Users of financial products need protection against unscrupulous traders and shoddy products, just like any other kind of consumer. More so, in fact, since you cannot judge a financial product from the look and the feel. Thus, there are rules regarding the nature of the products on offer. And there are rules to govern the operations of the markets themselves, the professionals who trade in them and the vendors of investment products. But remember that there is a limit to the protection that can be offered. At the end of the day, the principle of ‘buyer, beware’ prevails.
The City’s supervisory systems feature frequently in press reports and they have been in a state of almost constant flux over the past two decades. A new supervisory system for investment products, investment advisers and the markets was introduced in the period 1986-88 and was never long out of the news. It replaced a ramshackle regime that frequently left investors at the mercy of con-men such as unscrupulous investment advisers and promoters of dubious commodity investment schemes. But it laboured under the same disadvantages as all regulatory systems. The abuses that it prevented were not news. When it was forced to move publicly against investment operators, it risked the criticism that it should have prevented the abuse from taking place at all. It is now being replaced in its turn by a more unified system under a single regulatory body, the Financial Services Authority or FSA.
There are two main approaches to regulating financial markets: statutory regulation and self-regulation. Most financial systems have some elements of both. The American system leans towards statutory regulation. A statutory body, the Securities and Exchange Commission (SEC), monitors the issue of securities to the public and the securities markets in which they are traded and reinforces the work of self-regulating bodies such as the New York Stock Exchange.
In Britain the regulation of the financial system has traditionally been a mixture of statutory and non-statutory measures, but until recently with a strong bias in favour of self-regulation. That is now changing, with the pendulum swinging in favour of statutory regulation. But the edges have always been blurred. In the system that prevailed from the second half of the 1980s to the late 1990s, the apex of the regulatory system was occupied by a body called the Securities and Investments Board (SIB). The SIB was not a part of government or a government agency, but rather a private-sector organization. However, it drew its authority from legislation – the Financial Services Act of 1986 – under which regulatory powers were delegated to the SIB. The scope of the SIB or its subsidiary Self Regulating Organizations (SROs) covered, inter alia, the operations of brokers, marketmakers, investment managers, sellers of investment products, financial intermediaries of various kinds, commodity scheme operators (a previously glaring gap) and even publishers of investment newsletters and tip sheets. But a number of areas remained outside the scheme. Banks were regulated by the Bank of England, for example, and building societies had their own separate regulator.
By the end of the second millennium the operations of the SIB had effectively been subsumed into the new body, the Financial Services Authority. But this new monolith also took under its wing most of the regulatory functions that had previous remained outside the SIB system. It acquired responsibility for supervising banks, the wholesale financial markets of the City, building societies and friendly societies and was even acquiring regulatory powers over Lloyd’s of London (see below and Chapter 19). But the FSA was not technically an arm of government, any more than the SIB. In terms of structure it was a company limited by guarantee and it was to be financed by the industries it regulated, rather than from the public purse. But the FSA, too, would derive its powers from legislation, which was going through the parliamentary process at the turn of the century. The Financial Services and Markets Bill, which would delegate its regulatory powers to the FSA, was expected to become law in the first half of the year 2000.
The basic principle underlying both the new legislation and its predecessor Act is that virtually anyone wishing to carry on a ‘regulated activity’ (a broad definition that embraces most types of investment or financial business) in the UK must be authorized to do so. The maximum penalty for undertaking a regulated activity without authorization is two years in jail plus a fine. Whether you are a bank, a stockbroker, a fund manager or an insurance salesman, you need authorization. The only major gap – and this was still being debated at the turn of the millennium – was the supply of various forms of loan and mortgage. Technically, loans are not investments. So the man or woman who tries to sell you a pension must be authorized, but the person who tries to sell you a mortgage does not need authorization for this activity (though the bank or building society he represents would, as an organization, be regulated by the FSA). It looked, however, as if some aspects of the mortgage business were likely to be subject to FSA scrutiny in the future.
With whom do you register for authorization? Under the old SIB regime, you registered with the appropriate Self-Regulating Organization or with the SIB direct. Authorizations granted in this way will be carried over to the FSA once it acquires its full powers. But in future new authorizations will be granted (or refused!) by the FSA itself. Likewise, under the old regime each SRO had its own rulebook, which it was required to enforce. The FSA is developing its own single rulebook which will seek to apply a consistent approach to all those who are registered with it.
At the start of the SIB regime there were five Self-Regulating Organizations. These later boiled down to three, whose activities are being incorporated within the FSA. They are (or were):
• The Securities and Futures Authority (SFA). This body covered three main activities: dealing in securities, dealing in the financial and commodities futures markets and dealing in international bonds from London. It therefore embraced members of the London Stock Exchange, of the Liffe financial futures market and the commodities markets as well as London eurobond dealers. Prior to their amalgamation in the SFA, there were initially separate bodies for members of the London Stock Exchange and of the futures markets.
• The Investment Management Regulatory Organization (IMRO) brought together those managing the main forms of pooled investment: investment trusts, unit trusts and pension funds.
• The Personal Investment Authority or PIA emerged from the amalgamation of two previous SROs. One of these was the Financial Intermediaries, Managers and Brokers Regulatory Association (FIMBRA) which covered insurance brokers and independent investment advisers. The other was the Life Assurance and Unit Trust Regulatory Organization or LAUTRO. This covered the marketing of pooled investment products by the companies that provided them – an activity that was regulated separately from the investment management side. It therefore embraced the retail marketing of life assurance and unit trusts. The PIA thus covered the retailing aspect of investment products, whatever the distribution channel, and was the body of most relevance to the general public.
In addition to the SROs, there were several other types of body that existed under the SIB regime and which therefore become part of the FSA framework. Certain professional bodies whose members undertake investment business that is incidental to their main activities –accountants or lawyers, for example – could apply to be Recognized Professional Bodies (RPBs) to avoid the need for their personnel to seek authorization individually. The markets in which investments are traded did not need recognition as investment businesses if they obtained recognition from the SIB as Recognized Investment Exchanges (RIEs), though their members still needed to be authorized to carry on investment business. The London Stock Exchange is, of course, a Recognized Investment Exchange, as is the Liffe financial futures market.
The Financial Services and Markets Bill sets out four statutory objectives that the FSA would be responsible for implementing:
• maintaining market confidence in the financial system
• promoting public awareness of the financial system
• securing the appropriate degree of protection for consumers
• reducing financial crime.
It will be interesting to see how, in the long run, the FSA approaches these different remits. Regulators tread a tightrope. If you over-regulate, the business may find operating conditions too difficult and will go elsewhere. If you under-regulate, scandals erupt which destroy confidence in the financial system and may also have the effect of driving respectable business away. The FSA, like its predecessor bodies, will almost certainly regulate with a lighter touch in the wholesale markets (money markets, foreign exchange, etc.) than in markets that impinge directly on the public. The wholesale markets are the province of professionals, who should be able to look after themselves to a reasonable degree. Markets and products that are open to the public are a different matter. And even in the early days of its life it is clear that the FSA is taking its ‘public awareness’ brief seriously. As well as guidance for financial businesses, it produces a fair volume of information for the general public, ranging from the pitfalls of transferring a pension to the technicalities of ISAs. It also publishes ‘investor alerts’ when practices surface that call for a cautionary comment.
The educational role is new, but the FSA inherits a series of standards to apply from the SIB regime. Some are self-evident. Those authorized to carry on a regulated business must be fit and proper – and of adequate financial standing – to do so. Spot checks on a firm’s records can be carried out where necessary and a range of sanctions ranging from a rap on the knuckles, through fines, to removal of authorization can be meted out.
The basis of an investment business’s relationship with its customer normally needs to be set out in writing. The investment business has to deal fairly with its client. There has to be a complaints procedure. Unsolicited calls to sell investments (cold calling) are normally prohibited except for insurance and unit trusts.
Adequate arrangements for segregating clients’ money from that of an investment business are required, though in practice this has sometimes been one of the shakier areas. Much pain in the past had been caused by investment managers who collapsed, taking clients’ money down with their own. And – an interesting provision for brokers and tipsheet writers, though one that is difficult to enforce – published investment recommendations must be researched and be able to be substantiated.
In the past, different City businesses – the stock exchange, the banking system, etc. – had their own arrangements for compensating (up to certain limits) clients who suffered from the default or misdeeds of a member business. That is set to change, with the FSA establishing a new single compensation scheme, to be operated by a separate company, not by the FSA itself. The idea is that the new scheme will divide into three sub-schemes, for deposits, investments and insurance. It is intended to be simpler than the old arrangements and will replace five existing schemes.
The new regulatory structure is designed mainly to supervise those who operate in the investment business. The nature of many of the investments in which they deal is still shaped by legislation.
The affairs of companies (both private companies and those whose shares are traded on a market) are largely governed by the Companies Acts, of which the latest comprehensive revision is the Companies Act 1985. The Department of Trade and Industry (DTI) is the ministry responsible for enforcing companies legislation. Companies Acts cover matters such as preparation and submission of accounts, requirements for prospectuses, duties and rights of auditors, safeguards for creditors and shareholders, duties of directors, powers to appoint inspectors into the affairs of a company, and the like. But they also touch on some aspects of securities markets and share trading. Disclosure of 3 per cent shareholdings in a public company (it used to be 5 per cent shareholdings) is a Companies Act provision. So is a provision which gives a company the power to require disclosure of the investors who lie behind nominee shareholdings. The prohibition of insider trading (dealing in shares on the basis of privileged price-sensitive information) is now covered by the 1993 Criminal Justice Act, but the DTI has powers of investigation. The Companies Acts prohibit a company from giving financial assistance for the purchase of its own shares except with a lengthy process of shareholder approval: one of the key issues in the Guinness affair which surfaced in 1986.
Companies, public or private, are required to file accounts, annual returns and a variety of other information, including information on the directors, with the Registrar of Companies. The public may access this information via Companies House (headquartered in Cardiff) or various other offices in the UK including one in Bloomsbury, London. Basic information, including a company’s registered office, can be accessed via the Internet (see end of chapter). The Registrar is not exactly a regulator, except to the extent that he ensures that companies file the legally required information.
The new accountancy regime established at the beginning of the 1990s under the aegis of the Financial Reporting Council (FRC) also has a part to play in companies regulation. In the late 1980s, accounting standards in Britain threatened to come into disrepute as lax interpretation of the rules frequently allowed company managements to present the picture they wanted, and to mislead shareholders and others in the process. Not only has one of the FRC’s arms, the Accounting Standards Board (ASB), considerably tightened up on the rules under which accounts are prepared. Another arm, the Financial Reporting Review Panel, can take to task companies which it considers are breaking the financial reporting rules, requiring them to amend their presentation. If they refuse to do so, it can apply to the courts. A sub-committee of the ASB, the Urgent Issues Task Force, can give rapid interpretations of disputed issues in the accounting rulebook, again with the threat of court action from the Financial Reporting Review Panel should companies refuse to comply.
The new accounting regime is not statutory. But by a typically British process its decisions have virtually the force of law. Companies are required under the Companies Act to prepare accounts which give a ‘true and fair view’. Giving a true and fair view normally implies conforming to the relevant accounting standard, or justifying any departure. Thus, companies that unjustifiably depart from accounting standards in their presentation can be accused of a breach of the Companies Act and the accounting authorities have the power to test the issue in the courts.
The new accounting regime has sometimes been accused of inflexibility – imposing tight rules rather than allowing room for interpretation in the light of individual circumstances – and the issue sometimes surfaces in press comment. After the laxity of the 1980s, some rigidity was probably inevitable. But the proof of the pudding is in the eating. The reliability and usefulness of company accounts improved enormously in the 1990s.
Unit trusts had been regulated for many years under the Prevention of Fraud (Investments) Act. Now they are authorized and supervised under the FSA regulatory structure.
Other Acts govern the affairs of specific types of business. Insurance companies are governed by the Insurance Companies Acts as far as the running of the corporate insurance business is concerned – investment management and selling would come under the FSA structure. Building societies come under the Building Societies Act though nowadays the regulator is again the FSA.
Banks are regulated under the Banking Act – a revised Act reached the Statute Book in 1987 – and supervision, as noted, has moved from the Bank of England to the FSA. A problem in banking supervision is the international nature of the operations of major banks: a key factor in the Barings debacle and in the earlier collapse of the Bank of Credit and Commerce International (BCCI) where the head company was registered in Luxembourg. Though losing its responsibility for prudential supervision of the banking system, the Bank of England retains responsibility for the overall stability of the banking system as a whole.
The Lloyd’s insurance market used to govern itself within the powers granted by a specific Act of Parliament. The latest Lloyd’s Act, which came into force in 1983, tightened up the self-regulatory requirements in response to a variety of scandals. But Lloyd’s has lost its fight to retain complete independence. Its exercise of its self-regulatory powers will now be directed in some respects by the FSA, which will also be involved directly in the authorization and approval processes and regulation of advice given by members’ agents.
The London Stock Exchange used traditionally to regulate its own members who, in the past, could be disciplined by the representative Stock Exchange Council. Though the Council has gone, in some respects the LSE probably changed least under the SIB (and now the FSA) regime. The difference is that the job of regulation is now split between the stock exchange and the FSA structure. Broadly, the stock exchange is responsible for matters relating to the running of the market and the FSA for policing the financial health of the market’s members. If a stockbroker was unable to meet his commitments (in other words, went bust), he used to be hammered on the stock exchange floor. More financially than physically painful, this meant the market was told of his default and that he had ceased to trade. Prosaically, the message would now go out on the screens.
The City Panel on Takeovers and Mergers (the Takeover Panel) was established by City institutions (including the stock exchange) in 1968 to police the takeover jungle where most abuses occurred (see Chapter 10). It is not directly part of the FSA regulatory framework, though nowadays its decisions have the backing of the FSA’s range of sanctions, if required, and its decisions may possibly carry a right of appeal to the FSA (see Chapter 10).
The internationalization of securities markets poses various problems for regulators. First, it is difficult for the supervisors of any one country to monitor effectively the activities of an international securities house, which can switch its ‘book’ between Tokyo, London and New York in the course of a day.
Second, some markets such as the euromarket are truly international in that they are not attached to any one country. There is no official supranational body with the power to enforce rules on all participants: a cause for concern which crops up periodically in press reports of discussions among leading bankers.
Finally, the international nature of today’s securities business can frustrate the efforts of the best-intentioned domestic supervisory authorities. The removal of exchange controls in Britain, combined with the use of nominee names, means that the British as well as foreigners can deal anonymously in British markets via the medium of a Swiss bank and run little risk of detection if they flaunt the rules. It is also very difficult to clamp down on dubious investment schemes selling from overseas to investors in Britain – a problem which is unlikely to be eased by the coming of the Internet.
Britain has a tradition of fairly light regulation in many areas, which has been a significant factor in attracting international business to Britain and maintaining the City as an international financial centre.
And there have been loopholes in the regulatory defences. The SIB regulatory structure did not prevent the theft of many hundreds of millions of pounds from the pension funds of companies run by the late Robert Maxwell in the early 1990s, though many City institutions must share responsibility for this disaster and pensions legislation has subsequently been somewhat tightened. The SROs have, however, been active in fining or closing down investment advisers who failed to obey the rules.
The highest-profile action of the SIB concerned the mis-selling of personal pensions. An investigation suggested that hundreds of thousands of individuals had been persuaded by salesmen and saleswomen to opt out of perfectly good occupational pension schemes in favour of taking out personal pensions that were likely to deliver far lower benefits. The government must shoulder a fair degree of responsibility for this situation, having encouraged individuals to make personal pension provision without ensuring that adequate safeguards were in force. But the SIB, if it did not prevent this debacle, showed itself reasonably tough in addressing the consequences.
Major insurance companies were fined and forced to send their salesforces back to the classroom for retraining. Moreover, those responsible for giving incorrect advice (or their employers) have had to compensate their victims for the financial loss they were likely to suffer – a process that is not complete yet and involves sums running into billions of pounds. But the directors of the culprit companies escaped virtually unscathed.
The 1990s were a troubled period for the vendors of life assurance and savings products in other ways. A major bone of contention was been the question of polarization (see glossary) under which financial intermediaries had to decide whether they were independent investment advisers or whether they simply marketed the investment products of one group. The system encouraged many one-time independents to link with a particular provider of savings products and raised fears that genuinely independent advice had become even more scarce. Moreover, the ‘independence’ of supposedly independent advice is itself open to question when the advisers are paid in the form of commission on the products they sell (see Chapter 21). The regulatory system did, however, ensure that buyers of life assurance and investment products received rather more information than in the past on the commission the salesperson would receive. But given the enormous complexity of many savings products, it must still be open to question whether most buyers are likely to be directed towards the most appropriate product. And promotional literature is often at best complex and at worst deeply confusing. It remains to be seen whether the FSA can bring radical improvements in this area.
Ideally, a regulatory system prevents misdeeds rather than detecting and prosecuting wrongdoers once abuses have occurred. The fallback for serious cases of financial crime is the state’s powers of criminal prosecution. But the British legal system has often proved ineffective in delivering convictions in high-profile cases of alleged financial crime.
Frequently (and often unfairly) blamed for this state of affairs is the Serious Fraud Office, though overall it has a conviction rate of over two-thirds in the cases it brings. The SFO has the brief of investigating and prosecuting cases involving serious and complex fraud, particularly where there is a public interest aspect. This would include most of the major cases that are likely to hit the newspaper headlines. It used to deal only in cases involving £5m or more, but the threshold is now down to £lm for cases that satisfy its other criteria.
The real problem is that major frauds are often of a complexity that tax the trained accountant, let alone the understanding of a lay jury, and alleged fraudsters usually seem able to obtain the best legal representation however low their fortunes are said to have sunk. There have been suggestions that cases of complex fraud should be dealt with by a judge and expert assessors rather than by a judge and jury, but they have so far been resisted. An added complication is the number of different individuals and bodies that may be picking over the carcass when fraud is alleged in connection with the demise of a company. Liquidators attempting to salvage something for shareholders and creditors may not find it easy to get information when some of those involved face criminal charges. And the existence of criminal charges can hamper the press’s own investigative efforts.
You will also frequently read references to the Fraud Squad. In practice, most police forces have their experts in financial crime, and London’s Metropolitan Police has a large fraud section. But in the context of City crime the body probably referred to is a branch of the Criminal Investigation Department of the City of London Police. With – in 1999 – around ten officers seconded at any one time to the SFO and 55-odd at its own Wood Street headquarters in the City, it both investigates Square-Mile crimes itself and passes on high-profile cases to the SFO. The Maxwell investigation started with the City Fraud Squad and moved to the SFO when the scale of the debacle emerged.
The chief website for matters of a regulatory nature is, of course, that of the Financial Services Authority at www.fsa.gov.uk/. Note in particular the growing range of publications for consumers, most of which can be downloaded free. Note also the Central Register, where you can check whether a vendor of financial products has the relevant authorization. There are details on the pensions mis-selling affair and there are up-to-the-minute ‘investor alerts’ about matters of current concern (the dangers of ‘day trading’ featured strongly when the stockmarket was roaring away at the end of 1999). For professionals there is also a section on wholesale market supervision. The Department of Trade and Industry site at www.dti.gov.uk/ contains information on the DTI’s regulatory and investigation role. The Companies House website is at www.companieshouse.gov.uk/; as noted, you can get very basic information on a limited company (address, date of registration, etc.) free over the net and there is guidance on where and how to get more detailed information. If you want to know what sort of information on members of the public is being stored by various organizations in their computer databases, look at the Data Protection Registrar’s site at www.dataprotection.gov.uk/. The Accounting Standards Board has a very useful site at www.asb.org.uk/ with links to the other constituents of the UK accounting authority. If your interests extend to regulation in the United States, the Securities and Exchange Commission site at www.sec.gov/ is well worth a visit. Again, there is useful educational material but there is also a facility to examine company filings with the SEC on the EDGAR database.