This article was originally written for and featured in InCOMPLIANCE.
Franklin D Roosevelt once said: “rules are not necessarily sacred, principles are.” Wise words which went unheeded by Yohichi Kumagai, the former executive chairman and managing director of the London branch of the Japanese insurer, Mitsui Sumitomo (“MSIEu”). Mr Kumagai’s breach of Principle Three of the FSA’s Principles for Businesses and Statements of Principle Five and Seven of the FSA’s Statements of Principles and Code of Practice for Approved Persons resulted effectively in his life-time ban from working in the UK in the financial services sector, in addition to a personal fine of £119,303. MSIEu itself was fined £3.35 million by the FSA and both those fines were discounted by 30 per cent because Mr Kumagai and MSIEu agreed to settle at an early stage of the FSA’s investigation.
Senior management must take responsibility for the firms they run
The case of Mr Kumagai provides salutary lessons for those in senior management roles, especially for foreign firms wanting to establish a presence in the London/UK market. This is because many of the factors which led to Mr Kumagai’s demise arose through the fact that he was responsible for the Japanese’s parent company’s growth into non-Japanese client business in Europe and the Middle East, without being sufficiently careful to ensure proper regulatory compliance. This was made worse by the fact that despite the FSA putting him on notice as to which areas needed to be remedied, he failed to take the necessary steps.
There can now be no misunderstanding as to the FSA’s hardening attitude towards regulatory compliance. In commenting on the case, Tracey McDermott (acting head of enforcement, whose appointment as the FSA’s permanent director of enforcement and financial crime has just been announced) said of Mr Kumagai’s case:
“senior management must take responsibility for the firms that they run. Kumagai failed to respond adequately to the changing risks facing his business even after they had been pointed out by the FSA. If those who hold senior positions in financial services firms had had any doubt about how seriously we view their regulatory responsibilities this fine and ban should make our position crystal clear.”
The three key areas upon which the FSA focused when evaluating where the risks in MSIEu’s business lay were the need for:
- An appropriately skilled and experienced board
- Proper Management Information (“MI”)
- Capital Adequacy
Skill and experience
It was explicitly stated to Mr Kumagai by the FSA that expansion into European markets would need careful and focussed oversight from an appropriately skilled and experienced board. The FSA was particularly concerned that MSIEu’s senior personnel did not possess sufficient skill and experience of both the underlying non-Japanese underwriting business and also of the UK regulatory system. Plainly the real risk of having inexperienced senior staff is that systemic risks can go unnoticed and unchallenged with potentially catastrophic results for the UK market and/or consumers.
As Chief Executive, it was held to be Mr Kumagai’s duty to ensure that critical posts within the organisation were filled with appropriately skilled individuals, and the FSA found that he had failed to discharge that duty. By way of example, MSIEu is an insurance business, yet Mr Kumagai did not have a Chief Underwriting Officer. That failure came in for particular censure by the FSA, as did the fact that other crucial roles remained unfilled or filled only on a temporary basis.
Proper Management Information
This case reiterates the importance of having clear and effective MI in order that senior management can control and regularly assess the business.
MSIEu’s failure to implement adequately a proper IT infrastructure for underwriting and the processing of claims also led to MSIEu’s fine and Mr Kumagai’s ban and fine. Without an appropriate IT system in place, it was apparent that senior management, the finance function and auditors could not access up-to-date financial information with the risk that the amount of reserves that MSIEu ought to have been holding in order to meet all future claims could not be calculated properly, leading to deficiencies in the reserves.
The FSA considered that Mr Kumagai should have taken better steps to make sure that those members of staff to whom the task of implementing the IT system had been delegated were competent.
The point to note is that senior managers bear a responsibility to monitor employees in key and senior roles to ensure that those employees are capable of performing their roles proficiently and to a high standard, and are actually doing so.
The FSA has strict requirements as to the amount and quality of capital that a firm should hold at all times. The reason for this is that capital adequacy provides a buffer against a firm’s failure and consequently guards against disorder in the market. MSiEu failed to hold sufficient capital to meet the FSA’s requirements.
The Final Notice observed that:
“Mr Kumagai’s failure to address doubts about MSIEu’s capital adequacy in a more timely manner shows insufficient understanding of the importance of timeliness in dealing with compliance with regulatory requirements, even if he was confident that additional capital could be required at short notice from its Parent Company.”
A month or so before Mr Kumagai was fined and banned, John Pottage, the former chief executive of UBS’s wealth management business in the UK, successfully challenged in the Upper Tribunal a £100,000 fine levied by the FSA for corporate governance failings. Mr Pottage was alleged to have breached Principle 7 by failing to supervise his own team adequately and by failing to ensure that proper checks and balances were in place on his desk. The somewhat beleaguered UBS was fined £10 million (later reduced to £8 million).
The Upper Tribunal held that the actions taken by Mr Pottage to deal with operational and compliance issues as they arose were reasonable. The FSA’s retort was predictably bullish:
“we have always recognised that pursuing disciplinary action against senior management in large firms is very challenging. But we also believe strongly that senior management must take responsibility for the businesses they run.”
The absence of any actual failure at MSIEu and Mr Pottage’s acquittal begs the question why Mr Kumagai was handed such a draconian penalty. The authors suggest that the answer lies in the fact that determining what is operationally reasonable is not a straightforward check-box exercise. Each case appears to turn on its own specific facts. The approach of the FSA appears to be that these more difficult cases need to be pushed; otherwise, only dishonesty cases will be run (which are much easier to prosecute), leaving a large area of exposure.
In any event, it would appear that the financial penalty handed to Mr Kumagai was relatively modest considering his position. In 2012, for individuals, fines ranged from £11,550 for Mr David Thornberry, a compliance officer, for failings in relation to the protection of client money to £3,638,000 for Mr David Einhorn for engaging in market abuse. The serious financial penalties are meted out where an individual has behaved dishonestly and/or for personal gain. There was absolutely no suggestion of dishonesty on the part of Mr Kumagai.
In addition, the following mitigating factors greatly assisted Mr Kumagai: he fully co-operated with the independent review into the firm’s failings; he recognised at an early stage that the steps he had taken at the material time had been insufficient and resigned voluntarily; he co-operated fully with the FSA investigation; and he had had a long and successful career in Japan with no previous disciplinary findings recorded against him. Accordingly, the lesson to learn is that there is usually an advantage to be gained in co-operating with the FSA at the early stages of an investigation.
The Final Notice for Mr Kumagai and MSIEu was published on 8 May 2012. Later that month, Hector Sants, the FSA’s then Chief Executive, made his last speech as CEO of the FSA in which he stated his view that the financial crisis of 2008:
“exposed significant shortcomings in the governance and risk management of firms and the culture and ethics which underpin them. This is not principally a structural issue. It is a failure in behaviour, attitude and in some cases, competence. While the issue of good governance is primarily for firms and shareholders to address… events have demonstrated that regulators should play a role. Indeed, post the crisis, society and parliament made clear that they expect regulators to have a view and be willing to intervene. I personally feel that insufficient progress has been made on the key issue of effective corporate governance.”
The authors are seeing more and more cases where the FSA is challenging firms in all areas of their businesses, and are attempting to link those to the overall corporate governance of the firm, even in circumstances where there is no obvious connection. The FSA is examining what and how messages from the top are being filtered down to the front-line. All firms (and their senior managers) should take note of decisions such as the one in Kumagai and ensure that their arrangements are in good order because the FSA is on the prowl.