July 10, 2009
On 6 July 2009, the UK’s financial services regulator, the Financial Services Authority (FSA), continued its "credible deterrence philosophy" by issuing a consultation paper (CP09/19) outlining proposals to change its current policy on determining the level of civil financial penalties imposed for regulatory breaches. These new proposals are consistent with the FSA’s other recent indications that it can no longer be seen as a light-touch enforcer (see our previous client update: "The UK Financial Services Authority Demonstrates "Credible Deterrence Philosophy" with Prosecutions").
What is somewhat startling about the FSA’s proposals is quite how harsh they could potentially be in practice, for both corporations and individuals, but particularly for individuals. More details are provided below, but one of the FSA’s proposals would result in a minimum £100,000 penalty for individuals who commit market abuse, with no reduction for financial hardship but with an individual’s earning capability only serving to increase, but not decrease, the amount of the penalty imposed.
The consultation period closes on 21 October 2009.
The FSA’s proposed framework for ascertaining penalties
The FSA has proposed that it should apply a 5-step framework in the future to ascertain what penalty should be imposed, whether on a corporation or on an individual, for regulatory breaches. The 5-step framework is based on three objectives:
The proposed 5-step framework is as follows.
Step 1 – Disgorgement
In cases where it is possible to identify and quantify a benefit directly derived from the breach, whether in the form of a profit made or a loss avoided, Step 1 is to deprive the person of that benefit (plus interest). This Step may be avoided if arrangements are voluntarily put in place to identify and compensate any consumers who suffered loss as a result of the breaches, thus removing all benefits obtained.
Step 2 — Discipline: Figure determined that reflects the nature, impact and seriousness of the breach
The method by which this figure will be determined will depend upon the case, i.e., whether it is a case against a corporation, a non-market abuse case against an individual or a market abuse case against an individual.
Case against a corporation
The Step 2 figure will be 0%, 5%, 10%, 15% or 20% of the corporation’s pre-tax income over the period of the breach from the product or business area to which the breach relates (a minimum of one year if the period of the breach is less than one year, or the breach was a one-off event).
Factors that will be taken into account in deciding which level is most appropriate include:
Non-market abuse case against an individual
The Step 2 figure will be 0%, 10%, 20%, 30% or 40% of the individual’s pre-tax income (plus benefits, including but not limited to bonus, pension contributions, share options and share schemes) from the relevant employment in connection with which the breach occurred, for the period of the breach (again, a minimum of one year if the period of the breach is less than one year, or the breach was a one-off event; where the breach lasted longer than one year, part years may be treated as full years for the purpose of determining the relevant income). The higher maximum percentage of income comprising the penalty for individuals over corporates is to reflect the importance the FSA places on approved (regulated) persons complying with its rules.
Examples of factors that would tend to attract the higher levels of penalty include the individual deliberately not following his or her employer’s internal procedures or seeking to conceal his or her misconduct.
Market abuse case against an individual
Where the market abuse is referable to the individual’s employment (for example, trading on the basis of inside information obtained in the course of employment), the Step 2 figure will be the greater of:
Where the market abuse is not referable to the individual’s employment, the Step 2 figure will be the greater of:
Step 3 – Discipline: aggravation or mitigation
Adjustments to the figure arrived at in Step 2 will then be made if there are any mitigating or aggravating circumstances. Examples include:
Step 4 — Deterrence
If the FSA determines that the combination of the disgorgement element (if applicable) and the financial penalty calculated in Steps 2 and 3 is insufficient to achieve deterrence, the FSA will increase the financial penalty in Step 4. Circumstances where the FSA may consider it appropriate to increase a penalty include:
Equally, if the FSA considers that the penalty calculated in Steps 2 to 4 is disproportionately high for the breach concerned, it may decrease the level of the penalty to be imposed.
Step 5 — Discount for Settlement
At Step 5, the existing discounts for early settlement will be applied.
Serious Financial Hardship
As premised above, the FSA’s consultation paper considers the possibility of amending its policy on taking into account a person’s financial situation in assessing penalties to be imposed. Whilst the FSA does not consider the purpose of a penalty should be to render a person insolvent or threaten insolvency (the purpose is to disgorge, discipline and deter as noted above), it does not necessarily mean that the FSA would not be prepared to pursue the payment of a penalty in circumstances where it would lead to a corporate or individual becoming insolvent.
In particular, the FSA believes that serious financial hardship could be a reason to reduce a penalty to be imposed against a corporate (for example, if consumers would be harmed or market confidence would suffer were that to occur or to allow a corporate to continue in business and/or pay redress to consumers), but thinks that the same considerations do not necessarily apply in the case of individuals, as taking a person’s financial situation into account may reduce the deterrent effect of the penalty.
In the case of individuals, the FSA has proposed two options: (i) no reduction on the grounds of serious financial hardship; or (ii) reduction on the grounds of serious financial hardship, but only in cases where payment (either immediately or over a reasonable period of up to 3 years) would result in an individual’s net annual income falling below £14,000 and their capital resources (excluding their home and personal possessions) falling below £16,000.
If the first option is brought in, namely no reduction on the grounds of serious financial hardship, this could have disastrous consequences for individuals who do commit regulatory breaches, particularly market abuse, especially if they have benefited little from such actions. A simple example illustrates the point:
Mr A is a personal assistant to a director of a listed company, B Ltd. He obtained inside information from reading his boss’s emails and used that information to trade in B Ltd’s shares and make a profit of £10,000. In the 12 months leading up to the market abuse, Mr A earned a gross salary of £25,000 and had benefits of £2,000 by way of pension contributions and bonus.
Step 1 — Disgorgement
As a result of his market abuse, Mr A made a profit from his trading of £10,000, which is therefore the Step 1 figure.
Step 2 — Discipline: figure reflecting the nature, impact and seriousness of the breach
The Step 2 figure is the greater of:
The Step 2 figure in this case would therefore be the minimum level of £100,000.
Subject to any adjustment for aggravating and mitigating factors and any discount for early settlement, therefore, without any consideration of his financial hardship, Mr A would be paying £100,000 by way of penalty from a gross income (plus benefits) of £27,000 (and his profit of £10,000). Depending upon his assets, and the FSA giving Mr A a significant time within which to pay, one could see the result as requiring Mr A to sell his home or even being forced into bankruptcy.
Even were the FSA to implement option 2 and take into account serious financial hardship, the proposed thresholds are so low (£14,000 in the case of income) that they are unlikely to give individuals much comfort in practice.
As noted above, if the FSA’s proposals are implemented as suggested, they will have an unprecedented effect on enforcement proceedings in the UK. In particular, the implementation of those proposals could have extremely serious consequences for both corporations and individuals, but particularly individuals. Even ignoring the proposed minimum fine of £100,000 for market abuse, basing a penalty on up to 40% of an individual’s gross income and benefits will require serious life-style changes to be made for any individual who has committed a serious regulatory breach.
But then again, the FSA has not named it "credible deterrence" for nothing. As Margaret Cole, FSA Director of Enforcement said about the proposals: "they are an important step in pushing forward [the FSA’s] ethos of credible deterrence. By hitting companies and individuals in the pocket where it hurts, the fines will be a stark warning to others on what they can expect to pay for flouting [FSA] rules".
 30% if settlement occurs during stage 1 (the period from commencement of an investigation until the FSA has a sufficient understanding of the nature and gravity of the breach to make a reasonable assessment of the appropriate penalty and communicated that assessment to the person concerned and allowed a reasonable opportunity to reach agreement as to the amount of the penalty); 20% if settlement occurs during stage 2 (the period from the end of stage 1 until the expiry of the period for making written representations or, if sooner, the date on which the written representations are sent in response to the giving of a warning notice); 10% if settlement occurs during stage 3 (the period from the end of stage 2 until the giving of a decision notice); and 0% if settlement occurs during stage 4 (the period after the end of stage 33, including proceedings before the Financial Services and Markets Tribunal and any subsequent appeals).
 Indeed, the FSA has recently obtained its first bankruptcy order against an individual for an unpaid fine.
Gibson, Dunn & Crutcher LLP lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work or Rachel Couter (+44 20 7071 4217, [email protected]) or Selina Sagayam (+44 20 7071 4263, [email protected]) in the firm’s London office.
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