Beyond financial failings: misconduct and diversity developments in 2021
This article was originally published on Thomson Reuters Regulatory Intelligence here.
The growing weight that regulators attach to non-financial misconduct means they increasingly care not only about what a firm does, but also how it does it. Discrimination, sexual misbehaviour and lack of diversity have joined a list originally dominated by excessive risk taking. This trend saw significant developments in the EU, the UK and Ireland during 2021.
Last December, Elizabeth McCaul, a European Central Bank (ECB) supervisory board member, set the tone for the year ahead when she said the ECB would take a "stricter and more intrusive" approach to fit and proper assessments in 2021 and pay closer attention to reassessments, particularly when new facts emerged.
"We will closely scrutinise matters that may impair a board member's suitability, such as previous criminal convictions or ongoing legal proceedings," McCaul said.
"We also intend to examine the individual accountability of board members more closely. Directors who are guilty of misconduct, or who turn a blind eye to misconduct by their peers, should not be able to hide behind the collective responsibility of the board."
The UK has the region's most mature conduct and accountability regime, as its Senior Managers and Certification Regime (SMCR) was phased in across the industry from 2016. The Financial Conduct Authority (FCA) has said that it views non-financial misconduct equally seriously as financial misconduct, and last November it banned three individuals convicted of sexual offences on the grounds they were not fit and proper persons. This summer's Upper Tribunal judgment in Frensham v FCA tested that stance.
Like the three persons last November, the FCA banned Frensham following a sexual offence conviction on the grounds he was not fit and proper. He appealed, partly relying on the High Court decision in Beckwith, a review of a Solicitors Disciplinary Tribunal ruling on lack of integrity. Beckwith ruled that regulatory requirements only apply to private life misconduct "realistically" touching on someone's exercise of their profession, a line the Frensham tribunal followed.
"The tribunal … found that non-financial misconduct occurring outside the workplace should impact a regulatory assessment of an individual's fitness and propriety where that behaviour 'engaged the specific standards laid down by the relevant regulator' and was qualitatively relevant," said Duncan Campbell, a managing associate at Linklaters, the law firm.
"This makes it clear that misconduct must engage the regulator's rules or objectives to justify a prohibition order or a refusal to approve an application."
That may seem like a reversal for the FCA's non-financial misconduct agenda but the Frensham judgment was more nuanced. The tribunal did not say that private sexual misconduct was irrelevant, merely that the FCA had not produced sufficient evidence of relevance to regulatory standards in Frensham's case. In any event, Frensham remained banned for breaching his PRIN 11 obligation to be open and cooperative with the FCA.
"We expect the FCA will learn from this and provide better evidence of the link between non-financial misconduct and its regulatory objectives in future cases, which will give the tribunal the chance to offer more clarity on whether and when non-financial misconduct will justify a regulatory ban or approval refusal," Campbell said.
Drive to improve cultures
The FCA regards conduct as wrapped up with its drive to improve cultures, arguing that healthy cultures where people feel able to speak up about wrongdoing will reduce all types of misconduct. Probably the sector's most respected measurement of cultures is the annual employee survey assessment conducted by the Financial Services Culture Board (FSCB), formerly the Banking Standards Board.
The FSCB's 2021 assessment showed disappointing progress. Cultural indicators improved between 2016 and 2017, plateaued in the 2018 and 2019 reports but then rose again in 2020, reflecting employees' response to support received during the pandemic. The pandemic also delayed the 2020 survey. When the 2021 survey was conducted just eight months later, half the gains made in 2020 had already been lost, making the progress line since 2018 nearly as flat as the Fens.
Furthermore, the culture picture may be worse among experienced employees because new joiners tend to be materially more enthusiastic than them, pushing up overall scores. The 2021 report observed that this had "a greater explanatory effect in several than any other demographic collected". None of this is to criticise the FSCB; its assessments simply show how difficult it is to achieve tangible, lasting cultural improvement.
"Even when the results have shown little change from one year to the next at an aggregate level, we often see significant variation at an individual firm level and within different business areas," an FSCB spokesperson said. "We are also working with the Bank of England on a project looking at the relationship between the way we measure and assess culture and outcomes in practice."
Diversity and inclusion
UK and EU regulators are drawing diversity and inclusion (D&I) into the misconduct arena. The UK regulators already regard existing SMCR managerial responsibilities for culture as including D&I, but joint FCA/Prudential Regulation Authority (PRA) Discussion Paper21/2 (DP21/2) proposed to make it an express responsibility to improve D&I.
"For dual-regulated firms, D&I could be expressly mentioned in the PRA's culture prescribed responsibilities PR(I) and PR(H)," Campbell said. "For solo-regulated firms, D&I could be expressly mentioned in the statements of responsibilities of FCA senior management functions that already have responsibilities for remuneration, recruitment and fair treatment of customers."
In some circumstances, such as national talent shortages or regional demographics, individual accountability for improving D&I could produce causation arguments, especially as DP21/2 mooted linking it to senior managers' remuneration.
"It may well be difficult for the FCA/PRA to say that, for example, a failure to meet a level of target representation of an under-represented minority at senior levels, was caused by a failure by a senior manager to take reasonable steps," Campbell said. "But a lot will depend on the circumstances of each case."
Diversity and inclusion in the form of an obligation to have a gender-neutral remuneration policy was included in the fifth CapitalRequirements Directive EU 2019/878 (CRD5) and the Investment Firms Directive EU 2019/2034 (IFD). EU regulators have nudged matters further and are developing their approach to non-financial misconduct and D&I. In 2021, the ECB, the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) issued or proposed guidance that put more weight on diversity.
"ESMA and the EBA exert influence in these areas through their guidance on assessing the suitability of members of management bodies and key function holders," Campbell said.
"The ESMA and EBA's latest guidelines and the ECB's proposed Fit and Proper guidelines require firms to implement measures to promote diversity within management, including by taking diversity into account in recruitment decisions. They have a particular focus on gender diversity at this time."
Of the two publications, the ECB draft guidelines go furthest on non-financial misconduct: 3.2.2, paragraph 5 deems dismissal, suspension or resignation for "gross misconduct" relevant to its fit and proper assessments, even if it did not result in legal proceedings. The EBA/ESMA guidelines do not specifically mention non-financial misconduct but have sufficient flex to cover it when applied in specific situations, Campbell said.
Senior Executive Accountability Regime
July saw the Irish government publish draft legislation, the General Scheme — Central Bank (Individual Accountability Framework)Bill, to introduce a Senior Executive Accountability Regime (SEAR). The terminology differs, but SEAR broadly follows the UK SMCR's framework of clear conduct requirements, fit and proper certification and the assignment and mapping of individual managerial responsibilities.
As SMCR did for the UK FCA, SEAR would enable the Central Bank of Ireland to attach more importance to non-financial misconduct and cultures.
SEAR would be Europe's first detailed conduct and accountability regime outside the UK (although such regimes are in place in Australia, Singapore and Hong Kong), but has been a long time in the making. It was first announced in 2018 but last month the financial committee of the Oireachtas, the Irish parliament, expressed concern about SEAR's slow progress as it is unlikely to come into effect until early 2023.