Banking StandardsWritten evidence from Gregory Mitchell QC

Sanctions for Bank Directors

1. These submissions are the views of Gregory Mitchell QC of 3 Verulam Buildings and have been prepared for the assistance of the Parliamentary Commission on Banking Standards.

2. I have set out my views in a summary form at the outset. Thereafter I have set out brief answers to the particular questions raised based upon the views I have set out in summary form. Where I have left a question blank that is because I have no particular view on that question.

Introduction

3. I have practised as a commercial barrister for 31 years including 15 years as a QC. My core areas of practice have been banking litigation and insolvency. I have acted in many claims both for banks and also against banks in relation to a wide variety of issues. I have advised companies, creditors and insolvency practitioners on many aspects of insolvency law and have also acted in claims against directors in claims for compensation for alleged breach of duty. I have sat as a Recorder in crime (a part time judge) since 2000 and have presided over trials by jury in several cases of fraud and other financial crimes.

Summary

4. The core question is: what additional sanctions are necessary under English law in order to deter commercially unacceptable conduct by the directors of banks? The question can only be answered by looking first at what sanctions already exist under the law as it stands today and considering whether existing law is adequate or not. There would appear to be little purpose in enacting new law if existing law already provides adequate remedies. My view is that the civil law already provides adequate remedies so as to deter commercially unacceptable conduct of directors of any company including banks. To the extent that there has been a failure on the part of banks to pursue such remedies that is a matter that requires further consideration but not legislation.

5. A director of a company who has been guilty of misconduct is subject to potential sanctions of some significance under existing law. These sanctions can be classified under three headings: (1) claims for compensation for losses caused by the breach of duty made by the company and/or a liquidator; (2) disqualification from acting as a director under the Company Directors’ Disqualification Act 1986 (“CDDA 1986”) and/or disqualification from acting as a director under any regulatory regime applicable to the particular business eg under the Financial Services and Markets Act 2000 (“FSMA”); (3) criminal sanctions eg under the Fraud Act 2006 or for breach of the Companies Act 2006 (“CA 2006”) or the Insolvency Act 1986 (“IA 1986”).

(1) Claims for Compensation

6. Company directors owe fiduciary and common law duties to the company. Prior to the CA 2006: “(9) The directors of a company stood in a fiduciary relation and owed fiduciary duties to the company (and not in general to individual shareholders) in the exercise of their power as directors. These fiduciary duties had been worked out by the application of traditional equitable principles relating to the analogous role of trustees: the fundamental duty was that of undivided loyalty to the company. (10) Directors also owed a duty of care to the company (and not in general to individual shareholders).” (Hollington 6th ed para 2–08). Although the fiduciary duty of a director in equity had been extensively determined by case law the allied question of a director’s duty of care had not been the subject of the same amount of case law.

7. In civil proceedings the Court will award compensation to the company against a director for any loss caused to the company by a breach of those duties. The Law Commission (Law Com No 261) reported in September 1999 on “Regulating Conflicts of Interests and Formulating a Statement of Duties” and recommended a statutory statement of director’s duties (4.48). In Part 5 the Law Commission recommended:

that the duty of care and skill of a director should be set out in statute as a dual objective/subjective test (5.2). The CA 2006 has set out in broad terms the content of the duties of company directors. The Act is not an exhaustive statutory code because under s. 170(4) “The general duties shall be interpreted and applied in the same way as common law rules or equitable principles, and regard shall be had to the corresponding common law rules and equitable principles in interpreting and applying the general duties”.

8. S.172 provides a statutory statement of a director’s duty to promote the success of the company. It is in part subjective since the duty is to act in the way the director “considers, in good faith, would be most likely to promote the success of the company…”. S. 172 goes on to list some of the factors to which a director should have regard. It is well established that commercial decisions are for the board and not for the Court, see “There is no appeal on merits from management decisions to Courts of Law: nor will Courts of Law assume to act as a kind of supervisory board over decisions within the power of management honestly arrived at” (Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821 at 834.

9. S. 174 provides an important clarification and statement of the duty of a director’s duty to exercise reasonable care, skill and diligence. It provides for a dual objective/subjective test:

(1)A director of a company must exercise reasonable care, skill and diligence.

(2)This means the care, skill and diligence that would be exercised by a reasonably diligent person with:

(a)the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and

(b)the general knowledge, skill and experience that the director has.

10. This dual objective/subjective test is similar to the test for the statutory liability of “wrongful trading” which was introduced in s. 214 IA 1986 as a result of the recommendations of the Cork Committee on Insolvency Law and Practice (1982—Cmnd 9558). The report dealt with the inadequacies of insolvency law as it then stood and led to the IA 1986 and the CDDA 1986. One of the many innovations suggested in the Cork Report was the introduction of a new statutory liability of “wrongful trading”. The justification for this is set out in Chapter 44 of the Cork Report. The difficulty that then existed was that directors of an insolvent company could only be made liable under statute for fraudulent trading under s. 332 of the Companies Act 1948 and this required proof of subjective dishonesty on the part of a director to a criminal standard. The Cork Report recommended (paragraph 1783) the introduction of a new liability determined on an objective test. A director could be made personally liable for the debts of an insolvent company if he caused it to carry on trading incurring debts, where he knew or ought to have known, that there was no reasonable prospect of the company meeting those debts. This new liability was introduced by s. 214 IA 1986. A precondition for a claim for wrongful trading arising at all is that “the company has gone into insolvent liquidation” (s. 214(2)(a)).

11. The introduction of this new liability for wrongful trading has not been as effective as might have been anticipated at the time of the Cork Report. Directors may avoid the insolvent liquidation of a company (a precondition for liability under s. 214 IA 1986 at all) by the appointment of administrators and/or the release of debt under a Company Voluntary Arrangement (“CVA”) or if some other “rescue” occurs. Even where insolvent liquidation has not been avoided the liquidator may often be unwilling to risk the costs of bringing proceedings even where the case is a strong one. Claims under s. 214 are usually expensive to prosecute because of the factual complexity of reconstructing the financial affairs of the company.

12. Where a bank which might otherwise have become insolvent has been rescued by governmental action liquidation is of course avoided and a claim under s. 214 IA 1986 is inapplicable. It is worth noting however that s. 214 was expressly disapplied in respect of Northern Rock PLC and Bradford & Bingley whilst wholly owned by the Treasury (SI 2008/432 Art 17 & SI 2008/2546 Art 13(1)) suggesting that some possible risk from s. 214 was anticipated.

13. However wherever a bank has suffered loss as a result of negligent business decisions taken by the board` a claim for breach of duty under s. 172 or s. 174 CA 1986 might succeed depending upon the particular facts of the case. A claim under s. 172 may be more difficult to prove because the section makes it clear that the duty is to act in the way the director considers in good faith will promote the success of the company having regard to the matters specified in that section. Nevertheless where a director has caused a company to embark on what transpires to have been a seriously mistaken transaction there will be some burden upon him to establish that he did in good faith consider the transaction to have been likely to promote the success of the company and why.

14. Where a bank has failed as a result of imprudent transactions and has been rescued by governmental action then a claim under s. 174 may be less difficult to prove than one under s. 172. The standard of care is variable depending under s. 174 depending upon the circumstances and the Court might well expect the highest standard of care from a director of a bank. The Court hearing such a claim will apply a standard of care that is appropriate in all the circumstances of the case, including the knowledge skill and experience of the director, the particular role that he played in the transactions that led to failure, and the remuneration that he received.

15. A failed bank which has been rescued by governmental action is likely to have a new board of directors appointed after rescue—even if not immediately. A claim against a former director is an asset of the company and the new board are under a legal duty to consider whether or not there is a claim worth pursuing. The new board might take the view that making a claim was not in the best interests of the bank because of the reputational damage that could be caused to it by litigation, the costs of the litigation and the likelihood that the defendant directors even if wealthy would have wholly insufficient assets to meet any judgment.

16. There may be powerful commercial reasons why no litigation for compensation has been brought against directors of failed banks. However company law does provide an appropriate remedy if the new board of a failed bank decided to pursue it. One matter for detailed consideration is how on rescue of a failed bank some contractual provisions may be inserted so as to facilitate the bringing of proceedings against the former directors. This is a matter for the future. In relation to the rescues that have already occurred questions may arise as to whether potential civil claims have already been fully investigated and if so with what result.

(2) Disqualification

17. S. 9 of the Insolvency Act 1976 provided for the disqualification of a director where he had been a director of two companies each of which had gone into insolvent liquidation, the second having occurred within 5 years of the first, and his conduct making him unfit to be a director. The Cork Report in Chapter 45 recommended a wider disqualification regime and this was brought into effect under the CDDA 1986. The power in the court to disqualify directors for up to 15 years arises in various circumstances: s. 2 conviction of an indictable offence in connection with the company, s. 3 persistent breach of the companies legislation,

s. 4 fraud in the course of winding up, s. 6 director of an insolvent company and unfit to be concerned in the management of a company. Most disqualification cases are brought under s. 6 a precondition for which is the insolvent liquidation of the company.

18. A separate disqualification regime applies under FSMA.

(3) Criminal sanctions

19. There are many criminal offences that may be committed by directors of a company for example under the CA 2006, IA 1986, the Fraud Act 2006. There are many circumstances where there appears to be strong evidence that an offence has been committed and yet no prosecution is brought. The costs of prosecuting financial crimes is often substantial because of the complexity of the material that has to be assembled. The costs of jury trials are particularly high in factually complex cases and the outcome is often unpredictable.

A jury may not reach a conclusion at all—if they are not unanimous or there are insufficient numbers for a majority verdict (essentially 10 of 12 agreeing with the verdict). A jury never gives reasons for its decision.

Specific Answers to Questions Raised

1. What are your views on extending criminal sanctions to cover managerial misconduct by bank directors?

I believe it would be wrong to do so. Managerial misconduct by bank directors can be adequately sanctioned by civil claims for compensation made under the CA 2006 and existing common law and equitable principles together with disqualification where appropriate. If there is a reasonable case that a director of a bank has caused loss to the bank by acting without due care and skill then a claim for compensation could be brought. The civil courts are the most appropriate forum for the determination of the difficult factual question as to whether or not the particular defendant was in breach of duty or not. Although civil claims are expensive to litigate the result is a public and reasoned judgment by an experienced judge who has read and heard all of the evidence. The civil courts have a wealth of experience in deciding the facts, the appropriate standard of care, and whether or not a particular defendant has been guilty of a breach of duty.

It would be wrong in principle to introduce criminal sanctions for mere negligence in the conduct of a business. There are also powerful pragmatic considerations against such an offence. Even if such an offence were introduced prosecutions might be substantially more costly than civil proceedings, the criminal standard of proof (being sure) rather than the civil (more likely than not) would apply, and juries might well not convict or reach a verdict at all. The Cork Report recommended the introduction of a statutory liability in civil law for “wrongful trading” because the criminal offence of fraudulent trading under s. 332 of the Companies Act 1948 was hard to prove. It would therefore be a retrograde step to create a criminal liability of negligence in the conduct of a banking or any other business. Even where the jury returned a conviction on such a charge, a powerful plea of mitigating circumstances could be made based upon the particular circumstances of the case. Judges would be unlikely to impose severe sentences for offences of negligence in business judgment. The end result could be a substantial expenditure of taxpayers’ money for very questionable benefits.

2. What are your views on the possible formulations of a criminal offence based on options (i) to (iv)?

Strict liability offences tend to be summary offences tried in the magistrates courts and on conviction punished by a small fine. More serious offences require proof of fault—mens rea—and are indictable and subject to custodial sentences. If a strict liability offence of being a director of a failed bank were enacted then what would be the penalty? A fine which in relation to the loss caused to the bank was small would hardly appear to be appropriate at all and might result in considerable public disquiet. A custodial sentence would be equally inappropriate for different reasons—it would hardly seem fair to impose a serious penalty for an offence for which no mens rea had been proven. Negligence and incompetence can be sanctioned as above by civil proceedings which are a much more appropriate forum for determining such issues than criminal proceedings. Recklessness is an ingredient of many offences which require mens rea. Recklessness is often a difficult concept for juries to apply. There is a considerable body of case law on its meaning in different contexts both in civil and criminal law illustrating the difficulty of the concept. If a criminal case could be proved showing that a director had acted recklessly then a civil claim for compensation could be proved.

3. Do you think that an offence based on one of those options would be likely to discourage those considering positions of leadership within banks?

Yes and see answer to 5 below.

4. Will the possibility of criminalising behaviour which can already be sanctioned under Financial Services and Markets Act 2000 (FSMA) act as a greater deterrent?

No.

5. Do you think that it is likely that the threat of criminal action will stifle perfectly legitimate activity and ultimately deter growth in the banking sector?

It could cause significant damage to the banking industry in the UK in different ways. First such an offence might lead to the resignation of experienced directors of a bank that was encountering difficulty at the most inopportune time for the further conduct of the business of the bank. Resignations of directors might lead to speculation that the bank was in trouble leading to a run on the bank at the worst possible time and aggravating its difficulties. Second such an offence might make it difficult for new directors to be appointed leading to a vacuum at the top of a bank which was capable of rescue at the time when it most needed experienced directors. Third such an offence might lead to banks over time moving their seat to other jurisdictions. Fourth such an offence would be damaging to the reputation of English law. A criminal offence of being a director of a failed bank whether based on strict liability or on negligence would be likely to be seen as irrational and unfair.

6. What are your views on the statement that there appears to be significant reluctance from regulators to take criminal prosecution against banks or individuals responsible for compliance functions? To the extent you agree with the statement, what, in your opinion, are the reasons for this reluctance?

Criminal prosecutions are costly and time consuming. The result of a prosecution particularly where the outcome depends upon the decision of a jury is often very uncertain. Regulators will naturally be cautious about starting prosecutions even where the evidence appears strong because of the risk that large amounts of money and time will be invested in a prosecution that may fail.

Civil and Regulatory Sanctions

Rebuttable Presumption

On 3 July 2012, HM Treasury published proposals to amend FSMA in order to put in place a rebuttable presumption that a director of a failed bank is not suitable to be approved by the regulator as someone who could hold a position as a senior executive in a bank. The Government also proposed two groups of “supporting measures”, which could be taken forward by the regulators under existing FSMA powers:

(a)Introducing clearer regulatory requirements on individual responsibilities and the standards required of people performing certain key roles; or, in the alternative, a “firm-led approach” (with the onus on the firm and individual to set out a detailed written statement of the responsibilities and duties of each role); and

(b)Requiring banks explicitly to run their affairs in a prudent manner, and requiring bank boards to notify the regulator where they become aware that there is a significant risk of the bank being unable to meet the threshold conditions for authorisation.

7. What are your views on the proposal to introduce a rebuttable presumption that the directors of failed banks are not suitable to hold senior executive positions in other financial institutions?

My view is that this would be wrong in principle. If a person is to be disqualified from pursuing his particular profession or business that should be on proof of wrongdoing. A rebuttable presumption would in practice punish the innocent along with the guilty. A director who was entirely innocent of any wrongdoing might be unable to afford the cost of rebutting any such presumption and be unable to work. question whether such a provision might be challenged under human rights principles. Furthermore such a provision might lead to the resignation of the board of a bank in difficulty at the most inopportune time and result in real difficulty in new appointments being made—as in Answer 5 above.

8. Does the rebuttable presumption go any further than the current regulatory regime?

Yes.

9. Do you think that the introduction of the “rebuttable presumption” could discourage skilled individuals from accepting key management positions?

Yes.

10. Do you think introducing the presumption would send a clear message that bank senior executives and boards have a responsibility to ensure there is a strong focus on downside risks?

No. The Companies Act 2006 together with the common law and equity should send that message if they were applied. A successful civil claim for compensation made against a director who had failed to focus on downside risks would be likely to send that message in a clearer and fairer way. A reasoned judgment of a civil court setting out the standard of care and the respects in which the director had failed to comply with the standard would send a much clearer message for the future. There would be a detailed analysis by a Judge which would provide significant guidance to the industry for the future.

11. What are your views on the possible supporting measures aimed at clarifying management responsibilities and changing the regulatory duties of bank directors?

A clarification of responsibilities and duties is a good idea in principle. However it is for the directors to exercise their commercial judgment. It seems doubtful whether any stated clarification would have avoided the errors made in the banking industry.

Existing Regulatory Sanctions

The Financial Services Act 2010 provided the FSA with greater enforcement powers. The FSA has the power to fine authorised persons and approved individuals for misconduct. The 2010 Act extended these powers to enable the FSA to suspend or limit an authorised person’s permission or an approved person’s approval. It also enabled the FSA to impose a fine on an individual performing a controlled function without approval in addition to being able to prohibit the individual from working in the financial services industry. It also included provisions in respect of the disclosure by the FSA of decision notices.

12. Despite the range of enforcement powers currently available to the FSA, are additional powers necessary? If so, what would those powers be?

No.

13. What are your views on amending FSMA to include a power to prohibit an individual from performing a controlled function on an interim basis?

This might be useful. The civil courts grant injunctions on an interim basis in order to prevent harm from occurring and there is no reason in principle why there should not be such a power provided it was exercised subject to adequate safeguards.

14. Considering the current powers and measures, do you think the perceived shortcomings in being able to hold individual directors personally culpable are as a result of statutory or regulatory deficits or as a result of regulators and law enforcement agencies not utilising the powers already available to them as fully as they could?

On the rescue of a failing bank the new board should be specifically required to take legal advice on whether or not there are civil claims for breach of duty that can be taken against the former or outgoing directors of the bank. Even without such an express requirement the new board of a bank or any company is always under a duty to consider whether there are claims against former directors that ought to be pursued.

15. What are your views on extending the limitation period for taking action against approved persons?

Legislation versus Regulation

16. In order to make bank directors more accountable (due to the adverse impact a large failed bank can have on the wider economy), what are your views on amending the approved persons’ regime under FSMA rather than the Companies Act 2006 and the Insolvency Act 1986. To the extent you consider changes should be made to the legal framework, please articulate how you think this could be achieved given the legislation would apply to all company directors

As above directors can be made personally liable for breach of duty and that should be a sufficient sanction.

The Approved Persons’ Regime (APER)

1. The Upper Tribunal ruling in John Pottage v The FSA (FS/2010/0033) highlighted that enforcement action against senior managers is only likely to be successful where there is evidence of actual wrongdoing by the executive concerned. In your opinion, what changes could be made to some of the statements in APER about the standard of conduct expected of directors in order to make it easier to bring enforcement?

2. In your opinion, has a lack of direct senior management accountability inside firms for specific areas of conduct contributed to the shortcomings in holding individuals personally culpable? Do you think APER should be revised to remedy this?

3. Would it be beneficial for the regulator to adopt a more intrusive approach to senior appointments as part of the Significant Influence Function (SIF) process? How could such an approach be adopted?

4. Do you see merit in requiring the regulator to re-appraise SIF individuals at set intervals and on other occasions if it believes that circumstances justify it.

5. What are your views on extending APER so that it applies to all bank employees in order to enable the regulator to take disciplinary action against employees who are currently outside the scope of APER?

6. Do you see merit in the establishment of an independent professional body with mandatory membership which has the power to impose civil and possibly criminal sanctions? In your view, could such a body provide a solution for the issue of global matrix management structures that can exist within universal banks?

Cost

23. Understandably, there is considerable cost in pursuing individual actions. What changes do you think could be made in order to ensure that cost does not act as a deterrent in pursuing all but the largest cases?

There are no easy solutions to the problem of the cost of civil proceedings. Sir Rupert Jackson reported in December 2009 in his comprehensive Review of Civil Litigation Costs. Some parts of the report have been introduced in Part 2 of the Legal Aid Sentencing and Punishment of Offenders Act 2012. However cost remains a serious problem in civil litigation. Costs are also a serious problem in criminal proceedings.

International

24. Do you think introducing additional criminal, civil or regulatory sanctions would have an impact on the international competitiveness of UK banks?

Yes the impact would be adverse see answer to question 5 above.

25. In your opinion, are there other legal or regulatory regimes that the Commission should be considering? Please provide your reasons for suggesting the applicable regime

No.

Other

26. The regulator has an extensive range of enforcement powers but is arguably hesitant in using those powers. What are your views on the introduction of sanction(s) that could be imposed against the regulator to the extent they do not deploy their powers appropriately?

I doubt whether such a proposal is feasible or useful. A regulator is obliged to act in accordance with his statutory duties and in an extreme case could be subject to an application for judicial review.

27. What are your views on applying different sanctions for different types of directors—for example, non-executive directors?

Company law already provides a nuanced distinction between different directors according to their knowledge skill and experience—see s. 174 CA 2006 and s. 214 IA 1986. The particular distinctions to be made should depend upon the particular circumstances of the case and not upon the label put upon a particular office.

28. Are there any other measures or legal/regulatory changes that the Commission should consider?

Yes. Where a company becomes insolvent the liquidator is bound to consider whether to bring civil proceedings for compensation against the former directors and the Secretary of State for Business Innovation and Skills may bring proceedings for disqualification under the CDDA 1986. Where a company has been rescued then neither of these apply. The Commission should consider how to encourage the board of directors of a rescued bank to pursue civil claims against any directors where there is good evidence that they have acted in breach of duty and caused loss. A rescued bank may often be reluctant to commence such litigation for many commercial reasons, such as the adverse publicity that may result, legal costs, management time and difficulties of enforcement. One matter for detailed consideration is how on rescue of a failed bank some contractual provisions may be inserted into the agreements under which the rescue is achieved so as to facilitate the bringing of proceedings against the former directors. Where the rescue has already occurred and there are no such provisions in place then the question arises as to whether the board has given sufficient consideration to the issue of civil proceedings for breach of duty against former directors.

2012

Prepared 24th June 2013