The aims of the proposals outlined in the FSA’s consultation paper were greater transparency, improved consistency and higher penalties in order to achieve credible deterrence.

The key changes that the FSA has made to DEPP are to:

The starting point to determine the discipline element (step 2) will be to set the penalty based on a percentage of a minimum of a year’s "relevant revenue" (see below) (for firms, ranging between 0-20%) or income (for individuals, ranging between 0-40%), or where the conduct continues for longer than a year, for the period of the breach.

In the case of a one-off event (such as an isolated incident of mismarking), the relevant revenue or income will be that derived during the 12 months preceding the end of the breach. The percentage used will depend on the seriousness, nature and impact of the misconduct, adopting a sliding scale from levels 1 to 5 on the basis that the more serious the misconduct, the higher the percentage applied.

While increased transparency and consistency are to be welcomed, it is questionable to what extent they will be achieved. Some of the difficulties in the new approach are:

Subjectivity. The FSA will retain a high level of discretion in determining penalties, particularly in steps 2 (discipline), 3 (mitigation) and 4 (deterrence) (see box “Five-step approach”), so if the FSA considers that a penalty is too low (or too high), it can change it. The factors that the FSA will take into account in determining by how much to increase or decrease a penalty (in steps 3 and 4), examples of which are outlined in the revised guidance, are highly subjective. This lack of certainty already exists in the current regime; however, it is far from clear how the revised guidance will improve matters.

Defining relevant revenue. The absence of a definition of "relevant revenue" (in step 2) and the lack of clarity on the meaning and application of an "appropriate alternative" indicator of harm (where revenue is not an appropriate measure on which to base the step 2 calculation), will make it difficult to compare cases involving similar conduct, achieve consistently calculated penalties, and predict the level of future penalties.

This is particularly so where commercially sensitive material relating to the calculation of relevant revenue may, as envisaged by PS10/4, be omitted from a final notice. Similarly, at step 1, inconsistencies may arise in the calculation of the financial benefit derived directly from the breach for the purposes of achieving disgorgement.

Minimum of 12 months' revenue/income. The FSA's insistence on basing the step 2 calculation on a minimum of 12 months’ relevant revenue or income, even where the breach lasted for less than 12 months or was a one-off event, means that there is a risk that the penalty for a breach lasting one week will be broadly the same as the penalty for a breach lasting a year.

Litigation risk factors. When agreeing the terms of a settlement, the FSA recognises the importance of sending clear, consistent messages and is committed to settling only where the agreed terms of the decision result in acceptable regulatory outcomes. However, it remains to be seen whether other "litigation risk" factors (on both sides) act to distort some penalties which are the product of extensive negotiation or mediation.

The FSA remains committed to the view that increasing penalties should increase compliance with its rules. Time will tell if this view is correct. However, there is no apparent correlation between significantly higher penalties levied in the US, or the lower penalties levied on the Continent, and comparative levels of misconduct.

Indeed, reputable financial institutions expend considerable resources in seeking to comply with their regulatory obligations. They do so for a variety of reasons other than the size of any financial penalty. It is doubtful that the risk of a substantially increased penalty will cause such institutions to act any differently.

The FSA has dismissed concerns that substantially increased penalties on approved persons will act as a deterrent to individuals becoming approved persons, but has given no reasons for rejecting the concern.

It is possible that the introduction of a more prescribed framework for the calculation of financial penalties will mean that there is less scope for negotiated settlement. In particular, there is likely to be a lack of flexibility regarding the starting figure for negotiations once the relevant revenue and level of conduct have been determined by the FSA. In the past, some firms and individuals have been willing to reach a settlement with the FSA which has resulted in an increased financial penalty, but on the basis that the firm or individual is not found in breach of a particular FSA principle or rule. It is possible that the new framework will mean that the scope for reaching this sort of agreement is reduced.

Currently, most cases against authorised firms settle at an early stage. It is likely that, with significantly higher penalties, more firms (and even more individuals) will decide to challenge the FSA, particularly in the light of the very high threshold for serious financial hardship (see box “Financial hardship”). This may result in significant FSA resources being tied up in challenging cases before the Regulatory Decisions Committee and the Financial Services and Markets Tribunal and, in the long run, prove counter-productive for the FSA’s desire to establish credible deterrence.

PS10/4 is at www.fsa.gov.uk/pubs/policy/ps10_04.pdf.