Legal & General: Financial Services and Markets Tribunal decision

The Financial Services and Markets Tribunal recently published its decision in the challenge brought by Legal & General (L&G) to a £1.1 million fine imposed by the Financial Services Authority (FSA) for alleged rule breaches and consequent alleged mis-selling of endowment policies (Flexible Mortgage Plans - FMPs) by L&G between 1997 and 1999.

The case has important consequences for the retail investment industry and the FSA alike; not only has it provided some guidance on how the Tribunal considers it should function, and guidance on what firms should be doing procedurally, but it is additionally anticipated that FSA may have to make changes to the way investigations are conducted. Consequently, firms may be encouraged to challenge decisions they do not agree with, when in the past they have been cautious to do so.

The case against L&G

The FSA contended that L&G's sales and compliance procedures had failed to ensure that their advisers sold FMPs only to those customers for whom they were suitable; and that FMPs were sold to customers for whom they were not suitable either because those customers were not prepared to accept the risks that the policy might mature with insufficient value to pay off the mortgage (the capital shortfall risk) or because they did not properly understand the risks. It sought to prove (i) that L&G's compliance procedures were deficient (the procedures case) and (ii) that there had been actual mis-selling of FMPs by L&G representatives and that the proportion of those was unacceptably high. The FSA claimed that the mis-selling (the mis-selling case) had been caused, or contributed to, by the difficiencies in L&G's procedures.

L&G's position

L&G denied those allegations and maintained that it had had proper and reasonable sales and compliance procedures in place during the Relevant Period, and that the allegations of mis-selling were flawed; that it had taken proper steps in accordance with the rules and followed the guidance of the regulator, which in substance had approved the very methods of which criticism was made.

It claimed it had been subjected to an unfair inquiry by the FSA and that the decision of the Regulatory Decisions Committee (RDC) was unjust.

The Tribunal's decision in summary

In relation to the procedures case, the Tribunal held that there were a number of defects to L&G's selling procedures. In relation to the mis-selling case, the Tribunal held that these procedural defects would have caused, or contributed to, mis-selling. However, they held that the amount of mis-selling was limited; it found only eight cases out of the sixty that FSA had reviewed to be mis-sales and stated that it was only "commonsense" that suggested the procedural defects would have caused more. It said it would be "unjust" to extrapolate a conclusion of general mis-selling in relation to all L&G sales of FMPs from the sales review that PricewaterhouseCoopers (PWC) had conducted. While such a review was a valid and acceptable tool in identifying regulatory breaches, in this case the review was flawed; the sample size was far too small to provide reliable evidence and the evidence within it was of poor quality.

The Tribunal will reconvene at a later date to make a decision about the amount of the fine that L&G should pay, but have stated in their decision that their provisional view is that there should be a reduction in the penalty of £1.1million imposed by the FSA. Both parties have been given the right to make further submissions and L&G may seek its costs.

Practical points arising from the Tribunal's decision

A number of specific points came out of the decision:

Cases before the Tribunal

• When FSA's statement of case was submitted to the Tribunal, it appeared to contain a further claim of individual mis-selling that had not been raised before. At the hearing, the FSA confirmed that its case, set out in the original decision notice, had not changed. Responding to this, the Tribunal was clear that, on the basis of commonsense, fairness, and the FSA's wide powers, the case before the RDC should not normally change before it is brought before the Tribunal. It added that the FSA's statement of case should usually be confined to the charges contained in it.
• The Tribunal emphasised that it was not dealing with the principles and practice of civil litigation and that the Tribunal procedure was designed to ensure that the Applicant knows the charges it faces and that neither party ambushes the other one and unfairly takes it by surprise.
• A point specific, perhaps, to the facts of this case but of wider application, was that the Tribunal stated that the factual evidence from customers in this case had been more beneficial than the expert evidence in guiding them on what a customer's reactions might have been and PWC's conclusions in relation to the sales review did not persuade them.
• However, it did make clear that the lack of evidence - as would have been seen in civil litigation - on the standards of behaviour required at the relevant time in order to comply with the rules or broader requirements, such as "best endeavours" or "due skill, care and diligence", created a difficulty in the absence of an objective standard or explicit guidance as to how L&G were to perform. It may be that such evidence will be expected in future cases.

FSA's evidence gathering

• Firms can expect the use of sales reviews to obtain evidence to continue but in light of the Tribunal's comments these may involve a far greater number of cases, and, therefore, time, cost, and disruption to business. Further, all the "responders" in such reviews may need to give evidence "live" at the hearing, as opposed to relying on their written testimony.
• FSA's misselling case failed because of FSA's defective sales review. The Tribunal considered the sample size was too small to extrapolate the results into the wider population of FMPs. The Tribunal was guided by the opinion of L&G's expert, who considered that the sample size in a review should be around 1,800 policyholders to achieve a desired response rate of 600 customers. The categories of customers reviewed should include customers who had surrendered FMPs, medium and high risk endowment mortgage plan policy holders, and customers taking out repayment mortgages. This may set a benchmark in future cases.
• The Tribunal also held that the evidence from the review was too unreliable because customers' recollections were either very limited or not consistent. In addition to the eight proven cases, out of the 47 cases about which the FSA did not put forward evidence at the hearing, the Tribunal identified a further 14 possible mis-sales. The Tribunal stated that, given the unreliability of the review evidence, the "live" evidence had been crucial in reaching its decision. Therefore, this may also be a benchmark for future cases.

Firms' selling practices

• The decision emphasises that firms will need to ensure that their customers are informed about the risks associated with their investment and that this information and the customer's understanding is clearly recorded on the relevant documents. Care must be taken to ensure that the forms completed by an investor are crystal clear.
• Firms should approach the use of sample wording in suitability letters with caution and ensure that, if it is used, it does not prevent the discussion with the customer about risk, and attitude to it, being clearly recorded and identified on the forms, and the recorded recommendation accurately reflecting this attitude.
• Firms need to ensure that the supervision and checking functions are conducted adequately enough to ensure advisers are providing information and advice as they have been trained to do and the forms are adequately designed to show that this is the case.
• However, firms will not be expected to have procedures in place which will guarantee that non-compliance will never happen and no representative will ever be in breach of an applicable rule; procedures should be reasonably effective in ensuring employees and representatives perform their functions in compliance with the relevant rules.

Learning point for the RDC

• While the Tribunal acknowledged that it had had much more time to consider the issues and had the benefit of much more evidence than the RDC, it considered that the RDC was in error in its approach to the mis-selling case and its conclusion that there was mis-selling was not justified by the PWC report put before it.

Broader points going forward

• The FSA has been criticised variously for making claims for which it does not have the supporting evidence and some believe this is because it is vulnerable to political and consumerist pressure and the desire to be seen as a tough and effective regulator. However, now, with a Tribunal that has shown itself to be independent, impartial and incisive, the FSA will need to ensure its decisions are robust enough to stand up to the Tribunal's scrutiny if it is going to retain its credibility.
• The nature of the Tribunal's decision and the fact that the Tribunal has shown itself not to be merely an FSA rubber stamp, may see a rise in the number of firms making appeals against FSA decisions, some of whom may have accepted penalties in the past for fear of the consequences of challenge.
• The immediate reaction of the FSA, as reported in the press, was that it envisaged needing to investigate cases far more intrusively in order to gather the greater evidence the Tribunal considers necessary. L&G was reported as calling for a modification of FSA's enforcement practices and a review of the independence of the RDC.
• The FSA has now announced that a review of its enforcement processes will take place to consider the processes followed by, and communication between, the enforcement department's different components, the role and involvement of senior FSA management, and its accountability to the FSA Board. The review will be led by David Strachan, FSA's director of retail firms and sector leader for insurance, and will report to an FSA Board sub-committee, which importantly will co-opt as a member the new Chairman of the RDC, Tim Herrington.
• The FSA anticipates announcing the review's conclusions in July and there is no doubt that the regulated industry will await this announcement, and the possible future changes to the investigation process, with great interest.