Conduct of Persons in Financial Services: Causing a Financial Institution to Fail

25 04 2014

imagesThe Financial Services (Banking Reform) Act 2013 (the Act) is yet another Leviathan statute. The Act is spread out over eight parts encompassing one hundred and forty-eight sections and contains ten schedules. First of all, this wide-ranging legislation implements the recommendations of the Independent Commission on Banking (or ICB, chaired by Sir John Vickers). Equally, it also implements the recommendations of the Parliamentary Commission on Banking Standards (or PCBS, in relation to the LIBOR scandal) which aim to improve culture and standards in the banking sector. Moreover, under section 17, the Act also provides the Bank of England with the new stabilisation “bail-in option” under the Banking Act 2009. See updates here and here.

Independent Commission on Banking

In its final report, the ICB remarked that:

Banks are at the heart of the financial system and hence of the market economy. The opportunity must be seized to establish a much more secure foundation for the UK banking system of the future.

Recommending structural reform of the banking industry, coupled with measures designed to increase the capacity of banks to absorb losses, the ICB’s work focused on cost effective solutions as regards rescuing failing banks. In order to seclude banking activities where the continuous provision of services is vital to the economy and to a bank’s customers, Sir John Vickers emphasised that wholesale or investment banking within a banking group required separation – or “ring-fencing” – from retail banking. Similarly, measures ensuring the economic independence of retail banking from the larger banking group and the former’s independent governance were also necessary.

Moreover, the ICB also recommended that large UK banking groups should be required to hold equity and other regulatory capital, and long-term unsecured debt sufficient to cover at least 17 per cent of the group’s risk-weighted exposures because the regulatory capital and debt forming part of this “primary loss-absorbing capacity” would be available to bear losses in the event that the bank failed. Furthermore, deposits eligible for protection under the Financial Services Compensation Scheme should be made preferential debts in the event of insolvency.

Causing a Financial Institution to Fail

Quite interestingly, Part 4 (i.e. sections 13 – 38 and Schedule 3) of the Act targets conduct of persons working in the financial sector by amending part 5 (performance of regulated activities) of the Financial Services and Markets Act 2000 (FSMA). In doing so, the Act introduces a new system for senior managers and banking standards and these provisions implement the PCBS’s recommendations. Moreover, a new criminal offence – as regards decisions that have caused a bank to fail – is also created.

The new crime for reckless bankers is set out in section 36 (Offence relating to a decision causing a financial institution to fail) of the Act (see also section 37 (Section 36: Interpretation) and section 38 (Institution of Proceedings)) . This provision states that:

(1) A person (“S”) commits an offence if —

(a) at a time when S is a senior manager in relation to a financial institution (“F”), S —

(i) takes, or agrees to the taking of, a decision by or on behalf of F as to the way in which the business of a group institution is to be carried on, or

(ii) fails to take steps that S could take to prevent such a decision being taken,

(b) at the time of the decision, S is aware of a risk that the implementation of the decision may cause the failure of the group institution,

(c) in all the circumstances, S’s conduct in relation to the taking of the decision falls far below what could reasonably be expected of a person in S’s position, and

(d) the implementation of the decision causes the failure of the group institution.

(2) A “group institution”, in relation to a financial institution (“F”), means F or any other financial institution that is a member of F’s group for the purpose of FSMA 2000 (see section 421 of that Act).

(3) Subsections (1) and (2) are to be read with the interpretative provisions in section 37.

(4) A person guilty of an offence under this section is liable —

(a) on summary conviction —

(i) in England and Wales, to imprisonment for a term not exceeding 12 months (or 6 months, if the offence was committed before the commencement of section 154(1) of the Criminal Justice Act 2003) or a fine, or both;

(ii) in Scotland, to imprisonment for a term not exceeding 12 months or a fine not exceeding the statutory maximum, or both;

(iii) in Northern Ireland, to imprisonment for a term not exceeding 6 months or a fine not exceeding the statutory maximum, or both;

(b) on conviction on indictment, to imprisonment for a term not exceeding 7 years or a fine, or both.

HM Treasury’s Consultation

Indeed, the requisite standard of liability – i.e. recklessness – for the section 36 offence is quite deliberate because lower standards of liability such as strict liability or negligence would dissuade talented persons from working in management positions in the banking sphere. In HM Treasury’s consultation of July 2012, Sanctions for the directors of failed banks, the Government considered four options in relation to managerial misconduct and criminal liability:

  • Being a director at the relevant time of a failed bank (strict liability for bank failure)
  • Negligence (failure in a duty of care which leads to a reasonably foreseeable outcome)
  • Incompetence (failure to act in accordance with professional standards or practices)
  • Recklessness (failure to have sufficient regard for the dangers posed to the safety and soundness of the firm concerned or for the possibility that there were such dangers)

The consultation – which traced its roots to the financial crisis and the egregious RBS bailout – explained that, in the present context, an excessively onerous “strict liability” rule would have meant that:

Bank directors would be held responsible for the failure of a bank regardless of whether their actions were a significant contributory factor to the failure and whether those actions were reckless or negligent.

The Government thought that it would be controversial to impose severe criminal penalties on individuals who were not involved in wrongdoing. Fairness aside, such a regime would deter people from accepting board appointments and rather than properly dealing with issues of misconduct, the approach would inevitably hinder economic recovery. That, of course, would be highly counterproductive.

Negligence and incompetence were already actionable by regulators against individuals and firms. Individuals’ competence needs to be vetted by regulators prior to approval in any event. Moreover, actions in contract and tort as regards negligence are also possible. So, in respect of bank managers and directors, creating a criminal offence for negligent misconduct did not necessarily add anything new to the statue book. If anything, it would be harder to criminally prosecute someone for the offence because regulatory proceedings under FSMA are easier to action.

Thus, it is plain that in the interests of economic recovery, the standard of liability in connection with the offence aims to strike a fair balance by demonstrating society’s revulsion of bankers’ misconduct on the one hand, and the need to ensure that people do not refuse to work in the financial services sector on the other.

Of course, as noted above, one of the most reckless things that RBS did was to acquire ABN AMRO. And the FSA (as it then was) described the move in The failure of the Royal Bank of Scotland report as an extremely risky deal:

The acquisition of ABN AMRO by a consortium led by RBS greatly increased RBS’s vulnerability. The decision to fund the acquisition primarily with debt, the majority of which was short-term, rather than equity eroded RBS’s capital adequacy and increased its reliance on short-term wholesale funding. The acquisition significantly increased RBS’s exposure to structured credit and other asset classes on which large losses were subsequently taken. In the circumstances of the crisis, its role as the leader of the consortium affected market confidence in RBS.

RBS decided to make a bid for ABN AMRO on the basis of due diligence which was inadequate in scope and depth, and which hence was inappropriate in light of the nature and scale of the acquisition and the major risks involved. This was the inevitable result of making a contested takeover, where only limited due diligence is possible. In proceeding on that basis, however, RBS’s Board does not appear to have been sufficiently sensitive to the wholly exceptional and unique importance of customer and counterparty confidence in a bank. As a result, in the Review Team’s view, the Board’s decision-making was defective at the time. RBS believed in its ability to integrate businesses successfully after the acquisition of NatWest; in the case of ABN AMRO, it underestimated the challenge of managing the risks arising from the acquisition.


In light of the above, it is unsurprising that recklessness is the standard of liability in the new section 36 offence. Despite some tension in the case law, in principle, recklessness points to either taking unreasonable risks or disregarding them. Like negligence and incompetence, regulatory action remained possible against individuals but for the Government:

The more egregious character of recklessness may make it a more suitable subject for criminal sanctions. Creating a new criminal offence involving recklessness would send a very clear signal that society (which might have to pay a heavy price for dealing with the consequences of recklessness) is determined to prevent and deter that conduct. At the very least, it would surely make bank directors think twice before taking certain decisions. It would probably slow down the taking of such decisions; a responsible bank board might, for example, obtain legal advice about whether a decision could be considered to be reckless.

Defining recklessness or excessive risk taking by bank management requires a clear idea of what would constitute normal or non-excessive risk taking. Banking business inevitably involves taking risks. Business and investment decisions of all kinds are always forward looking and involve a degree of judgement about future developments that is necessarily less precise than, for example, the kinds of prediction that are possible under the laws of the natural sciences or engineering. It would be inherently more difficult, therefore, to decide whether someone ought to have been aware of a risk that occurred, or that they were aware of a risk but wrongly decided that it was not significant, or to judge whether it was reasonable or unreasonable to take a particular risk.

Equally, the Government also expressed its concerns about practical matters such as disclosure, causation, costs, picking the right people causing failure and extraditing individuals who were no longer in the UK.

In relation to HM Treasury’s consultation, Sanctions for the directors of failed banks of July 2012, most respondents opposed the introduction of criminal sanctions as they (a) would deter people from working in banking and (b) did not add anything new to existing regulatory powers over regulated persons. One respondent favoured amending the Company Directors Disqualification Act 1986 as an alternative to the new criminal offence. Most respondents favoured recklessness as the appropriate standard of liability in relation to the offence.

Over the years, the courts have interpreted recklessness time and time again. Recklessness is concerned with unjustified risk taking. It repays the analysis above to expand upon its meaning. The key authority is Regina v G & Anor [2003] UKHL 50. In this landmark case on recklessness, their Lordships’ House (as it then was) held that a person acts recklessly with respect to:

  • A circumstance when he is aware of a risk that it exists or will exist, and
  • A result when he is aware of a risk that it will occur, and it is in the circumstances known to him, unreasonable to take the risk

The word “risk” does not need to be qualified and there is no doubt that R v G, which sets a subjective standard for recklessness, has general application. On the other hand, Lord Bingham of Cornhill (as he then was) had prefaced his judgment with the explanation that “the agreed facts of the case are very simple.” Two boys – an eleven and a twelve year old – were charged with arson contrary to section 1 of the Criminal Damage Act 1971.

images-1The trial judge directed the jury in line with R v Caldwell [1982] AC 341 – that the risk taken by the boys (in setting fire to a wheelie bin which ended up burning down adjoining buildings and caused £1 million in damage) should be perceived by reference to a reasonable person. Applying that test the (hesitant) jury convicted them.

The Court of Appeal (Dyson LJ, Silber J and HHJ Beaumont QC, [2002] EWCA Crim 1992) held that the Caldwell test had been rightly applied: the Court was not at liberty to depart from applying the test. But, on the other hand, in their Lordships’ House, Lord Bingham (with whom Lords Browne-Wilkinson, Steyn, Hutton and Rodger concurred) allowed the appeal and quashed the boys’ convictions.

On proper analysis, their Lordships considered that the correct test was that the defendant actually foresaw that the harm may occur yet disregarded the risk by continuing to perform the act – i.e. Cunningham recklessness: see R v Cunningham [1957] 2 QB 396.


It will be interesting to observe whether, in the coming years, the new section 36 offence in the Act (and the offence in section 91 of the Financial Services Act 2012, i.e. making a false or misleading statement or a false or misleading impression) will add anything new to the judicial saga in relation to recklessness.

Or will the courts be happy to maintain the same test (subjective) for recklessness which Lord Bingham applied to the two boys who set fire to a wheelie bin (but were not alert the dangers)? Originally, the test was applied to a man, i.e. Cunningham, who, when short of money, tore off a gas meter from the wall in his prospective mother-in-law’s house and failed to switch off the gas by turning the stop tap. Because of his behaviour, his prospective mother-in-law was partially asphyxiated as she slept in her bedroom with the result that her life was endangered.

How the courts treat the new offence as regards causing a financial institution to fail (and indeed for making a false or misleading statement or a false or misleading impression in connection with the setting of a relevant benchmark) remains to be seen. It will be intriguing to know how the learning on recklessness – if at all – will evolve with the new criminal offences in the context of financial services.

But society at large can nevertheless find some comfort in knowing that for a jury to convict someone – for causing a financial institution to fail or for making a false or misleading statement or a false or misleading impression in connection with the setting of a relevant benchmark – full  intention is not required.



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