By James Hamilton, J.D., LL.M.
A more
effective enforcement and sanctions regime against individuals is the
centerpiece of a proposed sweeping and radical revision of the regulation of
financial institutions proposed by the U.K. Parliamentary Commission on Banking
Standards. As the U.K.
moves towards legislation ring fencing investment banking from retail banking
in its version of the Volcker Rule, the attribution of individual
responsibility will, for the first time, provide for the full use of the range
of civil powers that regulators already have to sanction
individuals, including fines and a ban from the industry.
In the case of
failure leading to successful enforcement action against a firm, there will be
a requirement for relevant senior officers to demonstrate that they took all
reasonable steps to prevent or mitigate the effects of a specified failing.
Those unable to do so would face possible individual enforcement actions,
switching the burden of proof away from the regulators. In addition, a criminal
offense will be established applying to senior management carrying out their
professional responsibilities in a reckless manner, which may carry a prison
sentence. Following a conviction, the remuneration received by an individual
during the period of reckless behavior would be clawed back through separate
civil proceedings.
The Commission
recommends a new criminal offense for reckless misconduct in the management of
a financial firm. Be in no doubt about the difficulty of securing a conviction
for such a new offense, said the Commission. But, it should be implemented
based on the reasoning that the possibility of criminal liability for recklessly
carrying out professional duties would give pause to the senior officers of UK financial
institutions. The Commission recommends that the offense be limited to
individuals covered by the new Senior Persons Regime, so that those concerned would
have no doubts about their potential criminal liability. Further, the Commission
would expect this offense to be pursued in cases involving only the most
serious failings, such as where a financial firm failed with substantial costs
to the taxpayer, lasting consequences for the financial system, or serious harm
to customers.
Corporate Governance. The Commission also proposes a deep and far
reaching reform of corporate governance so that there are individual and direct
lines of access and accountability to the board of directors for the heads of
the risk, compliance and internal audit functions and much greater levels of protection
for their independence. There should also be direct personal responsibility on
the board chairman to ensure the effective operation of the board, including effective
challenge by non-executive directors, and on the Senior Independent Director,
supported by the regulator, to ensure that the chairman fulfils this role.
Whistle blowing procedures should be overseen by a named non-executive director,
who would be held accountable when an individual suffers detriment as a
consequence of blowing the whistle.
Ass part of
the reform of corporate governance, the Commission calls for an end to box
checking by regulators and a move towards judgment-based financial regulation.
Regulators should identify the risks to a judgment-based approach from overly prescriptive
international rule books and ensure that Parliament is kept fully informed of
them. Importantly, there should be mandatory dialogue between regulators and the
external auditors of financial statements and a separate set of accounts for
regulatory purposes.
Very
importantly, the Commission emphasized that non-executive directors in
systemically important financial institutions should have a particular duty to
take a more active role in challenging the risks that businesses are running
and the ways that they are being managed. For non-executive directors to be
more effective, they may need to make more use of their current powers under
the U.K. Corporate Governance Code to obtain information and professional
advice, both internally and externally. In this context, it is essential that
the office of the board chairman be well-resourced so that it can provide
independent research and support to the non-executive directors.
More
granularly with regard to corporate governance, fundamental reform may be
needed to the nominating process, especially concerning non-executive
independent directors. The Commission asks the Financial Reporting Council,
which has oversight of the U.K. Corporate Governance Code, to publish proposals,
within six months, to address the widespread
perception that some natural challengers are sifted out by the
nomination
process.
There is a
danger that non-executives directors are self-selecting and self-perpetuating.
In the interests of transparency, and to ensure that such directors remain as
independent as possible, the Commission recommends that the regulators examine
the merits of requiring each non-executive vacancy on the board above the ring-fence
threshold to be publicly advertised.
The
obligations of directors to shareholders in accordance with the provisions of
the Companies Act of
2006 create a particular tension between duties to shareholders and financial
safety and soundness. For as long as that tension persists, said the
Commission, it is important that it be acknowledged and reflected in the UK
Corporate Governance Code and in the new Senior Persons Regime. The Commission
has several recommendations in the light of this, which should at the very
least apply to financial institutions above the ring-fence threshold.
The UK
Corporate Governance Code must be amended to require directors of financial
institutions to attach the utmost importance to the safety and soundness of the
firm and for the duties they owe to customers, taxpayers and others in
interpreting their duties as directors. In this respect, Section 172 of the
Companies Act of 2006 should be amended to remove shareholder primacy and
require directors to ensure the financial safety and soundness of the company
ahead of the interests of its members.
In a radical
move, the Commission recommends that the Senior Independent Director should,
under the proposed Senior Persons Regime, have the specific duty to annually assess
the performance of the board chairman and, as part of this duty, ensure that
the relationship between the CEO and the chairman does not become too close and
that the chairman performs his or her leadership and challenge role.
The Commission
expects the regulators to maintain a dialogue with the Senior Independent
Director on the performance of the Chairman. In fact, the Senior Independent
Director should meet with the regulators each year to explain how the Chairman
has held the CEO to account, encouraged meaningful challenge from other
independent directors and maintained independence in leading the board.
Each board
should have a separate risk committee chaired by a non-executive director who
possesses industry knowledge and strength of character to challenge the
executive effectively. The risk committee should be supported by a strong risk
function, led by a Chief Risk Officer, with authority over the separate
business
units. Boards must protect the independence of the Chief Risk Officer, and personal responsibility
for this should lie with the chair of the risk committee.The Chief Risk
Officer should not be able to be dismissed or sanctioned without the agreement of
the non-executive directors, and his or her remuneration should reflect this requirement
for independence.
The Commission
proposes a new tool, special measures, which are designed to provide for the
deployment of a broader range of regulatory powers when the Financial Conduct
Authority and the Prudential Regulation Authority are concerned that systemic
weaknesses of leadership, risk management and control leave a firm particularly
prone to standards failures.
Special Persons Regime. As the primary framework for regulators to
engage with individuals, said the Commission, the current Approved Persons
Regime is a complex and confused mess. It fails to perform any of its varied
roles to the necessary standard. It is the mechanism through which individuals
can notionally be sanctioned for poor behavior, but its coverage is woefully
narrow and it does not ensure that individual responsibilities are adequately
defined, thereby restricting regulators’ ability to take enforcement action.
The proposed Senior
Persons Regime should provide far greater precision about individual
responsibilities and would serve as the foundation for some of the changes to
enforcement powers. The new regime will encourage greater clarity of
responsibilities and improved corporate governance and establish beyond a doubt
the individual responsibility that can provide a sound basis for the regulators
to impose remedial requirements or take enforcement actions.
Remuneration. The current remuneration regime must be
reformed to align risk and reward and stop incentivizing poor behavior. The
Commission recommends that a new Remuneration Code be introduced on the basis
of a new statutory provision.
The Commission
recommends that statutory remuneration reports be required to disclose
expected levels of remuneration in the coming year by division, assuming a
central planning scenario and, in the following year, the differences from the
expected levels of remuneration and the reasons for those differences. The
disclosure should include all elements of compensation and the methodology
underlying the decisions on remuneration. The individual remuneration packages
for executive directors and all those above a threshold determined by the
regulator should normally be disclosed, unless there is a good reason for not
doing so. The Commission further recommends that the remuneration report should
be required to include a summary of the risk factors that were taken into
account in reaching decisions and how these have changed since the last report.
The Commission
did not go so far as to recommend the setting of levels of remuneration by
Government or regulators. However, the Commission reminded financial firms that
many consider the levels of reward in recent years to have grown to grotesque
levels at the most senior ranks and that such reward often bore little relation
to any special talents.
Ideally,
remuneration requirements should be mandated internationally in order to reduce
arbitrage. The Commission expects U.K. authorities to strive to
secure international agreement on changes which are focused on the deferral,
conditionality and form of variable remuneration, and the measures for its
determination, rather than simply the quantitative relationship to fixed
remuneration, because it is changes of this kind that will most improve behavior
in the long term. In particular, the Government should ensure that the standards
under the CRD IV Directive contain sufficient flexibility for national
regulators to impose requirements in relation to instruments in which deferred
bonuses can be paid which are compatible with the reform.