Image of UK FSA Due Process Article.jpg
 

UK Financial Services Authority Provides Superior Due Process To Prospective Respondents When Compared With SEC Process

By Joseph I. Goldstein and Adriaen M. Morse Jr.

The authors are with Mayer, Brown, Rowe & Maw LLP's Washington office. The authors represent Sir Philip Watts, the former Chair­man of Shell's Committee of Managing Direc­tors, in SEC and FSA investigations into a 2004 recategorization of Shell's proved oil and gas reserves and the associated securities class action litigation, In re Royal Dutch/Shell Transport Sec. Litig., Civil Action No. 04-374 (D. N.J.).

 

Many Americans believe that the U.S. Constitution  gives them greater rights than those enjoyed by foreign citizens under their own legal systems, in particular in the context of governmental interaction with private citizens. Among these are freedom of speech, right to privacy, and the right to due process under the law. But when it comes to regulatory investi­gations and enforcement of the securities laws, much can be learned from the land that spawned many of the concepts that became enshrined in the Constitution. In many cases, the United Kingdom's Financial Services and Markets Act of 2000 ("FSMA") and the processes followed by the Financial Services Authority ("FSA"), the U.K.'s securities regulator, provide far greater due process than is available under the U.S. securities laws and the procedures employed by the U.S. Securities and Exchange Commission ("SEC" or "Commission") in enforcing these laws.

The FSA's processes require a full review of the mer­its of the investigative team's case by an impartial panel. During this review process, the FSA provides counsel for parties concerned in the investigation with full access to evidence. ln addition, these parties are permitted to brief the FSA's enforcement decision­-making body, the Regulatory Decisions Committee ("RDC"), as to all relevant factual and legal issues. Fi­nally, the RDC conducts a hearing on the merits of the FSA's proposed action.

These significant procedural safeguards are missing in SEC cases.

FSA Investigations Compared to SEC Investigations

At the investigative stage, FSA processes differ little from typical SEC investigations. Like the SEC, the FSA has the power to compel production of documents and attendance at interviews.[1] As with the SEC, interviews are conducted subject to criminal charges for making false statements to investigators.[2]

SEC Wells Notice

It is at the conclusion of the investigative phase that the FSA and SEC processes diverge. Once the SEC in­vestigation is completed and the SEC Enforcement Staff ("SEC Staff") decides to recommend to the SEC Com­missioners[3] that they authorize an enforcement action, the SEC Staff typically provides notice of its decision to prospective respondents. This is the first step of the "Wells process" which, although generally followed by the SEC Staff, is not mandatory.[4]

A Wells notification usually includes a telephone call from the SEC Staff to counsel for prospective respon­dents informing counsel that the SEC Staff intends to recommend an action. During the telephone call, the SEC Staff might offer a brief statement as to the general nature of the allegedly violative conduct. At the same time, the SEC Staff sends a letter that states the specific statutes and regulations the SEC Staff alleges have been violated and a general statement of the conduct that prompted the SEC Staff's recommendation. This "Wells letter" provides only a brief overview of the SEC Staff's proposed charges and is generally two to three pages in length.

Counsel may, through meetings with the SEC Staff, gain more detail as to the specific violations, but this process is inconsistent and the quality and quantity of information provided by the SEC Staff varies, depend­ing on the inclinations of the SEC Staff and the particu­lar office involved. Follow-up meetings are also discre­tionary, although typical. Prospective respondents do not have a right to review transcripts of SEC testimony, exhibits, or other documents used by the SEC Staff in its investigation and, generally, the SEC Staff does not provide access to third-party evidence.

FSA Warning Notice

In contrast to the SEC's Wells process, the United Kingdom's FSMA calls for far more information to be disclosed to subjects of investigations prior to the FSA making a final enforcement decision. The FSMA re­quires that, at the conclusion of its investigation, FSA Enforcement Staff ("FSA Staff") must set out allega­tions in a nonpublic Warning Notice that is then pro­vided to individual respondents.[5] The FSMA further re­quires that the Warning Notice, comparable to a litiga­tion complaint, contain factual allegations supporting the specific findings of the FSA Staff as to which stat­utes and rules were violated.[6]

Potential Settlement Discussions

Following the Wells notification in the United States and the Warning Notice in the United Kingdom, the regulators and prospective respondents may, and often do, engage in settlement discussions.

Post-Wells Notice Process

Following the Wells notification, prospective respon­dents have the opportunity to provide a written submis­sion to the SEC setting out reasons why the SEC Staff should not make an enforcement recommendation and why the Commission should not accept any such rec­ommendation.

When making a Wells submission to the SEC, re­spondents have no right to obtain from the SEC Staff access to its evidence, documents upon which the SEC Staff relies, transcripts of witness testimony taken by the Staff, or the advice or analysis given by the SEC Staff to the Commission. Most significantly, respon­dents have no direct access to the ultimate decision­makers--the Commission itself. Even the indirect com­munication via the Wells submission is limited: the Commission limits Wells submissions to 40 pages.

After receiving the Wells submission from a respon­dent, the SEC Staff submits a memorandum (the "Ac­tion Memo") to the SEC Commissioners, generally without attaching exhibits or evidence.[7] The Action Memo provides an analysis of the prospective respon­dent's Wells submission, and is tailored to support the SEC Staff's recommended course of action. The Action Memo, with the Wells submission attached, is for­warded to the Commissioners in advance of the non­public Commission meeting during which the SEC Staff's recommendation will be considered. Prior to the closed Commission meeting, the SEC Staff may meet with Commissioners and their staffs to discuss the en­forcement recommendation.

During a closed Commission meeting, the SEC Staff formally presents its view of the case to the Commis­sioners. The Commissioners usually vote on whether to authorize the recommended action (sometimes with mi­nor modifications) at the conclusion of the SEC Staff's presentation. Prospective respondents have no right to learn about the substance of meetings between SEC Staff and the Commissioners, no opportunity to review or respond to the points raised in the Action Memo or the undisclosed meetings, and no right to meet with the Commissioners and respond to their concerns.

Post-Warning Notice Process

By contrast, the FSA permits respondents to respond, point by point, to the FSA's Warning Notice allegations using the FSA Staff's evidence; review advice given by FSA Staff to the Regulatory Decisions Committee ("RDC"); respond to the RDC with their own comments on the advice given; and interact with the RDC and re­spond to questions from the FSA's ultimate decision-­makers.

The FSA maintains a clear separation between the FSA staff who investigate possible violations and those who decide whether the conduct at issue should be sanctioned. This separation is embodied in the RDC, with a permanent full-time Chairman[8] and three experienced panel members drawn from a pool of individu­als with business and financial expertise who are not employees of the FSA. None of the RDC members are involved in the investigations of matters by FSA En­forcement.

Recent Changes in FSA Process

Recently, the FSA process was overhauled following a loss in Legal & General Assurance Society v. FSA, in which the Financial Services and Markets Tribunal[9] criticized the FSA's decision to bring an action against several former company executives.[10]

The Legal & General case raised public and press concerns about the practice of FSA Enforcement pro­viding the RDC with undisclosed legal advice and con­ducting private discussions of the merits of cases. The Legal & General case led to a comprehensive review of the FSA's enforcement process. The FSA selected David Strachan, FSA director of retail firms and sector leader for insurance, to lead the review.[11] His team published the results of their review (the "Strachan re­port") in July 2005.

The Strachan report contained a number of recom­mendations to improve the enforcement process. These included measures to further strengthen the RDC func­tion by improving the RDC's objectivity:

  • Implementation of a dedicated RDC legal function to assist the RDC in its decision making, allowing the RDC to remain independent of FSA Enforcement in ob­taining legal advice and support;
  • Disclosure to Warning Notice respondents of all substantive communications between the RDC and En­forcement to ensure that persons subject to enforce­ment action are not defending one theory of the case while Enforcement argues to the RDC that it should ap­prove a case on a different basis; and
  • Overhaul of RDC hearings to make them interactive, preclude ex parte meetings between Enforcement and the RDC, and require full disclosure of submissions by each party to the RDC.[12]

The FSA's investigation of individuals involved in Shell's recategorization became one of the first cases to employ the RDC's new processes recommended in the Strachan report.

RDC Enforcement Decision Process

At the beginning of the RDC process, FSA Staff fol­low FSMA requirements by disclosing to Warning Notice respondents relevant documents and witness transcripts. These include both the evidence upon which the FSA relied to support its allegations as well as that which might undermine its allegations.[13] Counsel for individuals may identify additional documents that they believe the RDC should consider. In addition, if the FSA Staff withholds certain documents on the basis that the FSA Staff does not believe the documents would ''un­dermine" its case, counsel for respondents may argue to the RDC that the documents are necessary for a com­plete understanding of the case and the RDC may in­struct FSA Staff to provide the relevant documents. The evidentiary record before the RDC will include all rel­evant documents obtained by the FSA and, in the case of a joint investigation with the SEC, those obtained from the SEC that are relevant to the FSA's case.

Respondents provide written submissions to the RDC addressing the FSA's claims in the Warning Notice. FSA Enforcement may respond with written represen­tations attempting to rebut the legal and factual argu­ments in respondents' submissions. At the same time, the RDC may also send specific written questions to the parties and provide all parties with the responses to these questions.

Thereafter, in contrast to the SEC process, the RDC holds hearings to hear argument from FSA Staff and counsel for respondents as to whether it should approve the actions taken by the FSA Staff. The FSA may, de­pending upon the importance of the case, retain exter­nal barristers to argue its case to the RDC. Counsel for respondents appear before the RDC to argue their cli­ents' cases. This may include foreign lawyers, such as U.S. counsel, who are permitted to appear before the RDC and participate in. the proceeding on their clients' behalf.

Following the hearing, the RDC may issue follow-up questions to respondents and FSA Staff. Again, the RDC provides all parties with copies of these questions and each party's responses. The RDC then meets to de­cide whether it is "satisfied" that respondents' conduct violated the U.K.'s securities laws as alleged by FSA Enforcement.[14]

The RDC hearing represents the culmination of the U.K.'s regulatory due process in securities enforcement matters. The hearing provides a forum for objective and knowledgeable individuals not involved with the investigation to review the evidence and arguments and weigh whether there is a basis for an action.[15]

A Transparent Result

The FSA has demonstrated that it is capable of reach­ing a decision not to approve an action recommended by FSA Enforcement, even in difficult cases. For ex­ample, on November 9, 2005, after an RDC decision not to approve an enforcement action against former Royal Dutch Shell ("Shell") executives, the FSA announced that it "ha[d] been pursuing enquiries into the roles of certain individuals in the misstatement of Shell's hydro­carbon reserves. Those enquiries have reached a con­clusion and the FSA will be taking no further action."[16]

This decision was particularly difficult because the FSA had previously announced a "no admission no de­nial" Shell settlement that included, for the FSA, un­precedented financial penalties.[17] The FSMA's require­ment for full access to information and documents and the RDC process, which provided a hearing on the mer­its before a neutral decision-maker, permitted the FSA to make its decision upon proper consideration of all the evidence and arguments from all involved parties. A prospective respondent in an SEC proceeding cannot expect similar treatment.

Proposal

The SEC's Commissioners currently decide whether to bring actions based upon a review of an Action Memo prepared by SEC Enforcement Staff and a pro­spective respondent's Wells Submission. Unlike the RDC, they do not receive the benefit of defense coun­sel's review of the SEC Staff's case, the testing of its evi­dence, and a hearing at which argument from both sides is presented and issues can be discussed.

We propose that the SEC adopt a process similar to that followed in FSA investigations. The process should permit prospective respondents to gain access to all rel­evant evidence and provide a neutral forum to hear ar­guments from all parties and determine whether a pro­posed enforcement action should be brought. Such a process would assist the Commission in making fair and appropriate enforcement decisions.

The current process relies too heavily upon the SEC Staff's own subjective assessments as to the strength or weakness of its cases and does not provide a meaning­ful forum in which the evidentiary record can be re­viewed and considered by a neutral decision-maker aided by insights from counsel for prospective respon­dents with full access to the investigative record.

The SEC could, pursuant to the Administrative Dis­pute Resolution Act of 1990 ("ADR Act"),[18] by rule adopt a process similar to the FSA's. Many federal agencies already employ federal Alternative Dispute Resolution ("ADR") processes to resolve issues and achieve equitable results in a multitude of arenas, from agreements with the Environmental Protection Agency for cleanup of Superfund sites to resolving disputes be­fore the Federal Energy Regulatory Commission.[19]

Each executive branch agency, including the SEC, is required to "adopt a policy that addresses the use of al­ternative means of dispute resolution and case manage­ment," including "examin[ing] alternative means of re­solving disputes in connection with . . . enforcement ac­tions."[20] The SEC issued its policy in August 1998, stating that "[t]he Commission is committed to the use of ADR as a management tool to resolve disputes at an early stage, in an expeditious, cost effective, and mutu­ally acceptable manner."[21] However, the SEC's policy also specifies that "[i]t is not intended to apply to in­spections and law enforcement investigations."[22] In practice, the SEC has not used ADR as suggested in this article. The SEC has limited its use of ADR in the en­forcement context to court-ordered mediations, has not published its internal ADR guidelines, and the court-­ordered mediations in which the SEC has engaged are nonpublic.[23] In short, the SEC has not availed itself of a potential means of improving its enforcement pro­cesses.

The SEC should, pursuant to the ADR Act, appoint an appropriately composed panel that would consider spe­cific allegations made by the SEC Enforcement Staff in light of all of the evidence developed during investiga­tions. The process should, as with the FSA's, require SEC Enforcement to provide prospective respondents with a detailed written summary of specific violations of the securities laws that discusses any supporting evi­dence, provide prospective respondents with copies of the evidence relied upon by the Staff in making its case and any exculpatory evidence, and permit prospective respondents to submit their own arguments and evi­dence directly to the panel. Finally, the panel should hear oral argument from the parties and make an inde­pendent decision based on its review of the evidence.

The potential costs and administrative burdens im­posed by this proposed process would be mitigated by various factors. First, most matters that proceed to the Wells notifications stage are settled at that point. Second, in cases where the SEC intends to pursue an en­forcement action, the SEC Staff must in any event mar­shal the evidence and prepare for trial; the proposed hearing process would· require far less preparation, since it would consist of a presentation of the SEC's evi­dence obtained during the investigation. Third, many respondents would not pursue litigation of matters, whether administratively or in the federal courts, after an impartial panel had reviewed the merits of their case and decided against them. Similarly, the SEC would benefit from identifying and discontinuing non­meritorious actions prior to litigation via a relatively in­expensive, speedy administrative process. This would outweigh the costs to the SEC of lengthy litigation of non-meritorious cases to final, adverse judgments.

Conclusion

At the conclusion of FSA Enforcement's investiga­tion, the FSA process provides respondents with an opportunity to review relevant evidence and argue before the RDC, an independent decision-maker, that the pro­ceeding should not be brought.

In the United States, an equivalent for the RDC func­tion does not exist. This is unfortunate. In the United Kingdom, which does not have due process enshrined in a Constitution, a respondent receives due process both at the stage when its securities regulator makes its enforcement decision and, provided the RDC approves an action and the respondent exercises the right to re­fer the matter to a Tribunal, when a Tribunal reviews the facts de novo. In the United States, subjects of secu­rities investigations must await litigation to directly confront the investigative team's allegations. A process similar to that followed by the FSA should be adopted by the SEC.

ENDNOTES:

[1]  See, FSMA §§ 171-73.

[2]  FSMA § 17 4(3). During a joint investigation, the FSA and SEC may conduct joint interviews and testimony and share documents obtained by each regulator.

[3]  Only the full Commission may authorize enforcement actions.

[4]  The Wells process is so named because Commissioner Wells headed the Advisory Committee on Enforcement Poli­cies and Practices that recommended providing persons under investigation an opportunity to present their position prior to the Commissioners' authorization of an enforcement proceed­ing. See Procedures Relating to the Commencement of En­forcement Proceedings and Termination of Staff Investiga­tions, Sec. Rel. No. 5310, at 2 (Sept. 27, 1972) (noting that the SEC was not adopting a formal requirement that SEC Staff provide notice and permission to present a statement in all cases and that "[t]he staff, in its discretion, may advise pro­spective defendants or respondents of the general nature of its investigation, including the indicated violations as they pertain to them, and the amount of time that may be available for pre­paring a submission. The staff must, however, have discretion in this regard in order to protect the public interest and to avoid not only delay, but possible untoward consequences which would obstruct or delay necessary enforcement ac­tion").

[5]  In addition, if the Warning Notice "identifies" and "preju­dices" a person against whom an action is not proposed, the FSA is required by the FSMA to provide such a person with no­tice and an opportunity to respond. FSMA § 393.

[6]  The FSA may also provide counsel for respondents with additional materials, including any "advice on evidence" to the FSA from external counsel regarding the sufficiency of the evi­dence supporting the FSA Staff's allegations; an evidence schedule summarizing the evidence on which the FSA relied in issuing the Warning Notice; and the FSA Staff's analysis of earlier submissions made by counsel for respondents to the FSA.

[7]  The Action Memo is reviewed, in draft form, by the SEC's Office of the General Counsel ("GC") and other interested SEC divisions (e.g., the Division of Corporation Finance for finan­cial reporting and disclosure issues and the Office of the Chief Accountant in matters involving auditors), if applicable, and comments from these sources are often incorporated into the final Action Memo. In some cases, GC and other divisions may also provide summary memoranda analyzing issues within their spheres of interest.

[8]  The current RDC Chairman is Tim Herrington, a former financial services partner of Clifford Chance LLP in London.

[9]  The Financial Services and Markets Tribunal ("Tribunal")
is independent of the FSA and its members are appointed by the Lord Chancellor. FSA Handbook, § DEC 5.Ll <http:// fsahandbook.info/FSNhtml/handbook/DEC/5/1 >. Any person against whom the FSA issues a decision notice may refer that decision to the Tribunal and receive a full rehearing of the mat­ter. Id.,§ DEC 5.1.3. The FSA is required to abide by the Tribu­nal's decision and the Tribunal's order is enforceable as if it were an order of the county court or, in Scotland, as if it were an order of the Court of Session. Id.,§ DEC 5.1.7.

[10]  Legal & Gen. Assurance Soc'y Ltd, v. FSA (Financial Ser­vices and Markets Tribunal, Jan. 13, 2005) <http:// www.financeandtaxtribunals.gov.uk/decisions/seldecisions/ legal_general. pdf >.

[11]  The review looked at all aspects of the FSA's enforce­ment decision-making process:

  • the processes followed by supervisors, enforcement staff  and decision-makers when considering possible breaches of statutory or regulatory requirements, and the nature and ex­tent of the communications and interactions between them;
  • the role and involvement of senior FSA management throughout these processes;
  • options for making regulatory decisions based on a fair procedure by persons separate from the investigators; and
  • the accountability of decision-makers to the FSA Board.

FSA, Press Release, FSA announces scope of enforcement processes review (Feb. 2, 2005) <http://wwwJsa.gov.uk/pages/ library/communication/pr/2005/014.shtml >.

[12]  FSA, Enforcement Process Review: Report and Recom­mendations (Jul. 19, 2005) <http://www.fsa.gov.uk/pubs/other/ enf_process_review _report.pdf>.

[13]  FSMA § 394.

[14]  FSMA § 123(1).

[15]  If the RDC decides not to take the action proposed in the Warning Notice then, "it must give a notice of discontinuance to the person to whom the warning notice or decision notice was given." FSMA § 389(1). In contrast, if the SEC decides not to go forward with an enforcement recommendation, the SEC Staff should, but is not required to, provide respondents with a letter indicating that no enforcement action is currently con­templated by the SEC. In practice, this letter is not regularly provided.

[16]  FSA, Press Release, FSA closes enquiries into Shell indi­viduals (Nov. 9, 2005) <http://www.fsa.gov.uk/Pages/Library/ Communication/PR/2005/118.shtml>.

[17]  Final Notice to Shell (Aug. 24, 2004), <http:// www.fsa.gov.uk/pubs/final/shell_24aug04.pdf>; In re Royal Dutch Petroleum Company and The "Shell" Transport and Trading Co., p.l.c., Sec. Exch. Rel. No. 50233 (Aug. 24, 2004) (SEC Order against Shell). As part of the settlements, Shell agreed to pay penalties of £17 million to the FSA and $120 mil­lion to the SEC.

[18] Pub. L. No. 101-552, 104 Stat. 2736 (codified at 5 U.S.C. § 571).

[19]  See, e.g., Office of the Associate Attorney General, De­partment of Justice, Report to the Steering Committee, Inter­agency Alternative Dispute Resolution Working Group (March 17, 2004) <http://www.usdoj.gov/adr/asgreport0304.htm>.

[20]  Pub. L. No. 101-552, as amended by Pub. L. No. 104-320 § 4( a), 110 Stat. 3871 (Oct. 19, 1996).

[21]  Alternative Dispute Resolution Policy Statement, Ex­change Act Release No. 34-40306 (Aug. 5, 1998) <http:// www.sec.gov/rules/policy/34-40306.htm>.

[22]  Id.

[23]  See ADR Briefs: SEC Enforcement Preps for More ADR, 18 Alternatives To High Cost Litig.. 6 (Jan. 2000) ("[T]here are no specific types of cases that will get automatic ADR consid­eration. . . . The guidance requires that the case already be in litigation, either in federal court or at the administrative level. Cases under investigation won't be subject to ADR under the internal guidelines.").