An FSA Presence in the Boardroom, Contributed by Peter Wright and Deepak Arora, Fox Williams LLP
It is reported that the Financial Services Authority (FSA) is now attending the board meetings of large financial institutions considered a potential threat to the UK’s future financial stability, if not adequately supervised. This approach exemplifies the more pro-active and intrusive form of supervision that the FSA has adopted in recent years. The FSA’s CEO Hector Sants describes this new, more pugnacious, approach to be part of an “eyeball-to-eyeball” method of regulation.
The FSA has taken this step in direct response to the criticisms of its “hands-off” and “tick-box” approach to financial regulation, which were levelled at it in the aftermath of the financial crisis. Indeed, it was admitted by Adair Turner, the chairman of the FSA, that, with regard to the Royal Bank of Scotland (RBS), “the FSA operated a flawed supervisory approach, which failed adequately to challenge the judgment and risk assessments of the management of RBS.”1
However, while many regard recent developments in the FSA’s supervisory regime and structure as constructive and beneficial, a number of institutions in the City of London complain that an FSA boardroom presence could impede commercial decision-making and encourage an “out of boardroom” decision-making environment.
The consequences of the FSA’s new approach towards systemically important firms are considered below.
Management & Corporate Governance Failings
Under the requirements of the FSA’s Principles for Businesses (PRIN) and Senior Management Arrangements, Systems and Controls provisions (SYSC), all FSA-authorised firms are obliged to take reasonable care to organise and control their affairs responsibly and effectively, with adequate risk management systems in place. An authorised firm must, therefore, implement effective management and corporate governance structures. Depending on the nature of the firm, such structures are likely to comprise boards of directors and audit, risk, and compliance committees.
Although a combination of boards and committees can play an essential structural role in maintaining and promoting good corporate governance, they must be effective in practice. Ultimately a board or committee is only as effective as the people on it, the policies they implement and the way in which those policies are policed.
A major contributor to the financial crisis was a failure by senior management to foresee, assess and mitigate effectively the risks that their firms posed to the economy’s overall stability. It is widely agreed that these failings arose as a result of the culture that prevailed in those firms at the time and the perception that management favoured growth of business over prudence and appropriate risk management. The failure of RBS is a paradigm example of this.
A Better Understanding
If an FSA boardroom presence is now genuinely required for the FSA to monitor boardroom decision-making efficiently and to gain a better understanding of what members of the boards of economically significant firms consider important, this highlights the failure of the FSA’s previous policies.
In 2010, the FSA introduced a new vetting regime to improve the calibre of board members and other senior managers at banks and other financial institutions by applying a stricter assessment procedure. Much like recent developments, this regime was introduced as a direct consequence of the financial crisis and a belief that weak boards and inefficient decision-making led to the downfall of many firms.
Many feel that the FSA has been successful in raising the standards of boardroom personnel. If this is really true, however, the FSA’s current desire for additional intrusion into the boardroom begs several questions: has the FSA gone a little too far, and is this potentially opening the floodgates? Will the FSA in time seek to approve or ratify major boardroom decisions before they are finalised and implemented? Will the FSA move away from merely monitoring boardroom decisions to interfering actively in and possibly inhibiting the decision process?
If an FSA presence among directors will help to ensure that regulation is paid greater attention and prioritised on the boardroom agenda, then, although not ideal, this is no bad thing. Increased consideration of regulatory compliance can only be advantageous both to the FSA’s statutory outcomes and for good housekeeping in the financial sector.
Conversely, there are well-founded concerns that over-prioritising regulatory compliance could impact adversely on attention and care paid to commercial, non-regulatory matters. To achieve its outcome of financial stability, the FSA requires firms to be financially robust. A lack of profit (arising from a lack of effective and efficient commercial decision-making) could have its own negative consequences for firms concerned as well as the overall stability of the UK’s financial system.
Promotion Over Inhibition
A major concern voiced amongst the City is that an FSA presence in the boardroom will stifle open, honest, interactive and ultimately progressive debate. The FSA has declared that attendance in the boardroom is to monitor the management and senior governance of firms rather than to interfere in their commercial decision making. Yet, those at the receiving end of the “monitoring” suggest that directors and senior managers will end up saying things that they do not really mean, and thus instigate an era of “stage-management” in the boardroom.
The key risk is that the regulator’s presence may encourage more informal decision-making outside the confines of the boardroom, leading to confusion and mismanagement, and ultimately detracting from the outcomes an FSA presence is seeking to achieve.
The FSA’s approach also poses some risk to its own position as a regulator. There is concern that FSA representatives could be regarded as “shadow directors,” exerting influence over the company and driving key decision-making without being accountable to its shareholders.
While it is perhaps an overstatement to regard the FSA as pseudo or full “shadow director” of firms, such concerns are not without foundation and warrant some consideration in light of the legislation that governs this area. The Companies Act 2006 offers no statutory guidance as to the circumstances in which a person will be found to be a shadow director.
However, the legislation does provide that a shadow director is a person in accordance with whose directions or instructions the directors of the company are accustomed to act. Therefore, to become a shadow director, an FSA board representative must exert a real influence over the company’s affairs and direct the acts of the directors, such that the majority of the board acts on such instruction, as a matter of practice, over a relatively long period of time. Given the increasingly interventionist approach by regulators, it is interesting to consider whether such an approach could lead to the FSA being treated as a shadow director, and accordingly, assuming the liabilities and responsibilities of a director. This risk is, however, more of a concern to the FSA rather than firms.
As to whether the FSA (or its representative) will end up acting as shadow director is ultimately a question of fact and one that will be answered only in time. Should the FSA seek to monitor rather than actively interfere in boardroom decision-making, then the risk of the regulator inadvertently becoming a shadow director is greatly reduced. In any event, any active influence the FSA has on regulatory boardroom decision-making is capped. Regardless of an FSA boardroom presence, directors should continue to make regulatory compliant decisions in any case.
This is the year when the Government’s proposed dismantlement of the UK’s financial regulatory structure begins in earnest, with the introduction of the Financial Services bill expected shortly. As there is a risk that the regulatory reform programme and the accompanying legislative timetable may slip, the current approach of the FSA will give a good indication of the future direction and approach of the new Prudential Regulatory Authority (PRA).
The FSA’s current approach to monitoring board performance appears to be indicative of the style of intensive supervision that the PRA will be keen to pursue under the direction of Hector Sants (a former banker himself) and his deputy Andrew Bailey.
If pursued in the long-term, the presence of the regulator at some board meetings is likely to lead to a better understanding by the PRA of the institutions it will oversee. This should be of benefit to the PRA in pursuing its proposed supervisory strategy. However, if it becomes routine, then this could be a double-edged sword – should there be a substantial regulatory failing in a systemically important firm in the future, it will be very difficult for the regulator to argue that it did not have a line of sight over the relevant issues and questions will be asked as to why the regulator did not act earlier to prevent such a failing.
Currently, an FSA presence at board meetings extends only to those firms that are most likely to fall under the remit of the PRA. However, it is possible that the FSA will, if it has not already done so, start to adopt a similar approach to larger firms that will be regulated principally by the Financial Conduct Authority (FCA). This approach could be useful in enabling a regulator such as the FCA to get a good insight into how new products are developed and reviewed at board level and how a firm’s senior management perceives its clients. Such knowledge and insight could be invaluable, and a necessity, for the FCA if it is to follow through with its “product intervention” mandate to try to mitigate substantial consumer detriment through the mis-selling of financial products to retail customers.
It is clear that any future regulators will be mindful of the failings of prior regulators and the firms that they oversee. Observing and monitoring company boards, and the individuals who sit on them, is likely to remain an important issue and a tool that can potentially be developed further. Both executive and non-executive directors would therefore be wise to watch out for further developments in this area.
Peter Wright is a litigation partner in the firm’s London office specialising in financial services regulatory issues and is a leading member of the firm’s financial services group. Peter has substantial experience in conducting disciplinary cases before the FSA’s Regulatory Decisions Committee and before the Upper Tribunal (Tax and Chancery Chamber). An experienced litigator in the High Court, Peter often obtains emergency orders in relation to various forms of investment fraud, both in a domestic and international context in relation to share frauds, illegal deposit taking schemes and other activities. Telephone: +44 (0) 20 7614 2680; E-mail: email@example.com.
Deepak Arora is an associate in the firm’s financial services sector group in London. Deepak’s contentious experience to date includes a spectrum of commercial, financial and regulatory-based litigation. Telephone: +44 (0) 20 7614 2648; E-mail: firstname.lastname@example.org.
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.
© 2012 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.