Who pays for an FSA hit?

The FSA recently announced that its enforcement budget for 2005 will be doubled to a total of £5m.

This comes as no surprise. As the scope of the FSA regime widens in January the number of enforcement actions against insurance firms will increase.

The flip side of this is that more and more professional firms and individuals will be looking to their professional indemnity (PI)policies to meet the costs of defending these actions

The costs arising from enforcement actions can easily run into hundreds of thousands of pounds.

But insurers are having difficulties assessing whether these claims are covered or not.

The Financial Services and Markets Act [2000] imposes a very wide range of regulatory obligations on firms and 'authorised persons' - those high level individuals in finance and insurance who must be personally authorised and regulated.

Breaches of these duties and obligations can result in action of two distinct types:

- A claim for restitution and damages brought in the High Court (which can be brought either by the FSA, or by anyone who has suffered loss and damage)

- An FSA enforcement action. Sometimes both kinds of action will be brought at the same time, or in quick succession.

A High Court action can result in an order for damages, but the enforcement action can result in unlimited fines, public censure, variation or withdrawal of authorisation, and, worst of all a complete prohibition from ever being involved in regulated business in the future.

That is one reason why enforcement actions are often so desperately defended.

How does all of this relate to PI cover? It is not permissible to insure against regulatory fines and most PI policies exclude them in any event.

But an action for damages based on a breach of the financial services Act would be likely to fall within the scope of most PI policies.

Defence costs

Damages for breach of statutory duty are also very likely to be covered - the statutory duty under the Act goes beyond skill and care, but provides that business must be conducted with integrity as well. The legal costs of defending (and even investigating) such a claim may be covered too.

But problems can arise in relation to enforcement actions as it is not clear whether these are covered by PI policies or not.

The difficulty is that an FSA enforcement action is not obviously a "claim" of the sort that would fall within a standard PI policy.

The enforcement procedure is, undoubtedly, a judicial procedure, but on the face of it looks more like a disciplinary procedure than the sort of third party claim that PI insurers are used to dealing with.

Faced with enforcement claims some PI insurers have sought to argue that the enforcement process is not a claim at all, and therefore the policy cover simply isn't triggered.

Close reading

That issue, of course, turns on a close reading of the policy wording.

Some policies expressly cover losses associated with regulatory investigations and prosecutions - although there can be no question about defence costs falling within those policies.

Other policies are much narrower, and cover only claims for negligent acts, errors and omissions. But the FSA itself can be a claimant, alleging breach of statutory duty. And if the alleged breach is of the duty of skill and care - why is that not a negligent act, error or omission?

And what difference does it make if the FSA chooses to enforce the financial services Act through the courts, or before the regulatory decisions committee?

It can, after all, do both at the same time.

Areas likely to give rise to action by the FSA

1. Breaches of the FSA principles - which impose high level duties of care and conduct of business on authorised firms and individuals

2. Perimeter breaches - whereby firms and individuals carry on regulated activities without being authorised by the FSA

3. Market abuse - the blanket term under the Financial and Market Services Act for insider dealing and market manipulation

4. Money laundering - an offence which, like market abuse, can be committed by anyone, whether they carry out a regulated activity or not.

The FSA enforcement procedure

Appointment of investigators

The process begins with the formal appointment of investigators. They have extremely wide-ranging powers to compel the production of documents and information. Documents that are legally privileged can be withheld.

Interviews are very formal, and are conducted under the provisions of the Police and Criminal Evidence Act. Refusal to co-operate can result in an application that the firm or individual be held in contempt of court.

The investigation report

If the investigators consider there is a case to answer they will send an investigation report to the firm or individual setting out their findings.

Up to 28 days are given for a written response.

The regulatory decisions committee

If the investigators reject the written response, they will make a recommendation to the regulatory decisions committee that action be taken. The committee is the decision-maker of the FSA. It is an internal FSA body, independent of the investigation and enforcement divisions. Sanctions include unlimited fines, public censure, withdrawal or variation of authorisation, and even an indefinite prohibition against carrying on a regulated activity. If the committee accepts the recommendations, it issues a warning notice.

The warning notice

The warning notice sets out the background, the relevant legal principles, the findings of the investigators, the case to be answered, and the action which the decisions committee is minded to take. The firm or individual can simply accept the finding, but if it does not do so it has 28 days to respond. If the committee is not persuaded by the further representations, it issues a decision notice.

The decision notice

The decision notice sets out the finding that the regulatory decisions committee has made, and the action it intends to take. Again, the firm or individual can accept the decision or not - if not, the matter must be referred to the Financial Services and Markets Tribunal.

The tribunal

The tribunal is separate from the FSA. It consists of a chairman and lay members. Once a decision notice is received, the firm or individual has 28 days to refer the matter to the tribunal. The FSA must then file a statement of case within 28 days, and the firm or individual has a further 28 days to respond. The tribunal remits its decision to the FSA with appropriate directions. Appeals on points of law can be made to the Court of Appeal.

If there is a finding against the firm or individual the FSA will publish a final notice, setting out the findings and the sanction to be imposed.

There is a dedicated FSA mediation procedure called the early settlement procedure that can be used at any time.