The Libor Scandal and “Soft Law”

10 02 2013

Sustainable Banking 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 herehere 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-law’ 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.


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18 03 2013
Roger McCormick On Sustainable Banking | Global Corporate Law

[…] on a regulated activity) of the 2012 Act also inserts a new Part 4A into FSMA. Moreover, as noted previously, Part 7 of the 2012 Act in section 89 (misleading statements), section 90 (misleading impressions) […]

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