Financial Services and Markets Appendices to the Minutes of Evidence


Supplementary Memorandum by the Association of Unit Trusts and Investment Funds (AUTIF)

Q1. Do you believe that there will be sufficient certainty as to what constitutes breach of FSA rules, individual misconduct, and market abuse? If not, what can be put in the Bill to ensure greater certainty?

Q6. Do you believe that the enforcement procedures as now proposed, including those for market abuse, meet the standards of natural justice and the ECHR? If not, what more needs to be done? Are the Government in danger of writing in too many safeguards, and rendering the powers ineffective?

Q7. Do you find the Government's arguments against putting intent into the Bill, and Mr Davies's assurances, persuasive? If not, how would you like the Bill amended?

  These questions are related, so I will consider them together.

  No, we do not believe the rules are sufficient or clear. For two reasons—firstly, something I will call the exaggerated behaviour syndrome, secondly because hindsight plays such an important role.


  In my experience, market abuse is often just an exaggerated form of normal behaviour. Let me give you an example, large City brokers issue research reports every day on stocks. They may also own a position in a stock they write a positive report about. Will the FSA be able to say in advance when the issuance of a glowing report on a stock that the broker owns becomes market abuse? Will not intent come into it? Or will the FSA simply have to show that the price of the stock went up as clear evidence of intent to abuse? I hope not.

  How about a company which takes a short position in a stock? If the stock subsequently goes down, is this evidence of market abuse, or simply good investing?

  In most markets, the everyday buying and selling of stocks has the effect of moving prices up and down. When does an otherwise normal action become abusive action? How will the FSA know the difference when in both cases the effect of the action may be the same?

  This is what concerns me most, that hindsight will be used to determine whether a given behaviour was market abuse or not, when in practice both normal behaviour and intentional market abuse can have the same consequence.


  When is selling a loss leader product a legitimate strategy to gain share, and when is it predatory pricing to wipe out your competitor? Consumers benefit from the first, but can lose out if competition is reduced. How will the FSA know when something is OK for consumers and when it becomes market abuse?


  The Committee is right to be delving into this matter. In my mind, we are in danger of penalising honest people with 20/20 hindsight. Let me give you a live example. Today tracker or index funds are very popular, but in the future we might well come to believe that they distorted markets because of the way they invest in companies without thinking. Will the marketers of tracker funds be held to account under the market abuse regime even though they had no intention to abuse the market? In my experience, it is not easy to see that unintentional market abuse is taking place except with hindsight.


  The market abuse regime proposed to introduce a code of behaviour. Like the Committee, I am anxious to see how this is crafted without intent forcing its way in.

  While not yet accepting intent, Mr Davies in his response to a question by the Chairman said, "It is quite clear that we do not propose to prosecute people for accidental offences". Now the Oxford English Dictionary defines accident as "Anything that happens without foresight or expectation". Sounds like unintentional to me. I think the Committee is wise to continue probing this issue since I fail to see how any concept of natural justice can ignore intent in the financial services world where the chance outcome of risky transactions plays such an important role.


  We recommend that market abuse cases fall to the Enforcement Committee that will have to examine each case based on the facts.

Q3. Do you believe that the proposals for guidance and waiver will allow the FSA to give responsible traders enough certainty and comfort? If not, what more needs to be provided for?


  Guidance is mostly tied to innovation. Firms that plan to do business following normal practice don't need guidance. But if the UK is to be a centre of innovation and if the FSA is to meet its principle of taking innovation into account, then it must have a robust system of guidance on which regulated firms know they can rely. One particular concern for the investment fund industry is that we do not know whether the rule waiver power is intended to cover the investment fund rules. We are severely hampered at the moment because under the present regime it does not.

  Firms most often ask for guidance because an existing rule has become obsolete. It's important to be clear here. I am talking here about when the firm isn't asking for guidance on how to comply with a rule. It's asking for the FSA's agreement to actually breach the rule.

  For instance a rule that says you have to get something in writing from the consumer will have firms seeking guidance from the FSA about whether a fax is OK, or a recorded phone conversation, or an email. Consumers benefit from such innovation.

  Clearly, the FSA can't then turn around and prosecute the firm for breaching the rule. So some certainty is needed here.

  In fact because innovation and guidance go hand-in-hand, requests for guidance will often be the FSA's early warning system that a rule has become obsolete. This Committee has already heard about the need for re-writing existing rulebooks. I think it must be accepted that rules do become obsolete because of innovation and firms need to be able to rely on the FSA's guidance in this regard.

Q4. Are the FSA's proposed powers coherent? Are they sufficient?


  The FSA itself believes strongly that its powers should be used to promote "prevention instead of cure". But I fear they may have confused a firm's duty to try and prevent problems, with an absolute duty to prevent problems in all cases.

  I can tell you from experience that no processing environment is foolproof. No manager can know of every glitch in the system. You solve problems by having a process to identify them quickly, before they can harm consumers, and by refining the process on an on-going basis.

  I think we can be certain that if the powers of the FSA are used to fine firms when they themselves find a problem in the normal course of carrying out their controls reviews, then a climate of distrust will grow between the FSA and the regulated.


  I am concerned that hindsight will be used to say that when a company's system of controls uncovers a problem (say a dishonest employee) that the failure to prevent the problem in the first place is evidence the controls were weak. It is this Catch-22 logic that is the most dangerous part of the proposed Bill. Who will discipline the FSA if it goes down this regulatory path?


  Individual accountability is a good principle. Management should be expected to develop compliance procedures that are reasonably designed.

  But plainly, due diligence by management should be a defence against personal liability. Otherwise in the UK your only absolute defence is to be lucky. Anyone who tells you that you can run a financial service business error free every day has never tried to do it.

Q5. Are you satisfied with the proposals for the Tribunal, as they now stand? Do they make sense?


  Yes, we welcome the revised proposals for a Tribunal of first instance.

  But the Tribunal in procedural terms is after the fact. You get to the Tribunal far too late. Which is why we propose a stronger Enforcement Committee (see below).

  We want a fair system for all concerned. Neither the FSA nor industry should decide what is fair. Instead, the Enforcement Committee must be truly independent with a non-FSA Chairman and majority voting by independent members.

  In his testimony, in response to a question from Viscount Trenchard, Howard Davies described how firms will want to settle a matter quickly. As Mr Davies said "Sometimes they are not sure how strong their case is or they would like to get things settled and move on . . . "

  Isn't this the central issue? That in most cases, we are talking shades of grey. How well supervised was an employee who turns out to be dishonest? Here again hindsight is being used to say that the evidence of his dishonesty is proof that he was badly supervised. How strong is anyone's case where a dishonest employee has been particularly crafty?


  In his reply to Mr Kidney's question, Mr Thorpe described a process where the "option is then for the parties to sit down and discuss it and determine whether there is agreement about it." That sounds like a plea bargaining session to me.

  This is where much more strengthening and balancing of powers is required. Yes, of course, the option of going to a Tribunal exists, but it is expensive, time consuming and drawn out and as Mr Davies himself said firms prefer to "get things settled and move on".


  This is why we believe an Enforcement Committee enshrined in the Bill with an independent Chairman is essential. It needs both practitioner and public interest members and all should have votes.

  Only this way, can a set of guidelines be developed by the Enforcement Committee about when discipline is called for and when it is not.


  When we talk about the behaviour requiring a sanction by the FSA, many have in the mind the Maxwell, Barings or Morgan Grenfell situations. In fact, often we are talking about breaches of detailed rules, where no consumer lost money, but where firms failed to achieve perfection in the way they carry out their affairs. In many cases the firms find the errors themselves and bring them to the attention of the FSA.


  Many of the regulatory issues that will actually come before such an Enforcement Committee will concern proposals to discipline firms for relatively minor back office and administrative breaches. For this we need an enforcement regime that is quick, efficient and flexible. It needs to be both fair and transparent to those accused and also one that consumers can have confidence in, which I believe our proposals will achieve.


  We consider it essential that both the Enforcement Committee and the Tribunal are able to award costs against the FSA where there is a finding in favour of the accused. The prospect of high legal costs deters many firms and individuals from exercising their rights, and leads to pressure to settle early—to "plea bargain" in the American terminology.


  In his reply to a question by the Chairman, Mr Thorpe allowed that perhaps another avenue will exist. He mentioned "a form of mediation between the party who is accused . . . and the FSA." Clearly, it would be interesting to know more of how this mediation process might work. For instance will the mediator be independent? Does the Enforcement Committee suggest mediation before considering a matter further? I suggest, though, that a truly independent Enforcement Committee could avoid the need for yet another layer.

Q9. Are the FSA's powers of investigation excessive?

  This is a regulator which has unprecedented powers.

  The FSA can enter your house at night without a warrant and take whatever papers it wants. If you try and stop them you commit a criminal offence. They then require you to attend an interview, at which you will not have a right to silence—in fact using your right to silence will be an offence itself. They get no joy from you so they call in your spouse. He or she likewise has no right to silence.

  Plainly anyone would find these powers alarming.

Other issues


  There seems to be a great deal of consternation over the question of investor responsibility. We all want to avoid the pitfalls of moral hazard and of mis-selling.

  What are we to do?

  We think the issue is very simple.

  The first principle should be that consumers are accountable for all investment risk so long as they received a fair explanation of what they were buying.

  There are two qualifications—if a firm gives advice on an investment, the advice should be suitable given the investor's circumstances at the time. This last point is quite important. Suitability must be viewed in light of the situation when the advice was given.


  All too often again, hindsight is the criterion used to determine if someone was mis-sold. But almost all investment and saving decisions involve making assumptions about the future. For instance, before you tie up your money in a 90-day notice account, you need to be pretty sure you won't need the money in that 90 days. But if you lose your job the next day and now need the money, were you mis-sold?

  We have to guard against encouraging financial consumers down the road of "someone else is to blame if I lose money". For example, someone trapped in a negative equity housing situation may well wish to say they had a mortgage foisted on them by a greedy financial services company. Whereas someone who has made money congratulates himself on the wisdom of having borrowed and taken his chances in the housing market.

  We have to accept that in the financial world, there is an important difference between a good investment decision and a bad outcome. If with hindsight, bad outcomes are to be used as evidence of poor advice at the time, then consumers will be able to invest risk free, knowing someone else is to blame.


  Much is proposed about consumer education. It is obvious we need the public to understand more about money and financial matters. But if the Treasury is right and a large part of the population doesn't understand what a percentage figure is, then we are talking about a failure of the school system. I don't believe the FSA will ever have a budget large enough to educate consumers sufficiently from such a low level.

  Separately, participants in the market, and AUTIF itself, all provide educational materials for consumers. It actually is in the industry's interest for consumers to know how to tell a good product from a poor one.

  Much is talked about educating consumers about financial products. And that rules need to make sure that they only buy suitable products. But no one talks about educating consumers about how to purchase a house. Yet, this will likely become their largest financial asset or financial drain.


  No. The consolidation of the regulators will have a positive effect on the efficiency of the regulatory system if done properly. Currently all three SROs have published guidance about the Internet, which differs each from the other (e.g., where to put authorisation status of the owner of a website).

  The consolidation of five different compensation schemes and eight separate Ombudsmen schemes is also beneficial to the investor and to the industry.

  Can you object to a robust enforcement regime given the pensions mis-selling scandal, Barings, Morgan Grenfell and others?

  No, but I can object to an unfair one. Any regime which does not provide for a right to be heard, for due diligence to be a defence, for the right to examine the witnesses and evidence against you will never be acceptable. In the end a regime that is not fair will not be respected. In the UK we have long set the standard for justice by demanding that it not only be done but that it manifestly be seen to be done.


  The FSA should not be able to intervene or initiate a prosecution against a firm or an individual except where there was a clear statement of what is required of the firm and there is reasonable evidence that the firm has failed to observe that in a material way and in a way that puts investors at risk.

  The various functions of investigator, prosecutor, judge and jury should be clearly split, and a number of them made independent of the FSA executive.

  All disciplinary processes should provide for:

    —  The right to a pre-enforcement hearing.

    —  Independent composition of the judicial arm (the Enforcement Committee).

    —  Due diligence as a defence.

    —  The right to examine witnesses and evidence against you.

31 March 1999

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