City law firms unimpeded by banking relationships will be seeking a place on a new Financial Services Authority (FSA) panel of external advisers to carry out investigations into financial institutions. The panel, which will be announced in spring next year, will comprise firms that will compile reports under section 166 of the Financial Services and Markets Act (FSMA), also known as ‘skilled person’ reports, as part of the FSA’s drive towards a risk-based regulatory approach.
The FSA put out a tender questionnaire in October as part of its process to appoint the panel. The FSA will use firms on the panel when a financial services institution finds itself in trouble, using the reports to decide whether to fine or impose other sanctions.
The skilled person reports were historically the preserve of accountancy firms as they typically involved forensic examination of the banks’ finances. However, recent policy changes mean that these reports are arguably more suited to law firms to produce and they will therefore compete with accountancy practices to become approved firms.
‘As the importance of these reviews increases, with a growing number of them resulting in referrals to enforcement, it is of crucial importance that there is real rigour around the investigation of the facts, and clarity in relation to the legal and regulatory standards against which conduct or systems and controls are being assessed. These are classically the sorts of things that the leading law firms in this area have been very good at,’ said Nikunj Kiri, a partner specialising in financial regulatory work at Herbert Smith Freehills.
‘It is of crucial importance that there is real rigour around the investigation of the facts.’
Nikunj Kiri,
Herbert Smith Freehills
Work preparing these reports can be extremely lucrative. The average cost of a section 166 report, according to the FSA, is £251,000 and the highest fee paid by a single institution was £4.4m. The number of reports has also risen exponentially over the years, from 18 in 2006/07, to 140 in 2010/11.
The skilled person reports are not intended to be enforcement against financial institutions; they are principally information- gathering exercises or audits. However, given that many firms count major financial institutions among their clients, it raises the spectre of conflict of interest.
‘There’s a risk of a conflict between being the financial institution’s trusted adviser on the one hand and acting as an independent skilled person who reports on them to the regulator on the other,’ said Peter Bevan, a partner at Linklaters.
Under the current system, the FSA asks the institution to appoint a skilled person to prepare a report. The engagement continues to be with the client but the skilled person is ultimately reporting to the FSA. However, the FSA has new powers allowing it to contract directly with the skilled person, so the client of the skilled person becomes the FSA and not the financial institution itself.
Naturally, firms are reticent in declaring their intention to be on the panel. Sidney Myers, head of Berwin Leighton Paisner’s financial services regulatory practice, was unable to confirm whether BLP was seeking a place on the FSA-approved list. However, he said: ‘I can confirm that BLP has been appointed as a skilled person under section 166 FSMA several times in the past.’ Other firms, including Norton Rose, Shearman & Sterling and Ashurst, all refused to comment, while one partner at another City firm claimed to be ‘handcuffed’ and unable to answer.
Herbert Smith Freehills was slightly more forthcoming in stating that it was unlikely to tender for a position on the panel. ‘If you have a good relationship with a financial institution and you are asked to do a report on them for the FSA, for example with a view to identifying weaknesses in that firm’s governance, systems or controls, it has the potential for putting you in an invidious position with the institution, in terms of managing the relationship with them and possible tensions with the FSA,’ said Kiri.
‘We have occasionally been asked whether we would be willing to be appointed as a skilled person, but historically we have chosen not to take on these mandates,’ said Kiri.
Instead, the firm assists clients in managing the skilled person process rather than acting as the skilled person itself. For instance, it assists clients in communicating with the skilled person and making sure its report is accurate.
Bevan said one of the reasons his firm might become a skilled person is to be in a better position to help clients. ‘In those cases we might agree to take on an appointment as a skilled person, because that would actually be a very helpful experience for us to see the regulators on the other side,’ he said.
The Big Four accounting firms undertook half of the 88 section 166 reports in 2009/10, with top law firms handling just 1%. However, Karen Anderson, a partner in the financial services regulation team at Herbert Smith Freehills, said that using accountancy firms for these reports could give rise to a potential conflict of interest. ‘The FSA thinks that if an accounting firm has an audit relationship or has done a lot of consulting with a particular client, that might cause them to think whether they’re sufficiently independent to do the work of a skilled person,’ she said.
The likely increase in this type of investigation next year is largely the result of political and public pressure on financial institutions and the regulator. ‘In the current political environment the stock of banks is low and the stock of regulators has also been threatened,’ said one City partner. ‘They want to be seen to be doing their jobs.’
It will be interesting to see next year which firms will be prepared to potentially sacrifice their relationships with banks to pursue this revenue stream.