In the wake of the financial crisis, the Government has sought to diminish the extent to which financial institutions can hide beneath the umbrella of “collective responsibility”, and, in the words of the Parliamentary Commission for Banking Standards, “make individual responsibility in banking a reality”. To achieve this, it was announced that the recently-finalised Senior Managers’ Regime would come into effect on 7 March 2016.
The Senior Managers’ Regime will mark a culture shift in the regulation of financial institutions and their senior employees by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
To start with, the regime will apply to all UK banks, building societies, credit unions, PRA designated investment firms and UK branches of foreign banks. It is anticipated that HM Treasury may expand the scope of the regime to non-UK incorporated financial institutions.
Impact on financial institutions
Allocation of responsibilities
The regime is designed to provide for a clearer allocation of senior responsibilities. The “Significant Influence Function’” of the old regime has been replaced by the “Senior Management Function” (SMF), the scope of which has been extended to heads of key business areas, chairmen and non-executive directors. Importantly, those carrying out SMFs can be held responsible for poor boardroom decisions.
In order to give teeth to the reforms, firms will be required to provide “Statements of Responsibility” to the FCA and PRA when applying for approval in respect of any officers carrying out SMFs. Before a senior manager relinquishes their responsibilities, a “Handover Certificate” must be prepared explaining how they carried out their functions and identifying any issues.
Finally, to ensure that firms have all bases covered, institutions must provide a “Management Responsibilities Map” which sets out the key responsibilities of senior managers as well as reporting structures.
Reversal of the burden of proof
Previously, a regulatory breach by a firm would “imply” the misconduct of any individual who was “knowingly concerned”. Under the new regime, if a breach occurs in an area that is within an officer’s SMFs, that person will be guilty of misconduct unless he can show he took reasonable steps to avoid the breach. This is likely to lead to significant costs shifting away from the FCA to the individual’s lawyers, as the burden of proof now rests with the individual’s lawyers to prove their client’s innocence. This will have a consequential effect on the average investigation and defence costs incurred per individual under D&O insurance.
Extension of the time limits for disciplinary action
The time limit for the FCA or PRA to take disciplinary action against firms or individuals is extended from three to six years. In the case of misconduct, this will run from the date from which the regulator knew of the misconduct. In the case of failure to obtain approval in respect of a person carrying out SMFs, this will run from the date on which the officer began performing the unapproved function.
New criminal offence
Although it is anticipated that prosecutions will be rare, the regime also introduces a new criminal offence of “taking a reckless decision which causes a financial institution to fail”.
So what is the impact of this on D&O insurance?
In most cases, insurers will be considering tweaks to their policies as opposed to overhauls. There are, however, a few key areas which may require consideration.
Non-Executive Directors (NEDs)
Under the new regime, certain NEDs will also be considered to perform SMFs. Many policies distinguish between NEDs and executive directors because, historically, claims and (in particular) regulatory investigations have not targeted NEDs. It has been easier for NEDs to disclaim responsibility for decision-making and assert a lack of awareness of the events taking place within firms. Under the new regime, a NED with a particular SMF is more likely to be the subject of regulatory attention. Thought will therefore be required to the main limit of the policy versus any additional sublimit set aside specifically for NEDs.
However, the impact on NEDs should not be overstated and the board of directors may also wish to see some ring-fencing of cover given that they are still likely to be in the firing line for the majority of claims.
Insured v insured carve outs
In line with the cultural shift expected of financial institutions, there is likely to be heightened pressure to self-report and commence enquiries of senior managers which could then result in a regulatory investigation and/or an insured versus insured claim. Such claims are unlikely to fall within existing carve outs for “recognised” insured versus insured claims and reconsideration of policy terms may be called for.
Interaction between professional liability and D&O insurance
Although regulatory action is likely to focus on senior managerial individuals in their capacity as such, third party claims against such individuals and the entity may emanate from professional services to third parties. Further, there is not always a clear delineation between investigation of individuals in their senior managerial capacity and investigation in connection with the provision of professional services, the latter of which will be excluded under the D&O insurance. The adequacy of the professional liability cover will still need to be considered, therefore, and it will be necessary to ensure that the insurances dovetail so that there is no gap in cover.
Increase in investigation/defence costs
As highlighted, the reversal of the burden of proof is likely to lead to increased investigation and defence costs. Furthermore, the extension of the limitation period for the regulators to bring a claim is likely to lead to more claims being brought. Policyholders may therefore perceive that an increase to the level of D&O cover is required. That said, in circumstances in which the majority of the policyholders to whom the new regime will apply are likely to have several layers of cover available to them, it may be, instead, that it is a case of a more significant proportion of existing limits being eroded in future and a possible knock on effect on premium.
Although a significant change in practice for financial institutions, for those providing D&O cover the changes are likely to be more in degrees of emphasis than radical policy revision. It is however important to be aware of the regime and the potential for increased scrutiny of D&O insurance that this may bring.