Outsourcing andoperational risk
management
Risk management is of critical importance to financial institutions,financial markets, and the regulators and supervisors charged withpreserving the safety and soundness of the financial system. In lightof recent shocks, represented in part by the failures at Enron andWorldCom (and Barings, Long Term Capital Management, BCCI
and others before that), there has been a surge in regulatory
initiatives focused on financial institution risk.
In this context, operational risk management (process,technology, people, and external event risk) is a relatively new
subject of supervisory focus. International banking is now in theprocess of developing and rolling out new systems for assessing
and managing operational risk, driven by the new Basel Capital
Accord. Learning from past experience and recognising the fastchanging nature of financial services, regulators have chosen
risk-based supervision over myriad point regulations as the bettermeans of discharging their duties.
Given the widespread attention that has been focused on therise of outsourcing, it was only a matter of time for a debate tobegin on its relative costs and benefits. Key questions being
debated are whether outsourcing can enable financial institutions
to reach the efficient frontier of risk management, or whether
outsourcing can be a source of risk. Upon examination, it is clearthat it is possible to answer both with a ‘yes’.
While outsourcing has recently been a media focus, it isimportant to recognise that it has been a vital part of the banking
world for decades. For example, banks do not generally print theirown cheques.They rely on others to perform credit checks and tooperate credit card payment systems.The majority of banks in the
United States, albeit the smaller ones, utilise major providers to
perform many of the services at the core of their operations (forexample, CHECK BYSIS and FISERV).A strong argument can bemade that outsourcing in financial services provides a substantial
public service by enabling new entrants and smaller payers tocredibly provide a reliable and trusted service. The benefits to the
public are reflected in greater marketplace competition and thesurvival of community-based banks.

December 2004/January 2005
• Issue 7.10
Global..........................................................1
Risk management is of critical importance to financial
institutions, financial markets, and the regulators andsupervisors charged with preserving the safety and soundness of the financial system. Jonathan Rosenoer from IBM
discusses how outsourcing can be a vital part of coping withrisk.
Jersey ..........................................................3
Director General of the Jersey Financial Services Commission, David Carse, provides insights into his recent
work within Jersey, the challenges he faces and the successes
he has achieved.
Europe ........................................................5
Now that the legislative phase of the EU’s Financial Services Action Plan (FSAP) is drawing to a close andnational regulatory authorities in EU member states arefacing the implementation burden, Katie McCaw from
Norton Rose provides a timely look at the FSAP, its purpose and its place in the architecture of EU financial
services regulation.
UK ..............................................................9
Julie Patient from Lovells discusses the impact of the firstwave of the reforms under the revision of the Consumer
Credit Act 1974.
UK ............................................................10
Financial Regulation International regular, Joanna Gray,
examines the implications of the recent decision by theHigh Court in the case of the Financial Services Authority v Fradley (trading as Top Bet Placement Services) andanother.
UK ............................................................12
Julie Patient explores what the recent implementation of
the Distance Marketing of Consumer Financial Services
Directive will mean for financial services in the UK andEurope.
UK ............................................................14
Andrew Clark and Jason Dalrymple of PricewaterhouseCoopers present some of the issues facing senior
management in financial services firms and the practicalsteps which now need to be taken to address the provisionsof the Code of Market Conduct.
China ........................................................16
The forthcoming reform of China’s bankruptcy sector will
have some major implications, not just for China, but also
for international business and Hong Kong SAR. Michael
Barker and Rupert Purser provide the details.

© Informa UK Ltd 2004 Tel: 0207 017 5532

Financial Regulation International . December 2004/January 2005 . Issue 7.10

Over the past years, the face of financial services, likevirtually other industry, has been transformed by rapid
advances in information technology. Consumers haveenthusiastically embraced online banking, online
trading, and a host of new financial products madepossible by powerful new technology.The markets havealso imposed a more stringent discipline on financial
institutions, focusing on efficiency and profitable
growth. This has forced banks and others to look attheir assets and resources and determine how best to
employ scarce capital to the best effect.
Under the new supervisory goals for operational risk,
leading banks and others are charged with assessing andmanaging the risks they face. Once an institution
understands the risks, it has a range of choices:• do nothing;• hedge the risk with investment in business processes,
new technology and infrastructure;• transfer risk via vehicles such as insurance or
securitisation;• outsource to a provider with a better risk profile; or,• exit the activity or business generating the risk.
Obviously, each approach has an implication for abank’s risk position. Opinion however, is divided on
which approach is best to mitigate risk.
Part of the debate about outsourcing is reflected in apoint of view, where the focus is on whether you
should ever outsource core operations. This canquickly break down into a business school style debate
on strategies for success and case studies.
There is also debate based on first-hand experienceand what circulates in the press, as well as someanalysis.A recent European Central Bank (ECB) reportfound that the majority of banks that have outsourced
are already achieving expected results, and theremainder indicate that it is still too early to tell. The
UK’s Financial Services Authority (FSA) recognises
both the financial benefits of outsourcing, and its
capability to reduce the level of operational risk faced
by a firm. In this regard, it provides guidance on theways that banks select and then manage theoutsourcing relationship.This is also the experience inthe United States.
An approach to outsourcing consistent with risk
based supervision indicates that an institution cannot
avoid the risk of an important activity by having
someone else do the job. The institution retains
responsibility for the activity, no matter where it may
be handled and as such it needs to understand the risk
characteristics of the outsourced provider and monitor
2

them. Verification and inspection are always prudent
and regulators want to do it themselves as part of theexamination process.
In this circumstance, what are the arguments against
outsourcing? From the viewpoint of operational risk,
there is the chance that the outsourced provider will not
do a good job. Under risk based supervision, institutions
need to pay attention to this, make the appropriate
decision, and be prepared to respond to regulators andexaminers. To date, there is no reason to suspect that
institutions are not capable of making correct decisions.
There is also little reason to suspect that clients that are
unhappy with the delivered service cannot or will not
vote with their feet. Outsourcing actually supports
choice, as it can level the technology playing field forsmaller players.
Another argument voiced is over concentration risk.
Perhaps too much work will be absorbed by a single
outsource provider, which might fail to deliver in a waythat impacts safety and soundness.There are tools to deal
with this, however. These range from business impact
analyses to control evaluations, and to systems to preservebusiness continuity by enabling operations to resume
remotely at intercontinental distances within a matter ofhours in the event of a disaster.As these are the tools usedby very large financial institutions that can easily present
much greater risks to safety and soundness thanoutsource providers, their availability should similarly
reduce the risk posed by large outsourcers.
The adoption of outsourcing by many financial
institutions over a period of time suggests that thepurchasers of these services have found a benefit forthemselves and their stakeholders in so doing.The adventof risk based supervision provides both financial
institutions and regulators with the means of assessing therisks being run via outsourcing. So, is there more thatmight be done to manage operational risks in this area?
The field of operational risk is young.There is a lot ofroom for education. There needs to be a greater
understanding of the risks that make up operational risk,
as well as the events that drive risk, and the methods forcontrolling or mitigating risk as it is realised.There is also
room for systems that can detect, identify, assess andprioritise events as they occur and trigger appropriate
responses. And the regulators have said that there needs
to be greater sharing of data describing loss events.
While this data is useful for calculating loss distributions
that form the basis for capital charges, it would provide
a broader systemic benefit if it were available to help
understand and remediate operational weaknesses.
© Informa UK Ltd 2004 Tel: 020 7017 5532

www.informafinance.com

Outsourcing does, of course, pose logistical andjurisdictional challenges for regulators.This seems to be
an area that regulators express a desire for more thought
to be developed. But given the public benefits provided
by outsourcers, the desire of financial institutions toutilise their services and the rapid development ofoperational risk management and risk based supervision,
there does not appear to be an overriding reason toprevent financial institutions from utilising outsourcing
as a means of optimising their risk profiles.
A study that will be launched shortly has found thatbanks fail to adequately account for risk in their IT
investment, and that returns could be improved if
CIOs learned from portfolio theory.
The study initiated by ING and executed by IBM
has found that governance of IT investments and the
management of associated risks and constrained
capital are the most pressing challenges that banks facein improving IT project performance. The study,
which looked at 165 large IT projects (of up to e150
million) at leading financial services companies, foundthat for a variety of reasons one-third of projects run
over time, one-fifth run over budget and one-fifth fallshort of planned functionality.
Participants acknowledged their own responsibility for
project underperformance, attributing it to overly
optimistic business cases or unforeseen internal factors atleast half of the time. Even worse, most financial
institutions lack both the data and the business-oriented
metrics needed to measure returns on IT investments.
While banks are usually good at evaluating andprioritising business cases, few firms develop structured
risk assessments and determine risk mitigation measures(and the costs of such measures) prior to the executionof IT projects. Even fewer use risk assessment to evaluatebusiness cases and determine priorities.
Banks have lots of experience in applying advanced
portfolio management to reducing risk and improving
returns on invested assets, but too few are applying
these same disciplines to their IT investments.
Jonathan Rosenoer, Global Head of Operational Resilience and Risk Solutions, IBM
Financial Services Sector.The full report will be available shortly from IBM.

JerseyRegulatory pace and an island economy
The financial services legislation in Jersey has
undergone radical changes over the last five years.
These changes have been designed to ensure that Jersey
has a legal and regulatory framework for financial
services in keeping with their importance to theIsland’s economy. The finance industry accounts forover 55% of its GDP and keeps pace with the evolving
international standards set by bodies such as the BaselCommittee, IOSCO and the FATF. Although Jersey is
not a member of the EU it also has to pay increasing
regard to the regulations that flow from Brussels, sincethese set the ground rules for firms wishing to dobusiness with EU member countries.
The dilemma for a small jurisdiction like Jersey,
which recognises that financial businesses do have a
choice as to where they set up shop, is to put in placea regulatory regime that is effective in reducing risk to
the public and to the Island’s reputation, whileallowing business to develop and flourish with theminimum of bureaucracy. This is not an easy task, andany temptation to cut corners in terms of applying
international standards must be curbed, not least
because of the detailed scrutiny which financial centres
in general, and offshore centres in particular, are now© Informa UK Ltd 2004 Tel: 020 7017 5532

under from international assessors such as the IMF.
The body tasked with performing this difficult balancing
act in Jersey is the Jersey Financial Services Commission, astatutory body corporate set up under the Financial
Services Commission (Jersey) Law 1998. That law
established the Commission as an independent body withvarious statutory functions, including the supervision anddevelopment of financial services on the Island. The
Commission is accountable for its overall performance tothe Island’s parliament – the States of Jersey.
In carrying out its regulatory and supervisory
functions, the Commission is required by law to haveregard to three guiding principles:• The reduction of risk to the public of financial loss
due to the dishonesty, incompetence, malpractice or
the financial soundness of financial service providers;• The protection and enhancement of Jersey’s reputation and integrity in commercial and financial
matters; and• The best economic interests of the Island.
The concept of balance is thus built into theCommission’s statutory remit.
Trusts: pioneers

The centrepiece of the regulatory laws administered by3

Financial Regulation International . December 2004/January 2005 . Issue 7.10

the Commission is the Financial Services (Jersey) Law
1998. In its original form it only covered investment
business, which became regulated under the Law from
July 1999 onwards. In November 2000, the scope of
the Law was extended to cover the regulation of trustand company service providers. This is an area where
Jersey has been a pioneer and reflects the importanceof trust companies to the finance industry in Jersey, asservice providers in their own right and as theintroducers of business to other parts of the industry,
such as the banks and investment managers. It is thetrust sector which is at the heart of Jersey’s distinctive
character as a financial centre.
Other parts of the finance industry – banks, funds
and insurance companies – are presently regulated
under their own separate pieces of legislation. It has tobe acknowledged that this is not a totally satisfactory
situation. While the various laws are reasonably
consistent with one another, they are not completelyso, having been enacted at different times over theyears. One of the objectives of the Commission
therefore is to consolidate the various laws, to thegreatest extent possible, into the Financial Services(Jersey) Law 1998.The objective would be to producea ‘one-stop shop’ for the laws administered by theCommission, making life easier for all the various usersof the laws, including the lawyers who have to advise
their clients on their regulatory obligations.
Insurance: timing

The problem is finding the time to do this among otherpriorities, some of which are dictated by external events.
A case in point is the forthcoming regulation in Jerseyof general insurance broking and intermediation, which
is being achieved through an amendment to the
Financial Services (Jersey) Law 1998.This is somethingthat may well be desirable in its own right, but the
precise timing is being driven by changes to the UK’s
financial services legislation, which if not acted upon,
could deny Jersey-based intermediaries access to UK
insurance companies and the Lloyd’s insurance market.
The changes to the UK legislation have been driven
in turn by the EU Insurance Mediation Directive,
which was issued in December 2002 and has as its
objective the harmonization of general insurance
regulation throughout the EU.
As noted earlier, despite its non-EU status, Jersey
cannot afford to stand aloof from initiatives such asthese if it wants to continue to do business outside its
own shores.
4

While the industry in Jersey sees the need to regulate
general insurance mediation, the cost of regulatorycompliance is a lively topic for discussion in the Island,
just as it is elsewhere.
Efficient and effective

It is worth noting at this point that the Commission iswholly financed by the industry through fees. It
receives no financial support from the government; andwhile most people would accept that the success ofJersey as a financial centre hinges at least partly on thequality of its regulation, they want to be sure that they
are getting value for money and that the regulation is
being delivered as efficiently and effectively as possible.
Efficiency and effectiveness are two related but distinct
concepts. The former relates to the outputs of theCommission, for example, the number of supervisory
meetings and examinations that the Commission
conducts and how quickly and accurately theCommission can process applications for new licences
and registrations. Performance targets have been set for
the various administrative tasks that the Commission has
to perform. Partly, these measure internal efficiency. But
they can also be a powerful tool to increase theattractiveness of Jersey as a place to do business.
A good example of this is the regime for ‘expert funds’
that was introduced in February of this year. The new
regime provides for a streamlined authorisation process
for funds that are directed at ‘expert’ investors –individuals with high net worth or institutions – and theaim is to give the necessary regulatory approvals within
72 hours.This is an important consideration in a segmentof the industry where the time to market is important.
This serves to show that efficiency is, or should be, ameans to an end. What matters is the achievement ofeffective outcomes at the lowest possible cost.The resultof effective regulation should be a reduction in risk in
an environment that permits business to grow.
A modern and relevant legal framework for financial
regulation is one of the ingredients for this, and someof the steps that Jersey has been taking to achieve thishave already been described. Also important is that theregulator should be structured in a way that enables it
to deliver effective regulation.
In this connection, the Commission has recently
implemented a restructuring of its supervisory wing
into four specialist divisions, dealing with banking,securities, trust companies and insurance. Each of thesedivisions is headed by an executive director. Previously,
the Commission had used ‘mixed’ supervisory teams,© Informa UK Ltd 2004 Tel: 020 7017 5532

www.informafinance.com

each responsible for supervising a variety of financial
services businesses.
The new structure is intended to be more transparent
and to create clear leadership and accountability within
the Commission for each industry sector. It should also
help to promote greater industry expertise among
Commission staff because they will be specialists in the
sector under their responsibility.
In a nutshell, the new structure should help theCommission to get closer to industry. This is importantwhen the Commission, like other regulators, isincreasingly trying to apply a risk-based approach toregulation.This means trying to focus our attention to agreater extent on those institutions, products andcustomer relationships that are higher risk. We must
know which of our regulated entities fall into the higher
risk category so that these can be subject to closer

scrutiny, for example when we plan our programme ofon-site visits.
The risk-based approach also applies to ourregulatory policies, for example, devising a set of
guidelines for anti-money laundering that apply higher
standards of due diligence to the serious players whose
activities might threaten the Island’s reputation, while
protecting the man in the street from unnecessary red
tape when using financial services.
This is another example of balance in the regulatory
approach. Provided the Commission can strike theright balance – and this is central to everything we try
to do – Jersey should be able to achieve the twin
objectives of maintaining a competitive industry while
complying with the international standards for
effective regulation.
David Carse OBE, Director General of the Jersey Financial Services Commission

EuropeFSAP, Comitology and Lamfalussy: Europe’s
trilogy for financial services regulation
A fundamental objective of the European Union (EU)is establishing and developing the single market infinancial services.Whilst the founding Treaty, the Treatyof Rome of 1958, established the four fundamental
freedoms: free movement of persons, free provision ofservices, free movement of goods and freedom of
establishment, it was left to the Treaty on European
Union, the Maastricht Treaty of 1992, to provide for afurther freedom - the freedom of movement of capitaland payments. Maastricht laid the foundations for the
introduction of the single European currency and thedevelopment of a single European capital market(although the bare Treaty provisions could neverachieve this alone). The introduction in 1999 of thesingle European currency, the euro, within 12 (of thethen 15) member states of the EU, served to reinforce
the importance of the development of the single
market in financial services and made those remaining
barriers more prominent.
A single European market in financial services

The single European market in financial services1
would allow financial institutions authorised toprovide financial services in one member state toprovide the same services in every member state of theEU without the need to comply with different entry
requirements, and to be subject to a level playing fieldwithin a consistent regulatory environment. Not only
would this support the development of the single
European capital market and provide competitive
access to capital; the potential economic gains aresubstantial in terms of the productivity of capital andlabour, and in turn, GDP growth.
While the euro focused market participants’attention on the potential benefits of the single market
in financial services, the European Commission’s
ongoing objective to ensure the consistent and prompt
implementation of European law at a member statelevel was thrown into sharp focus. This momentum
provided the perfect opportunity to create thelegislative structure required to allow the single market
to develop its full potential. To that end, the Financial
Services Action Plan was drawn up.
The Financial Services Action Plan

In 1998, the Commission was invited to table a‘framework for action’ to develop the single market infinancial services. The resulting Financial Services Action
Plan (FSAP), published in 1999, contains a set of 42
original measures (comprising Directives, Regulations,

1 For these purposes, the concept of financial services within Europe is not confined to the field of investment services. It has been accepted over the last 15 years or so as extending to(amongst other things) banking, securities markets, admission to listing, insider dealing and market abuse, clearing and settlement, electronic commerce, accounting standards, pensions andconsumer protection.

© Informa UK Ltd 2004 Tel: 020 7017 5532

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Financial Regulation International . December 2004/January 2005 . Issue 7.10

Communications and Recommendations) and a further
six supplementary measures, intended to remove theremaining barriers to the single market in financial services
and fill certain gaps, so as to provide a comprehensive legal
and regulatory environment that would support the
integration of European financial markets. An end-2005
deadline was set for member states’ implementation of thelegislative provisions of the FSAP. Practically, this meantthat each piece of legislation contained in the FSAP (somethree-quarters of its measures) would have to be finalised
and adopted by around mid-2004 to allow member states
the required 18 months in which to draw up national
implementing measures.
Each measure of the FSAP falls within one of threestrategic objectives as follows:• A single EU wholesale market. The first objective is designed to allow securities issuers to raisefinance in a competitive Europe-wide market andto enable single point-of-entry access for investors.
It would also allow investment services to be offeredthroughout the EU within a sound prudential
framework, and create legal certainty for securities
trading and settlement. Amongst others, theProspectus Directive, Market Abuse Directive, theproposed Transparency Obligations Directive andthe Directive on Markets in Financial Instruments
are all designed to achieve this objective.
• Open and secure retail markets. The second
objective is aimed primarily at giving consumers
information and safeguards to enable them to participate in the single financial market, but also atensuring that barriers are removed to the cross-border provision of consumer financial services (with thenecessary legal and regulatory protection) and at
facilitating small-value cross border payments within
the EU. Two measures which are designed to fulfil
this objective are the Communication on a Single
Market for Payments and the Directive on Distance
Selling of Financial Services.
• State of the art prudential rules and supervision. The third objective is focused on ensuring thatno lacunae remain in the EU prudential frameworkand that the framework itself is capable of successful
enlargement. In addition, it attempts to set rigorous
standards that will sustain stability in the EU financial
market. The proposals for implementing ‘Basel II’
within the EU provide an excellent example of theCommission’s work in developing state of the art rules(particularly given that those Directives are not subject
to the ‘Lamfalussy process’ - as to which, see below).
6Lamfalussy

Recognising that cumbersome legislative measures
have done little to improve the efficiency and speed of
the European legislative process (by way of example,
the proposed Takeover Directive has been negotiatedfor 15 years to date!), the EU’s Economic and Finance
Ministers set a mandate in 2000 for a ‘Committee ofWise Men’ to review the EU regulatory frameworkand the legislative processes for the securities markets,and produce a report by early 2001.
The final Report of the Committee of Wise Men(chaired by Baron Alexandre Lamfalussy and thus
referred to as the ‘Lamfalussy Report’), published in
2001, proposed new legislative techniques for thereformation of European financial services and securities
law.This was the first attempt to address the problems ofincoherent, ambiguous and out-of-date legislation thatfailed to operate effectively at a national level. Indeed,
the Lamfalussy Report specifically referred to the FSAP
as being designed to fill the lacunae in European
financial services and securities regulation. However, italso recognised that the 2005 deadline was highly
ambitious - not least because of the lack of basic
legislative techniques designed to simplify and speed up
the process of adoption of European legislation.
The new legislative techniques proposed in theLamfalussy Report focused not only on speed, but on
quality, flexibility, consistency, transparency andefficiency. The Committee of Wise Men suggested
separating the ‘principle’ of legislation from the ‘detail’in order to minimise ambiguity - thereby allowing
detailed technical rules to emerge from the underlying
principles.
To that end, the Lamfalussy Report proposed a new
four-level approach to the adoption, implementation,
evolution and enforcement of legislation within EU
member states (hence the term ‘Lamfalussy process’):
Level 1This comprises primary legislative acts, Directives andRegulations that define the broad framework principles,or ‘essential elements’ of each piece of legislation. The
Commission, European Council and European
Parliament agree on the key political orientation foreach Directive or Regulation (and also the nature andextent of the Level 2 implementing measures), withadvice from the European Securities Committee (ESC).
The traditional method of agreeing and adopting
legislation at this level utilises the long-used codecision procedure whereby the Commission, Council© Informa UK Ltd 2004 Tel: 020 7017 5532

www.informafinance.com

and Parliament must all agree on the final text of apiece of legislation.This process takes on average three
years to complete and usually involves a number ofreadings of a proposed text, followed by lengthy
consultation periods, and then by numerous rounds ofamendments. Even when, for example, a Directive has
proceeded through the co-decision procedure andtakes effect within member states, if it is required to beamended, the proposed amendments are subject to afull-blown consultation under the co-decision
procedure - a lengthy and somewhat onerous process.
Under the Lamfalussy process, the co-decision
procedure will be restricted to agreeing the key
political orientation of a piece of legislation andagreeing on a short-form text.This will leave the detailto the Level 2 implementing measures, thus cutting
down the time spent on reaching agreement using theco-decision procedure.
Level 2

Level 2 measures comprise technical implementing
measures for the Level 1 legislation that will be
adopted by the Commission with the assistance of, andadvice from, the Committee of European Securities
Regulators (CESR).The Level 2 measures will containthe detail of the legislation that has been left out at
Level 1 and are designed to ensure the speedy adoptionof legislation, as well as to avoid the lengthy
consultation process involved in amending the Level 1
measures. Ensuring that these Level 2 technicalprovisions can be quickly and easily amended meansthat EU legislation is able to keep pace with market
developments. This method, which involves theCommission agreeing upon detailed implementing
measures with the assistance of one or both of theseCommittees, is known as the ‘comitology’ procedure.
Comitology forms the core of the Lamfalussy process.
It will have an increasing impact on the shape andsubstance of EU financial services legislation; indeed,use of the process was extended in early 2003 from thesecurities field to the banking and insurance sectors.
The Level 2 implementing measures for the Directives
agreed using the Lamfalussy process take the form of
Directives and Regulations, although the Lamfalussy
Report urges the use of Regulations rather than
Directives. Regulations have the benefit of being directly
applicable within member states’ legal systems without
the need for member states to draft implementing
legislation. Directives leave the form and method of
implementation to the member states. Thus there are© Informa UK Ltd 2004 Tel: 020 7017 5532

timing implications where Directives are the chosen
form of implementing measure.Although they are said tobe the best way to achieve harmonisation of member
states’ local laws, the heavy use of Directives preLamfalussy (and indeed, in non-Lamfalussy measures) has
led to inconsistent implementation of EU legislation andhas also meant that the Commission is unaware ofwhether correct and consistent implementation is being
achieved in each member state.
Level 3

Level 3 is designed to improve co-operation between
national regulators to ensure consistent transposition andinterpretation of the Level 1 legislation and Level 2
implementing measures.This involves CESR operating ina different capacity than under its Level 2 responsibilities- CESR will act as a regulatory committee within Level3, ensuring consistent implementation of the Level 1 and2 measures.This will be done through the developmentof CESR ‘Guidance’ covering national implementing
measures, the issuing of interpretative recommendations
and the setting of common standards where there are gaps
in the legislation, together with the comparison andreview of regulatory practices to define best practice andensure consistent application.
Level 4

Enforcement action by the Commission (or even thethreat of it) is recognised as the best way to ensure
consistent and timely implementation of legislation
within member states. None of the measures progressing
under the Lamfalussy process are (at the time of writing)in force, and, although Levels 1 and 2 are in place formany (with Level 3 Guidance being consulted on by
CESR), we are not yet in a position to see the operationof Level 4. It is expected that Level 4 will involve theCommission conducting rigorous checks on the texts ofnational implementing measures and their application andtaking action in the form of infringement proceedings
against any member state found not to be correctly (orpromptly) implementing any piece of legislation.
The Securities Committees - the ESC and CESR

The Lamfalussy Report recommended the creation of
the ESC and CESR, which will act as advisorycommittees to assist the Commission in implementing
the four-level approach.The roles of the two committees
are similar yet different - broadly, the ESC operates mainly
in an advisory capacity at Level 1 while CESR operates
mainly in a regulatory capacity at Levels 2 and 3.
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Financial Regulation International . December 2004/January 2005 . Issue 7.10

The ESC is composed of high-level representativesof the member states. Its work is twofold, as theCommittee acts in both advisory and regulatory
capacities. In its advisory capacity, the ESC advises theCommission on the adoption of Directives orRegulations at Level 1 and may be consulted by theCommission before it mandates CESR to provide
technical advice on Level 2 implementing measures. In
its regulatory capacity, the ESC assists the Commission
in exercising the Level 2 implementing measures.
CESR is an independent advisory body composed ofrepresentatives of the national supervisory authorities
in the securities field of each member state. Its primaryrole is to assist the Commission in the preparation of
Level 2 implementing legislation. The Commission
will issue detailed mandates to CESR to prepare
implementing measures within defined time limits.
CESR will also play a role in ensuring consistent dayto-day implementation of the Level 1 and 2 measuresat Level 3, through CESR Guidance.
The filter through into UK legislation

The end-2005 deadline for implementation of the FSAP
means that all member states should have begun
consultations on implementing the first major proposals
under the FSAP by the end of 2004. In turn, this meansthat the outstanding measures under the FSAP shouldhave been finalised and adopted by mid-2004. However,there is still a lot of work to be undertaken in relation tovarious aspects of the FSAP, including parts of thecompany law framework, and to the finalisation of the
Directives on Transparency Obligations, Consumer
Credit and Money Laundering, all of which (at the timeof writing) have missed the mid-2004 target for adoption.
It is worth remembering that, while the Level 1
Directives require timely implementation, so do theLevel 2 Directives (the Level 2 Regulations will bedirectly applicable in member states). Even before
implementation, the drafting of national legislative
provisions involves public and industry consultation,
feedback and re-drafting.
The FSA and HM Treasury are already consulting on

the implementation of some major aspects of the FSAP
within the UK, such as the review of the listing regime
required to implement a number of the FSAP proposals
and the implementation of Basel II within the EU
through the revised Capital Adequacy and Banking
Consolidation Directives. Certain parts of the FSA
Handbook (the medium through which most of the
FSAP Directives will be implemented in the UK) will
require substantial amendment, including the Interim
Prudential Sourcebooks for Banks, Insurers andInvestment Businesses (soon to become the Integrated
Prudential Sourcebook), the Conduct of Business
Rules, the UKLA Listing Rules and the Market
Conduct Sourcebook.
Some conclusions

The ambitious 2005 deadline for the finalisation of the
FSAP leaves EU companies and financial institutions
juggling various different regulatory deadlines. Given
that many EU companies and institutions will also be
struggling to cope with the added burden ofcompliance
withInternational
AccountingStandards/International Financial Reporting Standards
from 1 January 2005 and Basel II from 2007, it may beunrealistic to expect full and consistent application of all
aspects of the FSAP from 2005.
Some interesting issues arise in relation to the Accession
Countries that joined the EU on 1 May 2004. Those
countries, subject to certain transitional periods, arerequired to implement the entire FSAP into their national
legislative systems within a very short timeframe.
Furthermore, local legal, tax and accounting frameworks
will all require a degree of harmonisation, even before theprovisions of the FSAP can be considered for
implementation in Accession countries.The 10 countries’
successful integration into the single market willundoubtedly depend on their ability to plan and prepare
for the introduction of an entirely new system of financial
services regulation.
Katie G McCaw, professional support adviser to the International Securities Group, withparticular specialisation in international banking, securities and financial services regulation
at Norton Rose.

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UK
Consumer Credit Act 1974 – the revised
advertising regime
In December 2003 the UK Government publishedproposals for the modernisation of the Consumer
Credit Act 1974. The White Paper, “Fair, Clear andCompetitive – The Consumer Credit Market in the 21stCentury” set out wide ranging proposals to increase
fairness and transparency in the UK consumer credit
market as well as to strengthen and modernise thelicensing regime.The UK Government recognised thatits proposals would run in parallel with the update to
the Consumer Credit Directive but felt compelled tobring forward reforms ahead of any finalised Directive
because of concerns over the level of UK consumer
debt and the apparent lack of transparency in themarket.
The first wave of reforms is now in place. On 31
October 2004,The Consumer Credit (Advertisement)
Regulations 2004 applying to all consumer credit orhire advertisements came into force. The newAdvertising Regulations aim to simplify theadvertising regime for consumer credit and to allow
easier comparisons between lenders’ offers. They will
be followed in May 2005 by changes to the form andcontent of consumer credit and hire agreements, arequirement to provide customers with pre-contract
information in certain situations and changes to howlenders must calculate rebates for customers who settle
early.There will also be changes implemented later thisyear or early next year to allow lenders to conclude
agreements over the internet.
The Regulations apply to all adverts for credit andhire other than those offered exclusively to businessborrowers or residential loans offered by mortgage
lenders. Residential mortgage loans are now the subjectof direct regulation by the Financial Services Authority(FSA) and fall within the financial promotions regime
with detailed requirements for advertising set out in the
FSA Handbook. There are some significant differences
between the Advertisement Regulations and the
Financial Promotions regime.Whether this will lead toconsumer confusion is still an open question.
All adverts must be in plain and intelligible language,
be easily legible (or audible if appropriate) and specify
the name of the advertiser.There are certain trigger items
of information which, if included in the advert, require
the lender to include additional prescribed information,
including the annual percentage rate (APR). The APR© Informa UK Ltd 2004 Tel: 020 7017 5532

will also need to be included if the advert offers any
incentives, such as cash back or indicates that it is on
more favourable terms than other products. New
prominence requirements coupled with a reduction in
the amount of information that must be included in an
advert should mean that the amount of small print isgreatly reduced and may even be phased out altogether.
The Regulations seek to ensure greater consistency
between lenders in the use of the ‘typical’ APR. This
must now be the rate at or below which the lender
expects 66% of agreements to be concluded as a resultof the advertisement. This is likely to mean that credit
will appear more expensive from 1 November as adverts
reflect the change in the way the typical APR iscalculated, especially for those lenders that operate risk
based pricing. There may also be some circumstanceswhere the Regulations will have the effect of making
certain products look disproportionately expensive.
The Regulations introduce significant changes toadvertisements for credit cards with new requirements forcalculating and quoting the APR. For many years credit
card companies have been using a number of methods tocalculate the APR. The nature of a credit card productmeans that assumptions must be used when calculating
the APR.These assumptions are set out in the Consumer
Credit (Total Charge for Credit) Regulations 1980 (asamended) but differences on interpretation have lead todifferent companies applying different assumptions. This
practice has recently been highlighted before the Treasury
Select Committee, which has been carrying out a detailed
review of the Credit Card Industry in the UK. The
Regulations contain new assumptions which will
hopefully clarify the calculation and, perhaps most visibly
to the consumer, only the APR applicable to purchases
can be quoted. Again to increase transparency thecalculation of the purchase APR cannot take into accountany introductory period and must be based on the highest
rate of interest applying during the first three years of theagreement. The Regulations do not specify how rates
should be quoted for other balances, such as the cash
advance balance or balance transfers, and there is alreadydebate within the industry as to whether interest rates
should be quoted on a simple or compounded basis.
OFT frequently asked questions

In October 2004, the Office of Fair Trading (OFT)published a list of Frequently Asked Questions
setting out its initial views about questions raised by9

Financial Regulation International . December 2004/January 2005 . Issue 7.10

advertisers on its interpretation of the Regulations.
The need for this again highlighted issues with theclarity of the drafting of the Regulations. Certain
views expressed by the OFT have caused concerns
among lenders, particularly where it has adopted
what appear to be more restrictive interpretations tothose adopted in the past. An example of this is theinterpretation of the phrase ‘together as a whole’.
The Regulations specify that the required informationmust be contained ‘together as a whole’. Under theprevious Regulations, lenders would commonly set out
the required information in one area of the document but
would commonly intersperse information with certain
banner advertisements rely on a click through to comply.
The OFT has questioned this approach by stating that the
information should not be interspersed and,perhaps more
surprisingly, by stating that all of the required informationmust be repeated whenever trigger information is
mentioned. It appears to be of the view that this is the
only way to satisfy the requirement for equal prominenceof the required information, leaving very little scope foradvertisers to achieve equal prominence on other ways.
This interpretation is, however, likely to lead to repetitionof information and may adversely affect the transparencyof the advertisement.

regulations are enforced by the OFT and local trading
standards offices. It was a clearly stated aim of the
Department of Trade and Industry that enforcement
would be strengthened. Certain weaknesses in thedrafting of the previous regulations meant thatprosecutions were relatively rare. However, in recent
months the OFT has been making increasing use of its
powers under the Enterprise Act 2002 to force lenders
to withdraw misleading advertising campaigns.
Conclusions

How will the regulations be enforced?

The new Regulations do introduce some improvements
for borrowers in terms of clarity and prominence andshould make it easier for borrowers to make meaningfulcomparisons between different lenders’ adverts. They
may also herald the death of small print. However,consumers generally have a poor understanding of what
the APR is and what it means and this has not been dealt
with by the new Regulations. It therefore remains to be
seen whether they will actually make advertisements
more comprehensible for consumers. Lenders will
however need to carefully review how they market theirproducts.There is likely to be a significant impact on thesorts of messages that lenders can headline with and there
may also be an impact on how certain types of adverts,
such as banner adverts on the internet, canbe used.

Breach of the regulations is a criminal offence. The

Julie Patient, Consultant, Financial Institutions Group, Lovells

UK
Betting scheme contravenes Financial
Services and Markets Act 2000
On 21 October 2004 the Chancery Division of theHigh Court gave judgment in the case of Financial
Services Authority v Fradley (trading as Top Bet Placement
Services) and another. This case raised some interesting
issues on the scope of the definition, contained in
section 235 of the Financial Services and Markets Act(FSMA) 2000, of a collective investment scheme.
The defendants to this application for summary
judgment brought by the FSA were a Mr Fradley, who
traded as Top Bet Placement Services (TBPS), and a
Mr Woodward, who had been a director and company
secretary of a company called 147 Racing Ltd (147). A
betting scheme was operated from August 2002 by
147, pursuant to which unsolicited mail shots weresent to members of the public inviting them to ‘invest
in horse racing’. Members were to provide a minimum
10

betting bank, monthly contributions and were initiallyable to use the services of TBPS for bet placement. Ifthey used TBPS’s services they were sent TBPS’s terms
and conditions, which provided that the monies
representing the member’s betting bank would be held
in TBPS’s client account.The conditions also stipulated
that payments could only be made out of this accountfor the purpose of payments to bookmakers,
repayment to the member or payment of TBPS’s
management fees and the placement levy.
The scheme operated in this way until October 2002
and the Court referred to this as the scheme’s ‘first
period’. In October 2002, Mr Woodward resigned as
director and secretary of 147 and the scheme
documentation was revised so that it became
compulsory for members to use TBPS’s services. Thisremained the case until February 2003 and this wasreferred to by the Court as the scheme’s ‘second period’.
© Informa UK Ltd 2004 Tel: 020 7017 5532

www.informafinance.com

In February 2003, the FSA got involved in discussions
concerning the scheme as it took the view that thescheme may have been an authorised collective
investment scheme and it sought undertakings from 147
and TBPS that they would cease trading.The defendants
stated (and the Court accepted) that the scheme did notoperate from early February until early March 2003(‘the third period’). After that period, the scheme
documentation was revised again so that new members
were informed that they had the option to place theirown bets.TBPS’s terms of business were revised so thatbets would be placed strictly in accordance with themember’s instructions and in accordance with amandate from the member, and that members’ monies
were to be held on trust. Similar changes were made to
TBPS’s terms for existing members.
This documentation was used from early March until
April 2003 (‘the fourth period’). On 4 April 2003, Mr
Fradley moved to Dublin and continued operating thescheme until 21 August 2003 (‘the fifth period’), at
which point the FSA obtained injunctions against him
and 147 (which was subsequently wound up). During
the time the scheme operated: £1,415,000 was invested,with £425,000 being lost on bets; 147 received
membership fees in excess of £293,000;TBPS received
fees and levies in excess of £145,000; and insufficientmoney remained to repay members’ betting banks.
The FSA claimed that the betting scheme amounted
to a collective investment scheme within section 235of the FSMA 2000. This meant, it argued, that Mr
Fradley had been carrying on a regulated activity
without either authorisation or exemption under
FSMA 2000 and had therefore contravened section 19
thereof.
The FSA claimed that Mr Woodward was knowingly
concerned in Mr Fradley’s contraventions and was thus
liable to the same extent.The FSA sought with respect
to both defendants: declarations of the contraventions,
restitution orders and an account of profits alreadymade under section 380(2) of the FSMA, andinjunctions to restrain any future contraventions.
Court’s Ruling

In holding that the scheme was a collective investment
scheme during the first and second periods of its
operation, the Court addressed itself to several detailed
and refined legal arguments advanced by the counsel for
Mr Fradley, who attempted to argue that the scheme felloutside the definition of a collective investment scheme.
Firstly, as it had been argued that monies derived from© Informa UK Ltd 2004 Tel: 020 7017 5532

betting winnings did not constitute ‘property’ within themeaning of section 235(1) of the FSMA, there must be
some separate underlying property other than money.
However, the Court disagreed, stating that the terms ofsection 235(1) were wide enough to encompass thisscheme since it referred to ‘any arrangements’ relating toproperty of ‘any description’.The Court stated :“The wording [of section 235(1)] is, as the FSA claims,
entirely apt to cover Mr Fradley’s scheme: there werearrangements with respect to property (being the contributions themselves) whose purpose was to enable theparticipants to receive profits arising from the management(by placing bets) of that property. I see no reason why betting winnings should not be regarded as profits, and noreason why placing bets out of contributions should not be
regarded as management of those contributions. In my view,
the scheme falls within subsection (1).”Secondly, it was argued that, since during the first
period at least, members had the option of placing
their own bets, then one of the key requirements ofthe definition of a collective investment scheme wasabsent from these arrangements. This meant that theparticipants did not have day-to-day control over the
management of their contributions. It was argued that,
because some participants did have such control at theoutset of the scheme, this took the arrangements
outside of section 235(2). However, the Court rejected
this argument as too artificial:“As to [the argument that not all contributors used
TBPS’s services but rather placed bets directly], it seems
to me essential if a scheme is to fall outside the subsectionthat all the contributors should have day-to-day control: ifsome do and some do not, the scheme is within the subsection.That is because the application of subsection (2) toa scheme requires an answer to the question ‘Do the participants have day-to-day control?’; and if the answer is‘No’ – as it will be if some participants have control andothers do not – the scheme is within the subsection.Theremay, of course, be circumstances in which there is in reality more than one scheme; but in the present case theterms of the scheme were the same for all participants, andthere plainly was only one scheme. I do not think it possible to have one scheme which is partly a collective
investment scheme and partly not; so that as soon as one
participant chose to use the services of TBPS he relinquished control, and the scheme became a collective
investment scheme as regards all its members.”
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Financial Regulation International . December 2004/January 2005 . Issue 7.10

Therefore, with regard to the first and second periodsof its operation, the scheme fell within section 235(2).
Thirdly, the Court was satisfied that the requirements
in section 235(3) that, for a scheme to be a collective
investment scheme, contributions had to be pooled andmanaged as a whole was also satisfied when members’monies were paid into one account and large bets wereplaced using more than one participant’s money. One
collective bank account was used for bets and winnings
and the fact that in the fourth and fifth periods that
account was a trust account made no difference to thepoint. The bank had one customer, Mr Fradley, whomanaged the account on a pooled basis as a whole.
Finally secondary legislation provides an exemption
from the scope of section 235 for ‘common accounts’defined as:“(a) …. arrangements under which the rights or interests ofparticipants are rights to or interests in money held in acommon account; and(b) [where] money is held in the account on the understanding that an amount representing the contribution ofeach participant is to be applied (i) in making payments to him;(ii) in satisfaction of sums owed by him; or(iii) in the acquisition of property for him or the provisionof services to him.”Counsel for Mr Fradley had argued that these three
conditions were fulfilled by TBPS’s client account andthat the arrangements ought therefore to be exempt.The
Court disagreed for two reasons. Firstly, it argued that thefact that monies in the account could be used for theplacing of bets (which are technically void contracts
under the Gaming Act) meant that condition (iii) was
not satisfied, since the placing of bets was neither theacquisition of property nor the provision of services.
Secondly, the whole purpose of this common accountexemption was directed towards accounts akin to asolicitor’s client account, where monies from different
individuals was temporarily co-resident for mere
administrative convenience rather than, as here, where it
was for the collective purpose of onward investment.
Hence this ‘common accounts’ exemption did not savethe betting scheme from illegality either and the Court
declared that it was an unauthorised collective
investment scheme during the first and second periods.
This meant that Mr Fradley was indeed, as the FSA had
claimed, in contravention of section 19 of the FSMA. It
also granted the declaration and injunction sought
against Mr Woodward, since it took the view that all thatwas required for him to be ‘knowingly concerned’ in thecontravention was knowledge of the facts relating to thescheme’s operation, which rendered it a collective
investment scheme. He did not have to know of the factof illegality itself, simply the component elements of thatillegality.
This decision illustrates the width and reach of theprovisions relating to collective investment schemes.
The fact that gaming activity is itself already subject toa bespoke regulatory regime does not mean that those
who, by way of business promote collective gambling
activity, will not be caught by the financial regulatory
net as well.
Joanna Gray, University of Newcastle-upon-Tyne

UK
Implementation of the DMD
The EU has for many years recognised the need toensure consumers entering into any type of agreement at
a distance have adequate protections. The Distance
Selling Directive introduced protections covering many
products and services. The Distance Marketing of1
Consumer Financial Services Directive (DMD) extends
the regime to all consumer financial services. It setscommon standards for the provision of pre-contract andcontractual information to consumers prior to a contract
being concluded at a distance and contains provisions forwithdrawal rights in many circumstances.The DMD was

adopted in September 2002 with Member Statesrequired to bring it into effect in October 2004.
The DMD came into force in the UK on 31
October 2004. For products and services regulated
under the Financial Services and Markets Act 2000, theFinancial Services Authority (FSA) has implemented
the required changes through amendments to its
Handbook of Rules and Guidance, most notably to the
Conduct of Business sourcebook. For all otherfinancial products and services, the Financial Services(Distance Marketing) Regulations 2004 (SI2004/2095) apply. Both sets of regulation largely adopt

1 Directive 2002/65/EC concerning the distance marketing of consumer financial services (OJL 271/16, 9/10/2002) and amending Council Directive 90/619/EEC and Directives
97/7/EC and 98/27/EC.

12© Informa UK Ltd 2004 Tel: 020 7017 5532

www.informafinance.com

a ‘copy out’ approach, which is now the standard
approach to implementing this type of directive.
The DMD potentially applies to any financial
services contract concluded at a distance by aconsumer.To understand the full scope of the DMD it
is important to understand the key definitions of‘consumer’, ‘financial service’ and ‘distance’.
A consumer is “any person who, is acting for
purposes which are outside his trade, business or
profession.” This is a standard EU definition used inother consumer protection directives. Unlike thestructure of the FSA’s rules, this definition does notinclude any recognition of sophistication. Potentially,an individual making a multi-million pound
investment in an investment fund will be subject to thesame protections as an investor placing £5 in an instantaccess savings account, so long as the investment is not
one related to their trade or business.
A financial service is “any service of a banking, credit,
insurance, personal pension, investment or payment
nature”. This is a very broad definition, althoughinterestingly some financial service products are
purposefully omitted, for example, occupational pension
schemes. The definition also brings into regulation anumber of products and services which have previously
been free from regulation – such as consumer lending
products for amounts over £25,000 and generalinsurance products – although these are to be the subjectof more specific future regulation. The broad range of
products means that there are a number of different
regulators ensuring compliance with the new regime –the FSA, the Office of Fair Trading and the Treasury depending on the nature of the product or service.
A ‘distance contract’ is any contract for financial services“concluded between a supplier and a consumer under anorganised distance sales or service scheme run by the
supplier who for the purposes of that contract, makes
exclusive use if one of more means of distancecommunication.” This definition has been the subject ofmuch debate in the UK and is particularly important forproviders using a number of different delivery channels,
including branch premises.The DMD makes reference to“no simultaneous physical presence” and the question
arose as to whether “simultaneous physical presence”
needed to be some form of meaningful discussion
between the supplier or intermediary and the consumer.
The FSA’s current view is that in order for a contract tofall within the meaning of a distance contract: (a) firms
must have put in place facilities which are designed toenable a retail customer to deal with the firm exclusively© Informa UK Ltd 2004 Tel: 020 7017 5532

at a distance (such as by post, fax, internet, telephone or bydirect offer advertising); and (b) there must have been no
simultaneous physical presence of the firm (or theintermediary) and retail customer throughout the offer,
negotiation and conclusion of the contract. It is yet to be
seen whether the Office of Fair Trading - or indeed thecourts – will adopt the same interpretation.
There are two main requirements. Certain
information must be given to the consumer about thefirm, the service, the contract and complaints
procedure.The consumer must also be informed of theexistence or absence of a withdrawal (or cancellation)right. The DMD requires all contractual terms to beprovided unless an exemption applies.
Consumers will have a period of 14 (or in some cases30) calendar days to withdraw from the contract,
without the obligation to give any reason.The right ofwithdrawal does not apply to all distance contracts
such as: those secured by a mortgage on land; those oflife insurers, operators of collective investment schemes
and trustees; services related to foreign exchange,
money market instruments, transferable securities andunits in collective investment undertakings. There arealso no withdrawal rights for contracts whose
performance has been fully completed by both parties
at the consumers’ request before the consumer
exercises his right of withdrawal. Exercising the rightof withdrawal terminates the contract. Any sums paidby the customer must be returned immediately andwhere monies have been supplied to the consumer,
these must be repaid within 30 days of cancellation.
It is interesting to note that the withdrawal regime of
the DMD overlaps with the cancellation provisions of
the Consumer Credit Act 1974. Although thecancellation regime of the Consumer Credit Act is
triggered where there are face to face negotiations it is
not uncommon for lenders to treat all of theiragreements as cancellable. The risk of choosing thewrong option under the Consumer Credit Act can becomplete unenforceability.Applying both regimes to thesame agreement can cause difficulties - under theConsumer Credit Act if a borrower cancels and repays
in full by the first instalment date then interest cannot becharged. Under the DMD interest can be charged if theborrower specifically requests that the funds areadvanced before the end of the cancellation period. Is it
open to a lender to charge interest under one regime
when they are not permitted to do so under the other?
How will a lender know which regime the consumer
has used to cancel the agreement?
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Financial Regulation International . December 2004/January 2005 . Issue 7.10

The requirements on their face value do notappear onerous but for many institutions achieving
compliance has been a challenge. Processes can behighly automated – introducing a new step or changing
an existing process can cause significant issues. It is notuncommon for the full terms and conditions relating toa financial product to be disclosed after the conclusionof the contract with suppliers relying on contract or
pricing summaries.This will no longer be sufficient.
The DMD states that ‘sanctions must be effective,
proportional and dissuasive.’ In the UK, enforcement inrelation to any alleged breach will be carried out byeither the FSA or the OFT depending on whichauthority is the responsible regulator for the particulardistance contract. No details of specific penalties havebeen published.
The DMD has been implemented on a country oforigin basis in the United Kingdom. However, HM
Treasury has acknowledged that the DMD isambiguous as to whether the responsibility for
enforcement would be on a ‘host state’ or a ‘home state’basis. Its interpretation is based on an analysis of Article
16, which contains a transitional basis permitting
Member States to impose provisions in the Directive
on a host state basis where the Member State of originof the supplier has not yet implemented the DMD.
HM Treasury’s view is that a country of origin basis
must be correct since, under a home stateinterpretation, Article 16 would be redundant. The
effect of this is that the UK DMD provisions apply toa supplier established in the UK when it provides
services to a customer in the UK or in another EEA
country.The rules of the other EEA country may also
apply if this country has implemented the DMD on ahost state basis. The UK’s provisions do not apply tomarketing into the UK from an EEA firm entering
into a distance contract for financial services from anestablishment in another Member State where that
Member State has also implemented the DMD on acountry of origin basis. The UK rules do, however,
apply if that Member State has failed to implement the
DMD. Given what appears to be patchy complianceacross the EU, this may well mean that the UK
provisions will apply to in-coming EEA firms.
If regulated activity takes place in the UK, the DMD
will apply to a non-EEA firm unless an exception foroverseas firms applies under the terms of theRegulated Activities Order.
The DMD does not use the concept of residency andleaves open the issue of whether UK firms providing
outbound financial services to non-EEA customers haveto apply DMD requirements. However, the FSA has
made it clear in COB that some of the DMD
requirements do not apply in relation to outboundfinancial services from a UK firm to non-EEA
customers. In particular, the cancellation rights in COB
do not apply to non-EEA customers, although the precontractual information requirements generally do.
The DMD introduces important new rights into
consumer financial services agreements and imposes
additional obligations on financial service providers.
Complying with the new regime has been a challenge
for many service providers with considerable amountsof documentation requiring amendment. It remains tobe seen whether transition to the new regime has beensuccessful and whether consumers will notice any
significant benefits.
Julie Patient, Consultant, Financial Institutions Group, Lovells

UK
Implementing the Market Abuse Directive
In order to implement the Market Abuse Directive(MAD) the FSA has drawn on its experiences inprosecuting both firms and individuals. The result is a
substantial change to the Code of Market Conduct(MAR). Once the proposed rule changes are finalised in
November 2004, the market abuse regime will have amuch broader scope than it has at present and will
significantly extend the requirements on regulated firms
to demonstrate that controls exist within their businesses
to prevent market abuse.This includes the requirement
to report suspicious transactions to the FSA.
14

In implementing its revised rules, the FSA will still
expect firms to implement their own risk management
processes within the framework provided by them.
This however, may create difficulties for someinstitutions as to what to do at a practical level. Thereis no prescriptive answer to the question ‘what do I
need to do now?’The issue is much more one of ‘what
am I currently doing?’, ‘how does this fit in with the
MAR?’ and ‘what further steps do I now need to take?’
Whatever decisions are taken, firms need to be mindfulof the reputational risk issues that can arise by failingto adhere to the spirit as well as the detail of the rules.
© Informa UK Ltd 2004 Tel: 020 7017 5532

www.informafinance.com

This article presents some of the issues facing senior
management in financial services firms and thepractical steps which now need to be taken to address
the provisions of MAR.
One of the FSA’s four statutory objectives is the
reduction of financial crime. The FSA has indicatedthat it expects firms to have in place, at all times,
policies, procedures and controls to prevent financial
crime. It also expects the executive management ofregulated firms to be fully engaged with the issues.The
rulebooks currently used by the FSA to enforce its
approach to detecting and preventing financial crime
are the Money Laundering Sourcebook (ML) and theCode of Market Conduct.
The Money Laundering Sourcebook provides
prescriptive requirements and guidance in respect ofsystems and procedures that a firm is required to havein place in order to prevent detect and report money
laundering. The proposed Code of Market Conduct
outlines the FSA’s approach to preventing insider
trading and market manipulation.
In order to implement the directive and related
regulations the FSA proposes to make a number ofchanges to: listing rules; MAR; COB; and pricestabilisation rules.
The regime remains a behaviour-based regime andwill continue to require firms and individuals to beaware, in all their dealings, of the Approved Persons
Code, the FSA Principles and the detailed rulebooks.
The rule changes are substantial, but the spirit of theresulting regime remains in essence the same as thepresent regime. What has not changed is that theburden of proof that market abuse was not the intended
outcome of a particular behaviour or series of trades
remains with the ‘defendant’. This therefore puts
pressure on senior management to ensure that theappropriate controls exist within an organisation to beable to justify, after the event and should the need arise,
the bona fide purposes of any actions taken.
Individual traders and line management must, whenin the middle of a transaction, always be aware that theunseen consequences of those actions might in the
future be interpreted as being abusive.The FSA is keen
to emphasise that, notwithstanding the rule changes, if
a behaviour is prohibited now it will remain so once
the new rules come into force.

Under the Code there are eight relevant behaviours;• All EEA regulated markets are covered;• The range of equity, debt and derivative investments
is being extended to include any instrument that is
admitted to trading; and• In order to incorporate abuses arising from inappropriate management of conflicts of interest, the rangeof activities covered by the Code has been expanded.
• The current four offences are being replaced by two– insider trading and market manipulation.
The FSA accepts that there is a need, under certain
circumstances, for exemptions to the rules (safeharbours).These safe harbours are permitted providingthat the controls around the management of them canbe demonstrably seen to be working.
However, the safe harbours under the Directive havea narrower and more specific meaning than the present
regime; therefore the FSA will need to make somechanges to its safe harbour provisions.
In having to implement MAD, the FSA has beenpresented with an opportunity to revisit, with renewed
vigour, its approach to combating market abuse within
its managing of financial crime obligations. In ensuringthat regulated firms are controlling market abuse risk
and that compliance with the new rules is embedded
within their businesses, the FSA would expect senior
management to be taking action now. This actionneeds to:• Reassess documented processes that are in place toidentify possible areas of market abuse risk, anddocumentary evidence of the extent of market
abuse risk.
• Determine and confirm that compliance and control resources are adequate to address market abuserisk in an appropriate manner.
• Review monitoring programmes to aid in identifying market abuse risk, and ensure that the reportingof any suspicious transactions to the FSA will occur.
• Confirm that accurate, timely and up to datemanagement information is available on market
abuse risks.
• Review training of key staff throughout the businesson market abuse issues.
• Develop on-going awareness through monthly
compliance briefings on market abuse issues.
Management actions

The Market Abuse Regime

There are some key changes under the new rules:• The present code identifies four relevant behaviours.
© Informa UK Ltd 2004 Tel: 020 7017 5532

The extent of required actions is hugely influenced bywhat steps have already been taken by firms since N2
to implement the Code of Market Conduct:
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Financial Regulation International . December 2004/January 2005 . Issue 7.10

• Firms will need to review their safe harbour controls
to be able to demonstrate that they are meeting at least
the minimum standards expected under the Code.
• Compliance may require the establishment orenhancement of existing market abuse controls.
• Controls and relevant management information
relating to prescribed markets will need to beextended from the present narrow base to include amuch wider range of markets.
One of the most important factors in the avoidance ofmarket abuse is the development of a good complianceculture.To comply with the Code fully, related controls
need to be embedded throughout the organisation.
Some of the controls may well be in the businessalready but the key is now to link the controls in sucha way as to be able to meet the requirements of theCode. Management may need to enforce the Codethrough behaviour change and awareness training.
Senior management will need to realign existing
controls to ensure that market abuse behaviour under
the Code is prevented and appropriately managed.This
may involve linkages with financial crime controls andexisting suspicious reporting mechanisms.
Minimum controls

In order to avoid enforcement, senior management
needs to invest in controls which demonstrate thatmarket abuse risk is appropriately managed. Examplesof minimum controls and procedures include:• restricted lists;• minutes confirming the basis of investment decisions/investment actions;• details of post trade date transaction amendments;• details of off-market trades;• details of volume inducing sales;• correlation reports between the placing of buy/sellorders and changes to market sentiment;• counterparty trading pattern matching;• transaction pattern matching reports; and• suspicious transaction reports.
Conclusion

As a result of the FSA’s consultation paper on
implementing the Directive, the financial services
industry and listed corporates now know what theCode is likely to look like once the Directive comes
into force. The Code does not require senior
management to remove the risk of market abuse fromtheir businesses, but expects them to manage the risks
appropriately.
Senior management needs to review the extent of its
existing controls around market abuse in order to gain
comfort that they will still meet the FSA minimum
standards under the new Code. Most firms are likely toneed to make some changes to the control framework
they have in place. For any firms which have neglected
this area in the past now is the time to ensure thatsuitable market abuse controls are implemented.
Andrew Clark (020 7804 5761) and Jason Dalrymple (020 7804 7228), PricewaterhouseCoopers

China
Moving China’s Goalposts
The forthcoming reform of China’s bankruptcy sector
will have some major implications, not just for China,
but also for international business and Hong Kong
SAR. Many would argue that the People’s Republic ofChina will be the World’s next economic superpower.
Some would say that it is already. However, scraping
beneath the veneer reveals serious structural
shortcomings, both in the legal system, financial system
and in the transparency of commercial trade, where theobligation of a government agency to economic
entities established by it, such as Hong Kong-based
window companies, is often opaque.
This really should be no surprise from an enormous
country, with a population approximately equating to
one quarter of the entire planet’s, which only 30 years
16

ago had no private companies at all. It has been an
impressive transition towards a market based economy byanyone’s benchmark. No longer just a source of cheap
labour, goods and services, China has become a major
marketplace, craving all kinds of foreign products andinvestment. As China strides towards its WTO goal of asocialist market economy, through gradual reform andrestructuring, opportunities are abound for international
businesses, and pressure afoot ‘to be there’. For suchcompanies, the management of risk when investing in or
doing business in China is increasingly relevant.A strong
bankruptcy regime, and knowing how to use it, is one
central aspect of risk management in any jurisdiction.
The introduction of a new draft bankruptcy law toChina’s top legislature on 21 June 2004 could mark the
beginning of major changes to China’s investment climate.
© Informa UK Ltd 2004 Tel: 020 7017 5532

www.informafinance.com

This article looks at the current state of play, the policy
issues under debate, and the relevance that its enactment
could have on international business tomorrow.
The need for reform

The current bankruptcy regime in China is a long way
from being satisfactory. Whether managing risk,
contemplating recovery, or considering China’s own
aspirations, namely the development of a market
economy, conducive to free enterprise, foreigncompetition and a ‘survival of the fittest’ culture, it isclear that a major overhaul and modernisation isrequired.The potential benefits to China’s economy of amore efficient bankruptcy system, under which unviableeconomic resources can be closed down and redeployed
to more viable segments of the economy, and wherebusinesses can be reorganised and rescued, each in a waythat promotes optional market activity and investment,
but nevertheless safeguards employment and social
stability, are obvious. What is not obvious, however, is
how to achieve these goals within China’s existing legal,
institutional and cultural framework.
The problems with the current bankruptcy
framework in China are numerous, but in very generalterms could be summarised as follows:• Depending upon the type of entity in question,
the approval of the Ministry of Commerce, or ofsome other governmental or regulatory body, may
be required before bankruptcy procedures can beinitiated.
• The rules and regulations focus on the issues ofresettling employees and reallocation of existing
business/assets to other economic usage - only leftovers are paid to creditors.
• Creditors have very few legal rights or remedies,and very limited opportunity to participate in thebankruptcy process. As a result, laws enabling prebankruptcy transfers defrauding stakeholders to bereversed are not always enforced in practice. Similarly, disposals of assets in the bankruptcy are notalways handled in a way aimed at maximising
recoveries.
• There is limited involvement of the courts and inany event there is no independent judiciary withlegal or other expertise in bankruptcy matters.
• The current bankruptcy laws lack detail and depth
in many aspects and have to some extent become
outdated.
• China’s laws and regulations are not generally conducive to corporate restructuring or reorganisation.
© Informa UK Ltd 2004 Tel: 020 7017 5532

The Chinese authorities’ decision in 1998 to formallyplace Guangdong International Trust and Investment
Corporation (GITIC) into bankruptcy proved aparticularly painful experience for China. Many foreignbanks had made loans on the understanding that suchloans were backed by the provincial government, only tofind that the provincial government was not prepared tostand behind GITIC and repay them. One result of thiswas a reappraisal of risk management by foreign banks.
Further, the inefficiencies, opacity and creditor
unfriendliness of China’s existing bankruptcy framework
were exposed for the world to see.
Chinese authorities recognise that the current
bankruptcy system is not adequate to meet the needsof China’s economic system today and that an efficientsystem is an essential cornerstone of China’s effort tobuild a market economy.
However, the need to first improve and reform China’s
social security structure, to cater for the millions ofworkers who might be laid off through bankruptcy
procedures, with consequential risk of social unrest, hasbeen given priority over reform in the bankruptcy sector.
Another priority has been the need to reform (throughcorporatisation, privatisation or internal restructuring)
many state-owned enterprises (SOEs) (including stateowned financial institutions) into viable enterprises,
capable of surviving a market economy, private-sector
competition and an efficient bankruptcy regime.
Now that reforms in these areas have been on-goingfor a number of years, a draft of a new andcomprehensive law, currently entitled the PRC Enterprise
Bankruptcy and Reorganisation Law (DBL), has recently
been brought before the Standing Committee of the
National People’s Congress, China’s top legislature, forthe first of three hearings.The fact that the DBL has now
been brought before China’s legislature may indicate thegovernment’s confidence that the reforms to social
security and SOEs are now sufficiently advanced, suchthat the time has arrived for comprehensive reform in
the bankruptcy sector. If the DBL is enacted in 2005, asmany commentators and officials predict, it would
represent a major step in the bankruptcy reform process.
Baker Tilly Hong Kong and Freshfields Bruckhaus
Deringer have each been close observers andcommentators on the various drafts of the DBL as it has
evolved.This draft legislation has been undergoing draftingand consultation for around 10 years. Some commentators
suggest that such a long delay indicates how fiercely
Chinese officials have been divided over whether social
stability should have priority over market considerations.
17Financial Regulation International . December 2004/January 2005 . Issue 7.10

However, this would appear to unnecessarily politicise
what is a matter of necessity for any developed economy– there must be a social security ‘safety net’ before, or as
part of, an efficient bankruptcy process.
The current move towards reform in China’s
bankruptcy sector also coincides with a more general needto enhance protection of creditors’ rights, which has
recently assumed greater importance in light of China’s
post-WTO urgency to progress financial institution
reform and commercialisation of the major state-ownedbanks. A bankruptcy system providing more creditor
protection will improve the recovery rates of state-ownedbanks in their efforts to resolve their significant nonperforming loan ratios (through disposition, settlement orotherwise) and generally reduce the lending risk of suchinstitutions. Recently published estimates have placed
non-performing loans in China at around US$600 billion!
Current laws and regulations

Legal reform is certainly a good starting point in theprocess of reforming China’s bankruptcy sector, as
China does not yet have a unified bankruptcy law thatapplies throughout the country and to all types ofdebtor entities.
Today, China’s bankruptcy law is a patchwork ofoutdated legislation, held together by ‘quick fix’
regulations promulgated by the Supreme People’s Court(SPC), together with local rules and regulations in certain
localities. The legislation applicable to a particularbankruptcy or reorganisation depends on the nature and,to some extent, the provincial location of the debtor andwhether it is an SOE or an enterprise which is not stateowned (non-SOEs). Non-SOEs include collective,
private and foreign-invested enterprises.
Non-SOEs now play a major role in the Chinese
economy today and are not covered by any specialisedbankruptcy law. This gap has been temporarily filled
by some very basic and brief rules for the bankruptcy
of non-SOEs, as set out in The PRC Civil Procedurelaw (CPL), coupled by an interpretation from the SPC
providing that the PRC Enterprise Bankruptcy Law,
which applies only to SOEs, shall apply by reference
to non-SOE bankruptcies in matters on which the
CPL is silent.
During July 2002, further regulations were issued by
the SPC to provide much-needed supplemental rules
and procedural guidance to assist courts dealing with thebankruptcy of SOEs and non-SOEs alike. They areviewed by many as a ‘stop-gap’ measure pending thepromulgation of comprehensive bankruptcy legislation.
18

The draft new law

Currently, there are several ‘hot’ policy issues
surrounding the DBL:
• Whether it will create a truly unified bankruptcy
regime applying also to SOEs and not only to nonSOEs. The current draft applies to all enterpriselegal persons, but also provides that the State Council may separately enact regulations specifying thetime limit and scope within which the new bankruptcy law will apply to SOEs. It has been reported
that the new law may be applied to certain types of
SOE in a ‘phased manner’.
• Whether it will apply to financial institutions, particularly those poorly-managed state-owned banks
which might otherwise require bailing out by the
Chinese government (the current draft states that
there will be separate implementing rules for commercial banks, insurance companies and otherfinancial institutions).
• The extent to which social security expenses andemployees’ claims are to be given priority under any
bankruptcy or reorganisation process.
Press reports quoting various Chinese officials,
academics and central bankers suggest that the DBL’s
passage through the legislature will be no rubberstamping exercise. The DBL may therefore undergo anumber of further changes before it is enacted.
Nevertheless, the current draft of the DBL appears
to be very much a comprehensive piece of legislation,
containing many concepts familiar to the bankruptcy
regimes of many developed countries, such as:• application to court for initiation of bankruptcy
proceedings by debtor or creditor – no need forprior governmental approval;• advertisement of bankruptcy proceedings and stayof all other legal proceedings;• defined bankruptcy criteria including ‘cash flow’ test;• the administration to be handled by courtappointed insolvency administrators, who mustpossess specified professional qualifications, such as
certified public accountants and lawyers;• supervising powers vested in creditors’ meetings anda creditors’ committee;• investigation by the court of management’s conductand corporate affairs;• repudiation or assumption of pre-existing contracts
by administrator;• priority of security interests and certain types of‘preferential’ claim;• creditor classes and voting;© Informa UK Ltd 2004 Tel: 020 7017 5532

www.informafinance.com• rights for disgruntled creditors to appeal to court;• filing of claims, including joint claims, claims underguarantee and unliquidated claims;• conversion of foreign currency claims into RMB;
• provisions regulating insolvency set-off;• set aside of fraudulent preferences, transfers at
undervalue and other improper transactions;• overall supervision of process by court;• comprehensive reorganisation and rescue mechanisms; and• powers enabling Chinese courts to recognise foreign
insolvency proceedings.
Subject to the above comments regarding SOEs andfinancial institutions, the DBL would apply to all kindsof commercial enterprise and lawfully establishedeconomic entities, including partnerships and theirpartners and sole proprietorships. However, individual(consumer) bankruptcy would not be covered.
A comparison of the most recent draft of the DBL
against the draft of two years ago indicates a trend
towards preferring to increase the involvement ofcreditors, as the major stakeholders in any bankruptcy
process, and reducing the involvement of the courts.
These changes appear sensible, given that an independent
judiciary, experienced in bankruptcy matters, will needtime to be established and likely concerns that, at least
initially following enactment of the DBL, courts in
China’s provinces may tend to favour the borrower, its
employees and other local interests.
How would the new bankruptcy law affectinternational investment into China?

The enactment of the new legislation will not of itself
solve the current lacuna that is China’s bankruptcy
system. Nevertheless, a very important first step in thereform process will have occurred and international
investors will see tangible evidence of a majorcommitment on the part of the Chinese’s authorities
to a process of gradual development towards anefficient bankruptcy system.
It will likely take several more years for the courts
and their judges to develop experience and expertisein this area, for ‘test cases’ to be run and interpretationsdelivered, for regulations and procedural rules to be
made, for a reputable (and regulated) private sector
body of professional ‘administrators’ to emerge, for an‘administrator of last resort’ function to be set up (forcases where they are insufficient assets to pay the feesof a private sector practitioner), for treaties on crossborder recognition of insolvency proceedings to be© Informa UK Ltd 2004 Tel: 020 7017 5532

concluded with other countries, and for the process
and its rules to gain familiarity and understanding in
the minds of all involved.
Even though bankruptcy law reform in China will
be welcomed by international investors, in the shortterm they are unlikely to change significantly thevarious methods which they use to mitigate their
exposures to counter-parties in China, through theusage of ‘off-shore’ structures or otherwise.
However, and over a period of years, not months, one
would expect more confidence amongst international
investors, and perhaps:• greater reliance on contracts;• greater confidence in minority shareholder andjoint venture structures;• increased foreign lending, both on an unsecured andsecured basis;• increased shareholder value for those foreign companies which hold investments in Chinese companies;• positive revaluation of non-performing loans byboth sellers and buyers;• improvement to the financial condition of stateowned banks, through improved recovery rates inrespect of non-performing loans and reduced lending
risk, in turn leading to faster opening up of the financial sector to foreign competition in line with WTO;
• greater participation by foreign investors in auctions
and other disposals of non-performing loans bystate-owned banks or asset management companies;• possibly, opportunities for foreign professional firms
to sell their services in China’s bankruptcy sector;• better recoveries by foreign investors in respect of
their lending to Chinese counter-parties, or in
respect of non-performing loans which they havepurchased;• investors seeking to exit joint venture agreements
may have more negotiating leverage; and• more prospect of cross-border recognition of insolvency proceedings initiated outside China.
Implications for Hong Kong SAR

Hong Kong is fortunate to have its own welldeveloped bankruptcy system already. However,increasingly the effectiveness of Hong Kong’s system isbeing undermined by the need for reform in China’s
bankruptcy sector.
In recent years, particularly following the handoverof sovereignty over Hong Kong, there has been anotable shift towards closer integration between theeconomies of Hong Kong and other Chinese cities in
19

Financial Regulation International . December 2004/January 2005 . Issue 7.10

the Pearl River Delta area, such as Donguan,
Guangzhou and Shenzhen, some of which are also
special economic regions of China. While Hong
Kong companies continue to expand their businesses
into China, particularly into these cities or theirprovinces, throughtheestablishmentofmanufacturing facilities, joint venture arrangements
or otherwise, Chinese companies are expanding theirbusinesses into Hong Kong. It is seen as the financial
capital for the region, through public share listing,trade or investment.
Nowadays, and as a result of the integration
described above, nearly every medium or large
corporate insolvency in Hong Kong involves someassets, business or related entities in China. The
absence of a developed system in China to enable theChinese aspects of the case to be handled, andsatisfactory cross-border recognition of proceedings,
necessarily lessens the efficiency and effectiveness ofHong Kong’s bankruptcy system, which in turnimpacts confidence and international investment intoor through Hong Kong. It is therefore of significant
importance for Hong Kong, and for Hong Kong’s
government and business community, to promote andencourage the early development of an efficientbankruptcy regime in China, appropriate crossborder recognition between Hong Kong and China,
and an overall result that is truly one country, twosystems.
Fortunately, an opportunity for Hong Kong to haveits say may be available. After all, where else is China

likely to look for the some of the necessary bankruptcy
expertise and experience which it will certainly needto reform its bankruptcy sector, whether throughpromulgating new legislation, reforming its judicial
system or ensuring experienced and reputableprofessionals are available to handle bankruptcy cases?
In the drafting process of the DBL, China has alreadysought input from some of Hong Kong’s most
reputable insolvency professionals and academics. At atime when Hong Kong has ‘insolvency resource’available following its recent recession, China requires
large quantities of expertise and recent experience.
Could reform in China’s bankruptcy sector become aHong Kong affair? Will the Chinese authorities offer
this opportunity and will Hong Kong’s insolvency
industry grasp it?
Conclusion

The investment climate in China is changing and the
new bankruptcy law will be a significant landmark.As
with any change, there are opportunities for those
who see them. Tracking the progress of China’s
bankruptcy reform will be important for investors, as
will careful risk management and planning ofinvestments. For the business community andinternational investors in the Pearl River Delta, there
will be an increasing need to understand thebankruptcy systems of both Hong Kong and China,
and their interrelationships.
Michael Barker, partner of Freshfields Bruckhaus Deringer and head of Asia restructuring andinsolvency and: Rupert Purser, partner of Baker Tilly Hong Kong and insolvency practitioner

Editor: Virginie O’Shea • tel +44 (0)20 7017 4128 • fax +44 (0)20 7017 4135 • virginie.o’shea@informa.com
Associate Editors: Joanna Gray, Solicitor and Senior Lecturer in Law, University of Dundee
Karel Lannoo, Senior Research Fellow, Centre for European Policy Studies
Dr. George A. Walker, Solicitor and Senior Lecturer in Law, Centre for Commerical Law Studies
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