Investor Protection in the United Kingdom

1. Investor Protection in the United Kingdom Prepared for China Securities Investor Protection Fund Nicholas Morris, Managing Director, Asia January 2008

2. Disclaimer IPA has based the comments in this presentation on review of the legislation, documentation and regulations relating to financial services in the UK. In doing so, it has used its professional judgement to summarise, paraphrase and interpret the rules. However, IPA cannot be held responsible for any actions taken on the basis of this presentation. It strongly recommends that reference is made to original materials before any action is taken in these complex areas.

3. Agenda • UK Legal and Institutional Framework • Relationship to European legislation • Regulation and self-regulation • Evolution of investor protection system in UK • Financial Securities Compensation Scheme • Role and objectives • Organisational structure • Funding arrangements • Coverage and payment processes • Limits to compensation • The FSCS 2007 Funding Review • Financial Ombudsman Service • Role and objectives • Organisational structure • Detailed aspects of the system • Co-operation between agencies • Bankruptcy of securities companies • Investor Education in UK

4. UK Legal and Institutional Framework

5. The Modern UK System • The Financial Services Authority, the Financial Ombudsman Service and the Financial Services Compensation Scheme are separate organisations • Each of these organisations is an independent body, set up under the Financial Services and Markets Act 2000. • The Financial Services Authority (FSA) is the regulator (or “watchdog”) for financial services firms • The Financial Ombudsman Service (FOS) deals with complaints from consumers against firms that are regulated by the Financial Services Authority and it can require firms to pay compensation • The Financial Services Compensation Scheme (FSCS) can pay compensation to consumers with claims against firms that are regulated by the Financial Services Authority and financially unable (or likely to be unable) to pay the claim themselves.

6. Some UK History • 1980s: greater competition, mergers between banks, brokerage firms and dealers. • 1986 Financial Services Act introduced a two-tier system of regulation. • The Act created the Securities and Investments Board (SIB) to oversee five self-regulatory organisations (SROs): • The Securities Association for brokers and merchant bankers; • The Association of Futures Brokers and Dealers (AFBD) for futures and options; • the Financial Intermediaries, Managers and Brokers Regulatory Association (Fimbra) for high street investment advisers; • The Life and Unit Trust Regulatory Association (Lautro) for life insurance, pensions and unit trusts; and • The Investment Management Regulatory Organisation (Imro) for fund managers. • The first two merged to form the Securities and Futures Authority (SFA), and the second two merged in mid 1990’s to form the Personal Investment Authority (PIA).

7. Problems in the UK System • Disasters in the financial services industry precipitated recent reforms in the UK. • For example: • Collapse of Barings, the UK’s oldest merchant bank, in February 1995. This resulted in some £800m of losses incurred on the Singapore exchange via the actions of the so-called rogue trader Nick Leeson. • The Bank of England and the Securities and Futures Authority (SFA) shared responsibility for the regulation of Barings’ banking and securities activities, but clearly failed to detect any problems. • An official report by the Banking Board of Supervision was very critical of the lax regulation of both the SFA and the Bank of England. • Even after the collapse of Barings, problems continued as the SFA’s attempts to punish Barings’ managers for not detecting the presence of rogue trading largely failed. • Other notable difficulties that beset UK financial services in the 1990’s include pension mis-selling, the Maxwell pension scandal, and the BCCI collapse, inter alia • Government response was to set up the Financial Services Authority (FSA)

8. Legislation and Role of the FSA • The UK regulatory regime is now determined by the Financial Services and Markets Act 2000. • It gives the Financial Services Authority (FSA) four statutory objectives: • Maintaining market confidence in the financial system • Promotion of public understanding of the financial system • Consumer protection • Reduction in financial crime

9. UK Statutory Framework • HM Treasury, Financial Services Authority (FSA) and Bank of England are all responsible for aspects of financial services regulation • Inter-relationship is governed by a formal ‘Memorandum of Understanding’ between them • Competition Commission, Office of Fair Trading and Stock Exchange also involved • Stock Exchange, and its members, are formally permitted to ‘self regulate’

10. FSA Responsibilities • Authorisation and prudential supervision of banks, building societies, investment firms, insurance companies and friendly societies • Supervision of financial markets and of clearing and settlement systems • Conduct of operations in response to problem cases affecting firms, markets and clearing, and settlements systems within its responsibilities • Regulatory policy in these areas • The FSA will also advise on the regulatory implications for firms, markets and clearing systems of developments in domestic and international markets and of initiatives, both domestic and international, such as EC directives.

11. Responsibilities in the UK System

12. Supporting Legislation • The Financial Services and Markets Act 2000is supported by a large number of orders, regulations and provisions, including: • Asset Identification Rules • Legal Assistance Regulations • Money Laundering Regulations • Compensation Scheme Regulations • Designated countries and territories • Reconition requirements • Mutual Societies Orders • Disclosure regulations • Bankruptcy and treatment of assets rules • Gaming contracts orders • Rehabilitation of offenders

13. Relation to European Legislation

14. Development of European Financial Markets • In 1999 the ambition of a fully integrated financial market was expressed in the EU's Financial Services Action Plan, which stated an ambitious timetable up to 2005 for the revision of the EU regulatory regime in the financial area, including the directives concerning the securities markets. • The changes concerning the regulation of securities relate especially to the following directives: • The Markets in Financial Instruments Directive, MiFID, (previously the Investment Services Directive) • The Prospectus Directive • The Market Abuse Directive • The Transparency Directive • The Takeover Directive

15. Markets in Financial Instruments Directive (MiFID) • Promotes competition and standardise regulatory requirements across the European Economic Area. • MiFID applies to a broad range of instruments, including transferable securities, money market instruments, units in collective investment undertakings and various types of derivative. • MiFID envisages trading in financial instruments taking place on regulated markets operated by a market operator (e.g. the Exchange’s Main Market), multilateral trading facilities (such as AIM), which can be operated by market operators or investment firms, or on an over-the-counter (“OTC”) basis. • The MiFID framework is made up of the overarching, high-level directive and a range of additional measures. These include implementing laws (a directive, which it is necessary for individual Member States to transpose into national law, and a regulation, which has direct force) and recommendations developed by regulators on a pan-European basis (the so-called “Level 3” measures).

16. European Parliament and Council Directive : 97/9/EC: Investor-Compensation Schemes • Enacted on 3 March 1997 • Requires Member States to set up one or more investor compensation schemes. • All investment firms supplying investment services must belong to such a scheme (credit institutions may be exempted provided that they already belong to a scheme which guarantees protection at least equivalent to that provided under a compensation scheme and that they fulfil certain specific conditions). • The compensation scheme operates where: • the competent authorities have determined that in their view an investment firm appears, for the time being, to be unable to meet its obligations arising out of investors' claims and has no early prospect of being able to do so; or • a judicial authority has made a ruling which has the effect of suspending investors' ability to make claims against an investment firm. • Cover has to be provided for claims arising out of an investment firm's inability to: • repay money owed to or belonging to investors and held on their behalf in connection with investment business; or • return to investors any instruments belonging to them and held, administered or managed on their behalf in connection with investment business. • The Directive sets a Community minimum level of compensation per investor of Euro 20,000

17. Example of European investor protection NGO • The European Group for Investor Protection (egip, Europäische Investorenschutzvereinigung e.V.) is an independent, registered NGO seated in Berlin and serving the dialogue between capital markets and politics. • Egip aims at helping to improve the framework for institutional investors in Germany and the European Union, and to promote a more professional Corporate Governance. One basic prerequisite for that is a better public understanding of the developments in the international capital markets. Egip is engaged in improving that understanding. • Egip is financed through services for long-term institutional investors (e. g. pension funds, investment companies, and asset managers), who use us as a think tank and communication platform. 

18. Regulation and Self-Regulation

19. Stock Exchange Self-Regulation • FSA is concerned with investment banks and brokerages treatment of customers • are they being advised correctly and not defrauded? • Stock Exchange regulates through their rules and procedures, with self-regulatory status • Market surveillance by exchanges is a key requirement of their self-regulatory status • Concerned with orderly markets, transparency, level playing fields and investor safety • Includes audits to ‘assist’ members in self-regulation

20. Stock Exchange Rules for Members • The Exchange is has recently undertaken a full review all of its secondary market Rules with three key objectives: • to ensure the Rules effectively govern member firms’ on Exchange business in a post–MiFID environment; • to align the Exchange’s Rules more closely with the structure of the various trading platforms; and • to simplify the Rules wherever possible and make them more user friendly. • Member firms were consulted throughout the proposed Rulebook re-write.

21. Lloyds (Insurance Market) Governance • An Act of Parliament, the Lloyd's Act 1982, defines the management structure and rules under which Lloyd's operates. Under the Act, the Council of Lloyd's is responsible for the management and supervision of the market. • The Council normally has six working, six external and six nominated members. • The appointment of nominated members, including that of the Chief Executive Officer, is confirmed by the Governor of the Bank of England. • The working and external members are elected by Lloyd's members. • The Chairman and Deputy Chairmen are elected annually by the Council from among the working members of the Council. All members are approved by the FSA. • The Council can discharge some of its functions directly by making decisions and issuing resolutions, requirements, rules and byelaws. Other decisions are delegated to the Lloyd's Franchise Board and associated committees.

22. Lloyds Management

23. The FSA and Lloyds • Lloyd's is regulated by the UK Financial Services Authority (FSA), under the Financial Services and Markets Act 2000. • The FSA also regulates Lloyd's managing agents, members' agents and Lloyd's brokers.  • The FSA and Lloyd's have common objectives in ensuring that Lloyd's market is appropriately regulated and, to minimise duplication, the FSA has agreed arrangements with Lloyd's for the co-operation on supervision and enforcement. • Lloyds runs a general fund for consumer compensation, and FSCS only intervenes if the General Fund is unable to provide support Structure of Lloyds Insurance Market

24. Evolution of the Investor Protection System in UK

25. Evolution of UK Investor Protection Rules • Initially set out in “A new framework for Investor Protection” White Paper, DTI, 1985 • Covered regulatory system and the scope of regulation; institutional structure; `Fit and Proper‘ test; rules for the conduct of business; competition; unit trusts; marketing of life assurance, unit trusts and similar investments; pensions; advertising and promotion of investments; public issues and take-overs; insider dealing; and enforcement. • Today this has developed into the FSA handbook system

26. The FSA Handbooks • FSA has integrated all financial services regulation and now administers through a system of handbooks • Developed as an online system • http://fsahandbook.info/FSA/index.jsp • Full handbook covers all types of firms • ‘Tailored’ handbooks cover specific types of firm • There are tailored handbook for different types of investment firms

27. High Level Principles of FSA • Principles for Businesses • fundamental obligations of firms • Senior Management Arrangements, Systems and Controls • Threshold Conditions • minimum standards for becoming and remaining authorised • Statements of Principle and Code of Practice for Approved Persons • The Fit and Proper test for Approved Persons • General Provisions and Fees

28. Conduct of Business for Investment Firms

29. Financial Securities Compensation Scheme

30. Establishment of the Financial Services Compensation Scheme (FSCS) • Financial Services and Markets Act 2000 required FSA to make rules for compensating customers when authorised firms are unable to do so • The Financial Services Compensation Scheme is the sole financial compensatory scheme. It was set up by the Financial Services Authority (FSA) in December 2001, and replaced: • Building Societies Investor Protection Scheme • Deposit Protection Scheme • Friendly Societies Protection Scheme • Investors Compensation Scheme • PIA Indemnity Scheme • Policyholders Protection Board

31. Duties of FSCS • Operate a compensation scheme that is procedurally fair and in accordance with the European Convention on Human Rights • Pay compensation to eligible claimants when a relevant person is (likely to be) unable to meet claims against it • FSCS may agree to pay reasonable costs of eligible claimant bringing or continuing insolvency proceedings against a relevant person • Make levies on participant firms in accordance with scheme funding rules to enable it to pay compensation, secure continuity of insurance or meet the costs of discharging its functions • Publish information for claimants and potential claimants on the operation of the compensation scheme, including making potential claimants aware as soon as possible after a default • Make and publish an annual report to the FSA

32. Recent FSCS Performance • FSCS completed over 31,200 claims in 2006/07 and spent just under £27.2m on management expenses. • 2006/07 was the first year that decisions made on claims exceeded new claims received. • Whilst endowment claims were the main focus, areas of claims presenting new challenges included splits, credit unions, Pensions Review claims and claims against insurance brokers. • Recoveries amounted to almost £40m. • Taken from FSCS Chief Executive’s Report, 2006/7

33. FSCS Claims Experience • For the financial year 2006/07 • Total claims completed were 31,260, an increase of 21% on 2005/06. • Total claims received were 24,540, a decrease of 2% on 2005/06. • The majority of new claims received related to endowments (21,675). • 86% of endowment claims were dealt with within six months. • Insurance payments numbered 16,844. • Total compensation payments amounted to £ 149.47m. • From 1 December 2001 – 31 March 2007 • Total claims completed were just over 73,700. • Total claims received were just under 84,200. • Insurance payments numbered 251,738. • Total compensation payments amounted to £958.29m, including insurance payments of £561.35m. Source: FSCS Annual Report 2006/7

34. FSCS Growth in Claims Claims received Decisions made

35. FSCS Enquiries Calls Correspondence

36. Number of Claims in 2006/7

37. Financial Summary • For the financial year 2006/07 • Total compensation payments amounted to £ 149.47m. • Total levies raised amounted to £73.10m. • Total recoveries received amounted to £39.98m. • Total management expenditure amounted to £27.18m. • Fund balances at 31 March 2007 amounted to £ 139.09m. • From 1 December 2001 – 31 March 2007 • Total compensation payments amounted to £958.29m. • Total levies raised amounted to £737.58m. • Total management expenses amounted to £89.56m. • Total recoveries received amounted to £360.37m. Source: FSCS Annual Report 2006/7

38. FSCS Payments by Type Insurance Investments Pensions Source: FSCS Annual Report 2006/7

39. Levies 2006-7 Source: FSCS Annual Report 2006/7

40. FSCS Investment Claims Process Source: FSCS Annual Report 2006/7

41. Source: FSCS Annual Report 2006/7

42. FSCS Governance • Follows the provisions of the Combined Code on Corporate Governance issued in July 2003 (updated in June 2006) - UK listed companies • Board • Non-executive Chairman • 7 non-executive Directors • Chief Executive and Director of Claims • Induction, appraisals and training for Directors • Finance and Audit Committees • Claims Decisions Committee • Board Composition and Splits Working Groups • Operation of a Risk Register • Publishes all defaults in Annual Report

43. Financing FSCS • As at 31 March 2007: • FSCS had negotiated facilities for business purposes of £52m, comprising a 364 day revolving credit facility of £50m, repayable over 5 years, at a floating rate of interest based on LIBOR; and an overdraft facility of £2m at a fixed margin above base rate. • FSCS held £2.017 million in short term deposits • During the year FSCS received £126,000 in interest and paid £72,000 in finance leases (£36,000 of which was allocated to future periods)

44. Rules on Compensation • Detailed rules specified in FSA Handbook • 14 Chapters specifying, for example: • How the FSCS should operate • Eligibility for compensation • Definition of when financial difficulties occur • Assignment of rights • Limits to compensation • Payment and calculations • Funding • Paticipation by EEA firms (who can ‘top up’ schemes operated by Home States) • Specific application to Lloyds (where the Central Fund is expected to pay if it can)

45. Some Compensation Specifics • To receive compensation, must be eligible, have protected claim, claim against relevant person in default, normally within 6 years and assign rights to FSCS • FSA Handbook specifies detailed list of persons not eligible to claim • In the case of insurance insolvency, FSCS will first try to find continuity of insurance • Limits apply to different types of claim. In most cases amounts cannot exceed the amount which would have been payable in a claim against FSCS • FSCS only pays compensation if the firm is unable, or likely to be unable, to meet liabilities • Otherwise amount paid by agreement or Financial Ombudsman will set repayment level if firm can pay

46. Types of Claim • Protected claims • Deposits (with UK or EEA firm) • Contracts of Insurance (different rules for early claims) • Investment business • Home finance mediation • Non-investment insurance mediation • Not covered • Reinsurance contracts • Lloyds Members who are covered by the Central Fund

47. Payment Requirements • FSCS must pay claim as soon as reasonably possible after: • It is satisfied that conditions have been met • It has calculated the amount • In any case within three months unless the FSA grants an extension • There are specific cases where postponement is permitted • FSCS may pay interest on compensation if it deems this appropriate • If claim relates to an Additional Voluntary Contribution policy, must follow FSAVC Review Model Guidance published by FSA in May 2000 • Compensation may be reduced if the FSCS believes there was contributory negligence by the claimant or the amount is greater then claimant might reasonably have expected on similar investments

48. Protected deposit Protected insurance contract, and non-investment insurance mediation Protected investment business Protected home finance mediation 100% of claim to maximum of £35,000 A) 100%, B) 90% for some categories, C) 100% of first £2,000, 90% remainder of claim, unlimited 100% of first £30,000, 90% of next £20,000 100% of first £30,000, 90% of next £20,000 Payment Limits

49. Assignment of Rights • FSCS may make any payment conditional on claimant assigning whole or part of his rights • After assignment, any amounts payable in respect of rights go to FSCS • FSCS will pursue only those recoveries which it believes are cost-effective • If the FSCS recovers amounts for the claimant, it can charge reasonable costs • FSCS must endeavour to ensure that claimant is not disadvantaged by accepting compensation and assigning rights • If FSCS decides not to pursue rights, claimant can apply to have rights reassigned

50. The 2007 FSCS Funding Review