The regulation of professional firms

The Financial Services Authority’s long-awaited Consultation Paper 30, on the future regulation of professional firms, finally saw the light of day in late October.  Much of the contents had been widely anticipated.  As from a date which has yet to be determined in the second half of the year 2000 (referred to as “N2”), the FSA will become the sole financial services regulator and the Recognised Professional Bodies (“RPBs”), including the Law Societies, will lose their authority to regulate the financial services provided by their member firms.  The FSA will therefore become the sole arbiter of standards of qualifications and practice, through responsibility for monitoring may be contracted back to individual RPBs.

Mainstream and non-mainstream

One of the key issues addressed by the paper is where the dividing line should be drawn between what the paper terms “mainstream” investment business and the “non-mainstream” business in which solicitors who do not hold themselves out as financial experts are unavoidably involved when providing legal advice.  The intention is that the former should be subject to FSA regulation and that the latter should be excluded.

As far as mainstream business is concerned, the paper proposes two categories of person within a firm over whom the FSA should have authority.  The first category comprises “authorised” persons, i.e. financial services specialist practitioners, whether solicitors or fee-earners.  Most such persons have already passed an approved examination, but for those who have not, and have instead been accorded qualified person status through “grandfathering”, the FSA intends to retain the power to require that a specified examination should be passed at some time after N2.

The second category of person over whom the FSA will hold sway is the “approved person”, meaning broadly those within the firm who are “likely to be able to exercise a significant influence” over authorised persons or will be involved with them in dealing with clients or their property, in relation to regulated activity.  This category will certainly include compliance partners, but it may also extend to other partners and members of firms’ management committee.  Approved person status will probably not necessitate any financial services qualification, but will bring the individuals concerned within the disciplinary powers of the FSA.

The concept of non-mainstream business was discussed in a consultation paper issued by the Treasury in February 1999.  This sought views on a draft Financial Services and Markets Act (Regulated Activities) Order, delineating the scope of regulated activities under the Financial Services and Markets Bill (“FSMB”), which will replace the Financial Services Act of 1986.

One of the principal objectives of the Treasury and the FSA in structuring the new regime has been to provide reassurance to solicitors with a purely incidental involvement in financial services that they would not be vulnerable to the risk of committing the crime of undertaking regulated activity without authorisation – i.e. to avoid the need for “precautionary” authorisation.  Clearly there is an element of self-interest here, because the reality is that the FSA has no wish to double the number of organisations for which it is responsible, by taking onto its books solicitors who are not involved in financial services proper.

CP 30 makes no attempt to define “non-mainstream”, but reiterates three criteria laid down by the Treasury in its statement of 13 October 1999 on the regulation of professionals (the text of which can be found on the Treasury web site www.hm-treasury.gov.uk) and supports this with a number of examples of activity which would be likely to qualify.

The Treasury criteria are that in order to quality for exclusion from regulation:

1. the activity concerned is ancillary and subordinate to a professional service,
2. that it does not involve marketing packaged financial products and
3. that the firm receives no payment other than from the client.

Among the examples of activities cited in CP 30 as being likely to qualify as non-mainstream are:

• Solicitors arranging the scale of shares for executors or the purchase of shares for trustees, without providing investment advise.
• A solicitor acting in relation to an estate or trust holding unit trust and share certificates and collecting the dividends accruing.
• A conveyancing solicitor expressing the opinion that the mortgage which a client is arranging for himself may be unsuitable and recommending that the client consult an Independent Financial Adviser (“IFA”).
• A solicitor acting in relation to an estate and recommending the sale of all the assets, including unit trusts and shares, to pay funeral expenses and debts.
• A family lawyer obtaining from an IFA valuations and advice as to the best way of dealing with unit trusts, pensions and joint life endowment policies, and negotiating a financial settlement on the basis of this information.
• A solicitor discussing with a client investment advice received from an authorised third party, commenting upon it and arranging deals consequent upon it, but not providing alternative product recommendations to the client.

What is noteworthy about these examples is that they are all very restrictive except for the last one, which enables solicitors who profess no financial expertise to tail perilously close to the regulatory wind, by discussing with clients matters outside their own competence and making arrangements in regulated investments on the basis of those discussions.

It is perhaps because of this risk of solicitors exceeded the limits of the proposed exclusions that CP 30 anticipates that some firms may wish to seek authorisation for non-mainstream business even though they have no intention of undertaking mainstream business.  The FSA predicts – and clearly hopes – that the number of firms seeking authorisation on this basis will be “few” in number and warns that increased regulatory costs may be a deterrent.  However, it also states that such authorisation should be subject to “less burdensome” regulatory requirements (probably excluding the need for a financial services qualification).

A curious consequence of including among the examples of non-mainstream business situations in which firms act as a conduit for third parties’ advice and arrangements is that by virtue of the Treasury’s third criterion mentioned above, firms acting in this way would be prevented from receiving any remuneration from the third party for their efforts.  By contrast, if they limited themselves to referring clients to third parties and had no further involvement in the advice and arrangements, this would appear to fall outside the definition of investment business altogether, and cease to be subject to this condition (such referrals would, however, encounter a different problem, in that under the ruling of the VAT Tribunal in the 1998 case of Cheshire Trafford, commissions shared by authorised persons with introducers will be subject to VAT if the introducer has not participated in making the exempt arrangements).

CP 30 therefore opens up the disappointing possibility that there could in future be four levels at which law firms might be involved in financial services:

1. As mere introducer of business to third parties, outside the legislation
2. As an unauthorised provider of non-mainstream services
3. As an authorised provider of non-mainstream services
4. As an authorised provider of mainstream services.

Limiting unauthorised professionals’ involvement with authorised third parties to simple introductions would go a long way to achieving the simplicity of a regulated / unregulated dichotomy, which was the original objective of both FSA and Treasury.

Mainstream: the specifics

For firms conducting mainstream business, the principal concern has been the possible imposition of capital adequacy requirements.  These would impact unfairly on law firms for two reasons: first, because the requirements would be determined by reference to the revenue generated by the firm as a whole (not just from financial services;) and secondly, because the quantum would be increased to take account of the fact that solicitors (unlike financial advisers) invariably hold client money.

In the event, the FSA appears to have been influenced favourably by the value of the other client protections offered by law firms, and states that it does not plan to introduce a full financial resources regime, but rather to require firms to submit to a basic solvency test, possibly by demonstrating the ability to meet their debts as they fall due.  However, the possibility is mooted of also requiring firms to demonstrate periodically that positive net assets are being maintained at all times, which would necessitate a decision as to whether partners’ personal assets should be brought into account.

CP 30 records that suggestions have been made to the FSA that firms which provide discretionary portfolio management services should be subject to the same expenditure-based requirements as apply to members of IMRO, but indicates that it could be persuaded that this would be inappropriate at the present time.

Compensation and indemnity schemes have also come under scrutiny.  As regards compensation, the FSA notes that investment business claims on the RPBs’ professional schemes have been low, and states that it is included to accept the recommendation of the Law Societies that the profession should continue to operate its own schemes and be excluded from the Financial Services and Markets Compensation Scheme.  As regards indemnity, the FSA has concluded that it should limit itself to determining that the structure of the cover provided is appropriate to the activities to be regulated by the FSA.

The Law Societies’ lobbying has also borne fruit in relation to the accounts rules.  The FSA has been persuaded that the Solicitors’ Accounts Rules provide client protection at least equivalent to the FSA’s own similar rules, and that they should continue to be the only such rule to which firms conducting mainstream investment business should be subject.

There is, however, little that can be done to avoid the increased cost of FSA regulation, and CP 30 contemplates that the cost of authorisation might rise to similar levels to those already applicable to members of the SRO’s where the charge will usually exceed £1,000 pa “for even a smaller firm”.  Solicitors involved in mainstream investment business will also be subject to the new Financial Services Ombudsman Scheme, under which enforceable money awards can be made against firms by disgruntled clients.  It may be a small comfort that the scheme will be run by a solicitor.

Responding to CP 30

The FSA has circulated copies of CP 30 to all firms and invited comments from solicitors by no later than 14 January 2000.  Firms are encouraged to take full advantage of this opportunity.  Past experience suggests that volume of response can in itself be persuasive.  There are those whose impulse is to fight the very idea that a new regulator should seek to overturn what is arguably a perfectly satisfactory system and to impose in its stead one designed to eradicate abuse of which the profession has been innocent.  However, unless the wild card of regulator arbitrage can be played – challenging the constitutional authority of the FSA to exercise its authority in post-devolution Scotland – this battle would appear already to have been lost.

Others prefer to swim with the tide; to recognise the benefits of improved standards of competence and control and to seek to minimise the financial impact on firms’ ability to continue providing the invaluable service which only solicitors are able to offer to their clients, as men and women of affairs: a service which will be further enhanced when the profession embraces the opportunity to make solicitors the centre of new multi-professional groupings, by adopting the concept of the MDP.

Firms which have the resource and the will to provide a seriously professional financial service should be able to take the changes in their stride.  The main impact of the FSA’s proposals will be on small firms, some of which may be obligated to think in terms of using the financial services agencies of their larger brethren or possibly outsourcing to a pooled solicitors’ financial services joint venture, along the lines of the SPCs.

The overriding concern is that the new regime should not make it necessary for law firms to ring-fence and segregate financial services activities from the tax and other legal services to which they are complementary.  The pursuit of regulatory tidiness must not be permitted to prevail over the interests of the client.

Ian Muirhead is Managing Director of Solicitors for Independent Financial Advice