A league table of Bad Banks might lead to improvements in the ethics of Banking, argued LSE’s Professor Roger McCormick at a UCL’s Centre for Ethics and Law event on Sustainable Banking. He drew on evidence to the Banking Standards Committee criticising the idea that what Banks needed were more lawyers and compliance staff. Doubting the efficacy of Codes of Conduct, he advocated a focus on steps that might genuinely influence banking conduct. If it is the case that codes and process measures can simply be worked round and recognising that basic values may be important it was necessary to find other techniques. Structures played a role: Professor McCormick pointed to the de-federalisation of Barclay as a positive sign that the Bank might be taking control of the compliance and ethics problems it faced, with reporting lines direct into the CEO.

But there was a profound need to realign the interests of boards who had often not been informed of illegalities and other problems in their Companies.

One approach was to look for proxy indicators of poor culture and magnify attention on those. Interestingly, Banks’ Sustainability Reports do not, he emphasised, contain information on regulatory findings and fines in spite of guidance that they ought to. McCormick has been developing a tabular format for collating and simplifying the information into a league table to make the information more impactful. The information is collated by researchers including fines and the nature of any breach. 
Professor Emilios Avgouleas of the University of Edinburgh applauded the initiative and warned against too superficial a reliance on the notion of cultural change. To understand what we meant by a sustainable bank we had to think about what the purposes of a bank were and how those purposes could best be served. Complexity and incentives meant that utility banking, hedging and speculation had merged into a melange of one purpose where gambling and outsmarting competitors had become more important than long term financial health. For Avgouleas incentives were the key; at the moment they encouraged manipulation and short termism. Steps like McCormick’s league table had potential, he thought but regulators needed to concentrate on incentives not culture. In particular, a naming and shaming approach would not prevent a serious financial sustainability event in the future.

With the seminar taking place on the day the Francis Report was published, a member of the audience posed the broader question: isn’t cultural failure a broader social phenomenon? And if so, where does that failure stem from? The audience member felt that was a failure of societal values. An interesting area of deliberation which the Centre is involved in encouraging dialogue, is what role if any law and regulation has to play in shaping such values.

Blog Editor Comment

Ever wonder which banks were the most sustainable? Have a look at the 2012 Financial Times (FT) short list here, the general FT page here and the sustainable banking and finance special report (June, 2012) here.

With all of us, who study the financial markets and banking and finance law, extremely excited about next month’s legal cutover to the Financial Services Act 2012 (which brings in the new regulators, the Financial Conduct Authority and Prudential Regulation Authority), one thing is for certain. The Financial Services and Markets Act 2000 (FSMA) has come to be so heavily amended that even seasoned lawyers are experiencing difficulties digesting all the changes.

Just with the LIBOR scandal in mind consider the follow summary. Section 7 (extension of scope of regulation) of the 2012 Act amends section 22, inserting a new section 22(1A) of and Schedule 2 to FSMA by expanding the Treasury’s power within the meaning of section 22 to specify by order what activities are “regulated” activities (and thus subject to the general prohibition in section 19 of FSMA). Moreover, section 11 (permission to carry on a regulated activity) of the 2012 Act also inserts a new Part 4A into FSMA. Furthermore, as noted earlier, Part 7 of the 2012 Act in section 89 (misleading statements), section 90 (misleading impressions) and section 91 (misleading statements etc in relation to benchmarks) creates new criminal offences; for interpretive purposes, the types of relevant agreements and investments are set out in the Financial Services Act 2012 (Misleading Statements and Impressions) Order 2013. The activities connected to specified benchmarks are inserted to the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 by the Financial Services and Markets Act 2000 (Regulated Activities)(Amendment) Order 2013 and the latter also amends the meaning of “consumer” as contained in section 1G of FSMA. As far as regulation is concerned, this is just the tip of the iceberg and one could go on and on …

While regulation the above regulation is not undesirable, surely there must be another way to do things?

LSE Sustainable Finance Project: International Comparative Legal Risk

Note: the Project is still looking to complete its funding package; please email R.S.McCormick@lse.ac.uk, rsmccormick@btinternet.com or call +44 (0)7802 604 316

The concept of Sustainability is frequently discussed in the context of  financial markets. Many banks issue Sustainability Reports (by whatever name called) every year and nearly all of them wish to be perceived as having an acceptable response to the demands of the ESG agenda. They do not want to be seen, for example, as financiers of “dirty projects”, users of child labour or manufacturers of cluster bombs. But does this response go far enough in view of the issues thrown up by the financial crisis?

It is an important part of the LSE Sustainable Finance Project to consider  how society’s understanding of the scope of the ESG agenda should embrace more effectively the sustainability of (a) retail and wholesale financial market practices; (b) business models and cultures (including their operational risk management effectiveness) within individual banks; and (c) the financial system itself. The project centres around the question: what does Sustainability mean in the context of banks and the financial system?

Recent remarks by luminaries such as Mervyn King and Andrew Haldane suggest that the public is very much in the dark as to the financial position of banks. (Haldane referred to auditors having to pin the tail on a “boisterous donkey” when trying to assess bank balance sheet items). It would seem to be even more in the dark about the “cultures” that operate within banks and the impact they have on governance and risk management. The LIBOR Scandal (see the UK test case Graiseley Properties Ltd & Ors v Barclays Bank Plc [2012] EWHC 3093 and Graiseley Properties Ltd & Ors v Barclays Bank Plc & Ors (Rev 1) [2013] EWHC 67) has caused questions of culture and ethics to climb society’s agenda in relation to bank reform (as evidenced, for example, by the establishment of the Parliamentary Commission on Banking Standards and its reported proceedings). At the same time, concern over banks’ ongoing difficulties with operational risk,  which continue to result in substantial losses as well as the imposition of heavy fines, has  increased. The legal risks (deemed by Basel II to be an example of operational risk) attendant on poor op risk management are becoming increasingly serious, as are the reputational risks.

The International Comparative Legal Risk work programme seeks objective (or “concrete”) indicators in relation to  such “cultural” (or behavioural) issues and suggests way of assessing them and presenting them in an accessible format. It also raises questions about the relationship between Sustainability and governance and the differing practices of regulators in different jurisdictions (both as to substantive behaviour and the accessibility of information). Analysis of the immediate financial consequences of poor op risk management is a central feature of the exercise.

The principal long-term objectives of the ICLR programme are as follows:

1. Enable comparisons to be made of how individual banks have performed in relation to regulatory disciplinary measures and comparable op risk (or legal risk) issues; key “indicators” of performance are selected for this purpose;
2. Compare accessibility of information across relevant jurisdictions relating to Objective 1;
3. Compare disciplinary records of financial regulators regarding fines levied against major banks and comparable measures;
4. Compare how banks have sought to comply with applicable corporate governance rules and standards in their home jurisdictions;
5. Establish objective indicators of bank under-performance in relation to ESG matters;
6. Explore possible correlations between a bank’s record on disciplinary matters and its record and policy on ESG matters and corporate governance;
7. Encourage dialogue and explanation;
8. Promote greater transparency and accessibility of information; and
9. Encourage banks to take active steps to improve their performance and develop a shared understanding of “best practice” in the key areas.

The motivation for the programme stems in part from a desire to make progress on the adoption of stronger governance practices and ethical principles by banks and to understand  how such progress  can be verified and how civil society can get beyond the “square one” represented by the ongoing expressions of disaffection and protest relating to banks and bankers generally. It is envisaged “square two” should include a greater analysis of the social aspects of individual bank behaviour. In this connection, “social aspects” means those aspects of behaviour that relate to (i) the “riskiness” of the behaviour (whether in relation to the bank’s shareholders, its customers, other stakeholders or the financial system (and thus society as a whole)) or (ii) a perceived disregard of the values that are adopted by the society that the bank is, in principle, supposed to be serving. For analysis to be worthwhile, it is felt that the results should be presented (a) in as accessible a format as possible and (b) in a way that enables comparisons amongst banks to be made. The four Phases of work described below have been devised by the ICLR Steering Group (which includes academics from LSE, UCL and QM) with this in mind.

Proposed Work Programme

The Work Programme currently under consideration for 2013 (and then for repetition in subsequent years) is described below

1) In the period up to end [      ] (Phase 1): to commission researchers to compile information on 10 banks covering the period to end December 2012, using the form which is summarised in the attachment as ICLR 1, for completion by [    ]. The 10 banks would all be household names and significant participants both internationally and domestically. (They may also be “SIFIs” but it is not intended that, as the project progresses, its scope should be limited to SIFIs).  4 would be from the UK, 4 from the US and 2 from continental Europe. There is no “magic” in the number chosen: if we had more resources, we would enlarge the exercise. But 10 is a reasonable number to start with. The jurisdictions covered would be, principally, the US, the UK and the other EU countries. Others may be added as long as it is practical to do so, given the need to treat all 10 banks in the same way.

2) The result of the work described in 1) is not a “league table” of “bad banks” as such, even though the data could easily be used to draw one up (simply by reference the monetary totals). But the data would also be relevant for:

a) comparing regulators and jurisdictions with each other;

b) comparing the amounts paid in relation to the different heads (set out in Form ICLR 2, attached);

c) considering which of those heads seem to be most problematic for (i) particular jurisdictions and (ii) particular banks; and

d) studying trends (per bank, per jurisdiction and per “head” of problem) over the period of time (5years) covered by the study.

3) After the completion of Phase 1, the steering group would study the results and determine the best way of presenting them (Phase 2).

4) After Phase 2, each of the banks concerned would be given an opportunity to comment on the findings to date that relate to that bank. (Phase 3)..

5) After Phase 3, the completed findings would be published (in [    ]), with an accompanying seminar/meeting at LSE. (Phase 4)

6) Subject to the results of the 4 Phases, the exercise would subsequently be repeated to bring the findings up to date for the 12 months ending December 2013, so that a rolling five year finding (this time for the 5 years ending December 2013) starts (with the cycle being repeated each year).

Senior regulators have been reported as wanting to “pry more closely into how well banks are tracking and reducing risks” (FT, front page 26.11.12). This work programme offers a methodology for doing that in relation to some of the most important op risks faced by banks.

Roger McCormick

18.3.13

Form ICLR1                                                                          Draft 1

Notes

1)     Amounts originally denominated in non-GBP  to be converted to GBP at a rate set annually (as of November 2012: 1.2 for euros and 1.6 for US $)

2)     Amounts only to be included when they have crystallised (e.g. a judgement has been given, a settlement agreed, or a provision made in accounts). Mere allegations do not “count”

Form ICLR2                                                      Draft 2

List of Codes applicable to Form ICLR1

Proprietary Trading

The term “proprietary trading” when applied to a bank could in theory refer to any trading activity which results in a proprietary position for that bank – in other words, where price movements in the relevant market affect the bank’s bottom line.

At paragraph 10, the report explained that:

There is no commonly-accepted definition of proprietary trading. Most activity undertaken by banks results in some form of proprietary position. In principle, the type of trading which causes the greatest concern is where the bank is using its own funds, raised from shareholders, depositors and creditors, to speculate on markets, without any connection to customer activity. This has been the main focus of our consideration. Some banks, particularly US investment banks, historically had units dedicated to such activity. However, an examination of proprietary trading which only considered such units would be inadequate, because speculative activity can also take place alongside customer-related trading.

The Chairman of the Parliamentary Commission on Banking Standards, Andrew Tyrie MP, commented:

• Proprietary trading carries large risks, both prudential and to banking standards.
• Many banks based in the UK agree. Their evidence to the Commission makes clear that, at the moment, they do not engage in proprietary trading, nor do they wish to.
• As the US experience demonstrates, the use of legislation to define and prohibit proprietary trading may be difficult. In any case, it may impose an additional burden on regulators already charged with implementing a ring-fence.
• Therefore, the Banking Commission does not feel it appropriate to recommend the immediate prohibition of proprietary trading.
• Instead, the Prudential Regulation Authority (PRA) should use its existing tools such as capital add-ons or variations of permission to bear down on these risks. This may require some amendment to the legislation currently before Parliament to give the PRA a mandate to act.
• Banks should be required to agree with the PRA a regular statement of risk exposures in their trading book. More transparency is needed. These statements should be published and Parliament will require an annual report from the PRA on them.
• Banks which the PRA judges to be engaged in trading activities that cannot be shown to be serving their clients should be incentivised to exercise greater control.
• The immediate risk to UK banking standards from proprietary trading may be limited. However, effective regulatory oversight will be particularly important for the future. At a time when banks are under less intense scrutiny, proprietary trading could re-emerge as a greater risk.
• Were this approach to prove ineffective, further measures, including prohibition, could be desirable.
• We expect the PRA to report on the implementation of our recommendations, drawing also on the experiences of other countries which are currently implementing restrictions on proprietary trading. This should be followed by an independent review of the case for further action.”

The conclusions and recommendations in the Third Report are set out on pages 47 – 51. Some of the conclusions and recommendations contained within the Report include:

1. On prudential concerns

Para 22:
 Proprietary trading gives rise to prudential risks…The Commission has concluded that the prudential risks associated with banks engaging in proprietary trading are not necessarily different in kind from those associated with a range of other banking activities, many of which made a greater contribution to the recent financial crisis. However, having greater exposure to markets than is necessary for client servicing increases the potential for risks that may not be fully understood until the next crisis.

2. On cultural concerns

Para 31:
 The argument that the trading function within banks, in particular the proprietary trading function, could have harmful cultural effects has been convincingly made. The Commission is concerned that the conflict of interest which can arise from a bank attempting both to serve customers and trade its own position cannot be easily managed, and can be corrosive of trust in banking no matter what level of safeguards are put in place supposedly to separate these activities. The Commission is also concerned that the presence of proprietary trading within a bank, with its potential to generate high short-term rewards for individual traders, could have a damaging effect on remuneration expectations and culture throughout the rest of the firm.

3. On the extent of proprietary trading in UK banks

Para 39:
 Many of the leading UK banks have told us in evidence that they do not currently engage in proprietary trading, and a number of them agree that proprietary trading is not a suitable activity in which customer-oriented banks should engage. However, such reassurances alone cannot provide a guarantee against the re-emergence of proprietary trading over time, as public attention on banks’ activities fades, economic circumstances change and another generation of bank leaders less scarred by recent events emerges.

4. On defining proprietary trading

Para 76:
 The Commission has received extensive evidence from banks, and particularly from regulators and independent experts about the practical difficulties of establishing a definition of proprietary trading which meets the standard necessary to support effective enforcement. An individual proprietary trade may outwardly appear to be similar or identical to trades arising from client activity such as market-making, with the main difference relating to the intent behind the trade.

5. On prohibiting proprietary trading

Para 88:
 The UK ring-fence, in its electrified form, is intended to protect core banking services by separating all investment banking activity, including proprietary trading, in contrast to other jurisdictions which are proceeding with structural reforms focused solely on proprietary trading. Given the present uncertainty about the feasibility and burden of prohibiting proprietary trading within banks, the Commission believes that it would not be appropriate to attempt immediate prohibition using the legislation currently before Parliament.

6. On the Commission’s recommendations for regulatory action

Para 97:
 The main UK-headquartered banks have told us that they do not engage in proprietary trading at the present time and do not wish to do so. The Commission recommend that the PRA, with immediate effect, ensure that their regular scrutiny of banks monitors this assertion and holds banks to it. In particular, the PRA should play close attention to trading units which have characteristics such as large open or arbitrage positions and volatile revenue flows. Were a bank unable to demonstrate satisfactorily that certain trading activities relate to their core business of serving customers, this would be an indication of proprietary trading or of a more general prudential weakness in the bank. In such cases, the PRA should use its existing tools such as capital add-ons or variations of permission to bear down on such activity and incentivise the firm to exercise tighter control. As part of their commitment to enhanced disclosure, banks should be required to agree with the PRA a published statement of risk exposures in their trading book and of control issues in their trading operations raised by the PRA during the last year. Parliament will expect the PRA to report on these statements. It is possible that the PRA may not be able to justify use of existing tools in this way under its current mandate. The Commission therefore further recommend that the Government consult the regulators on whether the current legislation needs amendment to give regulators the authority to carry out activities in pursuit of these regulatory aims.

7. On the Commission’s recommendation for review

Para 98:
 The Commission further recommend that the current legislation require the regulators to carry out, within three years of the Act being passed, a report to include:

• Analysis of the monitoring and corrective actions conducted in  accordance with the recommendations in paragraph 97;
• An assessment of any impediments encountered to such actions;
• The impact, by then, of the moves towards ring-fencing on banks’ trading activities;
• Lessons about the feasibility of defining and prohibiting proprietary trading within banks, based on the experience of other countries, in particular the USA, attempting to do this; and
• A full assessment of the case for and against a ban on proprietary trading.

Para 99:
 The Commission expects this report to be presented to the Treasury and to Parliament and to serve as the basis of full and independent review of the case for action in relation to proprietary trading by banks. The Commission that legislation be introduced to provide for such a review and to provide assurances about its independence, including a role for the House of Commons Treasury Committee in the appointment of the persons to carry out the review.

6 February 2013 has marked lawyers’ calendars with an important message from the UK Supreme Court: English courts will not accept the jurisdiction over a dispute which has the “centre of gravity” in another country. In particular, the Supreme Court found that in a tort claim, where the key issues in the litigation would on the face of it be factual not legal, law governing the tort was of very little, if any, potency for the purposes of defining the appropriate forum. The Supreme Court also refused to invoke non-exclusive jurisdiction clauses in favour of English courts noting that the connection with another country was of such strength and importance that England could not be said to be clearly or distinctly the appropriate forum.

For the reasons explained below, Lord Neuberger PSC and Lord Mance, Lord Clarke, Lord Wilson and Lord Reed JJSC upheld the lower courts’ judgments dismissing the jurisdiction of English courts and claims on piercing the corporate veil in the widely reported case of VTB Capital plc (Appellant) v Nutritek International Corp and others (Respondents) [2013] UKSC 5. (On appeal from [2012] EWCA Civ 808 and [2011] EWHC 3107 (Ch) respectively.) See case preview on this blog here.

Facts of the case

The case arose from a Facility Agreement dated 23 November 2007 entered into between VTB Capital plc (“VTB”), an English incorporated bank, and a Russian company, Russagroprom LLC (“RAP”), under which VTB advanced around USD 225m to RAP. The advance was primarily to enable RAP to buy six Russian dairy companies and three associated companies from Nutritek International Corp (“Nutritek”). RAP defaulted on the loan in November 2008. VTB believed the security provided for the loan to be worth only in the region of USD32m to USD40m.

VTB claimed that it had been induced in London to enter into the Facility Agreement, and an accompanying interest rate swap agreement, by misrepresentations made by Nutritek. The misrepresentations alleged were, first, that RAP and Nutritek were not under common control, and second, that the value of the dairy companies was much greater than they were in fact worth. VTB’s case was that the misrepresentations were fraudulent.

Mr Konstantin Malofeev, a Russian businessman resident in Moscow, was said to be the ultimate owner and controller of Nutritek, Marshall Capital Holdings Ltd and Marshall Capital LLC. Therefore, VTB claimed that those companies and Mr Malofeev were jointly and severally liable for the alleged misrepresentations.

In order to bring proceedings in tort in England, VTB required permission to serve proceedings out of the jurisdiction, because the intended defendants were neither resident, nor otherwise found, within the jurisdiction. Such permission was obtained on 11 May 2011.

After being served, the respondents applied to Arnold J for the service to be set aside, claiming that England was not the appropriate forum. In response, VTB applied for leave to amend its particulars of claim to add a contractual claim. The Bank sought to hold the respondents liable for breach of the agreements as persons behind the borrowing, claiming that RAP’s corporate veil could in the circumstances be pierced. The respondents’ application to set aside succeeded and VTB’s application to amend failed before Arnold J, and the Court of Appeal upheld his decision on both points.

VTB appealed to the UK Supreme Court.

The Supreme Court Judgement

The Supreme Court (i) dismissed VTB’s jurisdiction appeal by a majority of three to two (Lord Clarke and Lord Reed JJSC dissenting), leaving VTB with the permission to serve the proceedings out of the jurisdiction set aside; (ii) unanimously dismissed the corporate veil appeal, so that VTB was not permitted to amend its pleaded case to include a claim on piercing the corporate veil; and (iii) unanimously discharged the freezing injunction obtained by VTB in respect of Mr Malofeev’s assets.

From the procedural perspective, the Court stressed that in a case such as this, if a court is not satisfied that England is clearly the appropriate forum in which to bring a claim, the permission to serve out must be refused or set aside. It then proceeded to note that where a judge has exercised his or her judgment to determine whether England is the appropriate forum, an appellate court should refrain from interfering with that decision, unless satisfied that the judge made a significant error. Importantly, the minority agreed with the majority that, in general, where the only challenge that can be advanced depends upon persuading an appellate court to balance the various jurisdictional factors differently, an appellate court should not interfere.

On the substance, the Supreme Court examined governing law, place of commission of tort, the factual focus, witnesses, aim of the alleged torts, and fair trial as factors relevant to the appropriate forum issue.

The Justices found that in VTB governing law (English) was a factor of very little, if any, real potency, for the purposes of defining the appropriate forum because the key issues in the litigation would on the face of it be factual not legal. In its turn, factual issues as well as oral and documentary evidence on both sides were focused on Russian witnesses and overwhelmingly on matters which had happened in and concerned Russia, thus, suggesting that Russia was the most appropriate forum to hear the dispute.

The Supreme Court also agreed with Arnold J’s [2011] EWHC 3107 (Ch) (29 November 2011) decision that non-exclusive jurisdiction clauses contained in the agreements were “a pointer to England, but not a strong one given that the claim is a tort claim not a contract claim” and, correspondingly, refused to invoke them.

With respect to veil-piercing claims, the Court reasoned that VTB’s proposed case does not give rise to arguable grounds for contending that the jurisdiction to pierce the corporate veil could be invoked in order to attach liability to Mr Malofeev. Firstly, it was not suggested by VTB that any of the other contracting parties under the two agreements was not liable. Secondly, at the time the agreement was entered into, none of the actual parties to the agreement intended to contract with Mr Malofeev, and he did not intend to contract with them. And thereafter, Mr Malofeev never conducted himself as if, or led any other party to believe, he was liable under the agreement. The Court added that the extension was not needed to enable VTB to seek redress from Mr Malofeev: if VTB established that it had been induced to enter into the agreements by the fraudulent statements which he was alleged to have made, then Mr Malofeev would be liable to compensate VTB.

Comment

In recent years the number of disputes brought to England from Commonwealth of Independent States’, or “CIS”, region has increased dramatically. This happens largely due to the reliability of English justice, which, unfortunately, CIS national court system does not offer at the moment. In such situation, every legal issue raised before English courts to clarify the perspectives of bringing legal proceedings in England as well as their possible outcome attracts a particular attention of CIS-based companies and lawyers.

In VTB the Supreme Court framed a number of pointers aimed at helping the parties define the appropriate forum in which to bring their claims in tort committed in England by the party being neither resident, nor otherwise found, within the jurisdiction. The Court relied on a well-established principle according to which English courts will not accept the jurisdiction over a dispute, unless the Claimant proves that England is clearly the appropriate forum to bring the claim. In answering this question, the Court considered a number of factors, among which were governing law, place of commission of tort, the factual focus, witnesses, aim of the alleged torts, and fair trial.

The Supreme Court found that not only law governing the dispute was of little significance for the purposes of defining the appropriate forum in VTB, but so were non-exclusive jurisdiction clauses in favour of English courts, since the “centre of gravity” of the dispute was obviously found in Russia. Indeed, almost all disputing parties originated from Russia and/or were managed from there, the alleged fraud was orchestrated primarily through the Russian company, the events constituting the torts took place mainly in Russia and most of the witnesses would be Russian. Therefore, such strong connection with Russia played a crucial role in the dispute.

Since, in addition, the Court did not doubt the ability of Russian courts to adjudicate the dispute governed by foreign law and ensure that the aggrieved party would be properly reimbursed, should the defendants be found liable, the finding that Russia was the most appropriate forum to consider VTB’s claims seemed to be quite logical.

Apart from the above, the Supreme Court introduced an important procedural clarification on when the upper courts should interfere with the lower courts’ judgments on jurisdiction and analysed the applicability of the veil-piercing doctrine to reiterate a well-known English approach speaking against its wide application. We believe, that the impact of the UK Supreme Court’s conclusions on resolution of disputes involving, in particular, CIS based parties will be felt quite strongly in future cases.

Authors: Andrey Astapov, Managing Partner, Anna Kombikova, Associate. 

44. Barclays’ continuing manipulation of its own LIBOR setting took place against a background of media concern about the LIBOR setting process during the [financial] crisis. On 25 September 2007, an article by Gillian Tett in the Financial Times entitled “LIBOR’s value called into question” noted the complaint of the Treasurer of one of the largest City banks that “The LIBOR rates are a bit of a fiction. The number on the screen doesn’t always match what we see now.”

45. On 16 April 2008, the Wall Street Journal published an article called “Bankers cast doubt on Key Rate amid crisis” by Carrick Mollenkamp. This noted that: “The concern: Some banks don’t want to report the high rates they’re paying for short-term loans because they don’t want to tip off the market that they’re desperate for cash. The LIBOR system depends on banks to tell the truth about their borrowing rates.

Paragraph 145 of the Barclays’ final notice (for breaching principle 2, principle 3 and principle 5 of the FSA’s Principles for Business) which anonymises identities stated that:

Barclays did raise concerns externally about the LIBOR submissions of other banks (which Barclays perceived to be understated) and on occasion referred to its own approach to submitting LIBOR. However, these comments did not fully explain Barclays’ approach and were inconsistent.

Equally, a Barclays’ LIBOR submitter wrote to manager E saying that (para 171 final notice):

My worry is that we (both Barclays and the contributor bank panel) are being seen to be contributing patently false rates. We are therefore being dishonest by definition and are at risk of damaging our reputation in the market and with the regulators.

The issue was escalated to compliance and management. They responded:

We have consistently been the highest (or one of the two highest) rate providers in recent weeks, but we’re justifiably reluctant to go higher given our recent media experience … [the FSA agreed] that the approach we’ve been adopting seems sensible in the circumstances, so I suggest we maintain the status quo for now.”  

In his evidence, Lord Turner had described chunks of Barclays’ contact with the FSA as “elliptic” and the Treasury Committee found little evidence that Barclays provided the UK authorities with a clear signal about dishonesty at other firms, or its own. Lord Turner confirmed to the Treasury Committee that the FSA’s Internal Audit Department was undertaking a review of how the FSA dealt with the contacts – communications from any firm or from media reports or other information sources which might have provided relevant information – about LIBOR. The review’s objective was to ascertain the suitability of the FSA’s response and make recommendations for future changes.

The Internal Audit Department’s Report covered the period January 2007 to May 2009.  Internal Audit searched 17 million records, reviewed 97,000 documents in detail, and interviewed 20 FSA employees or ex-employees.

The report spotted important areas where the FSA’s performance needed improvement “and makes valuable recommendations for the future, but does not suggest major regulatory failure on the scale identified in the Northern Rock (March 2008) or RBS (December 2011) reports.”

According to the report, from summer 2007 to early 2009, all levels of the FSA’s management had awareness of severe dislocation in the LIBOR market in the period. But the report states that the dislocation was reflective of market conditions, and would have occurred even if lowballing had not occurred.

However, the report sets out numerous instances where the available information provided some indication that lowballing may have occurred.  Of the 97,000 documents reviewed in detail, 26 are judged as providing a direct reference to lowballing or a reference that could have been so interpreted. Two telephone calls from Barclays in March and April 2008 were clear pointers relating to a specific firm: these were included in the FSA’s final notice published on 27 June 2012 in respect of Barclays.

Stemming from this rationale, the report concludes that:

• The FSA’s focus on dealing with the financial crisis, together with the fact that contributing to and administering LIBOR were not “regulated activities”, led to the FSA being too narrowly focused in its handling of LIBOR related information.
• Taking the information cumulatively, the likelihood that lowballing was occurring should have been considered.
• The information received should have been better managed.

FSA chairman Lord Turner commented:

As the financial crisis developed in 2007 to 2008, the FSA’s bank supervisors were primarily focused on ensuring they understood the prudential implications of severe market dislocation. And the FSA had no formal regulatory responsibility for the LIBOR submission process.  As a result, the FSA did not respond rapidly to clues that lowballing might be occurring.  There are important lessons to be learnt about effective handling of information: these are identified in the report and will be taken forward by both the FCA and PRA management. A particularly important lesson is the need to have staff focused on conduct issues even when the world rightly assumes that the biggest immediate concerns are prudential; and vice versa. The new ‘twin peaks’ model of regulation will deliver this.

Moreover:

The report also reveals that while some information was available relating to lowballing, there is, for the period covered, no evidence of any information, direct or indirect, available to the FSA which indicated that traders were manipulating  LIBOR for profit.   All of the authorities, both UK and US and elsewhere only discovered trader manipulation as a by-product of enquiries launched into potential lowballing.  This raises important issues about the regulatory tools best suited to identifying such market manipulation.  More intense supervision may not be the most appropriate lever. Better whistleblowing procedures, greater accountability of top management, and more intense requirements for self-reporting of suspicious activity may turn out to be more effective tools.

As noted earlier on this blog, LIBOR submissions and administration will become regulated activities with an approved persons regime (the first Wheatley recommendation) from 1 April 2013 and the FSA’s successors, together with the new LIBOR administrator (tendering for which began under the Hogg Tendering Committee on 26 February 2013), will agree appropriate market monitoring and oversight for LIBOR. Anyone who wants to gain quick insight into the dilemma/reform of LIBOR and simultaneously desires exposure to a comparative UK/US perspective should read Professor Bainbridge’s Reforming LIBOR: Wheatley Versus The Alternatives. Reading this work as a first step to build up an understanding of the LIBOR conundrum is fruitful because the paper draws together various threads spread across the panoply of documents on the LIBOR issue. The Professor’s verdict is:

Over all, however … analysis of the Wheatley Review strongly suggests that it will prove a viable starting point as a blueprint for reforming LIBOR and other interest rate benchmarks …Yet, the jury remains out on LIBOR’s long-term prospects. Even if the reforms discussed herein lead to a more accurate LIBOR benchmark free from manipulation, LIBOR could still fail if the market for interbank lending remains so depressed as to be unable to generate a sufficient number of actual transactions against which the benchmark can be anchored. Because the Wheatley Review focused only on the former, completing the reform process will require ongoing inputs from monetary policymakers.

But coming back to the report, six lessons are sketched out for the future/successor regulatory authorities which will supersede the FSA, with the arrival of the Financial Services Act 2012 (the cutover date is 1 April 2013): namely, the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). The report invites them to consider:

(1) Activities outside the regulatory perimeter and their implications

• Whether there might be other significant non-regulated activities, where wrongdoing by regulated firms in relation to those activities could breach the FCA and PRA Principles for Businesses, pose a threat to the safety and soundness of those firms, or potentially cause significant consumer or market detriment.

• It has been recommended that FCA and PRA’s senior management consider how such activities will be identified and assessed by the new regulatory authorities’ risk and governance frameworks, so that risk-based prioritisation decisions can be made in relation to them.

(2) Roles and responsibilities      

• It has been recommended that the FCA should satisfy itself that there is a clear division of responsibilities relating to LIBOR between the authorities (in the new regulatory framework), including for receiving and sharing LIBOR-related information and for acting on that information where necessary.

• It has been recommended that the FCA (in consultation with the PRA if necessary) should establish clear internal roles and responsibilities relating to LIBOR.

(3) Culture of the regulatory authorities 

• It has been recommended that FCA and PRA’s senior management embed appropriately the lessons from the Report in the cultures of the regulatory authorities.

(4) How the regulatory authorities use and record information and intelligence 

• It has been recommended that as an important element in developing the desired culture of the FCA and PRA, alertness to the need to share intelligence appropriately should be reinforced as a principle for all staff behaviour.
• The report also recommends that the FCA and PRA’s senior management should clarify responsibilities in relation to the use of information from external sources including analysts’ reports, media articles and market data.

(5) Circulating and escalating information       

• The report recommends that the FCA and PRA establish effective working arrangements for the circulation and sharing of information, including to whom information should be circulated and the action required of the recipient.
• It has been recommended that the FCA and PRA establish effective working arrangements for the escalation of information to senior management.

(6) Record keeping           

• It has been recommended that in developing their records management policies, the FCA and PRA include success measures and key performance indicators that take into account the lessons raised in the review and the review’s inherent data limitations. 
• The lessons to be learned in relation to lowballing include how the FSA might have better interpreted or responded to the information flows which were available at the time.  In relation to derivatives traders however, the report found no evidence to suggest that there were any communications, or, pieces of information which might have alerted FSA staff to this issue.
• The question raised by the report is whether it would have been feasible to have a supervisory approach in which facts relevant to the derivatives trader issues would have come to light.  It is not clear that it would have been, without an impractically intensive supervisory approach (e.g. regulators cannot have supervisors in every dealing room).  This illustrates that some potential problems cannot be spotted by direct supervision in advance but have to be:

(a)  Policed by firms themselves on a day to day basis;

(b) With effective processes for the supervisory review of firm systems and controls;

(c) Subject to whistleblowing and other procedures to bring problems to light;

(d) Subject to exemplary post facto penalties when offences do occur.

Affirming the Court of Appeal’s decision reported at [2011] EWCA Civ 1158, see Patten LJ at [55], the Supreme Court has unanimously dismissed the appeal in this case. The court held that there is no general rule that an authority such as the Financial Services Authority (FSA), acting pursuant to a public law duty, should be required to give a cross-undertaking in respect of losses incurred by third parties. Equally, on the facts of this case, no particular circumstances existed whereby the FSA should be required to give such a cross-undertaking. For the full details of this case in the Court of Appeal and High Court (which held that the FSA was required to give a cross-undertaking in respect of losses incurred by third parties), the preview to this case is available here.

Just to recap briefly, cross-undertakings are a critical feature of a freezing (formerly Mareva) injunctions. Usually, applicants must give a cross-undertaking in damages to the court. This is to compensate respondents and any affected third parties in the event  the court decides that the applicant was not entitled to injunctive relief (a discretionary remedy). Where no cross-undertaking is given, the courts will refuse to grant an injunction. However, in situations where freezing injunctions are procured by public bodies (such as the FSA) pursuing law enforcement functions, the courts usually do not require such bodies to provide a cross-undertaking in damages to safeguard the respondent’s position. Lord Mance of Frognal gave the leading judgment and Lord Neuberger PSC, Lady Hale, Lord Clarke and Lord Sumption JJSC concurred with his Lordship.

Factual Background

Just to briefly recap the facts, in 20 December 2010, acting in pursuance of its public duties under sections 3 to 6 of the Financial Services and Markets Act 2000 (FSMA), the FSA made a without notice application for a freezing injunction against Sinaloa Gold and PH Capital Invest under section 380(3) of FSMA. It was alleged that both Sinaloa Gold and PH Capital were involved in promoting the sale of shares in Sinaloa without proper authorisation and an approved prospectus and that PH Capital Invest had breached FSMA in various other respects.

Schedule B to the injunction stated that the FSA gave no cross-undertaking in damages. However, under Schedule B, the FSA undertook to cover both costs and losses incurred by third parties as a result of the injunction. The undertaking in connection to third party losses was accidental and therefore the FSA applied to have it removed. Opposing the FSA’s application, Barclays Bank – with whom Sinaloa Gold plc had six bank accounts – intervened in the proceedings. The FSA’s application to have the undertaking removed was refused in the High Court. Upon appeal, however, Judge Hodge QC’s decision was reversed in the Court of Appeal (Mummery and Patten LJJ, Hedley J). The Court of Appeal’s ruling preserved the undertaking in respect of third party costs but eliminated the undertaking in respect of third party losses. Subsequently, Barclays appealed to the Supreme Court.

The Supreme Court

Lord Mance held that:

• Whilst there is no continuing justification for the former blanket practice whereby the Crown was not required to give a cross-undertaking in any circumstances, a general distinction still exists between private claims and law enforcement actions (at [33]).

• In a private claim, a claimant seeking an injunction will ordinarily be expected to give a cross-undertaking in damages to the defendant(s) and to third parties. This can be justified on the basis that such a claimant should be prepared to back its own interest with its own assets against the event that it obtains the injunction unjustifiably with the result that harm is caused to the interest of another (at [30]).

• However, different considerations arise in relation to law enforcement actions, where a public authority is seeking to enforce the law in the interests of the public generally, often in pursuance of a public duty to do so, and enjoys only the resources which have been assigned to it for its functions (at [31]).

• In these circumstances public authorities cannot generally be expected to back their legal actions with the public funds with which they are entrusted for the purpose of undertaking their functions (at [33]). Such a requirement may inhibit public officials from fulfilling their public duties for fear of exposing public funds to claims for compensation.

• The position regarding the giving of any cross-undertaking cannot differ according to whether it is intended to protect a defendant or a third party (at [14] and [34]).

• In both instances the cross-undertaking covers the loss caused by the grant of an injunction in circumstances where the person incurring the loss is essentially innocent (at [34]).

• A pragmatic distinction can be drawn between an undertaking in respect of costs and an undertaking in damages. Public authorities should be able to enforce the law without being inhibited by the fear of cross-claims and the exposure of their resources, and this applies with particular force to any open-ended undertaking in respect of third party loss. It does not apply with the same force to a more limited cross-undertaking in respect of third party costs (at [35]).

• There are no special circumstances why the FSA should be required to give a cross-undertaking in respect of losses suffered by third parties on the particular facts of this case. In a case such as the instant one, where the FSA takes positive action to shut down allegedly unlawful activity, it does not in the course of so doing assume any responsibility towards or liability for breach of a duty of care enforceable at the instance of third parties (at [37] – [38]).

• The FSA enjoys a further power to freeze the assets of a permitted person, without making any application to a court, under Part IV of the FSMA. In the exercise of its powers under Part IV the FSA is excluded from any risk of liability by virtue of paragraph 19 of Schedule 1 to FSMA. There would therefore be an apparent imbalance were the FSA required to accept potential liability in cases such as the instant one concerned with the activities of unauthorised persons (at [37] – [38]).

Moreover, Lord Mance explained:

42. In the light of the factors identified in paragraphs 36 to 38, there is on any view no reason to move away from the starting position, which is that the FSA should not have to give any cross-undertaking in order to obtain an injunction under section 380(3). HHJ Hodge QC considered that such a cross-undertaking in favour of innocent third parties should be required “as a matter of course”, from the moment when any freezing order was first granted on an ex parte basis (para 66). The Court of Appeal was in my view right to disagree and substituted for the undertaking as originally given an undertaking in the limited form (i.e. excluding the italicised words) indicated in paragraphs 6 and 7 above. I would therefore dismiss this appeal.

Further observations

43. A further word is appropriate regarding the positions at the initial stage, where injunctive relief is sought on an ex parte (or ‘without notice’) basis, and at the later stage, when the matter comes before the court on notice to both parties as well perhaps as to third persons, such as Barclays. Normally, there would only be a very short period before an on notice hearing could occur, and normally one would expect any third person affected by an injunction to become aware of this risk, even if not given formal notice of the injunction by the FSA. Loss could in theory be sustained by either a defendant or a third person in that short period. But any cross-undertaking required as a condition of the grant of interim injunctive relief on a without notice basis would have to be in general and unqualified terms, and therefore be of the kind which could cause most concern to a regulator worried about risk and resource implications.

44. The present appeal concerns the position of the FSA at the without notice and on notice stages. The starting position at each stage should in my view be that no cross-undertaking should be required unless circumstances appear which justify a different position. Any inhibition on the part of a public authority about giving an undertaking is likely to be greater, rather than less, at a without notice stage. To require a blanket undertaking in favour of third parties at that stage would provide no incentive to third parties to come forward and identify any real concerns that they might have. The better approach is in my view to regard the starting position, that no cross-undertaking should be required, as being as applicable at the without notice stage as it is at the on notice stage. A defendant or a third party who is or fears being adversely affected by an injunction obtained under section 380(3) can and should be expected to come forward, to explain the loss feared and to apply for any continuation of the injunction to be made conditional on such cross-undertaking, if any, as the court may conclude should in all fairness be required to meet this situation.

45. Finally, whenever the court is considering whether to order an interim injunction without any cross-undertaking, it should bear in mind that this will mean that the defendant or an innocent third party may as a result suffer loss which will be uncompensated, even though the injunction later proves to have been unjustified. This consideration was rightly identified by Neuberger J in Miller Brewing at paragraph 40. 

Facts

Interest-bearing Notes were issued by a special purpose vehicle, Eurosail-UK 2007-3BL PLC (“the Issuer”), formed to hold income-producing assets, namely mortgage loans. Due to the insolvency of Lehman Brothers (see the earlier case decided by the UK Supreme Court involving Lehman Brothers here), with whom the Issuer had entered into swap agreements, the Issuer suffered a significant deficiency in its net asset position. The terms governing the issue of the notes provided that on specified Events of Default an enforcement notice could be served, the effects of which included altering the respective priorities of the Noteholders for repayment of capital and interest. One such Event of Default involved the issuer being unable to pay its debts within the meaning of section 123(2) – definition of inability to pay debts; “a company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities” – of the Insolvency Act 1986. The trustee of the Noteholders’ rights, BNY Corporate Trustee Services Ltd, commenced the current proceedings seeking a determination of whether that event of default had occurred.

The Event of Default in play in these proceedings is that Condition 9(a)(iii) (“Condition 9(a)(iii)”), is expressed in the following terms:

The Issuer … ceasing … to carry on business … or being unable to pay its debts as and when they fall due or, within the meaning of Section 123(1) or (2) (as if the words ‘it is proved to the satisfaction of the court’ did not appear in Section 123(2)) of the Insolvency Act 1986 (as that Section may be amended from time to time), being unable to pay its debts.

To expand upon the facts a bit more, on 16th July 2007 Eurosail issued notes to an aggregate value of £660m as part of a securitisation transaction in relation to a portfolio of UK Residential Non-Conforming Mortgage loans with a face value of £650m. The notes were of five classes, A to E, divided into subclasses 1 to 3, variously denominated in and classified as Euros, $US and £ Sterling. The A1 notes mature in 2027, all the rest in 2045. The rate of interest payable varies according to the class, currency denomination and maturity of the note. The Issuer’s risk in relation to changes in interest and exchange rates was “hedged” by means of interest and currency rate swaps with Lehman Brothers Special Financing Inc whose obligations thereunder were guaranteed by Lehman Brothers Holdings Inc. The securitisation transaction also included a Post Enforcement Call Option Agreement (“PECO”) which provided that in the event that the security for the notes is enforced and found to be insufficient to pay all amounts due in respect of them then an associate company of the Issuer is to have a call option in respect of the benefit of all the notes at a nominal price. On 7th May 2010 the Trustee issued a Part 8 claim.

Issues

(1) The proper interpretation of section 123(2) of the Insolvency Act 1986 as incorporated into a securitisation agreement, in particular whether a company is to be deemed “unable to pay its debts” by reason of the fact that on an examination of its balance sheet its liabilities exceed its assets, or whether some further test is involved.

(2) Whether section 123(2) is satisfied on the facts.

Court of Appeal: BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL Plc & Ors [2011] EWCA Civ 22 (07 March 2011)

In BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL PLC and others [2011] EWCA Civ 227, read judgment, the Court of Appeal (Lord Neuberger of Abbotsbury MR [as he then was], and Wilson and Toulson LJJ) affirmed Chancellor Sir Andrew Morritt’s High Court [2010] EWHC 2005 (Ch) decision and held that a company should only fail the so-called balance sheet test for whether it is unable to pay its debts (section 123(2) of the Insolvency Act 1986) if the company has genuinely reached the point of no return.

The Court of Appeal, held the “balance sheet test”, for whether a company is deemed unable to pay its debts within the meaning of section 123(2) of the Insolvency Act 1986 was not reducible to a single formula or set of principles that apply to all companies. Rather, judgement needed to be exercised by the Court whether the company “has reached the point of no return” and that this point is arrived at when allowing the company to continue to operate and pay its short-term liabilities is simply likely to reduce the overall pool of assets available to pay the company’s future and contingent creditors.

The Court allowed that, in this case, the company’s most recent audited accounts formed a suitable starting point when applying the test under section 123(2). However, such an approach was not always appropriate, and the characteristic limitations of a company’s accounts ought to be acknowledged.

The Court also ruled that, even where the holders of notes issued by a company granted a post-enforcement call option (PECO) to a third party, the company was still, technically, susceptible to direct action by the noteholders on a full recourse basis until the PECO was exercised. In the same way, the PECO in this case did not prevent the relevant notes from being treated as liabilities of the company when assessing whether it should be deemed unable to pay its debts under section 123(2). However, a distinction was drawn between whether a company was “bankruptcy remote”, meaning it was unlikely to be the subject of formal insolvency proceedings, and “insolvency remote”, meaning the company would not be deemed unable to pay its debts.

Moreover, the Court held that a PECO assisted in preserving a company’s bankruptcy-remote status (as the noteholders had no commercial interest in placing the company in insolvency proceedings where there was a PECO), but did not make it insolvency remote. Furthermore, there was nothing “commercially insensible” in finding that, despite the PECO, the noteholders’ rights against the company were full recourse until very late in the transaction.

Dismissing the appeal and cross-appeal, Lord Neuberger (Wilson and Toulson LJJ concurring) held:

Para 44: In the first place, I do not consider that the question whether section 123(2) applies simply turns on the question whether the liabilities of a company (however they are assessed) exceed its assets (however they are assessed). In practical terms, it would be rather extraordinary if section 123(2) was satisfied every time a company’s liabilities exceeded the value of its assets. Many companies which are solvent and successful, and many companies early on in their lives, would be deemed unable to pay their debts if this was the meaning of section 123(2). Indeed, the Issuer is a good example of this: its assets only just exceeded its liabilities when it was formed, and it was more than possible that, even if things went well, it would fall from time to time within the ambit of section 123(2) if the appellants are right as to the meaning of that provision.

Para 49: In my judgment, both the purpose and the applicable test of section 123(2) are accurately encapsulated in that brief passage. Subsection (2) was, in my view, included in section 123 to cover a case where, although it could not be said that a company “is [currently] unable to pay its debts as they fall due” (either because it has no debts which are currently payable, or because it has, or can achieve, the cash flow to pay such debts), it is, in practical terms, clear that it will not be able to meet its future or contingent liabilities. A future or contingent creditor of a company can often claim to be prejudiced by the company using its cash or other assets to pay current creditors or even for some other purpose, but, within bounds, that is an inherent risk in the futurity or contingency of the liability. It is only when it can be said that the company’s use of its cash or other assets for current purposes amounts to what may be vernacularly characterised as a fraud on the future or contingent creditors that it can be said that it “has reached the point of no return”.

Para 50:This is not dissimilar from the point made in relation to section 123(1)(e) by Briggs J in Re Cheyne Finance plc [2008] 2 All ER 987, para 51, when he contrasted “a momentary inability to pay … as a result of temporary liquidity soon to be remedied” with “an endemic shortage of working capital” which renders “a company … on any commercial view insolvent, even though it may be able to pay its debts for the next few days, weeks or months before an inevitable failure.” Mr Sheldon suggested that, if the last part of the passage, with its reference to future inability to pay debts, was correct, then section 123(2), as Professor Goode suggests it should be interpreted, would add nothing to section 123(1)(e). I do not agree. The point that I think Briggs J was making is that section 123(1)(e) does not require slavish adherence to the immediate present. It is unnecessary to decide whether that is correct, although it is only right to say that, as at present advised, I am inclined to think that it is. However, that does not call into question the conclusion that section 123(2) applies to a company whose assets and liabilities (including contingent and future liabilities) are such that it has reached the point of no return.

Para 51: This conclusion reflects the fact that section 123(2) is concerned with a case of a company not being able to pay its debts, not with an exercise of simply assessing its net assets or liabilities: it is true that the subsection provides that assets and liabilities should be taken into account, but that is for the purpose of addressing the ultimate question of whether the company “is deemed unable to pay its debts”. It is also true that the position described in section 123(2) is merely “deemed” to amount to inability to pay debts, but the same expression is used in section 123(1), and all its paragraphs are concerned with actual inability (or refusal) to pay debts. The fact that the state of affairs described in section 123(2) is deemed to amount to inability to pay debts can properly be taken into account when interpreting what it means.

Para 61: The appellants are on somewhat stronger ground in their contention that the figures in the company’s balance sheet, and audited and signed off annual accounts, should be accorded weight in the exercise envisaged by section 123(2). I do not think that it is possible or helpful to describe in general terms the weight to be given to such figures in such an exercise. Clearly, the fact that the figures have been audited and are said to convey a “true and fair” view of the company’s position in the opinion of its directors should normally have real force. However, the figures will inevitably be historic, they will normally be conservative, they will be based on accounting conventions, and they will rarely represent the only true and fair view. The court will ultimately have to form its own view as to whether the company in question has reached what Professor Goode described as “the point of no return”.

Para 65: When considering if section 123(2) applies, I am content to take the starting point adopted by Mr Sheldon, namely the asset and liability position revealed by the company’s most recent accounts. However, that may well not be appropriate by any means in all cases. Further, in many, I suspect most, cases, in order to answer the question posed by section 123(2), it will be necessary to consider whether to depart from those figures, and whether to take into account other, sometimes more important, factors.

Para 80: Bearing in mind the substantial assets of the Issuer, the relatively long period over which the Issuer’s liabilities have to be met, and the potential for significant change in the differences between the value of the Issuer’s assets and liabilities, I agree with the Chancellor that the appellants have not established that the Issuer has reached what Professor Goode called the point of no return, or the Cork Report’s point at which the shutters should be put up. The financial situation of the Issuer, bearing in mind its assets and liabilities, in particular its liabilities to the Class A3 and junior Noteholders, has not been shown to be such that, to use Briggs J’s language, the Issuer is on any commercial view insolvent.

Para 100: There is nothing commercially insensible in the conclusion that, for the purpose of Condition 9(a)(iii), the Noteholders’ rights against the Issuer are treated as full recourse, notwithstanding the PECO. The purpose of the PECO was to render the Issuer bankruptcy remote, in the sense of ensuring that it could not be wound up. But this conclusion does not cut across that purpose: it merely entitles the Noteholders and Trustee to invoke a ground which would support a winding up petition to justify the service of an Enforcement Notice. Further, whatever else may be in doubt, it is hard to argue against the view that the parties envisaged an Enforcement Notice being served if the Issuer’s liabilities were not met, as Condition 9(a)(i) provides.

Para 105: It appears to me that, unless a trustee has good reason to think that its actions will be subject to criticism or there is some other special reason, it should normally be unnecessary for it to make representations or to be represented at a hearing (save for instructing a note-taker), where, as here, its stance on the issues dividing the warring parties, is neutral. Directions can be sought at a relatively early stage to enable the trustee to make submissions (possibly in writing) if a point arises on which its assistance is required or on which it desires to have a say.

But prior to setting out the FSA’s responses, it is apposite to note the Committee’s Chairman Mr Andrew Tyrie MP (Conservative, Chichester) comments who said that:

• Our inquiry uncovered appalling behaviour and serious failings at many levels in Barclays; on the trading floors, on compliance desks and amongst senior management.

• It is now clear that these failures were not limited to a single institution. The systemic rigging of important rates appears to have been pervasive in the banking industry over a long period of time.

• Serious regulatory shortcomings also came to light. It is only right that the FSA has had to shoulder its share of the blame for this scandal.

• Following the Treasury Committee’s inquiry, significant steps have been taken to reform LIBOR as well as to reform the culture and practices within our banks and regulators.

• We must have more confidence that such behaviour will not happen again. Much work remains to be done.

• The welcome adoption of judgement-led regulation can help.

• We will attempt to monitor the extent to which the new regulators, respectively the Financial Policy Committee and the Prudential Regulation Authority, put these words into action.

• Mervyn King has made clear that the new approach need not necessarily require greater resources.

• What is clearly needed is a replacement of box-ticking intervention with the application of grey matter.

• The Treasury Committee will consider the FSA’s review into its own awareness of inappropriate LIBOR submissions when it is finalised.

• Some of the evidence we heard suggests early warning signs may have gone unheeded.

The FSA’s response is connected to parts of the Treasury Committee’s Second Report of Session 2012–13, Fixing LIBOR: some preliminary findings which were aimed at the FSA. A summary of the Committees concerns (in bold) and the FSA’s response are highlighted hereunder:

Paragraph 16 (self-disclosure of misconduct by Barclays and reputational damage)

Co-operation with an FSA investigation is a relevant factor in deciding whether it is appropriate to take action and in determining the appropriate sanction if action is taken. Barclays co-operated with the FSA and the US Commodity Futures Trading Commission (CFTC). As a result of that co-operation, Barclays identified and brought to the attention of the authorities much of the detail of the misconduct contained in the Final Notice in the course of these enquiries. The fact that the FSA will take such co-operation into account is reflected in the methodology used to set penalties. The FSA introduced a new penalties policy in 2010 to provide greater transparency on the fines imposed. The new policy, which applies to all behaviour which took place on, or after, 6 March 2010, is also intended to establish a more coherent and consistent framework and increase the amount of the penalties that are imposed. As the vast majority of the behaviour in the Barclays Final Notice took place before March 2010, the penalty was calculated under the previous policy.

Paragraph 17 (the desirability of encouraging other firms to confess their misdemeanours in a similar way)

The FSA’s flexible approach to its penalties policy also seeks to incentivise proactive disclosure. When assessing whether a penalty should be imposed at all, and if so, in what amount, the FSA has regard to matters such as whether the firm brought the breach to the FSA’s attention quickly, effectively and completely. Where a firm admits its own culpability and engages with the FSA in the executive settlement process, it can receive a substantial discount to the penalty. Early settlement has many potential advantages as it can result, for example, in the saving of FSA resources, messages getting out to the market sooner and a public perception of timely and effective action. It is in the public interest for matters to settle, and settle early, if possible. The subject of an investigation can benefit from a 30% discount if they settle early. This discount is reduced to 20% or 10% if the case is settled later in the process. In the case of Barclays, the Final Notice made clear that the firm qualified for a 30% discount as it agreed to settle at an early stage of the investigation. Prior to the application of this discount, the FSA had already taken Barclays’ co-operation into consideration in determining the penalty of £85 million which was then reduced to £59.5 million after discount.

So the benefits of co-operation with the FSA are cumulative.

Paragraph 39 (how will the FSA alter its supervisory efforts to counter weak compliance in future)

The Financial Conduct Authority’s new supervisory framework will focus much more clearly on ensuring that the interests of customers and market integrity are at the heart of how a firm is run. For high impact firms, the FCA will carry out firm-by-firm business model and strategy analysis to help the FSA form a view of where potential areas of conduct risk lie. Governance and culture, including a firm’s control framework, will be one of four key areas of focus for the FCA and will be subject to proactive, systematic supervision if identified during the analysis of a firm’s business model as an area of weakness. Governance and culture will also continue to be a key area of focus for small and medium-sized firms.

Paragraph 61 (Committee requiring the findings of internal FSA investigations to be published)

In its evidence to the Committee, the FSA said that it had committed to undertake an internal review into contacts with the FSA on LIBOR and its awareness of inappropriate LIBOR submissions. This will focus on the period 1 January 2007 to 31 May 2009. This work, which is being led by the FSA’s Internal Audit Division, is currently ongoing. It is expected to finalise this review in Q1 2013 and the FSA will revert to the Committee separately on this issue.

Paragraph 124 (FSA approving Barclays’ boss Bob Diamond’s appointment despite serious concerns his attitude to risk and a tendency to “push the limits”) and Paragraph 159 (FSA’s judgment to be resolutely clear about its concerns to senior figures in systemically important firms)

The FSA recognises the importance of being absolutely clear to firms about any concerns it has about senior figures. Under the ‘approved persons’ regime, certain functions within financial services firms (including ‘chairman’, ‘chief executive’, ‘director’ and ‘nonexecutive director’) are designated by the FSA as ‘controlled functions’. Only persons who have been approved by the FSA are allowed to perform those functions. Approval can only be granted where the FSA remains satisfied that the person is ‘fit and proper’ to perform the role in question. In all cases where the FSA approves the appointment of individuals to perform a controlled function, the FSA writes to the firm. It is worth noting that FSMA does not give the FSA scope to place conditions or set limitations on approvals. For example, the FSA cannot approve an individual to a position for a temporary period during a transitional phase for a firm, even if the FSA has concerns about the individual’s appropriateness beyond that period. However, where the FSA has specific concerns, it will continue to set these out in writing, clearly defining any issues that will need to be addressed by the individual or firm. The FSA will follow up on any concerns as part of its ongoing supervisory dialogue and take action where appropriate. Once the new regulatory framework has come into effect, the FSA anticipates that the PRA and FCA will write separately to the firm in situations where both have concerns about a senior appointment.

Paragraph 192 (that FSA needs power to remove senior executives but in its duty of care to shareholders needs recognition)

Once appointed, approved persons are expected to act in accordance with the Statements of Principle for Approved Persons, set out in the APER section of the FSA Handbook. If an approved person falls short of these standards, then the FSA, and in future the PRA and the FCA, will be able to take formal action against that person, subject to the procedures and safeguards set out in FSMA. However, the nature of the relationship between the PRA and systemically important financial institutions will be such that there may be situations where there is a loss of confidence in a senior executive. In such situations, the FSA recognises the importance of there being appropriate governance arrangements in place. Communicating any concerns about an individual to a firm’s Board, for the firm to then consider, will be a matter for the Chief Executive of the PRA, subject to consultation with the PRA Board.

Paragraph 7 (that the FSA lagged behind its U.S. counterparts and the delay has contributed to the perceived weakness of London in regulating financial markets)

The FSA noted the Committee’s concerns about when the former initiated its formal LIBOR investigations. This is an important issue. It was accepted that the CFTC was first to initiate enquiries. The FSA was aware of and engaged with the enquiries made by the US regulatory authorities during 2008 and 2009 and provided assistance to the CFTC from the outset of its investigation, by obtaining documents and information from Barclays. The FSA also received information from Barclays during this early stage of the investigation and continued to monitor the situation. Once evidence of potential wrongdoing emerged, the FSA considered it appropriate to take more active steps to investigate the issues, and appointed investigators under the relevant provisions of FSMA. The next phase of the investigation was conducted by the FSA in tandem with the CFTC and other US authorities as they became involved. For example, the first regulatory interviews were conducted on a joint basis in late 2010. Owing to the significant number of documents and individuals relevant to the investigation and the way in which the issues developed over time, this phase of investigation lasted until Spring 2012. The FSA then entered settlement negotiations with Barclays.

Paragraph 202 (that although otherwise empowered, the FSA took a narrow view of its power to initiate criminal proceedings for fraudulent conduct).

The FSA has extensive powers to investigate specified offences, both regulatory and criminal (as set out in the Financial Services Markets Act 2000 or “FSMA” as above). These powers of investigation do not, however, extend to other offences not specified in FSMA such as theft, fraud and false accounting. The police and the SFO do have powers to investigate these offences so the FSA cannot use its powers specifically to obtain material relevant to these offences. The FSA may of course discover evidence of these more general offences whilst conducting investigations under the powers set out in FSMA. For example, it may discover evidence of fraud whilst investigating whether a regulatory breach has occurred, or a market abuse offence has been committed. In these circumstances, there is a well established procedure for discussions to take place between the FSA and the SFO (Serious Fraud Office) or other prosecutors about how to deal with that evidence. This is in accordance with the Prosecutors’ Convention, to which both the FSA and the SFO are signatories. Such discussions might lead to the SFO opening its own investigation. In circumstances where the FSA has concluded an investigation and commenced a prosecution for offences that are specified in FSMA, it can, and does, include other ancillary offences in the same case. For example, the FSA might, in bringing a case for insider dealing, also charge the same defendants with money laundering offences. However, where such an offence is the core of the misconduct, it is more appropriate for it to be taken forward by other prosecution authorities. The FSA will provide considerable assistance to this, as it did, for example, to the CPS Prosecution of Tomas Wilmot for conspiracy to defraud last year. In the case of Barclays, as the FSA became aware of evidence of potential fraudulent misconduct in the UK, it discussed this evidence with the SFO. The FSA concluded that none of the offences specified in FSMA were applicable to the case, and found that regulatory breaches by Barclays had occurred. Therefore, the FSA did not take forward a prosecution in relation to the issues at Barclays and the issue of whether to charge ancillary offences did not arise. The SFO has now opened its own criminal investigation into the matter and we continue to support that investigation. The FSA therefore does not think it is the case it took a narrow view of its powers in considering evidence of fraudulent conduct. However, there may be merit in considering further the scope of the FCA’s powers in the future.

FSA Penalties Policy

In respect of misconduct which took place before 6 March 2010, the factors the FSA takes into consideration when assessing whether a penalty is appropriate and, if so, the level of that penalty, include:

• Deterrence

• The seriousness of the breach

• The extent to which the breach was deliberate or reckless

• The person’s financial circumstances

• The amount of benefit gained or loss avoided

• The person’s conduct following the breach

• The person’s disciplinary record and compliance history, and

• Whether action was also being taken by other regulatory authorities

Moreover, the FSA also considers penalties in other comparable cases. There is no formal weighting of any of the factors, rather it is an assessment in the round. The FSA sets out in each of its published notices which of the factors set out in Decision Procedure and Penalties Manual it considers apply in that instance.

The new policy, which applies to behaviour on, or after 6 March 2010, introduced a five-step framework that is based on disgorgement, discipline and deterrence:

• Step 1: the removal of any financial benefit derived from the breach

• Step 2: the determination of a figure which reflects the seriousness of the breach

• Step 3: an adjustment for any aggravating and mitigating circumstances

• Step 4: allows the FSA to make an adjustment to ensure that the penalty has a deterrent effect, and

• Step 5: if applicable, a settlement discount will be applied

These steps will apply in all cases but Step 2 differs depending on the type of case. For firms, where revenue is an appropriate measure the Step 2 figure will be 5%, 10%, 15% or 20% of the firm’s relevant revenue for the period of the breach. Where revenue is not indicative of the harm or potential harm that the breach may cause, the FSA uses an appropriate alternative.

For individuals in non-market abuse cases, the Step 2 figure will be 0%, 10%, 20%, 30%, or 40% of the individual’s gross remuneration and benefits for the period of the breach. Under the new policy, FSA takes into account at Step 3, mitigating circumstances which would tend to reduce the amount of any penalty imposed, such as proactive disclosure, the degree of co-operation during the investigation and remedial steps taken since the breach was identified. The FSA also considers aggravating factors that would tend to increase the amount of any penalty imposed.

The ideal of sustainability is key to all modes of human activity and the financial sphere is no different. Following the onset of the global financial crisis, the governance of banks and business entities emerged as a burning issue. The Libor scandal has only served to intensify calls for greater accountability and transparency. Like HSBC, Barclays and UBS which have already been fined, see post here, the Royal Bank of Scotland (RBS) has jumped on to the whirligig and it has been fined £390m ($610m) by UK and US regulators for its part in the Libor rate-fixing scandal. The Financial Services Authority has fined RBS £87.5m and £300m shall be paid to US regulators and the US Department of Justice.

A large body of opinion, myself included, advocates using criminal law punishments to bring about change and force banks and businesses to behave and become better citizens in the financial world. Key academics – like Professor Bainbridge and Barry Turner – have endorsed my views. However, on proper analysis, perhaps it was I who had unknowingly subscribed to such well-established positions. Yet, equally weighty reasons exist why “soft law” options may present more advantageous alternatives to solving the problems in the financial sphere. Last month, acclaimed lawyer and academic Professor Roger McCormick – author of the celebrated banking textbook Legal Risk in the Financial Markets and Director of the LSE’s Sustainable Finance Project – took the time explain to me why options other than criminal punishments needed exploration to tame the crises emerging in the financial world. And I remain extremely grateful to him.

Equally, I would like to make clear that Roger is not against criminal sanctions for bankers or banks. Rightly, he merely wants to develop a strategy that builds an efficient global banking system: one where consumers can participate in the regulatory process. After all, it is our money. “Banks are afraid of having a bad reputation”, argues Roger. There is truth in this reasoning. Surely, no one would want to keep money in a dodgy bank.

Criminal Sanctions 

Changes in the criminal law for manipulating Libor are in the offing, see here and here, but in order to get a flavour for Roger’s argument, it is worthwhile to examine the state of the existing criminal law (note that, subsequent to Royal Assent being given to the Financial Services Act 2012 on 19 December 2012, in future the FSA shall be superseded by the Financial Conduct Authority and the Prudential Regulation Authority from 1 April 2013, also see here). Under part 7, the Financial Services Act 2012 creates offences relating to financial services: for example section 89 (misleading statements), section 90 (misleading impressions) and section 91 (misleading statements etc in relation to benchmarks). See more on post-Wheatley criminal offences in an older post here. The benchmarks are not set out in the Act itself, but Libor is a relevant benchmark within the meaning of article 3 of the Financial Services Act 2012 (Misleading Statements and Impressions) Order 2013.

Until April 2013 though, criminal liability in respect of misleading statements and practices is placed on a statutory footing under section 397 of the Financial Services and Markets Act 2000 (FSMA) – the “portmanteau statute” (per Lady Justice Arden, FSA v Fradley and anor, [2005] EWCA 1183 at para 3) regulating financial services and markets. Market confidence, financial stability, public awareness, the protection of consumers and the reduction of financial crime are all regulatory objectives under the 2000 Act which created the Financial Services Authority (“FSA”) as a regulator for insurance, investment business and banking.

It is noteworthy that critics of FSMA feel that the removal of responsibility for regulating the banking industry from the Bank of England was one of the causes of the financial meltdown in the UK banking sector. The incumbent Governor of the Bank of England, Mervyn King – soon to be replaced by Mark Carney – shared this view and wanted the responsibility returned to the central bank.

Under section 397 of FSMA, two criminal offences concerning misleading statements and practices exist. When tried on indictment, persons found guilty of either of these offences may be subject to a maximum of up to 7 years’ imprisonment or to a fine, or to both. On summary conviction, a term of imprisonment for a term not exceeding six months or a fine not exceeding the statutory maximum, or both are imposable criminal sanctions.

The “first” offence applies where a person deliberately makes a misleading statement, promise or forecast, or dishonestly conceals facts from someone with the intention of inducing any other person to do or refrain from doing something in relation to an investment.  An example of this offence would be someone lying about a company’s financial position at a time when he was seeking to dispose its shares. It is also an offence to make the misleading statement, promise or forecast recklessly and to be reckless as to whether another person was so induced.

The “second” offence relates to the creation of a misleading impression about an investment with the intention of inducing another person to do or not do something in relation to that investment.  It covers matters such as market manipulation. For example, engaging in artificial trades in a particular investment in order to create the impression that there is more interest in the investment than really exists.

A defence is available against the first offence where a person can show that a statement, promise or forecast was made in compliance with price stabilising or control of information rules. Three defences are available against the second offence. Firstly, that the person concerned reasonably believed that his conduct would not create a misleading impression.  Secondly, that the person is engaged in price stabilisation in circumstances where this is permitted. Thirdly, that the person acted in conformity with the control of information rules under section 147.

Moreover, the second offence is not committed unless the action done takes place in the UK, or the misleading impression this creates arises in the UK. And furthermore, the Treasury has the power to prescribe those agreements and investments to which the provision applies.

Equally, an offence of fraudulent trading can also be found under section 993 of the Companies Act 2006. The wording of the provision is quite wide and it includes “any fraudulent purpose” carried on by “any business of a company”. When tried on indictment criminal liability on conviction warrants imprisonment for a term not exceeding ten years or a fine (or both). On summary conviction, the punishment is a term not exceeding twelve months’ imprisonment or a fine not exceeding the statutory maximum (or both).

Under Part V, section 52, of the Criminal Justice Act 1993 the criminal offence for insider dealing can lead up to fines or imprisonment for seven years but the provisions are limited to “price-affected securities” – a problematic concept to define. Equally, proceedings can only be instituted with the consent of the Secretary of State or the Director of Public Prosecutions. Moreover, bringing a criminal prosecution can be a difficult process, it is time consuming and securing a conviction requires proof of the mens rea element to be proved to the high standard of proof, i.e. beyond a reasonable doubt. So it is unsurprising that in their work Market Abuse Regulation, Virgo and Swan (2010: 6) opine that “[i]t is easy to see that with the high standards required in criminal prosecutions, criminal penalties cannot be used as flexible or efficient regulatory tools.”

In addition to the above, Martin Wheatley’s review, taken on board in full by the government, recommended that FSMA should be amended to create a new criminal offence encompassing “individuals who intentionally or recklessly make a false or misleading statement in relation to the setting of a benchmark”: for more on Wheatley see here, here and here.

There is, of course, an overwhelming European Union element to insider dealing and market abuse under Directive 2003/6/EC. Moreover, it is also the case that the European Commission has called for criminal sanctions for insider dealing and market manipulation and proposals for a Regulation and a Directive to prohibit and criminalise manipulation of benchmarks have also been adopted: see here for details. I shall expand on these developments in a separate post because for the present moment it is sufficient to note that whilst desirable, criminal sanctions might not always present the best possible outcome: a jury can always acquit an accused. Equally, for all we know, in relation to Libor, the trial may even require a specialist court or even a specialist jury! So it is appropriate to consider Roger McCormick’s proposed method to compel banks to behave as good citizens.

Sustainable Banking 

For Roger McCormick, sustainability denotes “a reconciliation between the needs of the present and the needs of the future.” Banks are no different and sustainability is central to finding solutions and addressing dilemmas. Moreover, an “honest recognition of losses” and “clear and publicly available information” facilitate an understanding of the extent to which banks are willing change their “bad habits”. So “proper indicators of sustainability, for banks’ own business and for the overall financial system” are in order and “‘soft-low’ pressure may be an appropriate choice to bring about changes.” Furthermore, owing to banks’ complex operations worldwide, jurisdictional problems and differences in the law from place to place do not make things any easier: if anything, the problem is only further exacerbated.

In his article, What Makes a Bank a “Sustainable Bank”? – written when news of Libor rigging broke in June 2012 – Roger compares the sustainability reports produced by two banks whose public image has been tarnished by the Libor scandal: RBS and Barclays.

Non-exhaustively, a comparison of the two banks’ documents was (minimally) a strong pointer for room for improvement in (1) customer relations (2) bank information verified by third party statements of confirmation (3) presenting information in a manner reflecting consensus on the issues which are important and those that lie at the periphery (4) providing more material about the banks’ disciplinary record, business model, culture and sustainability (5) presenting facts consistently on a year by year basis and in respect of other banks (6) improving the navigability of internet based documents and (7) ensuring greater consistency in the use of terminology and excluding irrelevant PR material.

Progress can be made in the above areas if:

Organisations that have an influential role in the content of sustainability reports take a fresh look at what the principal indicators of sustainability are in the context of banks and give more emphasis to issues that relate to a bank’s own business model, its culture and approach to ethical issues as opposed to the more “traditional” ESG [Environmental, social and corporate governance] issues. At present the focus at organisations like UNEP FI [United Nations Environment Programme Finance Initiative] remains on how financial sector investment specialists could do a better, more “ESG-aware,” job if reporting on sustainability was better and more widespread. That is a worthy objective. But it should not be pursued to the exclusion of looking more closely at what sustainability means for the banks’ own business and for the financial system. Through the lens of sustainability indicators, properly adapted for the peculiarities of banks, we could, if we wanted, start to learn a great deal more about bank behaviour and attitude than currently comes into the public domain.

So, one aspect of the argument is to convert sustainability reports – which presently serve as PR gimmicks – into catalysts for “change for the better”. This would preclude Libor rigging banks from attracting deposits: a Libor fixing bank would become incapable of achieving a high sustainability ranking leave alone being awarded the title of title of “sustainable bank of the year”.

Equally, “soft law” pressure – “not necessarily all that soft in its effect” – is a suitable alterative to drive change in the banking sphere, “an arena that looks both across jurisdictional boundaries and down to generations as yet unborn”. Customary law making processes are inappropriate in their ability to cope with the problem because they are not only hijacked by politicians’ agendas, but too monolithic in nature they are also “ill-suited to dealing with the difficulties that the differing time and space dimensions present.”

Instead, banks’ senior officers can be co-opted to understand that it is expected that sustainability reports must impart details in respect of banks’ commitments and culture. Were this approach followed rigorously, shocking events could be curtailed and “we can start to believe that some worthwhile change has at last been achieved.”

Baby steps, or small changes, in the right direction can achieve major changes. In the final analysis, rather than taking their word on their “culture”, we must compel bankers to explain what goes on inside their institutions. And meaningful reform will follow naturally. But prior to achieving results, “a greater level of consensus needs to be developed on what the objective indicators [which must be flexible, updated and mandatory] actually are of good and bad sustainable behaviour for a bank.” Banks must be compelled to report on issues that may embarrass them. They must not be able to wriggle their way out of matters that must be reported upon. Equally, banks’ “reports should then be backed up by clear and unambiguous assessment statements from independent third parties.” Finally, external assessments must not be ceremonial or relaxed: they must have teeth.

The conclusion is that:

To the extent that events like Rio+20 can look uncomfortably like “the West” lecturing the developing world whilst overlooking the catastrophes taking place in its own backyard, it would do no harm at all if the West (including the ESG community) took more positive steps to set its own house in order in relation to the sustainability of its banks and its financial system.

R (on the application of Prudential plc and another) (Appellants) v Special Commissioner of Income Tax and another (Respondents)

The Supreme Court has spoken on the thorny issue of legal advice privilege (or “LAP”). In sum, the relationship between lawyer and client is sacrosanct and, at least on the initiative of the Court, the ambit of LAP is not extendable to another species of legal advisor. In the provision of legal advice, LAP protects the communications between client and lawyer (acting in a professional capacity). Lord Neuberger of Abbotsbury PSC, Lord Hope of Craighead DPSC, Lord Walker of Gestingthorpe, Lord Mance and Lord Reed JJSC so held by delivering concurring judgments. But the affair was not without disagreement and Lord Clarke and Lord Sumption JJSC have produced their own dissenting judgments.

In the controversial ruling the Court said that even in circumstances where legal advice was imparted by a person who was a qualified person, LAP’s scope would not be extended to communications in connection with advice given by professional people – such as chartered accountants – other than members of the legal profession. It was a really great hearing to watch live online; despite Lord Pannick QC’s valiant efforts, he could not sway the Supreme Court to reverse Mummery, Lloyd and Stanley Burnton LJJ’s judgment [2010] EWCA Civ 1094 in the Court of Appeal when it heard the matter on appeal from Charles J [2009] EWHC 2494 (Admin) who had, of course, dismissed the claim for judicial review before him.

I. Background  

The full facts on this case are available in the case preview. Just to sketch the facts in outline, the issue at the heart of Prudential’s appeal was in respect of two written notices served under section 20B1 of the Taxes Management Act 1970 by Philip Pandolfo (the second defendant and the “inspector” of taxes) with the Special Commissioner of Income Tax’s (the first defendant) approval. Under the notices, Prudential Plc and Prudential (Gibraltar) Ltd – Prudential Plc’s subsidiary – were required to deliver up to the inspector documents relevant to Prudential (Gibraltar) Ltd’s tax liability. At first instance, although somewhat sympathetic to Prudential (the claimant), Charles J dismissed the judicial review claim on the basis that LAP could not be afforded to documents containing communications between tax accountants PricewaterhouseCoopers (“PwC”) – who offered legal advice on tax matters relating to tax affairs – and Prudential. The judge held that LAP only applied to the advice given by a qualified lawyer and, of course, the Court of Appeal upheld his decision.

The inspector’s notices were connected to PwC’s formulation of a tax avoidance scheme marketed in 2004 that was modified to benefit Prudential which implemented the scheme through a series of transactions. Understandably, the inspector wanted to know the details of the transactions. So he served the notices mentioned above and of course, relying on LAP, Prudential tried to conceal the transactional details.

II. Issues

Specifically, the issue at the heart of the appeal was whether, in light of being served a statutory notice from the inspector to deliver up documents in respect of its tax dealings, a company could defy complying with the inspector’s demand by saying that the documentation in question was protected by LAP when in fact accountants had provided legal advice in respect of a tax avoidance scheme. More generally, the appeal raised the question whether LAP’s scope ought to be broadened to include members of the professions outside the lawyers’ realm; if that were the case, then how far should things be taken?

III. The Supreme Court

Majority: Lord Neuberger (President), Lord Hope (Deputy President), Lord Walker, Lord Mance, Lord Reed

As noted above, the Court explained that LAP is universally considered to apply only to legal advice given to clients by their lawyers. It should not be extended to communications in relation to advice given by other professionals other than lawyers notwithstanding the fact that legal advice was imparted by the said professional; a qualified person. Lord Neuberger PSC’s reasoning remained embedded in his belief that the extension of LAP was a matter for Parliament rather than for the judiciary and at para 50 his Lordship held that “if Parliament has unequivocally endorsed the aspect or limitation then the courts should not, of course, alter it.” Setting out the intended ambit of LAP at paras 29 – 37 of his judgment, Lord Neuberger emphasised that the relevant provisions of the Taxes Management Act 1970 were substantially re-enacted by the Finance Act 2008 and it was “clear” to the Court that “Parliament … decided to maintain the difference between a person with whom communications attracted ‘legal professional privilege’ … and a ‘tax adviser’”.

Ultimately, Lord Neuberger’s threefold rationale, para 53, was that:

• The consequences of extending LAP were hard to assess and a clear and workable principle would become uncertain.

• The debate surrounding LAP’s extension raised issues of policy that Parliament ought to deliberate on. Moreover, owing to Parliament’s wide-ranging powers of inquiry and consultation and its democratic accountability, the consequences of LAP’s extension were best considered through the legislative process. Moreover, the need to vary the limits of LAP as a matter of urgency was not evidenced.

• Minimally, existing legislation relating to LAP indicated that it would be wrong – “inappropriate” – for the Court to extend the law on LAP to other professionals.

Since it is widely acknowledged that LAP applies exclusively to communications in connection with advice given by lawyers, widening its scope would take things beyond the principle’s understood limits: paras 29, 37. (Lord Hope DPSC concurring at para 80.)

Lord Neuberger flagged up numerous authorities and referred to Sir George Jessel MR’s treatment of the issue in Slade v Tucker (1880) 14 Ch D 824, 828 where the Court said that LAP remained “confined to communications between a client and his legal adviser, that is, between solicitor and client or barrister and client.” (Wheeler v Le Marchant (1881) 17 Ch D 675, 681-682 upheld this as the correct approach.) In Minter v Priest [1930] AC 558, 581, Lord Atkin approved and explained that “that the profession is the legal profession.” More recently, the courts refused to take things further than that: Dormeuil Trade Mark [1983] RPC 131 (Nourse J on trade mark agents), Wilden Pump Engineering Co v Fusfeld [1985] FSR 159 (Waller and Dillon LJJ on patent agents) and New Victoria Hospital v Ryan [1993] ICR 201 (Tucker J on personnel consultants).

Textbooks on the law of evidence and privilege took a similar view: para 32.

Equally, The 16^th Report of the Law Reform Committee (Privilege in Civil Proceedings) (1967) (Cmnd 3472) at para 24, said of LAP that “[t]he category of professional legal advisers is confined to barristers and solicitors”: para 33.

So it was pretty obvious that ramifications of extending LAP needed to be debated in the legislature which enjoyed wide powers of inquiry and consultation and its democratic accountability: para 62. Moreover, LAP’s extension to persons outside of the legal profession may only be appropriate on a conditional or limited basis, which cannot appropriately be assessed, let alone imposed, by the courts: para 65.

Lord Neuberger PSC also the rejected the “the argument [based on the European Convention on Human Rights] that so to hold would infringe article 8 [respect for correspondence] read together with article 14”: at para 75.

Agreeing with Lord Neuberger PSC, Lord Hope DPSC added, para 81, that:

As Sir Sydney Kentridge QC put it, the change we are asked to make would need a very good reason – evidence that something was not working properly. I agree with Lord Neuberger that no such pressing need has been demonstrated, and that to adopt the functional test would give rise to a significant risk of uncertainty.

Likewise, Lord Mance agreed with Lord Neuberger PSC: para 93.

Scotland

Lord Reed’s conclusion, para 114, was that if the question whether the common law privilege should be extended to legal advice given by accountants were to arise in Scotland, the courts would have to make a policy decision involving “consultation and consideration in the Scottish Parliament, providing the privilege where other professions are involved in the provision of legal services, on a conditional and limited basis.”

Dissent: Lord Sumption and Lord Clarke

Lord Sumption’s dissenting opinion – about which Lord Neuberger said that he “could not begin to improve on” – culminated in the following paragraph:

139. I would allow the appeal and remit the case to the High Court to decide whether the material requisitioned by the respondent would have been privileged if a solicitor or barrister had performed the functions that the accountants performed, and a direction to quash the notices if it would have been.

Lord Sumption’s point of departure was Upjohn Company v United States 449 US 383, 389 (1981) where the U.S. Supreme Court described LAP as “the oldest of the privileges for confidential communications known to the common law.” His Lordship also mentioned the principle protecting personal confidences – “secret professionnel” – in French law. After trawling through the national and international authorities, Lord Sumption returned to the Court of Appeal and the High Court’s judgments. His Lordship noted that Charles J had in fact considered Prudential’s case to be “compelling, indeed unanswerable” because it showed that “accountants do what lawyers are described as doing”.

Explaining that English law has always taken a functional approach to LAP, at para 128, Lord Sumption said this:

The courts below decided the question mainly on the ground that the wider implications of recognising a privilege attaching to the advice of accountants made it a matter for Parliament. Most of the argument addressed to us on behalf of the respondents and those interveners who supported them, was directed to this proposition. In reality, it comprises three distinct points. The first is a classic “floodgates” argument, namely that it would involve an extension of scope of the privilege which would considerably increase the number of persons whose advice qualified. The second argument is that recognising the privilege attaching to accountants’ advice would directly conflict with statute. The third is that fixing the boundaries of the privilege for legal advice from non-lawyers and determining the conditions on which it was exercisable were inherently legislative processes.

Both Lord Sumption and Lord Clarke opined that LAP should be extended to advice given by professionals, like chartered accountants, imparting skilled legal advice as an ordinary part of their function. So the recognition that the privilege attaches to the legal advice given by accountants would not be extending the scope of LAP. The functional approach prevalent under English law meant that the availability of LAP turned on the character of advice sought by the client and the circumstances in which the advice is given.

For Lord Clarke, if the advice was professional legal advice the adviser’s status remained immaterial. As his Lordship put it pithily at para 143:

Lord Sumption describes at para 123, the privilege extends to advice given by salaried legal advisers and to foreign lawyers. According to Lord Neuberger at para 29, it also extends to members of CILEX. The privilege also applied historically to scriveners. It is thus clear that it is not limited to advice given by solicitors and barristers. If it extends to foreign lawyers, it is to my mind impossible to see how it can properly be denied in the case of advice given by an accountant qualified to give advice on the law of tax.

Agreeing with Lord Sumption,  making a further point Lord Clarke, para 146, also said that:

In Moseley v Victoria Rubber Company (1886) 55 LT 482 Chitty J had said that it was quite clear that communication between a man and his patent agent were not privileged. He did not identify the rationale for such a rule. Nor to my mind did Wilden Pump Engineering Co v Fusfeld [1985] FSR 159.

Lord Clarke also hoped “that the whole issue will be considered by Parliament as soon as reasonably practicable”: para 140.

Accountants’ Response

Unhappy with the ruling, Michael Izza, the CEO of the Institute of Chartered Accountants in England and Wales (ICAEW) described the judgment as “undeniably disappointing news”. But he added, “the Supreme Court’s decision doesn’t mean our fight is over.”

Describing Lord Sumption and Lord Clarke’s approach as “an undeniable case” in the accountants’ favour he claimed that “[w]e want people to be free to seek advice from whichever adviser is best able to provide that advice, irrespective of their profession” and that “the current position is unprincipled and anti-competitive for individuals and businesses, who we believe should be able to seek the best professional advice upon the same terms whether from lawyers, accountants or indeed other appropriately qualified professionals.” Izza also pointed to the Legal Services Act 2007 and the creation of multi-disciplinary practices as changing “the way in which legal services are provided.”

Ultimately, Izza urged Parliament “to find a way to resolve how issues such as Legal Professional Privilege are addressed within these new structures.” Whatever Izza’s arguments might be, the truth is that the largest of accountants’ firms have misrepresented and cooked the books to enable massive corporate scandals: Enron and Tyco are just a couple of examples of such behaviour. But, of course, this is not to suggest that lawyers do not cheat.

Lawyers’ Victory

The Law Society, the Bar Council, the Legal Services Board and AIPPI UK Group intervened in the case and argued that lawyers are special.

For my part I fail to see what the fuss is all about, if accountants want their advice to be covered by LAP, then they can quite easily qualify as solicitors, barristers, foreign lawyers or members of CILEX. Or as Lord Neuberger explained, they can simply seek Parliament’s endorsement which in fact declined their invitation in 2001.

The case of WHA Limited and another (Appellants) v Her Majesty’s Revenue and Customs (Respondent, “HMRC”) UKSC 2009/0074 will be heard in the UK Supreme Court from 21 to 24 January 2013 and it shall be streamed online here. Lords Hope, Walker, Mance, Reed and Carnwath JJSC will hear the appeal.

Facts

WHA Limited (“WHA”) and Viscount Reinsurance Company Limited (“V”) are part of a group of companies providing motor breakdown insurance. V is the reinsurer, in effect standing in the shoes of the original insurer with whom the breakdown policies were taken out with. V contracts with WHA to handle the claims. WHA also contracts with garages to carry out repairs to vehicles. The garages invoice WHA the cost of the repairs. It was originally envisaged that WHA would treat the VAT added by the garages as input tax and not therefore charge it on to V.

The Court of Appeal, giving an interim judgment, held that this was not permissible and that WHA must charge V the VAT. However, V then passes this cost onto other companies within the group between which, due to geographical location, no VAT is due. Subject to adjourned consideration of arguments based on the doctrine of “abuse of rights”, Viscount was entitled to claim back the VAT from HMRC. This meant that the group of companies escaped paying VAT on the garage services.

The Court of Appeal’s subsequent judgment on the “abuse of rights” issue concluded that such a corporate structure was indeed such an abuse, as it held that its sole purpose was to avoid paying tax. In 2007, permission was granted to appeal to the House of Lords, whose role the Supreme Court has since assumed.

The case was stayed pending the result of proceedings in a case relevant to the instant one. In August 2010, the Appellants applied for the case to be further stayed pending the result of potentially relevant separate proceedings before the Court of Justice for the European Union (“CJEU”). A stay was granted. A directions hearing was subsequently fixed before the Supreme Court to take place in November 2011, at which the Appellants sought a reference on the issues arising in this appeal to the CJEU. This was refused.

Issue

Whether there is a “supply of services” for the purposes of the first WHA’s business by garages to the WHA, in addition to or instead of such a supply to insured parties, on which WHA may claim input tax under section 24(1) of the Value Added Tax Act 1994. If that question is answered in the affirmative, whether the EU law doctrine of “abuse of rights”, developed in Halifax plc v Customs and Excise Commissioners (Case C 255/02) [2006] 2 WLR 905 should be applied to strike down or “redefine” a scheme which would otherwise permit the second Appellant to reclaim VAT paid on the first Appellant’s invoices to it.

The Court of Appeal’s Judgment: WHA Ltd & Anor v Revenue and Customs [2007] EWCA Civ 728 (17 July 2007)

The Court held (Waller, Latham and Neuberger LJJ, read judgment) that a scheme designed to minimise the taxpayers’ liability to VAT in the context of the supply of repairs and parts provided pursuant to contracts of motor breakdown insurance was struck down as an abusive practice under Community law because its sole purpose was to achieve a tax advantage.

As noted above HMRC appealed against a decision [2003] EWHC 305 (Ch), [2003] S.T.C. 648 concerning the effectiveness of a scheme designed to minimise the liability to VAT of the respondent taxpayers in the context of the supply of repairs and parts provided pursuant to contracts of motor breakdown insurance.

Lord Neuberger [5] explained the proceedings as:

The matter came before us as the first part of an appeal from a decision of Lloyd J. He had allowed an appeal by the taxpayers against the decision of the VAT and Duties Tribunal (“the Tribunal”), in favour of the Commissioners for Customs and Excise, now Her Majesty’s Revenue and Customs (“HMRC”). In effect, we held, in part for different reasons from Lloyd J, that the Scheme had the effect for which the taxpayers contended.

His Lordship also explained [5] – [6] that:

First, WHA, Viscount and Crystal are and always have been part of the same group of companies. WHA is a wholly owned English subsidiary of an entity called Oriel, itself an English company. Oriel also owns all the shares in another English company called Warranty, which in turn owns all the shares in a Gibraltar company called Practical, of which both Crystal and Viscount are wholly owned Gibraltar subsidiaries. Secondly, under the Scheme, NIG’s insurance liabilities to motorists with MBI policies are 100% reinsured by Crystal, which in turn retrocedes 85% of its reinsurance liability to Viscount. Thirdly, under the Scheme, claims handling and contracts with garages for repair works and parts (“claims handling”) are, as it were, subcontracted by NIG to Crystal, and by Crystal to Viscount, and, finally, by Viscount to WHA.

Fourthly, the Scheme was set up in 1998, and replaced an earlier arrangement, under which NIG’s liability under the MBI policies was 100% reinsured by Practical, which in turn retroceded 100% of its liability to Warranty, and the claims handling was subcontracted by NIG directly to Warranty. Thus, the two main differences between the Scheme and the predecessor arrangement were (a) the involvement of a second Gibraltar company (Viscount) as an 85% retrocedent rather than the English claims handler (Warranty/WHA) as a 100% retrocedent, and (b) a claims handling contractual “chain” (through what the Tribunal called the “Gibraltar loop”), which included Viscount, from NIG to the ultimate claims handler (WHA), as opposed to a direct contract between NIG and the claims handler (Warranty).

To summarise the above, the motor breakdown policies were issued to members of the public by an English company (N). N reinsured its liabilities with a Gibraltar company (C) which in turn retroceded 85 per cent of the reinsurance to V (also a Gibraltar company). V contracted with the first respondent English company (W) to instruct garages to carry out any works required to be effected under the policies and to pay for those works. The garages rendered invoices to W and VAT was payable on those invoices. W rendered an invoice to V that W contended was exempt from VAT. On that basis W was able to claim repayment from the commissioners of the input tax.

Alternatively if VAT was chargeable on W’s invoice to V, V contended that it was entitled to recover the VAT it had to pay in respect of the invoice from W. As noted by his Lord Neuberger: V, C and W were all part of the same group of companies. HMRC sought to strike down the scheme on the basis that it amounted to an abusive practice under EU law. For HMRC in ordinary circumstances an insurer who provided in the European Union insurance services that were exempt for VAT purposes could not recover input tax attributable to those services, and that if the effect of the scheme was to make input tax incurred in the provision of exempt insurance services recoverable then it was contrary to the legislative purposes of Directive 77/388 (on the harmonisation of the laws of the Member States relating to turnover taxes – Common system of value added tax: uniform basis of assessment).

Allowing HMRC’s appeal Lord Neuberger of Abbotsbury held that:

• Applying Halifax it was contrary to the principle of fiscal neutrality to allow taxable persons to deduct input VAT even though in the context of their normal commercial operations no transactions conforming with the deduction rules of the Directive or of the national legislation transposing it would have enabled them to deduct such VAT. Whilst Gibraltar companies, namely V and C, were involved in the chain, the provision of the services comprising the repairs and parts were provided in the EU to W, and what W provided, albeit through two Gibraltar companies in the same group, was the provision of claims handling in the EU to a supplier of exempt services in the EU, namely N. Ex facie the VAT regime would plainly require that arrangement to result in an overall liability to VAT equal to the tax chargeable on the services, rather than, as resulted from the scheme, no net liability to VAT whatsoever. The fact that some of the steps in the scheme involved transactions that fell within Article 17(3) of the Directive, as opposed to Article 17(2), did not affect the application of the abuse principle explained in Halifax. In considering the application of the principle in Halifax the steps in the scheme could not be considered separately: the point of the abuse principle was that, although each step worked, the overall effect was unacceptable. So at [22], in answering the question whether the Scheme or part of it was contrary to the purpose of the Sixth Directive? Lord Neuberger held that “the whole point of the principle is that, although each step of the scheme in question works, the overall effect of the scheme is unacceptable.”

• Moreover, applying Halifax in order to establish abuse, tax saving had to be the sole purpose of the transactions at issue. In the light of the findings of the tribunal, the sole purpose of the scheme, and in particular the retrocession arrangement between C and V and the creation of the claims handling chain so as to include V, was to avoid or at any rate minimise any net liability to VAT by enabling the input tax paid by W to be reclaimed by W or, as it turned out, V. Under Halifax it was necessary to consider primarily the aspects of the scheme that were artificial and had no commercial purpose. Therefore, Lord Neuberger [24] held that the question of purpose was to be judged objectively and not subjectively, i.e. by reference to the terms of the scheme concerned and the commercial realities, not by reference to what the parties concerned say their intention was (or what their subjective intention is found to have been).

• The finding of abuse did not offend against the principle of freedom of establishment.

• The abuse principle could be invoked even though the scheme succeeded in avoiding VAT because of the provisions of domestic law rather than EU legislation.

• The scheme resulted in a tax advantage antithetical to the purposes of the Directive and that advantage was the essential aim of the transactions. Therefore, the two requirements identified in Halifax were satisfied. In the circumstances it was not necessary to seek to “redefine” the scheme, since W had paid the input tax and the commissioners had not refunded either C or V and therefore nothing remained to be done.