The Foskett Panel

Quantifying D & C Losses - Our Assessment Methodology

This guidance note is in four parts:

Overarching principle - compensation for financial D & C losses

  1. The amount of D & C losses is the amount required to put you into the financial position that you would have been in if the IAR Fraud had never happened. We therefore need to work out how much better off financially you or your Company would be if you (or it) had never been exposed to that fraudulent activity.

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How is our methodology different from the one used in the Customer Review?

  1. Firstly, we have published it. One of the key recommendations of Sir Ross Cranston in his Re-Review Panel Recommendations was that the Panel should publish its methodology before it begins work on individual cases, so that Customers are able to understand our approach from the outset.
  2. Sir Ross Cranston raised several concerns in The Cranston Review about the methodology used by the Bank for calculating D & C losses in the Customer Review. He said there was too much emphasis on the balance sheet of an entity as a measure of the value of the business when it entered the IAR and that this led to a flawed approach to assessing whether it had been appropriately referred into the IAR in the first place. He said, “that analysis was pervaded by the overarching attitude that the businesses did not have any value at the time of entry into IAR and were bound to fail”.
  3. He also said “there was an inappropriate focus on whether individual actions of the fraudsters were “reasonable”, and that there was a failure to consider properly what would have happened to the Company without the impact of the IAR Fraud".
  4. Another of his criticisms was that the methodology for assessing financial losses arising from reputational damage was “narrow in approach”.
  5. In designing our own methodology for assessing D & C losses, we have taken into account all comments and concerns raised by Sir Ross Cranston to ensure it is fair, reasonable and appropriately generous to the victim of the fraud.

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General approach to assessing D & C losses as a result of the IAR Fraud

  1. The general approach to assessing D & C losses as a result of the IAR Fraud will be as follows:
    1. Establish what actually happened to the Company from when the IAR Fraud started impacting the Company, and the actual cash flows in and out of the Company, including amounts paid to/by the Directors/Managers and Shareholders (the ‘Actual Scenario’);
    2. Construct a hypothetical scenario, representing what would, or could, realistically have happened to the Company and the Directors/Managers and Shareholders if the IAR Fraud had never happened. This may include what would have happened with honest, proper and reasonable actions by a hypothetical bank (which we shall call in this document the ‘Hypothetical Reasonable Bank’) and to the extent any advice would have been necessary from turnaround consultants, it would have been honest, competent and reasonable advice (the ‘Non-Fraudulent Scenario’); and
    3. Compare the position of the Company, Directors/Managers and Shareholders in each scenario. The amount by which each was financially worse off under the Actual Scenario is the amount of the D & C losses suffered.
  2. Further detail of each of these stages is explained below.

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Establishing the Actual Scenario

  1. From the information available to us (see our Scope and Methodology - Panel’s Information gathering stage), we will seek to establish what happened to the Company during the Relevant Period (see the notes below), including its financial state at the start and at the end of the Relevant Period and the financial activity in between, particularly:

    Cash inflows from:

    • Profitable trading activity
    • Loans advanced
    • Share capital injections
    • Sales/disposal of assets

    Cash outflows from:

    • Loss-making trading activity
    • Bank fees and interest/penalties
    • Loan and other creditor repayments
    • Assets acquired
    • Fees paid to QCS/Associates
    • Fees paid to (non-criminal) professional advisers
    • Gifts and entertainment expenses
    • Directors/Management remuneration
    • Insolvency/Administration costs
  2. We will note the chronology and timing of key events and associated cash flows. Where an event such as a disposal or a transfer of an asset (e.g. a property or a company) does not result in a negative cash flow, but nevertheless represents lost ‘value’, we will value the lost asset.
  3. This analysis of Company activity is also likely to be relevant to the position of Directors/Managers and Shareholders under the Actual Scenario (e.g. indicating what remuneration they received from the Company and/or what funds they injected into the Company).
  4. Customers who were Directors/Managers and Shareholders may have taken on personal debt or personal guarantees, or engaged in other personal transactions associated with the Company, that are not included in the Company’s cash flows. These will be relevant to the identification of the Actual Scenario for these Customers.

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Relevant Period – Actual Scenario

  1. The Relevant Period for establishing the Actual Scenario commences just before the fraudulent activity started to affect you or your Company. The earliest potential start date would be just before the entry of the Company into the IAR. However the trigger is the first event or transaction resulting from the IAR Fraud that financially affected the Customer.

    For example:

    Say the Company entered the IAR in December 2003, from which point it was immediately exposed to the fraudulent activity through interaction with the criminals.

    The first financial impact of the fraud might have been a loan advanced by the Bank in March 2004.

    Hence in this example the Company began to be financially affected by the fraudulent activity from March 2004 onwards, which would mark the start of the Actual Scenario.

  2. The end date of the Actual Scenario for the Company is the date it ceased any corporate activity, e.g. because it ceased trading permanently, the business was sold or the Company was liquidated. To the extent that Directors/Managers or Shareholders continued to be financially affected (e.g. the continuing impact of reduced earnings, a bank loan or personal guarantee in connection with the Company) after this date as a result of the IAR Fraud, this period will also be included in the Actual Scenario. This could be up to today’s date.

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Constructing the Non-Fraudulent Scenario

  1. Constructing the Non-Fraudulent Scenario involves considering hypothetical situations concerning what would, or could, have happened if you or your Company had not been affected by the IAR Fraud. It will involve making assessments about what would, or could realistically, have happened if a Customer had instead been given honest, proper and reasonable advice by a Hypothetical Reasonable Bank and, if it was necessary to refer the company to a turnaround consultant, making the assumption that the consultant had acted in a competent, reasonable and honest fashion.
  2. A number of questions may arise including -

    What would a Hypothetical Reasonable Bank have done in the Non-Fraudulent Scenario?

    For example:

    Would a Hypothetical Reasonable Bank have simply continued to support the business in the ordinary way by providing an appropriate overdraft or credit facility for its needs?

    Or if the Company was in financial difficulty would a Hypothetical Reasonable Bank have restructured the terms of the existing finance facilities, or advanced additional loans or overdrafts?

    Or would a Hypothetical Reasonable Bank have used its powers as a creditor to put the Company into some form of administration or liquidation process, and if so when?

    What would Company management, or Shareholders, have done in the Non-Fraudulent Scenario?

    For example:

    Would management have sold/acquired assets, continued or ceased certain trading activities, or made loans or injected funds?

    What would the outcome have been for the Company?

    For example:

    Would the Company have been able to operate within its existing credit facilities without the need for further finance?

    Would it have been able to service a bridging loan and within a few months been generating sufficient trading profits to start to re-pay a Hypothetical Reasonable Bank in instalments?

    Would it have succeeded in obtaining alternative financing if a Hypothetical Reasonable Bank had withdrawn support?

  3. There could be a number of potential scenarios, each based on reasonable assumptions about decisions that would have been made at the time, assuming a range of reasonable trading performance and external factors.
  4. The most likely permutations of events will be developed into one or more scenarios. These will then be modelled out by our financial advisers to calculate what the financial position of the Company and (consequently, where relevant) for the Directors/Managers and Shareholders would have been in each scenario. This exercise may generate more than one equally plausible scenario. If it does, we will adopt the scenario that is most financially favourable to the Customer as the Non-Fraudulent Scenario for comparison with the Actual Scenario.
  5. This analysis will demonstrate the impact of events that would have occurred differently, or in a different order, or at a different time, but with a different cash impact compared to the Actual Scenario.

    For example:

    Different cash flows may arise from different events occurring (such as an immediate pre-packaged sale and administration in the Non-Fraudulent Scenario, compared to continuation of a loss-making business for longer than was appropriate due the fraudulent activity).

    Or similar decisions might have been made in the Non-Fraudulent Scenario, but with different financial results - e.g. management may have decided to sell part of the business, but the proceeds would have been higher if the assets had been sold at arm’s length to entities not involved in the fraud.

  6. Modelling the cash flows arising from the Actual Scenario compared to the Non-Fraudulent Scenario will demonstrate the cash impact of the IAR Fraud on the Company, the Directors/Managers and Shareholders.

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Relevant Period – Non-Fraudulent Scenario

  1. For the purposes of constructing the Non-Fraudulent Scenario, the start date is the same as in the Actual Scenario. This is the last date before you and your Company started to be financially affected by the IAR Fraud.
  2. At this point the Actual Scenario and the Non-Fraudulent Scenario will start to diverge where events affecting you and your Company would have been different, or where the cash impact of events that occurred would have been different, had the IAR Fraud never happened.

    Building on our earlier example:

    Say the first cash flows affecting the Company due to the IAR Fraud were a loan advanced by the Bank in March 2004, whereas in the Non-Fraudulent Scenario a Hypothetical Reasonable Bank may have continued to provide support through an overdraft facility.

    Say, in the Actual Scenario QCS fees were paid in late 2004 and then in 2005 part of the business was sold at a loss under the influence of the fraudsters, whereas in the Non-Fraudulent Scenario there would no QCS fees paid and the business would have continued to trade.

  3. The Non-Factual Scenario runs parallel to the Actual Scenario so they can be compared. However, the end date of the Non-Fraudulent Scenario for the Company will depend on what outcome could realistically be predicted for the Company and would include for example, what actions might realistically have been taken by a Hypothetical Reasonable Bank, as opposed to whatever actions were in fact taken by the Bank in the Actual Scenario.

    For example:

    The end date could be the date of the Company’s closure if it had been honestly, properly and reasonably placed into an insolvency process by a Hypothetical Reasonable Bank.

    Or, if the business had been struggling, but based on realistic assumptions it could have been turned around, it could be the date that the Company might subsequently have been sold for a profit.

  4. Where the Actual Scenario for a Director/Manager or Shareholder extends beyond the end of the Company’s life, the Non-Fraudulent Scenario should match it for comparison.
  5. The Relevant Period covers the whole period during which the IAR Fraud continued to affect you financially. This could extend to long after the fraudulent activity ceased.

    For example:

    If a Director/Manager suffered reputational damage from association with the fraudsters and this meant that they could not start a new business or gain suitable employment after their Company had closed, the financial impact through loss of earnings could have continued for many years after the IAR Fraud had ended.

    The loss of a family home due to the IAR Fraud could potentially continue to have a negative impact on an individual’s financial position even today, even if, say, the Company had in the Actual Scenario been closed down years ago by the Bank.

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Financial loss arising from attempts to avoid the fraudulent activity

  1. D & C losses may have been suffered as a result of steps taken by a Customer to avoid the effects of the IAR Fraud, e.g. quitting the Company and leaving without compensation to avoid having to comply with the demands of the fraudsters.
  2. In the Non-Fraudulent Scenario, these actions would not have been taken. We would then need to consider what a Customer would have done differently and the cash flow impact of those actions on the Customer.

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The chance of certain events occurring

  1. In order to construct the Non-Fraudulent Scenario, the chance of each hypothetical step involving third parties will also have to be assessed and taken into account by us in our calculations. Some steps may involve a ‘yes’ or ‘no’ question, such as whether a Hypothetical Reasonable Bank would have lent further funds to the Company or not. Some questions may be a matter of degree, e.g. how much a Hypothetical Reasonable Bank would have lent to the Customer.
  2. For each such question where we have to consider the steps that could have been taken by the Customer or a third party in the Non-Fraudulent Scenario, we have to consider the “chance” of that occurring (see our guidance note ‘IAR Fraud and the Causation of Loss’ for more detail about our approach).

    For example:

    Assume that in a Non-Fraudulent Scenario, we consider there was a 30% chance of a venture capitalist stepping in and injecting funds, and that this would have saved the Company from an insolvency process and ultimately ensured its survival. Assume also that the positive cash impact for a Director/Manager was, say, £100,000 better overall than under the Actual Scenario, had this occurred.

    This would mean that the amount of financial loss to the Customer would be £30,000 (i.e. being the loss of a 30% chance of getting £100,000). This follows established legal principles that we will use to guide us governing hypothetical loss of chance situations.

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D & C losses are calculated net of any gains

  1. It is important to recognise that the D & C losses of a Customer are calculated as the net difference (losses less any gains) between the Actual and Non-Fraudulent Scenarios.

    For example:

    If a Director/Manager lost £500,000 in the Actual Scenario (e.g. in loans to the Company that were written off), but they would only have lost £100,000 in the Non-Fraudulent Scenario (after taking into account the chances of the events leading to this happening), the loss would be the difference between the outcome in the two Scenarios, i.e. £400,000.

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Compensatory Interest Rate – 8% per year

  1. Where we assess that a D & C loss was suffered at a certain date or during a certain period, the question of how a Customer is compensated for being deprived of the funds associated with that D & C loss will arise. It is possible that there was a particular ‘opportunity cost’ from being deprived of these funds. We will, of course, consider any specific suggestion as to what opportunities were missed as a result of not having the funds. However, where that does not occur or there are difficulties with the suggestion, some alternative means must be adopted of providing compensation to a Customer for being deprived of the relevant funds.
  2. Where a Court awards a successful party a money judgment, the interest payable is normally simple interest at a rate of 8% a year on the judgment sum awarded up until payment is made. The Financial Ombudsman Service adopts the same approach and awards a simple interest rate of 8% unless some other rate is appropriate. We will use a similar approach, applying a simple rate of 8% per year (called for these purposes the Compensatory Interest Rate) over the Relevant Period, unless we conclude that there is a plausible alternative scenario in which the Customer would have used the funds in such a way as to have achieved a better outcome.

    For example:

    If we consider that in the Non-Fraudulent Scenario a Customer would have been better off by £ 100,000 in 2004 and by £ 300,000 in 2005 compared to the Actual Scenario, we will add simple interest to each of those amounts at 8% per year (that is, £ 8,000 per year in respect of the £ 100,000 amount and £ 24,000 per year in respect of the £ 300,000 amount) for every year from the respective date of deprival up to the date of assessment in the Re-Review.

  3. Where a Customer has been deprived of an asset such as a company or a family home (rather than being deprived of funds), information may be available to show the value of the asset and how that would have changed over the period that the Customer would have owned it in the Non-Fraudulent Scenario. We will take any such material into account. In calculating D & C losses, we will ordinarily apply the higher of (i) the assessed increase in value of the lost asset, and (ii) the Compensatory Interest Rate (as described above) to reflect the assumed loss of opportunity.

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Amounts previously awarded by the Bank in the Customer Review

  1. For the avoidance of doubt, you will never be required to return any amount of compensation you have already received from the Bank as a result of the Re-Review. Our process is intended to assess only whether you should receive any additional compensation, and if so, how much.
  2. The only forms of compensation awarded by the Bank that could be offset against amounts of D & C losses that we decide to award are:
    1. QCS fees refunded to a Company (or its Shareholders);
    2. debt relief (where the Bank has written off or refunded amounts owed by an individual Shareholder or Director/Manager to the Bank);
    3. any amounts awarded as part of a Distress & Inconvenience payment ‘uplift’ that the Panel decides were compensation for D & C losses (although the uplift in the Bank’s offer was described as additional Distress or Inconvenience rather than being made under the category of D & C losses).
  3. For categories (a) and (b) above, we will be required to make this adjustment where applicable. For category (c) (Distress & Inconvenience ‘uplifts’), Sir Ross recommended that any such adjustment would be at our sole discretion, where we consider it appropriate in a particular case.
  4. If and to the extent this issue actually arises, we will look at the specific circumstances with considerable care. If we propose to make any such deduction from an award for D & C losses, we will explain why in our ‘minded-to’ decision, which you may challenge if you wish to.

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Additional debt relief, following the Cranston Review

  1. During the Customer Review, the Bank wrote off amounts owed by individual Customers to the Bank that were still outstanding. In The Cranston Review, Sir Ross recommended that the Bank amend its policy on debt write-off to include Customers that had repaid or refinanced their debts to the Bank, to ensure fair and consistent treatment between Customers. The Bank is, we understand, separately implementing these recommendations and therefore additional Customers may now also be eligible for such compensation.

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