Financial Services—a review of 2014’s legislation

Our panel of experts examines the impact of 2014’s legislation on financial services lawyers and their clients.

The experts

Duncan Black, partner, contentious financial services, Fieldfisher

Jon Holland, partner and co-head of the global financial services litigation team, Hogan Lovells

Nathan Willmott, partner, financial services investigations and head of the commercial dispute resolution group, Berwin Leighton Paisner

What were the key legislative developments of 2014?

Nathan Willmott: As we all know, the world of financial services regulation has become an ever changing environment—it seems that politicians in particular, but also domestic and European regulators, seem unable to leave systems in place for very long without tweaking them. Recently we have seen substantial changes as a result of the financial crisis, the LIBOR issues and the spot FX trading issues.

In addition to constantly changing rules, it seems that the political wind is in favour of entrusting the Financial Conduct Authority (FCA) with more and more responsibilities. In the past we have seen its responsibilities extended to include the sale of general insurance products, mortgage sales, benchmark regulation and—most recently—consumer credit firms. The consumer credit regime has for a long time stood separately from how other aspects of financial services are regulated in the UK. That has allowed practices to develop which are at odds with the types of customer outcomes that the FCA has sought to achieve. As a result, since taking responsibility for consumer credit the FCA has moved quickly to change market practices in a radical way, as part of its broader philosophy of early intervention.

Another big change, and one that has come in almost under the radar, was the Prudential Regulation Authority (PRA) replacing the longstanding Principles for Businesses with a new set of Fundamental Rules. These apply to all PRA regulated firms, including banks and insurers, and impose a significantly higher burden in terms of duties to manage risk, act in a prudent manner, and introduce the requirement under Fundamental Rule 8 to prepare for resolution (ie to have in place a plan to ensure appropriate continuity of services in the event that the insurer failed).

This is a brand new obligation for insurers (including managing agents at Lloyd’s) and although there is a very high level duty imposed there has been no guidance issued by the PRA on what specific steps insurers and Lloyd’s managing agents should be taking. As a result there is a real risk that insurers are unclear about the scope of their duties under Fundamental Rule 8, and what exactly is expected of them to meet the standard set by this new provision.

More generally the way that the Fundamental Rules were introduced took a lot of banks and insurers by surprise. Unlike the traditional approach to new rules, under which the finalised duties are published and then a further period allowed (often several months) before they come into force—to give firms adequate time to assess the duties and get themselves compliant—the finalised Fundamental Rules were published by the PRA in June and came into effect immediately. Many banks and insurers therefore didn’t appreciate that they had become subject to those rules at the time they were issued and I fear that knowledge of them remains low across the industry.

That’s one legislative change in 2014, the consequences of which are still to be worked out.

Jon Holland: For me the key legislative/regulatory developments this past year have related to benchmarks and the interest of the FCA in particular and other international bodies like the International Organisation of Securities Commission (IOSCO) who issued guidance in the middle of 2013 on principles on financial benchmarks.

The FCA has been looking at regulated firms, banks principally, to see how they are complying with the principles and setting benchmarks including but not limited to Libor. It is currently undergoing a thematic review which involves going to a number of banks and looking at how they are applying the principles, thinking about conflicts of interest in relation to the setting of benchmarks and how they are putting in place governance and systems and controls to make sure benchmarks are being set in accordance with the FCA rules and the IOSCO principles. So that’s been an ongoing theme throughout this year.

Duncan Black: It’s not technically legislation but there has been an interesting and significant amendment to the FCA’s rules on the client asset (CASS) rules that govern how financial services firms have to treat client money and client assets when they are doing business on behalf of their clients.

There have been spectacular failings in this area which were uncovered by the financial crisis, one of which being in relation to Lehman Brothers. When they went bankrupt in September 2008 it came to light that the English Lehman, among others, had failed to segregate its own money from client money which made it very difficult for the clients of Lehman to be able to identify what was their money as distinct from Lehman’s or from other clients’ money.

The Lehman collapse also illustrated that the client money rules as drafted had gaps for when a firm went bust.

So the CASS rules needed to be improved and they also needed to be enforced by the FCA. (Lehman had been supervised by the Financial Services Authority and they had also been audited by their own auditors and the issue had not been addressed).

Shortly after this, various other big firms discovered that they were not segregating the client money as they should have been so they reported as well and then we had the collapse of MF Global and exactly the same problem occurred again.

So it’s been a big issue and as a result we’ve got much stricter money rules coming in. It’s a three phase introduction—the first phase came in in July of this year, the second phase is in December and the third phase is in June 2015. Broadly speaking the intention behind these rules is to be much clearer in terms of how these client money rules operate in specific circumstances and who they apply to and what rights and information clients have.

One of the features of the Lehman client money problem was that clients didn’t always get or have access to the information that they should have in order to be able to monitor the client money itself. So one aspect of these rules is to improve the information clients are entitled to receive.

There are a whole raft of changes to the CASS rules which we hope will be an improved regime for the segregation of client assets because even now it’s a problem—in September this year Barclays was fined £38m for failing to segregate their client assets and although the Barclays case was in relation to historic conduct these things are still coming to light.

How did you react to these challenges?

Nathan Willmott: On the topic of consumer credit, for certain types of firms it was clear that a fundamental rethink of their business models would be necessary. Rather than tinkering with sales and arrears management practices, we advised firms that the board (and in some cases the wider group) would need to engage to reassess their offering to customers and identify whether it was viable in the new FCA world. For firms who didn’t follow this advice it was clear that they would be engaged in ongoing battles with the FCA, and ultimately they would stand little chance of winning the war.

On the subject of planning for resolution under PRA Fundamental Rule 8, our key advice to insurers has been to engage proactively with the PRA to understand their expectations. Given its statutory duty to focus on firms whose failure may impact the stability of the UK financial system, the PRA will clearly be more interested in resolution plans for the largest insurers, rather than smaller players who are not significant in any individual market. For the largest insurers who are part of a global group, their resolution planning under Fundamental Rule 8 will of course need to tie in to their global resolution planning. For smaller insurers, a much lighter touch approach is likely to be sufficient. However across the board the industry would welcome greater clarity from the PRA on what steps insurers are expected to take to meet their responsibilities under Fundamental Rule 8.

Jon Holland: Banks obviously appreciated the risks around the setting of benchmarks once the first Libor settlements were announced back in 2012. And so those banks who contributed to Libor have been thinking about what changes they needed to put in place in order to ensure that they were doing everything that was expected of them and that thinking has gradually expanded to other interbank benchmarks, ISDAfix for example, and they’ve been thinking about how they put in place systems and controls that are consistent with what the FCA expects, the IOSCO principles and of course with the expectations of the US authorities which have been articulated in all the settlements announced so far.

We’ve been helping a number of our clients with their thinking and the implementation of appropriate systems and controls to make sure that they are complying and that has been a real area of focus over the past year and could go on into the early part of next year.

Duncan Black: Many of our clients are subject to the client money rules so they have to rearrange their business methods and documentation so as to comply with the new regime.

Interviewed by Fran Benson

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

 

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