This article is part of our series marking the 10 year anniversary of the collapse of Lehman examining today's issues from the perspective of Lehman and Lehman's legacy.
This article examines some of the consumer protection issues which followed the collapse of Lehman Brothers in September 2008. The financial crisis which followed the Lehman collapse triggered a tsunami of litigation brought by consumers against financial institutions and, unsurprisingly, led regulators to impose a raft of changes aimed at better protecting consumers.
Tens of thousands of retail investors globally held over £1bn of investments in products issued by Lehman Brothers on 15 September 2008. When Lehman filed for bankruptcy, those products ceased providing an income stream and seemed likely to be worthless. Ten years on, the question we are asking ourselves is have all the changes intended to better protect consumers worked?
We will only really know the answer to that when the next seismic market event hits us. However, to borrow from the thematic findings in the FICC Markets Standards Board paper on “Misconduct patterns in financial markets” (published in July 2018) there are a limited number of repeat behavioural patterns, they are jurisdictionally and geographically neutral, they occur across asset classes and they adapt to new technology and market structures. So perhaps we should not be too optimistic.
So, what went wrong in 2008?
Consumer protection has been a long-standing priority for financial services regulators. A key part of the FSA’s approach in the noughties was the introduction of the Treating Customers Fairly (TCF) regime, which set out six customer outcomes which the FSA expected firms to deliver.
One of those outcomes was that “customers are provided with products that perform as firms have led them to expect’’. Given the outrage felt by customers left holding seemingly worthless Lehman paper in September 2008, it soon became clear that the TCF regime was not sufficient to protect consumers.
Immediate Lehman aftermath
A year after the Lehman bankruptcy, the FSA published three papers looking at different aspects of the Lehman backed structured products.
The first paper looked at the quality of financial promotions. Unsurprisingly, this had a focus on the explanations of the risk of capital loss. Of the financial promotions reviewed, a third were found to be not sufficiently clear with phrases such as “contingent capital protection” (which sounds very positive) being used to explain “a risk of capital loss” (which does not).
The second paper looked at the quality of advice on structured investment products sold both before and after the Lehman bankruptcy. Disappointingly, the FSA assessed 46% to be unsuitable and 23% unclear. One of the main reasons for unsuitability was that customers were exposed to an inappropriate level of risk.
The final paper was focused on TCF and was intended to be a “reminder” of product providers’ responsibilities for treating customers fairly as set out in the Regulatory Guide “Responsibilities of providers and distributers for the fair treatment of customers” (RPPD), which had been published in 2007.
In its 2010/2011 Business Plan the FSA acknowledged that its TCF regime had “in practice, remained essentially a reactive strategy”. The FSA recorded that its focus had been on appropriate sales processes and ensuring appropriate consumer redress, but that this needed to change into a more proactive supervisory approach to increase the probability of identifying issues before they gained industry wide momentum.
Post Lehman consumer complaints and litigation
With the fall of Lehman came a tsunami of litigation brought by consumers against financial institutions. Many of these related to investments which had lost money.
Some of that investment mis-selling litigation reflected genuinely poor practice by financial institutions. An example was the claim that Mr Rubinstein brought against HSBC in respect of a product which proved not to be truly “cash-like” after the insurance giant AIG stumbled in the days after the collapse. As the judge put it “it is difficult to understand how an advisor who did not realise that he was an advisor, and failed to prepare himself for his advice in the way that [Conduct of Business rules] required him to do, and failed to understand what he was advising about, and mislead his customer in the advice he gave, would serendipitously have chosen for him the most suitable of products.”
On the other hand, there were also several (often high net worth) customers who were asking the Court to order them a damages payment to recover losses for which they only had themselves to blame; they had not taken advice, had knowingly invested in a product which included a risk of loss, and that loss had crystallised.
Although there was a spike in litigation after Lehman, the majority of consumer issues over the past decade were resolved at the complaints stage, whether by firms, or through referral to the Financial Ombudsman Service (FOS). Given the importance that the TCF regime placed on ensuring that customers obtained an appropriate remedy if things did go wrong, it is perhaps a surprise that there has been so much change here. In many ways that was to do with the development of the claims industry.
In 2008 claims management companies (CMCs) were a nascent concept. They are now ubiquitous in consumer complaints, despite the mechanisms in the FCA handbook and the FOS supposedly facilitating a free and user-friendly dispute resolution procedure. Their role in the collapse of Wonga is a timely reminder that this industry has needed to seek new income streams as the financial crisis complaints have come to an end. It will be interesting to see what changes result from CMC regulation being passed to the FCA from April 2019.
It is also interesting to reflect on how differently the FSA managed its response to the Interest Rate Hedging Product mis-selling (IHRP) issue (triggered by the post Lehman low interest rates, and starting in earnest in 2011) from PPI which started two years earlier. For IHRPs the FSA stepped in relatively early, imposing s166 Skilled Persons Reviews (in the form of a redress scheme) on a number of financial institutions. This spared the Courts from the bulk of these claims and (arguably) dealt with the issue in a controlled and fair manner.
Enhanced regulatory supervision
One way that the FSA stepped up its supervision activities after its 2010 Business Plan was by undertaking several mystery shopping exercises, so as to identify poor conduct before losses had been caused and customers complained. After one such exercise Santander found itself in the Regulator’s spotlight and immediately stopped giving financial advice while it sorted out its processes. Importantly, it was not expected that any customers had lost money (as the stock market had increased since the products were acquired), however Santander was still fined over £12m by the FCA.
Another tool which was added to the FSA’s armoury was the 2013 power to intervene in the sale of products where the Regulator considered that there was a significant risk to consumers which required prompt action. At the time it was questioned whether the Regulator would ever use the power, but we have now seen it used in respect of contingent convertible instruments (CoCos), contracts for difference (CFDs) and binary options. In each case it appeared that other supervisory tools, such as Dear CEO letters and Discussion Papers, had failed to have sufficient effect and the FCA wanted to act decisively to protect consumers.
It is worth noting that the FCA’s product intervention powers have been used carefully. For CoCos, the FCA considered that they were unlikely to be suitable for the mass retail market and so restricted their distribution such that they could not be distributed to retail customers. For CFDs the FCA placed broader restrictions, including on leverage limits, applying a 50% margin close out rule, and imposing standardised risk warnings.
The FCA has also bolstered the responsibilities of providers of products by enshrining their RPPD responsibilities into new product governance rules in the Markets in Financial Instruments Directive (MiFID II). This has been coupled with focus from the EU regulators around enhanced disclosures to consumers purchasing packaged products.
Transparency regarding costs and charges
Currently there is a lot of focus on the costs and charges associated with investment services, in particular, those paid by pension schemes. The EU’s recent overhaul of MiFID I with MiFID II (which came into effect in January 2018) was the driver for that change.
From a UK perspective, our need for greater transparency of costs and charges has been highlighted by the avalanche of PPI complaints, which are not linked to Lehman but started just after its collapse. While PPI complaints arose initially from a classic mis-selling model (inadequate information provided, breach of duties to the consumer) these now largely focus on the issue of the customer not being informed of the high levels of commission wrapped up in the premium paid (following the Supreme Court ruling in Plevin), ie they are a perfect illustration of the problems that arise with an asymmetry of information.
Transparency has also driven legislators and courts in their continuing application of the Unfair Contract Terms Directive. In the UK, this was gold-plated with the Consumer Rights Act 2015, which placed further emphasis on transparency, plain and intelligible language and prominence in dealings with consumers. Meanwhile, a line of post-2008 cases in the Court of Justice of the EU repeatedly emphasised that for terms agreed with consumers to be fair they needed to be transparent. This did not mean simply clear and grammatically correct language, but also clear in the future economic effects to the consumer of agreeing to the relevant terms.
Focus on Culture and Individual Responsibility
Perhaps the most significant change to come out of the last decade has been the FCA’s focus on culture and individual accountability. The FCA noted in its 2013 Risk Outlook that: “Culture change within firms is essential if we are to restore trust and integrity to the financial sector and the FCA will continue to focus on how firms are managed and structured so that every decision they make is in the best interest of customers”.
Over the past couple of years the Senior Managers' Regime has been rolled out across the sector. Its basic principle is that a senior manager should take responsibility for the activities under their control and they should be accountable for that responsibility. We are still waiting for the first FCA Enforcement decision against a senior manager in that role, as opposed to their role as a regulated individual more generally, however from our work assisting financial institutions implement the Senior Manager rules, it does appear that this is creating behavioural change. The question remains though whether that is finally trickling down to the middle management layer which has for a while now been referred to as the “permafrost in the middle”.
So, what would we say is the Lehman legacy?
Consumers are certainly better protected than they were ten years ago. However, as the FCA notes in its current Business Plan, the long periods of negative or low inflation have led investors to gain exposure to more complex products in the hope of getting an improved return. To date many of those products are likely to either have produced a return (due to the continuing strength of the stock market) or to have not matured. So perhaps our conclusion should be that the current regime remains untested.
That said, when the FCA most recently repeated its review of suitability (which it did across 656 firms), it concluded that over 90% of sales were suitable. So why are we not all going off and celebrating the apparent improvement in consumer protection? Maybe because of the following six things.
First, the FCA Enforcement team have more open investigations into mis-selling this year than they did last year. Although it is not specified when the conduct under investigation relates to, it seems likely that some do relate to relatively recent conduct.
Second, the Financial Ombudsman Service continues to see a steady stream of complaints relating to investment advice.
Third, we are only now starting to see the wave of claims coming in from poor advice following the introduction of pensions freedoms in 2015.
Fourth, the FCA’s 2018 Retirement Options Review noted that, of those retirees not taking financial advice, 33% are retaining drawn down sums wholly in cash which is expected to mean that they will be losing out on income in retirement. This is perhaps an illustration of people still not trusting financial advisors.
Fifth, we currently face greater risks than ever from online fraud. Authorised push payment frauds are a growing problem and the FCA has currently proposed changes to its complaint handling rules to help victims. We may be being cynical here, but doesn’t that sound a lot like the approach taken with the “reactive strategy” that was TCF…?
Sixth, the protections and regulatory action considered above has not necessarily focussed on newly developing markets that were not very mature or even didn’t exist ten years ago. For example, products and markets derived from or related to cryptocurrencies have given rise to a range of risks and pitfalls for consumers (and new possibilities for abuse by malicious actors) not contemplated during the post-Lehman re-set.
The Lehman legacy from a consumer protection stand point could perhaps be described as leaving behind a regulator which is seeking to intervene more often, in more ways and earlier in the process, which must be a good thing. However, what may be the real hero of the hour is the FCA’s cultural revolution and its focus, as Andrew Bailey (FCA CEO) stated earlier this year, on the “simple concept” of “individual responsibility and accountability”. Of all of the post-Lehman changes this is the one which goes to the heart of what financial service firms are and stand for, and should ensure that the majority of consumers in the future will have a much more positive experience of the financial services industry.
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