Recent FSA enforcement developments

Prohibiting insurance against FSA fines

FSA proposes, in CP 191 (Miscellaneous Amendments - July 2003), to introduce a rule forbidding insurance against its fines from 1st January 2004. This rule change, if introduced, is unlikely to have a major impact as this type of insurance is rarely written. It would nonetheless, in principle, affect firms and individuals as follows.

• An FSA-authorised insurer may not enter into, or make payment under, a contract of insurance that indemnifies against an FSA fine;
• An other authorised firm may not enter into, arrange, or claim under such a policy;
• An individual (whether or not an approved person) will be unable to obtain such insurance because of the foregoing restrictions.

These restrictions extend to Lloyd's, EEA passported and treaty rights firms. But the restrictions do not apply to insurance against the costs of an FSA enforcement action, nor to insurance policies entered into before 24th July 2003.

Current Enforcement Statistics - FSA's Report 2002/03

According to FSA's Annual Report 2002/02, the Regulatory Decisions Committee (an FSA Board Committee that takes the decision to commence disciplinary and other major enforcement actions) considered 77 new cases between April 2002 and March 2003.

• 21 cases concerned proposals to refuse applications for authorisation of a firm or individual approval; of these, 6 applications were rejected, 7 subsequently withdrawn, 4 referred back to FSA for reconsideration and 4 carried forward.
• 53 cases involved proposed disciplinary action. Of these, 36 were completed, 6 discontinued, and 10 carried forward.
• 3 requests to commence civil or criminal proceedings were granted.
• All cases referred to mediation settled.

Powers of arrest

FSA has recently been quoted as saying that it will seek to arrest any individual who refuses to co-operate in the exercise of its investigation powers. FSA has powers to commence criminal prosecutions in a number of areas, but has no power to arrest. It can, however, request the police to arrest an individual where it suspects that he has committed an offence. An example is under section 397 Financial Services & Markets Act – market manipulation and similar offences – which, carrying a potential sentence of over five years, is an arrestable offence under section 24 of the Police & Criminal Evidence Act.

Were FSA to request the police to arrest an individual suspected of having committed this or any other offence, then that individual would be entitled to protection under the 'PACE Codes of Practice', including the right to consult a legal adviser, the right to be accompanied during interview, and the right to silence. If an individual were to make a statement to the police, then this would be admissible in any subsequent criminal or civil proceedings, including FSA discipline.

In order to facilitate these arrangements, FSA has recently entered into a Memorandum of Understanding with the City of London Police. It states that FSA may request police assistance when an individual suspected of having committed an arrestable offence declines to attend an FSA interview under caution on a voluntary basis, or such an invitation to attend might prejudice the investigation. FSA and the police will liase over any arrest, although the subsequent investigation will remain under FSA's conduct, with FSA deciding whether or not to prosecute.

Giving publicity to investigations

FSA's current policy is that it does not give publicity to the fact that it is investigating a firm. However, Sir Howard Davies is recently quoted as having said that

"We [FSA] have concluded that we ought to relax this policy to some degree. And in order to do that, we need to consult."[1]

FSA is understood to feel that this policy hinders its ability to gain favourable publicity over its ongoing enforcement work because the bar on announcing investigations is thought to create the impression of inactivity.

FSA is under a statutory duty of confidentiality that restricts it from divulging information obtained from a firm other than in defined and limited circumstances, although the fact that FSA is investigating a firm is probably not confidential information within this section.[2] Consistent with the absence of any statutory restriction against such disclosure, the FSA Handbook states:

"The FSA will not normally make public the fact that it is or is not investigating a particular matter, or any of the findings or conclusions of an investigation".[3]

There are exceptions. FSA may announce that it is investigating a matter to maintain public confidence in the financial system; protect consumers; prevent widespread malpractice; or help the investigation itself (eg by bringing forward witnesses).[4] The Handbook indicates that this may be appropriate where the matter under investigation is the subject of public concern, speculation or rumour and FSA's announcement may help contain such speculation or rumour.[5]

Once an investigation is complete, FSA may issue a Warning Notice to commence disciplinary or other enforcement action. Warning Notices and Decision Notices (issued at a later stage in the proceedings) are subject to a statutory duty of confidence, and neither FSA nor any recipient may publish any details about them.[6] In fact, no publicity is permitted until either the firm accepts the FSA decision, or it has been upheld by the Financial Services & Markets Tribunal or on further appeal.

FSA has to consult on any change to the Handbook of this nature, and this will give firms the opportunity to respond to proposed changes. Our view is that such an alteration to FSA's policy would be most undesirable from the market's perspective. It would be irrational for FSA to be allowed to publicise the fact that it is investigating a firm when any consequent decision to take enforcement action against that firm is subject to statutory confidentiality. It would also be disproportionate for FSA to issue damaging publicity that an investigation has been commenced, when it may harbour doubts but possess no evidence of wrongdoing when the actual commencement of proceedings, after a degree of wrongdoing may have been determined, must remain secret.

MONEY LAUNDERING – latest developments

FSA is continuing to develop its stance on anti-money laundering, which it described in July 2002 as supportive and collaborative, being

• To secure senior management acceptance and undertaking of their responsibility;
• To monitor compliance and to encourage early correction of weaknesses;
• To assess money laundering risk in the industry;
• To provide training support.[7]

Money laundering risks

FSA has now reviewed the general money laundering arrangements in four different classes of firm. While each has different characteristics, a number of common themes emerge that are of wider application.

Small firms theme work (March 2003)

FSA's July 2001 Report "Money Laundering – tackling our new responsibilities" identified IFAs that handled client money from overseas as one of six types of firm vulnerable to money laundering. FSA therefore carried out some review work among all IFAs and has reached the following conclusions.

Work carried out to a generally satisfactory standard:

• Establishing anti-money laundering procedures, although not all advisers were fully observing them;
• Appointing an appropriate person as MLRO, and giving him or her access to information about the firm's customers and their businesses;
• Maintaining records.

However, areas for improvement were:

• Considering all information known about the client, rather than just obtaining proof of identity on take-on, in order to detect unusual or suspicious transactions;
• Always obtaining appropriate client identification documentation in accordance with internal procedures;
• Providing training that is tailored to the firm and its activities, rather than generic.

International Banking Cluster (June 2003)

Areas for improvement were

• Need for additional know-your customer checks on clients from high risk jurisdictions, or carrying out high risk activities;
• Need to perform these checks on all clients, including those whose transactions are booked overseas.
• Weakness in account opening procedures, particularly with regard to accepting faxes and uncertified photocopies of identity verification documents, and failure to investigate beneficial ownership and ultimate control of corporate accounts or opaque structures;
• When dealing with correspondent banks, need to investigate their beneficial ownership and money laundering controls. Also, need to identify underlying clients.
• Need to obtain more detailed know your customer's business information to identify suspicious transactions.

Domestic retail cluster (August 2002)

FSA notes the adoption of good practice in relation to the use of dedicated account opening units that carried out consistent customer identification, and also automatic transaction monitoring systems.

Areas for improvement are:

• Need to monitor adequacy of know your customer procedures;
• Need for senior management involvement;
• Reliance upon manual transaction monitoring;
• Inadequate record keeping.

On-line broking & spread betting clusters (October 2002)

FSA sees these firms as characterised by non-face to face relationships and execution-only trading, but acknowledges that they generally do not accept cash or facilitate transfers to third party accounts, so lessening the risk of use for money laundering. FSA generally noted that firms were on their way to meeting standards other than in relation to customer identification.

Briefing note: Identification of existing customers by regulated firms (July 2003)

Financial services firms are required to verify the identity of their customers under the Money Laundering Regulations 1993 and the Money Laundering Sourcebook, but many customers may not have been subjected to this process because they were customers before the Regulations came into force, or the firm did not adequately comply with them. FSA views this position as a risk.

In July 2002 the six largest UK retail banks made an announcement, in terms required by FSA, that they would carry out a risk-based review of existing customers' identity. This work is proceeding, and meanwhile FSA has been considering whether to impose a similar requirement on other firms. FSA has now decided not to proceed with this step because it would not be cost-effective for firms, many of whom might already have taken sufficient steps towards this objective.

Instead, FSA reminds firms as follows:

• The ML Sourcebook requires firms to maintain effective systems and controls against money laundering. This includes training, verifying customer identity and monitoring subsequent transactions for suspicious activity;
• Guarding against money laundering is a particular responsibility of senior management;
• Firms should not ignore any gaps in their identification controls, whenever the customer was taken on. This may include pre-1994 customers;
• Firms that do not seriously address the risks of money laundering are exposed to the threat of enforcement action.

REDUCING MONEY LAUNDERING RISK (DP22 August 2003)

In this paper, FSA discusses the merits of setting standards for customer identity, know-your-customer and monitoring suspicious transactions. There are at present no specific requirements for them, and this paper is valuable in setting out what FSA views as good practice even if none of the proposals is adopted.

Know your customer

This enables firms to manage money laundering risks by reducing the likelihood of taking on a money launderer as a client, and increasing the risk of subsequent detection. In particular, knowing what is usual for or expected of a customer allows the firm to identify the unusual and report suspicions as appropriate. The scope of know your customer information can include

• The purpose and reason for opening the account or product
• The anticipated level and nature of the proposed activity
• The relationship of the signatories and beneficial owners
• The source and origin of funds
• Occupation, source of wealth and net worth for personal accounts.[8]

FSA acknowledges that the amount of information obtained, and the manner of verification (other than for identification, which is mandatory) may vary between firms, as will the frequency of updating, although this can be done when a new product or service is sold.[9] FSA does not consider that appropriate use of know your customer information is constrained by data protection considerations.[10]

Monitoring

The benefit of monitoring transactions is that it enables a firm to detect the unusual, and evaluate this information as a potential indicator of suspicious activity.[11] The merits of automated monitoring systems are discussed.[12] FSA, while acknowledging that different firms will have different monitoring requirements in view of frequency of transactions and level of information obtained, considers that effective monitoring involves the following elements:

Risk assessment - identifying characteristics that merit further scrutiny, including

• Is the transaction of unusual size or frequency for the customer;
• Does it involve early termination/transfer of the relationship;
• Is it a series of transactions, such as cash credits;
• Does the transaction relate to a high-risk country;
• Who are the parties to the transaction?

Detection – manual or automated detection of unusual transactions.

Internal reporting & review – management or the MLRO to consider whether the transaction is suspicious.

External reporting – to NCIS as appropriate.

Ongoing review & feedback within the firm.[13]

Other material contained in the Discussion Paper includes a diagram of the International & UK anti-money laundering framework (Annex 2) and extracts from international statements of good practice on know your customer and monitoring (FATF, JMLSG, Basel & Wolfsberg), upon which many of FSA's suggestions referred to above have been based (Annexes 4 & 5).

FSA ENFORCEMENT ACTION ON MONEY LAUNDERING

Recent disciplinary action taken by FSA against several firms for money laundering breaches highlights continuing concern over failure properly to perform basic account-opening procedures. In each case the breaches involved failure to obtain and record sufficient information about the identity of the customer to enable the firm to be satisfied that he or she was, indeed, whoever they claimed to be.

These cases highlight that firms require:

• Clear written client take-on procedures which staff understand;
• Those procedures to conform to JMLSG recommendations;
• The firm to monitor compliance with those procedures;
• Senior management to be satisfied on good grounds that those arrangements are operational;
• The need for the firm periodically to review and benchmark the adequacy of its anti-money laundering procedures.

FSA takes action on poor advertising (July 2003)

FSA has recently issued this press release to highlight its powers to require firms to take remedial action over misleading advertising.

FSA received over 200 financial advertising complaints between October 2003 and March 2003, and in some 40% of cases considered that the advertisement failed its "clear, fair and not misleading" requirement.

In 82 cases the firm was required to withdraw or change its advertisement, and on eight occasions the firm was required to write to its customers, point out further risks and offer a refund. Affected products were commonly equity ISAs, pensions, and capital protected/capital at risk products. FSA gives the example of an advertisement for a capital protected product in which returns were misleadingly implied as being as secure as in a deposit account, and it was not made clear that the moneys would be used to buy shares in an overseas investment company rather than being held by the firm itself. FSA considered that this advertisement did not provide a balanced view of the product, and required the firm to offer a refund to its customers.

Clarification and Revision of the Financial Promotion Rules & Guidance (CP 188 July 2003)

FSA emphasises that financial promotions for products offering income, capital growth or capital security must be clear and fair yet are too often complex and difficult to understand. FSA therefore proposes the following changes for consultation:

Structured capital-at risk products (né precipice bonds) are mostly sold to elderly customers to boost their retirement income. FSA plans to require firms offering these products with a specified level of income to include FSA's factsheet on high-income products with direct offer advertising. Firms will also need to provide specified risk warnings and, after purchase, periodical statements detailing performance.

Structured deposits are bank deposit accounts offering a return of capital with interest payable in accordance with a formula, often linked to an equity index or a basket of shares. FSA is concerned that the basis of the interest payment may be unclear, with potential benefits exaggerated and possible detriments glossed over, such as risk of no interest or lack of access to capital. FSA therefore proposed to apply some of its financial promotion rules to these products, such as in relation to description of the product, commitment and risks.

Further changes to financial promotion rules. FSA proposes the following additional items of guidance, which seem to be derived from FSA's current experience with structured products and deposits:

• Any risk of capital loss should be prominently stated, together with information enabling the likelihood to be calculated;
• If the investment cannot be accessed for more than one month after the last fixed payment due to the customer, then this should be stated;
• Unrealistic and unlikely headline rates should not be used;
• If capital protection benefits are not guaranteed, then counterparty risk should be explained.

[1] Sunday Telegraph 3rd August 2003

[2] section 348 Financial Services & Markets Act

[3] ENF 2.13.1G

[4] ENF 2.13.4G

[5] ENF 2.13.5G

[6] section 391 Financial Services & Markets Act

[7] Speech by Carol Sergeant to 2002 General Meeting

[8] paras 3.2, 3.6, 3.7

[9] paras 3.14, 3.18

[10] para 3.23

[11] paras 4.5, 4.10 – 4.12

[12] para 4.24

[13] paras 4.10 – 4.16; 4.21 – 4.23