you were aching to get in.
Gregory Mitchell: The point I wanted to make has already been covered to a great extent by Professor Black. We do have the representative action under English law. We do not have the American-style class action. We have various kinds of representative actions and they are commonplace in our courts, and have been for a considerable time. The procedure by which those actions can be brought may need to be looked at in relation to particular cases.
We also have test cases that are brought. For example, in respect of LIBOR, a test case is due to be heard in the Commercial Court next October in relation to the liability of a particular bank to a particular customer. That is likely to be a precedent on the basis of which other cases are decided. We also have a procedure whereby a group litigation order can be made. Where there are a large number of claims that all raise the same point, the judge is able to make an order under which all those cases are subsumed within one particular case.
So we do already have the representative action. It may need further work, but the concept is a familiar one.
Q2685 Mr Love: Professor Black, I have a final question. They did carry out some work, as you said, in 2009 and then they brought a claim that there was not adequate consultation. What, sensibly, can this Commission say about the need for this? We will be discussing the American system and no doubt we will cover some of these areas and find out about their experience, but what can we usefully say in this regard?
Professor Black: You could usefully say it is an area that could be re-looked at. If the issue was that there was not adequate consultation, the issue would be adequate consultation. But it should be seen as part of a suite of avenues for redress that already exist and which, to be honest, are much cheaper for the consumer. You already have a Financial Ombudsman Service, which is always free. No matter what the decision is, it is always free for the individual. You do have the possibility-the FSA already does this, as we have seen in relation to its enforcement actions-to require compensation and to require complete reviews, as part of the enforcement process. Those already exist, as it were. You will still have the representative action, as Gregory said, and you would still have the test case possibility. So what you are doing is adding to a suite of possibilities that already exist, rather than filling an enormous void. That is not to say it is not worth doing, but again, it is not a massive void that it would be filling. Would it potentially be useful? Some individuals might find that action easier to do.
I do have one slight worry, looking at the activities of claims management companies in relation to PPI, that what you would actually get is various companies saying to individuals that it would be in their interest to pay them a fair amount of money to take actions that actually those individuals can get for free under the Financial Ombudsman Service. That would be my main worry.
Mr Love: One of the issues we are looking at is regulation of claims management companies.
John Thurso: First, I apologise for not being here at the beginning. I have the gorgeous task of answering on behalf of the House of Commons Commission in the Chamber on occasional Thursday mornings-
Chair: Which means public spending, basically-how we allocate public spending.
Q2686 John Thurso: I am in charge of trying to keep it down. However, I read with great interest all your submissions, and my question is really to the two professors in relation to your submission. This is a slightly lengthy question, because I am rolling three things into one. Then I’ll shut up and let you give an answer.
The first observation is in relation to whom we should be dealing with. We keep talking about directors. Many bank directors are not bankers, and indeed most bankers are not directors and therefore the target. In your paper, you are broadly in favour of sanction, but suggest it will not change behaviour, so it is sort of palliative rather than curative. You also make the point that we ought to be looking at other ways, particularly the answers to question 28, which is the other measures that the Commission should consider-that really we ought to be looking ex ante rather than ex post on that.
I was particularly taken with the comments that you made in 28.4 and 28.5, where basically you talk about the role of the shareholder; everybody is talking about shareholders being more involved. Then, in 28.5, you make the point, which I think is extremely important, that "there is concern that UK company law gives legitimacy to the very activity that we want to discourage and provides legal support for the culture which needs to be changed"-i.e., the shareholders are really the last people who should be involved in this. Then, a little further on, you talk about remuneration and make the point that, possibly, no bonus should be paid for ring-fenced banks. Indeed, that chimes with some evidence we had on corporate governance recently from a professor whose name I now cannot remember, which basically shows that the more the members of the board, both non-exec and executive, own shares, the higher the risks they take.
Will you say a little bit more about the shareholder role and this idea getting the shareholders more involved is going in completely the wrong direction, and about the reality of what we can expect from sanction, and, if we want this to be cured, rather than giving people the right of retribution when it has gone wrong, should we be looking at other things? I am sorry, there are a lot of questions.
Professor Kershaw: That is absolutely our view. We think there are possibly some good reasons to look at the sanctions regime, but you cannot expect that to have a significant effect on culture. If the focus is upon cultural change and generating more ethical culture in banks, we think there are some things you can do, but you need to start with the basic incentives, because the basic incentives of senior managers and directors, and therefore of lower-level employees, are at odds with the sorts of cultural objectives you want to achieve, and you are not going to effect cultural change, no matter how strong your sanctions, no matter how well resourced the regulator is; it is just not going to happen.
Our submission focuses on some of the core areas that could alter those incentives. It is not just about remuneration, but we think remuneration is clearly important, for the reasons we have explained before. Particularly in ring-fenced banks, but in any bank that you think is systemically important, the incentives in that bank are skewed away from the interests of the broader community, effectively because the debt market will not sanction the bank because anyone lending to the bank knows that they will get bailed out if the bank fails, which, in effect, in short, gives freer rein to the risk-taking incentives of shareholders. So in a too-big-to-fail bank-a systemically important bank-those shareholders have the wrong incentives. They have incentives to take what we might call socially excessive risk. So there are different ways in which you can address that. Way number one is to say that we need to completely disconnect, in a systemically important bank, any very strong incentives that managers have to pursue shareholder value, and the easiest way to do that is to simply pay senior managers in ring-fenced banks through a salary and through nothing else apart from the salary. No bonus whatsoever.
The second thing you need to do is address what we might call the structural incentives contained within corporate law, which, for an oil company or a pharmaceuticals company we may think are wholly appropriate, but in systemically important banks that benefit from a too-big-to-fail subsidy those structural incentives created by corporate law could be wrong. There are two aspects of that. Aspect number one is what we have been talking about already: what is the objective that we ask directors to pursue-in whose interests should directors act? The second aspect of that is shareholder rights.
One response to the crisis is that shareholders have not done enough and need to be more attentive, aggressive and active, but there is a question mark as to whether that is appropriate, precisely because they have the wrong incentives. There is a question mark in UK corporate law - where we provide shareholders with more rights than the corporate laws of any other jurisdiction - about whether providing shareholders with these rights encourages shareholders to informally or formally exercise these rights, therefore encouraging excessive risk-taking.
From the work that I have done with other colleagues at the LSE, looking at the United States, we have generated some evidence that suggests, in the United States, where you can have different governance rights for different banks, the banks where they had stronger shareholder rights were more likely to fail-or more likely to take risk. That evidence can be interpreted in different ways, but we think that is the more compelling account of that evidence.
So we need to address structural incentives and remuneration, and if you do so in these ring-fenced banks, you will have safer banks and you will also drive, within any ring-fenced bank-I think-complete separation, but complete separation from the inside, rather than being imposed from the outside, being driven by people who really know how to structure that separation.
Q2687 John Thurso: So there is a strong intellectual argument that if you put all these things, ranging from people who we want to take risks at one end to people who we want to be much more prudential at the other end into one thing-one culture and one remuneration structure-you are really doomed to failure. One end or the other will fail. Therefore, the clarity of this is to drive to separation. The commercial logic, therefore-even if, in law, we do not do it because we have got a settled consensus-is that those who want to be risk takers will leave banking, which we want them to do and it is probably the right way, and banking will become a safe thing that is much more at the prudential end. That is the likely consequence of the answer you are giving, is it not?
Professor Kershaw: I think that is right.
Q2688 John Thurso: Professor Black, is there anything you want to add?
Professor Black: Make banking boring.
John Thurso: Amen to that.
Q2689 Lord Lawson of Blaby: What Professor Kershaw said in answer to John Thurso is of very great interest, and I am slightly concerned. We have not got time to go into it now, but we are taking it further. I am slightly concerned that there may be some unintended consequences that we would not want to see, and I think that needs to be explored a lot further. You say, quite rightly, that it is recommended any changes should be confined to the regulated sector. One of the principal characteristics of the regulated sector is that it has a regulator-actually, more than one regulator. Would it not be a better focus for this Commission to look and see what additional powers, or what changes or addition to remit, need to be given to the regulator? Should we not focus on how to make the regulators effective rather than what to do with shareholders, depositors, pressure groups or whatever?
Professor Kershaw: I disagree with that, to be honest with you. I think the core problem is the incentive structure of banks.
Q2690 Lord Lawson of Blaby: Well, the regulator may well have something to say about that.
Professor Kershaw: The regulator can affect the incentives of banks, and ex post sanctions can affect the incentives in banks, but for the reasons that we have given, they are less likely to be effective. If you really want to change culture within banks, you have to address the core incentive structures, I think, which are not addressed by the focus on sanctions.
Q2691 Lord Lawson of Blaby: I am not just saying sanctions; I am saying the regulator, including structure-all these things that the regulator is for. I am not saying sanctions alone; I am saying that it is the regulator that we need to empower to get banks on the right track.
Professor Black: To the extent that this goes to your report just before Christmas in terms of electrifying the ring fence, yes.
Chair: Nothing further to add on that huge point? Thank you very much for giving evidence. We may well be in touch asking for further help, and we have already asked for one specific piece that Andrew Turnbull wanted. Thank you very much indeed.