How jailing and fining UK financial industry non-exec directors could scare off talent

The global financial crisis in 2007–08 and the following recession were blamed in the US in part on "high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators" (Levin–Coburn Report of the US Senate).

The Financial Crisis Inquiry Commission also targeted failures in corporate governance and risk management at financial institutions.

These conclusions have been echoed in the UK, and the future role and accountability of senior management in avoiding another crisis or scandal have been scrutinised by many observers.

In response to these concerns, the UK government legislated last year to tighten the accountability of senior managers of financial institutions.

The new regime

The results of a recent consultation on the implementation of that legislation by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) are to be published shortly.

The FCA and the PRA proposals include a new senior managers regime (SMR), which will increase senior managers' individual accountability. The SMR will apply to non-executive directors of banks and other firms subject to regulation by the FCA and PRA.

Under the SMR, individuals seeking to become non-executive directors will be need to be authorised by the FCA, which will assess whether the candidate is a fit and proper person to perform the role in question.

The objective is to ensure "firms have high quality individuals in key roles to promote the right culture, governance and conduct to achieve fair outcomes for customers and ensure market integrity".

The FCA will also take a more "forward-looking and pre-emptive approach" to the ongoing supervision of firms, keeping the effectiveness of senior management under ongoing review.

Most notable, however, are two changes to the way in which non-executive directors will be held accountable for their decisions.

First, non-executive directors will be caught by a new "presumption of responsibility" for senior managers. If a firm breaches a regulatory requirement, non-executive directors will have to satisfy the regulator that they took "reasonable steps" to prevent the breach.

If they cannot, they could face financial penalties, as well as a suspension of their approval by the regulator. In effect, this means non-executive directors will face a presumption of guilt: if the firm breaches a requirement, the directors will be held responsible unless they can prove otherwise.

Secondly, if a firm fails, then a non-executive director could be prosecuted for a new criminal offence relating to "a reckless decision causing a financial institution to fail". The maximum sentence will be two years' imprisonment, though the FCA expects "such prosecutions will be rare".

What are the likely effects of these changes?

In an annex to the consultation document, Europe Economics (EE), a consultancy specialising in economic regulation, concludes that "detrimental labour market effects are a key indirect impact of the regulatory proposals".

As EE notes, "most individuals are likely to perceive the threat of imprisonment as a significantly more severe sanction than existing pecuniary sanctions, such as clawback and malus".

Some firms responding to EE's survey thought it would be "particularly difficult to retain non-executive directors, who are not remunerated in the same way as executive directors".

As EE comments, the reforms could mean that the more risk-averse, in particular, may be deterred from taking up non-executive directorships, because of the further liability under the new regime. This "could lead to the unintended consequence that positions are taken, on average, by less risk-averse individuals, as they are prepared to take on the additional responsibility".

That would be a perverse effect, since the purpose of the reforms was to encourage a more cautious approach to the governance of financial institutions.

Two other developments are likely to make it more difficult for firms to find non-executive directors in future.

The European Union's Capital Requirements Directive (CRD IV), which became effective in the UK in July, provides that directors of larger ("significant") investment firms may not hold more than either one executive directorship with two non-executive directorships, or four non-executive directorships.

This restriction on the number of non-executive directorships an individual may hold is likely to reduce the pool of available candidates.

At the same time, the UK's ring-fencing regime will require banks to separate their core banking services for individuals and SMEs from their investment arms.

Since the different operations must be carried out by independent legal entities, each with its own board, more non-executive directors will be needed.

It is difficult to argue against increasing the level of corporate governance and risk management within financial institutions.

Nevertheless, the right balance needs to be reached between punitive action and not scaring off good quality non-executive directors from taking on roles in large financial institutions where the penalty for getting it wrong could include imprisonment.

Simon Staples is a partner in the corporate team and head of capital markets at Ashfords LLP