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Welcome to the latest article in the the Journal of International Banking and Financial Law series -
"Irreconcilable differences? Bank directors, shareholders and regulators"
2014) 10 JIBFL 623 1 November 2014).
Written by James Palmer, Hywel Jenkin, Barney Hinnigan are partners at Herbert Smith Freehills LLP, all members of its multi-disciplinary financial services corporate governance team
This article explores the difficulties faced by bank directors in balancing company law and regulatory requirements.
Those tasked with governing UK banks have always faced difficulties in balancing competing interests. This stems in part from the fact that banks must be operated in accordance with both company law and applicable financial services regulation. The two regimes do not always operate in a clearly integrated and consistent manner. Banks are also among the largest and most complex organisations, which adds to the practical challenge of governing them effectively, particularly when they are run on a cross-border basis.
Consumer protection is a fundamental aim of conduct regulation in the UK. It is expressly recognised in the operational objectives of the Financial Conduct Authority and the Prudential Regulation Authority seeks to protect the markets as a whole (and thus consumers), by promoting the safety and soundness of firms. Short of insolvency, company law does not overtly seek to protect customer interests in the same way: the focus is on the relationship between the company, its management and its shareholders. Company law does, of course, recognise the need for boards to comply with separate legal and regulatory regimes applicable to the company's business.
The fundamental importance of banking services to the wider economy places additional scrutiny on the role of banks. The increased focus on individual accountability following the financial crisis means the regulatory spotlight is now fixed firmly on bank directors and senior managers. This additional focus has not, however, been accompanied by any real guidance, let alone solutions, in relation to the governance problems generated by the various competing regimes.
COMPANY LAW AND REGULATORY REGIMES
Directors of a company incorporated in the UK have a primary duty to "promote the success of the company for the benefit of its members as a whole" under s 172 of the Companies Act 2006 (CA 2006). The section also provides that a director should "have regard" to a number of wider objectives, including the interests of the company's employees and the need to foster the company's business relationships with suppliers, customers and others.
A bank and its directors must also comply with financial services regulatory obligations imposed by UK and European regulation. The firm's duties include the high level principle of treating customers fairly (TCF), as well as a raft of more detailed conduct of business and other requirements. Directors must ensure that the bank acts in accordance with these regulatory requirements to avoid both damaging the bank's reputation and financial penalties.
Given the different objectives of the company law and regulatory regimes, there is scope for conflict between them, and finding the path that satisfies both requires careful planning. Indeed, the Parliamentary Committee on Banking Standards (PCBS) was concerned that a bank director's company law duties could conflict with the objective of achieving financial stability of the bank. Following the PCBS report, the government consulted on whether it should introduce a new primary company law duty on banking directors to promote the financial stability of their companies over the interests of shareholders. In its consultation response in April 2014, the government noted a strong consensus among respondents that the statutory duties of directors should not be changed specifically for bank directors. For the time being at least, directors' general statutory duties will continue to apply economy-wide and remain unchanged. That seems to us to be the right answer, as industry specific responsibilities can sit alongside company law requirements.
As well as being required to balance their regulatory and company law responsibilities, the increased focus on individual accountability puts senior managers at greater risk of personal enforcement action in the event of a failure by the firm in an area for which they are responsible.
The regulators have stated in their joint consultation paper for the Senior Managers Regime that nothing in its focus on individual accountability is intended to undermine the fiduciary, legal and regulatory responsibilities of a bank's board, which will "retain ultimate decision-making power and authority over all aspects of a firm's affairs". However, a board's approach to collective decision-making may increasingly need to reflect that individuals who sit on the governing body face the prospect of individual regulatory sanction, which could lead to public disciplinary proceedings against them, as well as the forfeit of their earnings.
Given the extent of the new Senior Managers Regime, the likelihood is that an element of defensive decision-making will be introduced. This could have particular prominence when it comes to decisions over matters such as allocating budget to control functions or the systems necessary to mitigate risk. The individual responsible for a particular area may have a far lower risk tolerance than the other directors. The regulators may argue that this is precisely the effect they intend.
FINDING A BALANCE
As a general proposition, it is difficult to see that a director can be liable for breach of CA 2006 duties by causing a company to comply with applicable regulatory requirements. The fact that compliance with law or regulation may have significant "adverse" consequences for the company in the short term does not outweigh the overall benefits.
Company decision-making is, in the ordinary course, effected by the board acting as a whole (either directly or through appropriately authorised committees or executives). This day-to-day decision-making does not require individual directors to stand behind the company's actions personally, unless a director is in breach of his or her CA 2006 duties in respect of their specific decision. However, individual directors are perhaps more likely to consider their personal position where the steps necessary to ensure regulatory compliance are not expressly stipulated and the director with direct accountability reaches a more prudent or conservative judgement on what is required to comply than the rest of the board. This may arise, for example, in assessing what is required in respect of systems and control rules or TCF requirements. In some cases, the director may be wrong, and his risk-averse approach may go beyond what is required by the relevant regulatory rules and principles (especially where there is room for subjective judgement).
* * * * * *
The Senior Managers Regime
The banking crisis, and high profile conduct failings including LIBOR and PPI, have led to public and political pressure for individuals to be held responsible in the event that there are regulatory failings in a bank. This pressure was reflected in the PCBS June 2013 report: "Changing banking for good", which made a number of recommendations in relation to governance, which (following further consideration by the Treasury and the regulators) were enshrined into legislation in the Financial Services (Banking Reform) Act 2013 and ultimately developed into the Senior Managers Regime (which, at the time of writing, is still subject to consultation).
The Senior Managers Regime is designed to ensure clear allocated individual responsibility for decisions. This is to address what the PCBS described as the "accountability firewall" where directors and other senior individuals could point to the layers of delegated management between their direct control and the actions taken by a bank. This made it extremely difficult, if not impossible, to bring disciplinary action against any senior individuals as this would need to be either in relation to breaches of their own regulatory obligations, or where they were knowingly concerned in misconduct by the bank.
The measures designed to clarify the extent of personal responsibility include defined statements of responsibility, a responsibilities map to ensure that no areas fail to be allocated, the presumption of responsibility where failures occur within an area for which a senior manager is responsible (unless they can show they took reasonable steps to prevent the contravention) and even potential criminal liability for reckless decisions in the event that a bank fails. Changes in the related area of remuneration reinforce these measures by ensuring that directors face extended deferral of their pay with the prospect of clawback in the event of a later adverse finding into the conduct of their business area. All board members (executive and non-executive) will be within the scope of the Senior Managers Regime, as will the layer of executive managers below the board, which would typically be arranged into an executive committee.
Issues may also arise where conduct and prudential objectives do not align. For example, a remediation exercise might be approached very differently from a conduct and a prudential perspective (although the bank should, of course, argue that it will pay such amount as properly flows from its actions). In such circumstances, directors may have differing perspectives which reflect their personal regulatory responsibilities. Except in extreme cases, this is clearly an issue which is more likely to impact firms with smaller balance sheets, but this is an example of the overlapping nature of the competing interests directors must balance.
Where a board level difference of opinion does arise, firms will want to ensure that dissenting, or simply risk averse, directors can meet their regulatory responsibilities and demonstrate that they have done so (for example, by having a veto over matters where they have personal responsibility). The issues will be more acute for executive directors, since they will be responsible for particular areas of the business. In the absence of absolute control, a director would need to consider the extent to which his or her view as to the appropriate course of action is recorded, and whether to notify the regulator.
We remain in an environment where fear of regulatory breach is driving significant costs and extreme caution in relation to bank regulatory compliance. However, for directors to find an appropriate balance between their company law duties and regulatory responsibilities, a harder assessment, over time, of regulatory requests may be required. Where a regulatory request goes beyond what is legally well founded, it should be appropriately challenged. The impact of the challenge on the bank's regulatory relationship and the risks of an incorrect challenge would, of course, need to be considered. Most banks will no doubt seek to adopt risk management approaches which are not pushing against the boundary of what is permitted by regulation. However, standing up to regulators when their requests go beyond what is required is consistent with both directors' company law duties, and their regulatory duties.
Such a response, underpinned by rigorous analysis and sound judgement, will become an increasingly important part of the toolkit for banks seeking to avoid disproportionate compliance costs.
A consequence of the increasing focus on personal regulatory responsibility may be individuals seeking senior roles are not allocated regulatory responsibility (ie, where ultimate veto power has been surrendered to others). There may also be an increase in the use by banks of appointments which do not involve regulatory or company law responsibility, as a way of attracting those who can provide wise counsel while avoiding what might be perceived as an unreasonable regulatory burden. This is to be welcomed and should not be seen as a circumvention of the rules, if it improves banks' performance on the matter at the heart of their success and that of their customers: the quality of decision-making.
Directors and managers of banks within international groups face similar, but more complex, challenges to those operating in the UK alone. Where an international group has a UK-incorporated banking subsidiary, it will be subject to UK company law and regulation and will require its own governance and risk management arrangements. While the UK board may face internal challenges in ensuring consistency with the parent group's expectations, the clear obligation to comply with the applicable UK regime puts the directors in much the same position as any other UK bank board member balancing his or her regulatory and company law duties.
The regulatory position for overseas branches is more complex, resting on a distinction between matters which are the preserve of the home versus host state regulators. Generally, prudential matters will be for the home state, whereas conduct matters will be subject to the rules of the host state, because of the impact on the host state's consumers and markets. An overseas branch operating in the UK will not have directors with UK company law duties and any duties to shareholders will be governed by the law of the place of incorporation. As a general rule, the UK regulatory regime requires subservience of those home state duties to UK law and regulation. The issue is then to determine the extent to which UK law and regulation does apply to the branch. While the management of UK branches of overseas firms was initially excluded from the scope of the Senior Managers Regime, the Treasury has the power to amend this and the Chancellor, in his 2014 Mansion House speech, announced the government's intention to extend the regime to cover all foreign branches operating in the UK (subject to the UK's obligations under EU law).
The PRA envisages that at least one individual per incoming non-EEA branch will need to be approved as an Overseas Branch Senior Executive Manager, performing "the function of having responsibility alone or jointly with others, for the conduct of all activities of the UK branch of an overseas firm which are subject to the UK regulatory system". Managers of branches in the UK will often be responsible for implementing strategy formulated by their company board (and wider parent group) overseas. Nevertheless, the UK regulators will be seeking to hold them accountable (whether under the Senior Managers Regime or otherwise) for failures arising in the branch as a result of that strategy. Thus, branch managers must ensure that they fully understand the way in which the strategy will impact on UK customers and markets and, crucially, have the ability to mitigate those risks.
Furthermore, where the UK branch relies on services which are provided by the wider group, and which are therefore not within the direct control of the branch, then the regulators may view these as higher risk. In principle, there is no reason why these intra-group dependencies should be viewed any differently to a third party outsourcing arrangement and they should be permissible if the UK branch has appropriate oversight. Such arrangements are becoming, in some cases, increasingly formalised through service level agreements. The difficulty is that, in practice, the branch may not have the resources or control required either to carry out these functions itself or to secure an alternative provider, which puts branch managers (and regulators) in the uncomfortable position of reliance on the goodwill of overseas directors, who may themselves be subject to their own competing interests.
This branch issue and the burdens which regulators are seeking to impose on executives within UK branches, rather than on those with ultimate authority in the home state parent, have a clear tension with the EU passporting regime and the traditional division of responsibilities between home and host state regulators. This also raises questions of free movement under what is now Art 56 of the Treaty of Rome, if, for example, a continental bank seeking to operate in the UK using its home state IT systems is required to incur disproportionate costs as a result of the regulatory responsibilities being imposed by the UK. The UK regulators' sensitivity to recovery and resolution outcomes for UK retail customers could, if not kept proportionate, conflict with the fundamental principle of banks freely doing business across the EU. This recent, resolution driven, push to subsidiarisation within the UK will come under scrutiny as the rest of the world returns to the globalisation trends which have dominated the last 30 years in the industry. We can only hope that some of these challenges will lead to a return to regulatory focus on mutual recognition of other countries' standards and regulatory regimes, in appropriate cases, and in particular, where that allocation of responsibility is recognised by the home state.
Journal of International Banking & Financial Law/2014 Volume 29/Issue 10, November/Articles/Irreconcilable differences? Bank directors, shareholders and regulators - (2014) 10 JIBFL 623
To contact the authors: Email: firstname.lastname@example.org; email@example.com; firstname.lastname@example.org
© Reed Elsevier (UK) Ltd 2014
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