King and Country: Reflections on the Costs of Market Misconduct

Read as updated SSRN paper with reference to the Panama Papers. Because of the Budget 2016, the chancellor has been accused of “looking more like Gordon Brown as a purveyor of gimmicks.” In difficult times when calls for his scalp over the row regarding the budget seemed to have eclipsed everything else, the rare bit of good news for George Osborne is that he can use the opportunity provided by the threat of Brexit – “a leap in the dark” which may cost the UK £100 billion or 5 per cent of GDP and 950,000 jobs by 2020 – to camouflage and obfuscate the real problems of conduct in the world of economics and finance. On the other hand, in an important interview with Charles Moore the former Bank of England governor Mervyn King showed hallmark signs of euroscepticism and said the people need to make up their own minds about the upcoming referendum. King also warned that lenders have not stopped taking excessive risks with savers’ money and the result is “bankers have not learnt the lessons of the Great Crash”. Unsurprisingly, in his somewhat controversial new book The End of Alchemy he makes the case against financial sorcery by arguing that it must be squeezed out of the world’s banking system. Perhaps, such failings are amplified further because “financial crises are a fact of life” and we are “moving into a rerun of the credit crunch”. Indeed, Lord King calls banks “the Achilles heel of capitalism.”

Below I sketch important/emerging issues in the intersecting themes of economics, law and misconduct as seen in the media, especially through the lens of “conduct costs” – some other themes are also explored. Mentioning Walter Bagehot and his classic text Lombard Street, which argued that the BoE should provide short-term financial support in times of crisis, King advises us that the old “lender of last resort” model (LOLR) is in need of revision because “banking has changed almost out of recognition since Bagehot’s time.” The former governor argues that the time has come to replace LOLR with the pawnbroker for all seasons (PFAS) system. For him, it is time for financial institutions to drop LOLR and embrace PFAS and be prepared to advance funds to just about anyone who has sufficient collateral. “The essential problem with the traditional LOLR,” argues King “is that in the presence of alchemy, the only way to provide sufficient liquidity in a crisis is to lend against bad collateral – at inadequate haircuts and low or zero penalty rates.”

Case Comment: Maximillian Schrems v Data Protection Commissioner

Schrems v Data Protection Commissioner and another (Case C-362/14) EU:C:2015:650

Comparing the mass surveillance under the Commission’s US Safe Harbour Decision to the world of financial misconduct, Max Schrems said: “It’s like with the banking crisis, there was outrage and then we all kept on walking by. Letters went sent, words were said. The usual drill. But there was not really any change.” The young Austrian law student’s successful campaign, funded through small donations totalling €65,000, to close the legal loophole that allowed US corporations to circumvent EU law caused quite a stir because the CJEU declared the Commission’s US Safe Harbour arrangement invalid. The Grand Chamber held that because of Articles 7, 8 and 47 of the Charter of Fundamental Rights of the European Union (CFR), Commission Decision 2000/520/EC did not prevent Ireland’s supervisory authority from examining the claim made by Schrems (who was concerned about the protection of his rights and freedoms) in regard to the processing of personal data relating to him which had been relayed from Ireland to the US (a third country) when he contended that the law and practices in force in the third country did not ensure an adequate level of protection. Commission Decision 2000/520/EC was adopted under Article 25(6) of Directive 95/46/EC, or the Data Protection Directive, and through it the European Commission deemed the US to provide adequate protection.

The CJEU was unimpressed with the attitude of the Ireland’s Data Protection Commissioner (DPC) who refused to investigate a complaint made by Schrems regarding Facebook Ireland Ltd transferring the personal data of its users to the US to keep it on servers located there. The ruling brought an end to more than 4,400 US firms – including Amazon, Apple, Facebook and Google – easily transferring European customers’ details abroad under the 15-year old agreement which was seen by many in the industry as a get out of jail free card. The scrapping of the pact, which purported to have an overriding effect over the scrutiny of national regulators (who must protect data moved by a company to a foreign server), sparked outrage in America and the Obama administration was “deeply disappointed” by the ruling. Overall, the decision tends to be seen as protectionist and anti-business in America. It also crystallised growing suspicion of US firms, Safe Harbour’s main beneficiaries, in the aftermath of Edward Snowden’s disclosures about the scale of the American government’s digital espionage programmes.

Notable Economic Forecasts

The UK has recently been dubbed by the Legatum Institute as “the third cheapest place in the world to start a business, far cheaper than the US or Germany.” The strength of the UK economy, which makes it one of the world’s most prosperous countries, is the underlying reason for creating successful businesses and opportunities for those seeking entrepreneurial roles. The Legatum Institute 2015 Prosperity Index, which is a league table ranking countries on the basis of economic success and a series of wellbeing indicators, ranks the UK (behind Germany) as the fifteenth most prosperous country in the world. (Norway has topped the ranking for the seventh consecutive year as the world’s most prosperous country.) However, as observed on this blog, misconduct in financial services is spiralling and no end to the conundrum appears to be in sight. In relation to trade, contrary to the findings of the Legatum Institute, the Institute of Chartered Accountants in England and Wales (ICAEW) has also found that business confidence in the UK is weakening and that investment is muted and exports are low.

For example, the Q4 2015 ICAEW/Grant Thornton UK Business Confidence Monitor results argue that though “still firmly in positive territory … the post-election honeymoon maybe over”. Exports and manufacturing have not been rebalanced which means there is continued reliance on domestic demand. In addition to the fall in business confidence after the post-election bounce, the Q4 2015 ICAEW/Grant Thornton report further found that exports are sliding below domestic sales, firms are restricting their budgets for R&D because they lack long-run confidence and skills shortages are rising – albeit wages are increasing steadily. The upshot is that business confidence is at its lowest level since 2013. Confidence in the services sector remains positive but is declining in the production sector.

On-site ESMA Inspections: Chancery Division Gives Procedural Guidance

European Securities & Markets Authority (ESMA) v DTCC Derivatives Repository Ltd [2015] EWHC 1085 (Ch) (25 April 2015)

This is a first of a kind judgment given by Mrs Justice Rose. It involved the application of the European Securities and Markets Authority (ESMA) for authorisation to conduct an inspection at the premises of a trade repository, the DTCC Derivatives Repository Limited (DTCC), in England. Rose J began her judgment by clarifying that DTCC was not suspected of engaging in misconduct and that the intended inspection was simply part of ESMA’s general supervisory functions. DTCC, which was notified, agreed to cooperate fully with the visiting ESMA officials but the agency nevertheless required the High Court’s authority to proceed with the inspection. In light of the novelty of the situation, the court handed down a short judgment to set out the principles that apply to the exercise of ESMA’s power. The court reiterated the Chancellor’s guidance that future applications for authorisation by either ESMA or the Financial Conduct Authority (FCA) under regulation 17 of the Financial Services and Markets Act 2000 (Over the Counter Derivatives, Central Counterparties and Trade Repositories) Regulations 2013 (the Domestic Regulations) can be submitted for consideration on the papers in certain cases.

First, where the company subject to the inspection has been informed of the inspection and has indicated its intention to submit to the inspection. Second, where the application is made by ESMA, that the FCA has been informed and does not wish to be heard at a hearing of the application. Third, the application does not seek a power to seal business premises or books and records, does not include a request for records of telephone and data traffic and does not request the issue of a warrant. Her Ladyship also said that the judge or master, on considering the application, may indeed decline to deal with the matter on the papers and direct that a hearing should take place.

Supreme Court: The Meaning of “Criminal Property” in POCA 2002

R v GH (Respondent) [2015] UKSC 24, 22 April 2015

The Supreme Court (Lord Neuberger PSC and Lord Kerr, Lord Reed, Lord Hughes and Lord Toulson JJSC) heard this case on appeal from a judgment of the Court of Appeal (Lloyd Jones LJ, Irwin and Green JJ) reported at [2013] EWCA Crim 2237. Unanimously allowing the appeal of the Director of Public Prosecutions (DPP), giving the only judgment Lord Toulson held at para 47 that the “character of the money did change on being paid into the respondent’s accounts.” This case involved fraud which had been perpetrated through the Internet via four “ghost” websites falsely pretending to offer cut-price motor insurance. To execute his plans, B used associates who opened bank accounts for transmitting the proceeds generated by the scam and H was an associate of this nature. A ghost website in the name of AM Insurance was operated from 1 September 2011 to January 2012. Before the site became live online, two bank accounts, in Lloyds Bank and Barclays Bank, were opened by H and B subsequently took control of these accounts and bank cards linked to them. The Supreme Court held that section 328 of the Proceeds of Crime Act 2002 (POCA) does not require property to constitute criminal property before an arrangement came into operation because such a construction is likely have serious potential consequences in relation to banks and other financial institutions.

The public was swindled into paying £417,709 into the Lloyds’ account and £176,434 into the Barclays’ account for insurance cover that did not exist. Charged under section 328(1) – i.e. entering into or becoming concerned in an arrangement which he knew or suspected would facilitate the retention, use or control of criminal property, namely the money received into the accounts, by or on behalf of B – H was tried in the Central Criminal Court. To the jury, the DPP articulated its case on the premise that whilst H may not have known the details of B’s fraud, the circumstances in which the accounts were opened pointed to H’s knowledge (or at least suspicion) that B had some criminal purpose. Yet Recorder Greenberg QC held that no criminal property existed at the point in time H entered into the arrangement and that H therefore had no case to answer.

European Supervisory Authorities on Risk in EU Financial Systems

The bi-annual report of the Joint Committee (JC) of the European Supervisory Authorities (ESAs) – i.e. the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA) – has identified a number of risks to financial stability in the EU. These risks include uncertainties in global emerging market economies, an intensified search for yield in a protracted low interest rate environment, prolonged weak economic growth in an environment marked by high indebtedness and the risks related to conduct of business and Information Technologies (IT). Subsequent to the last report in spring 2014, the instant report focuses on the delicate economic recovery within the EU that can be observed in weak balance sheets both in private and public spheres. Presently favourable market conditions may conceal shortcomings in a weak economic environment and the ESAs consider high indebtedness and low private sector credit growth to be particularly testing and they place emphasis on continued structural reforms that drive improvements in competitiveness and revive lending.

On the one hand, the report explains that ongoing asset quality reviews and stress tests in the banking and insurance sector will present a clearer picture of asset quality and help improve the reliability of balance sheets of EU financial institutions. However, on the other hand, the report emphasises that ongoing balance sheet repair and debt restructuring should remain a key priority in moving forward.

FCA on MiFID II and the Future of European Trading

Directive 2004/39/EC, the Markets in Financial Instruments Directive (MiFID), governing the provision of investment services in financial instruments by banks and investment firms and the operation of traditional stock exchanges and alternative trading venues, has been in force since November 2007. Considered to be a core pillar in EU financial market integration, MiFID has been credited with creating competition between these services and bringing increased choice and lower prices for investors. However, the financial crisis revealed weaknesses and with the aim of making financial markets more efficient, resilient and transparent, and to strengthen the protection of investors, the European Commission published its legislative proposals regarding MiFID II and Markets in Financial Instruments Regulation (MiFIR) in October 2011. These entail wholesale reform that will change financial markets, banking services and the bank-customer relationship.

In April 2014, MiFID II and MiFIR were endorsed by the European Parliament. In May 2014, the Council of the European Union adopted the legislation. Subsequently, the MiFID II legislation came to be published in the Official Journal of the European Union in June 2014. In July 2014, MiFID II and MiFIR entered into force. They must generally apply within Member States by January 2017. It is therefore unsurprising that the Financial Conduct Authority (FCA) considers this legislation to be “the future of European trading in the balance” and has hosted a conference on it.