Evidence submitted by the Financial Conduct Authority (SME0033)

SME Finance

Financial Conduct Authority Written Evidence

Introduction

1. The Financial Conduct Authority (FCA) welcomes the Treasury Committee’s SME Finance Inquiry. Our response focuses primarily on the ability of small and medium sized enterprises (SMEs) to resolve disputes with financial services firms.

Funding options available to SMEs

2. Much of SME lending is unregulated. As such, we have only limited data on SMEs’ funding options. Our 2017 Sector View[1] on retail lending notes that there are a small number of lenders with a large market concentration in the SME banking market. This may reflect the relative complexity of serving this market compared to retail customers. Nevertheless, we do observe challenger banks seeking to enter this market (though the entry costs are higher than say for mortgage lending because it requires more specialist market knowledge). Further, there has been innovation in the supply side with firms seeking funding via crowdfunding and peer to peer platforms. From the demand side, as we noted in our 2015 Discussion Paper ‘SMEs as users of financial services’ (DP 15/7), purchasing financial services are not core business operations for most SMEs and they do not have specific teams or functions tasked with pursuing complaints or claims.[2] Furthermore we have also observed that smaller firms behave more like retail consumers. In terms of types of product used, our Sector View notes that around half of SMEs use credit cards and two fifths use overdrafts.[3]

The ability of SMEs to resolve disputes and access fair and reasonable compensation when they borrow money

The effectiveness of existing arrangements for dispute arbitration and settlement

3. We reviewed the regulatory protections available to SMEs in DP15/7 and asked whether we should improve them. Our analysis and the feedback we received suggested the current approach to whether and how SME finance activities are regulated broadly strikes the right balance between protecting SMEs and ensuring SMEs can access financial services. This is because the Senior Managers and Certification Regime (SM&CR) will deliver greater accountability and raise standards of conduct at all levels, across all activities, both regulated and unregulated. We also believe that voluntary industry codes can help raise standards in unregulated markets and are consulting on how we can encourage the take-up of good quality codes and standards by authorised firms. We continue to keep under review whether SMEs have appropriate regulatory protections.

4. Our review did confirm that many SMEs struggle to resolve disputes with financial services firms and seek redress when things go wrong. For many SMEs, going to court is the only option for disputes that cannot be resolved directly with firms. This is because larger SMEs are currently not eligible for the main alternative route to redress in the financial services industry, the Financial Ombudsman Service (‘the Ombudsman’).
    
5. Litigation is, however, costly and time consuming and, consequently, when things go wrong only a very small proportion of SMEs take their disputes with financial services firms to court.[4][5] Even well-resourced businesses might find it difficult to take legal action. This is because financial services disputes often coincide with cash flow stresses and other threats to the business. In these circumstances the cost and speed of redress is often critical to an SME’s ability to stay in business.

6. Furthermore, where SMEs do take disputes to court, their causes of action are much more limited than those available to individual consumers, even if the SME benefits from protections under our rules. This is because section 138D of the Financial Services and Markets Act 2000 (‘FSMA’) only gives a right of action for damages to ‘private persons’ where a firm breaches our rules. A company acting in the course of business does not meet this description. Instead companies must rely on the more limited causes of action available under the general law, e.g. for misrepresentation, breach of contract or negligence.

The Financial Ombudsman Service

7. The Ombudsman is the permanent dispute resolution service for the financial services industry, established under FSMA. The Ombudsman deals with complaints about both regulated and unregulated activities that have not been resolved by regulated firms to the consumer’s satisfaction, or where firms have failed to respond to the consumer within eight weeks of the complaint being submitted. If a resolution cannot be achieved by the parties agreeing to a provisional assessment (often mediated by the Ombudsman), the dispute is passed to an ombudsman for a formal determination. If the complainant accepts the ombudsman’s determination it becomes legally binding on the firm.  Ombudsman decisions do not bind the complainant, who can choose to reject the decision and pursue other avenues (eg they can still go to court). Typically, around nine in ten disputes are resolved by the Ombudsman without the need for a formal determination.[6]

8. The statutory remit of the Ombudsman is to resolve disputes ‘quickly and with minimum formality’. The Ombudsman determines complaints on the basis of what is, in its opinion, ‘fair and reasonable in all the circumstances of the case’, rather than strict legal liability (see paragraph 9). In doing so, the Ombudsman takes account of the law, rules and good practice in the industry. Other than by judicial review, there is no possibility for the firm to appeal an ombudsman’s decision. This means the Ombudsman is an appropriate mechanism for the resolution of relatively straightforward, lower value disputes. (While the Ombudsman can recommend any amount of compensation, firms are only required to pay up to the binding award limit set by the FCA.[7] The current limit is £150,000 and was set at this level following our last review in 2012.)

9. The Ombudsman is not a court and its determinations do not create binding legal precedent. However, the Ombudsman does, through the determination of complaints and publication of ombudsmen’s decisions, effectively establish standards for the determination of similar, future complaints, and which firms and SMEs will become aware of.  Our Dispute Resolution: Complaints sourcebook (‘DISP’) includes guidance in relation to firms’ consideration of Ombudsman decisions.[8]

10. At present, only individual consumers, small charities and trusts and ‘micro-enterprises’ are eligible to access the Ombudsman.[9] We are currently consulting on extending access to the Ombudsman to a new category of larger SMEs, charities and trusts (see below).

Consumer redress schemes

11. The Ombudsman provides an independent dispute resolution mechanism and access to redress for individual disputes brought by individuals and some businesses. Where the FCA judges there may have been a regular or widespread failure by firms to comply with regulatory requirements, the FCA can establish an industry wide consumer redress scheme under section 404 of FSMA. Other conditions must also be satisfied before such a scheme can be set up. The FCA must also have judged that consumers have suffered (or may suffer) loss or damage for which a remedy would be available in legal proceedings. Finally, the FCA must consider that it is desirable to establish a scheme to secure redress for consumers, having regard to the other ways in which they may obtain redress (eg through the Ombudsman).[10] These conditions are set out in FSMA.

12. A consumer redress scheme may require firms to review their conduct, for example in relation to the sales of a particular product to customers, and determine whether redress is due and in what amount. The FCA may also appoint competent third parties (for example, an accountancy or law firm) to oversee the operation of the redress scheme.

13. Section 404 consumer redress schemes are an appropriate mechanism for cases involving large numbers of consumers, where harm or potential harm has already been established, and where there is a need for consistent determination of who is entitled to compensation and how much. The Ombudsman or the courts are unlikely to be an efficient way to deal with such cases.

14. SMEs are less likely than individual consumers to benefit from a section 404 scheme. This is because businesses are generally not considered to be ‘consumers’ in their capacity as borrowers. Additionally, any businesses that could be considered consumers for the purpose of a section 404 scheme would have no legal remedy for breaches of the FCA’s rules. This is because section 138D of FSMA restricts such remedies to ‘private persons’ (see paragraph 6). The Government would need to amend the definition of who is a ‘private person’ in secondary legislation to change this.

15. Exercising our powers to establish a redress scheme under section 404 requires the FCA to undertake a public consultation and to put in place procedural rights for firms. This means securing redress for consumers can take a considerable length of time. Where this is the case, and where appropriate, it may be possible to set up voluntary redress schemes more quickly to address detriment.

The merits of the Financial Conduct Authority’s proposals for expanding SME access to the Financial Ombudsman Service

16. The FCA has the power to set the eligibility criteria for accessing the Ombudsman in relation to its ‘Compulsory Jurisdiction’.[11] Anyone meeting these criteria has the legal right to refer their complaint to the Ombudsman; those outside the criteria do not. To help ensure more SMEs have access to independent dispute resolution where they have a dispute with a financial services firm, we are currently consulting on allowing a broader range of SMEs to refer their complaint to the Ombudsman (CP18/3). The consultation closes on 22 April and we intend to make final rules in summer 2018.

17. In order to be eligible for the Ombudsman we are proposing that businesses must have fewer than 50 employees and turnover of under £6.5million per year and a balance sheet total of under £5million. Our analysis suggests that above these thresholds, businesses are more likely than not to have the financial and legal capability to protect their own interests.

18. The consultation proposals will make a significant difference to a large number of SMEs who may currently have difficulty resolving disputes with financial services firms. The proposals should result in around 160,000 more SMEs being able to refer unresolved disputes with financial services firms to the Ombudsman.  This will mean around 99% of all SME businesses in the UK will be eligible, with only the very largest SMEs remaining out of scope. We estimate this could mean up to 1,500 more disputes involving SMEs being considered by the Ombudsman each year.

19. We believe our proposals will lead to more SMEs receiving appropriate redress when they have suffered harm due to the actions of a financial services firm. Over time, we hope the changes will contribute to better services to SME customers in the first place, leading to fewer complaints and better outcomes for SMEs, as well as contributing wider benefits to the real economy.

20. As part of our consultation we are also inviting views on other changes to the Ombudsman that are within the FCA’s powers. In particular, we recognise that allowing larger organisations to complain to the Ombudsman could increase the number of claims significantly in excess of the Ombudsman’s binding award limit.

21. However, as we note in CP18/3, if the Ombudsman had a significantly higher award limit, then the parties to the highest value complaints might expect the basis for decision making and the investigation process to more closely resemble those of a court, perhaps with representation, hearings and appeals etc. The Ombudsman’s award limit and its approach to dispute resolution are factors in financial services firms’ willingness to do particular kinds of business, and to serve particular types of customers. A higher award limit, particularly without changes to the Ombudsman’s approach, may reduce the supply of financial products and services that benefit SMEs.

The case for establishing a new ‘tribunal’ body for settling SME banking disputes and the means by which such a body could be created

22. A ‘tribunal’ can have a number of features that distinguish it from the courts. These include market specialists playing a role in decisions alongside judges, and a mixture of adversarial and inquisitorial systems, with the latter being particularly important in enabling complainants to be unrepresented; and a low-cost or costs-free regime.

23. Within the financial services dispute resolution system, we see a role for both the Ombudsman and a tribunal as they meet different needs. For example, the Ombudsman provides a quick and informal process for relatively low value financial services disputes. A tribunal, on the other hand, would provide a more formal, court-like approach for higher value disputes, or disputes involving complainants above the Ombudsman’s eligibility thresholds. A tribunal would also meet the demand of some complainants to have their ‘day in court’ – so that their case is heard in public with the parties giving oral evidence. While the Ombudsman can hold oral hearings, it does not generally do so. The Ombudsman does not have the power to compel the attendance of witnesses, take evidence on oath or test evidence by cross-examination.

24. We have provided some high-level comments in the next section on how a tribunal might interact with the industry’s existing mechanisms. However, as our Chief Executive, Andrew Bailey, stated at the Committee’s oral evidence session on 7 February 2018, the FCA does not have the power to create such a body. Such changes would require primary legislation and are therefore a matter for the Government.

The design, governance and operation of such a tribunal body, and the potential relationship between it, the Financial Ombudsman Service, and the Financial Conduct Authority

25. As set out above, setting up a tribunal is a matter for the Government. However, the creation of an additional statutory dispute mechanism within the financial services industry – whatever its design, governance and operation may be – is likely to have implications for the existing mechanisms, particularly the Ombudsman. It is, therefore, essential that the roles and responsibilities of the various schemes and the relationships between them and the court are clearly delineated in order to avoid unnecessary duplication and confusion among the users of the services and firms.

26. In terms of the relationship with the FCA, one issue would be the development of a charging scheme if the intention were for the system to be financed, at least in part, by a levy on firms collected by the FCA. We would expect, in the short term at least, the costs of a tribunal to be less predictable than the costs of the Ombudsman due to the greater complexity and value of the cases it would be likely to handle. Another issue would be whether we had an automatic right to intervene in proceedings, given that our rules may be under consideration.

The impact of additional avenues for redress on (i) the balance of power between SMEs and lenders; and (ii) the supply of, and demand for, credit

27. As with any change to regulation, improving SMEs’ access to redress needs to be carefully weighed against the impacts the changes could have on the supply and pricing of the different financial products and services offered to SMEs. Expanding access to redress could shift the balance of power between SMEs and the financial services firms, and therefore reduce SMEs’ access to different products and services, including lending.

28. The FCA’s cost benefit analysis for consultation proposals to improve SMEs’ access to the Ombudsman found that these outcomes are unlikely under our proposals. We will, however, continue to engage with the industry and SMEs and keep the impact of our proposals under review. It is difficult to speculate on the likely impact of a tribunal without knowing the specifics of its design, governance and operation.

29. The impact of improvements to dispute resolution may of course also be positive. For example, making it easier for consumers to resolve problems may increase revenues and profit margins as a result of greater consumer confidence in the products offered by firms. We have seen something similar with section 75 of the Consumer Credit Act. Section 75 makes the credit card company just as responsible as the retailer or trader for the goods or service supplied, thus providing incentives to consumers to use credit cards rather than debit cards or cash for large purchases.

The regulation of SME lending

The level of protection currently afforded to SMEs when they borrow money and the potential impact of changing the regulatory perimeter

30. Much lending to SMEs is currently unregulated. Changes to the regulatory perimeter are, of course, a matter for Government.

31. In the case of consumer credit, we regulate credit agreements with an unincorporated business, such as a sole trader or small partnership[12], unless the amount of credit is more than £25,000 (or another exemption applies). We also regulate hire/leasing agreements with sole traders and small partnerships if the hire could last longer than three months and does not cost more than £25,000. However, if the customer is a limited company (or another type of incorporated business), credit and hire/leasing agreements are not regulated.

32. In the case of mortgages, we regulate lending to sole traders and unincorporated partnerships if the mortgage is secured on land that is also being used, or partly used, for a home.[13] Our regulation may also apply to these types of businesses if they are borrowing to acquire or retain property rights in land or in an existing or planned building. As with consumer credit, if the customer is a limited company (or another type of incorporated business), mortgage agreements are not regulated.

33. We recognise that any change to the regulatory perimeter would need to balance, on the one hand, increased protections for SMEs as customers and, on the other, potential adverse implications for SMEs, in particular in terms of access to and cost of credit.

34. Relevant factors may include:

• The extent to which SMEs may be experienced or financially sophisticated in relation to financial products or may have access to professional advice.
• The frequency with which SMEs purchase financial products.
• Whether SMEs need access to bespoke products or services or may benefit from additional flexibility that may be constrained in a regulated environment.
• The protections for company directors inherent in limited liability structures.
   

Other non-regulatory or quasi-regulatory options for policing SME lending, such as the establishment of industry codes and standards

35. Other ongoing initiatives should also improve outcomes for SMEs. In particular, the Senior Managers and Certification Regime (SM&CR) will deliver greater accountability amongst senior management of authorised firms and raise standards of conduct at all levels, across all the firm’s activities, both regulated and unregulated. The regime came into force for banks in 2016 and will soon come into force for the vast majority of financial services firms[14].

36. We also believe that voluntary industry codes can help raise standards in unregulated markets. Our consultation (CP 17/37) explores how the FCA can encourage the take-up of good quality codes and standards by authorised firms, which can help reinforce the application of the SM&CR by providing a clear basis on which firms can communicate their expectations and assess individuals.

37. Where appropriate, we can consider giving formal recognition to relevant codes and standards in unregulated markets, where these interrelate with markets that we regulate, as a way of improving market conduct.

38. As such, our proposals to improve SMEs’ access to the Ombudsman can be seen as part of a package of measures that, in combination, should improve the protections available to SMEs and improve conduct in areas where we have limited powers to act.

March 2018

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