Prudential Regulation Authority Rulebook

2.1

A building society can only be or remain established under the 1986 Act if its purpose, or principal purpose, is making loans which are secured on residential property and funded substantially by the society’s members¹ (the principal purpose test) (section 5 of the 1986 Act).

2.2

If an established building society no longer meets the principal purpose test, the PRA may:

1. (a) direct it to submit a restructuring plan designed to ensure that the society will meet the principal purpose test by a certain date and that it will continue to meet that test in the future (section 36 of the 1986 Act);
2. (b) direct it to submit to its members for their approval at a meeting the requisite resolutions for a transfer of the society’s business to a company (section 36 of the 1986 Act); or
3. (c) petition the High Court for the society’s winding-up (section 37 of the 1986 Act).

2.3

Building societies are subject to lending and funding limits, which help to determine their compliance with the principal purpose test (sections 6 and 7 of the 1986 Act).

2.4

Section 7 of the 1986 Act provides that at least 50% of the funds (excluding those qualifying as own funds) of a society (or, if appropriate, of the society’s group) must be raised in the form of shares held by individual members of the society (excluding share accounts held by individuals as bare trustees for corporate bodies) or by a small business.

2.5

When the PRA assesses a building society’s compliance with the principal purpose test, it takes into account:

1. (a) whether the society is meeting, and is expected to continue to meet, its lending and funding limits (sections 6 and 7 of the 1986 Act);
2. (b) the actual and projected proportion of the society’s gross income that is, or is expected to be, derived from activities that are related to the making of loans secured on residential property. (Income from the society’s property related insurance and valuation services might be regarded as related to the making of loans secured on residential property, but income from the society’s motor insurance business (if any) would not); and
3. (c) all other relevant quantitative and qualitative factors.

2.6

The PRA expects societies to draw up their corporate and other business plans so as to provide reasonable assurance that they will comply with the principal purpose test and their other obligations under the 1986 Act.

2.7

In particular, societies should ensure that any programme of securitisation does not threaten compliance either with the principal purpose, or with the lending or funding nature limits. Sections 6(3) and 7(3) of the 1986 Act respectively make clear that only items included in total assets or total liabilities in a society’s accounts count towards the nature limits.

2.8

The adoption of International Accounting Standards by some societies changed the accounting treatment of securitised assets for those societies from 1 January 2005. The Building Societies Act 1986 (Modification of the Lending Limit and Funding Limit Calculations) Order 2004 (S.I. 2004/3200) amended the 1986 Act so that securitised assets and related liabilities may continue to be excluded from nature limit calculations, regardless of how they are included in the accounts of a society. Therefore societies which use International Accounting Standards to prepare their accounts will not be disadvantaged in relation to the nature limits.

2.9

Section 9A of the 1986 Act prohibits a society or its subsidiary undertakings (subject to certain defined exemptions) from:

1. (a) acting as a market maker in securities, commodities, or currencies;
2. (b) trading in commodities or currencies; or
3. (c) entering into any transactions involving derivative investments.

2.10

Section 9A of the 1986 Act contains definitions of the above terms, and societies are directed particularly to section 9A(9) for the purposes of compliance monitoring.

2.11

Section 9A of the 1986 Act also includes a purpose test for entering into derivatives contracts and a safe harbour clause for society counterparties stating that any transaction in contravention of the section 9A of the 1986 Act prohibitions is not, however, thereby invalid and may be enforced against the society.

2.12

The exemptions in section 9A of the 1986 Act fall into two broad categories:

1. (a) those which allow a society or subsidiary undertaking to provide certain retail services to its customers, including:
   1. (i) acting as market maker in currency or securities transactions of less than £100,000;
   2. (ii) trading in currencies (but not commodities) up to a value of £100,000 per transaction;
   3. (iii) entering into contracts for differences in respect of customers who wish to hedge exposures arising from their own loans or deposits with the society or a connected undertaking; or
   4. (iv) acting as market maker or entering into derivative investments in its capacity as manager of a collective investment scheme; and
2. (b) those which allow a society or subsidiary undertaking to use derivative investments in order to limit the extent to which it, or a connected undertaking, will be affected by changes in interest rates, exchange rates, any index of retail prices, any index of residential property prices, any index of the prices of securities, or the creditworthiness of any borrower(s).²

2.13

The Treasury may, by negative resolution order, amend the £100,000 transaction limit and may add factors to, or remove factors from, the list found in paragraph 2.12. The factor relating to credit worthiness was added to the original list in section 9A(4)(b) by the Building Societies (Restricted Transactions) Order 2001 (SI 2001/1826). The Treasury may, by affirmative resolution order, make more significant amendments to section 9A(4)(b) of the 1986 Act.

2.14

Boards should have procedures and controls to ensure that use of section 9A of the 1986 Act exemptions by their society (and subsidiary undertakings, if any) is within the law. The exemptions permitting transactions of up to £100,000 (as market-maker in currency or securities transactions, or trading currencies) may not be abused by artificially breaking up larger transactions into a number of smaller amounts falling within the £100,000 ceiling (section 9A(8) of the 1986 Act is the relevant anti-avoidance provision).

2.15

Compliance with the 1986 Act may be assisted by specifying the purposes and circumstances in which hedging transactions may be undertaken, or derivatives used, both in the financial risk management policy documents and in the internal arrangements for delegation, identifying the specific authority in section 9A of the 1986 Act. Whatever the hedging policies adopted, and however the control and authorisation arrangements are organised, it is important that they should be accurately and fully documented.

2.16

Building societies have a particular constitutional form: they are mutuals run for the benefit of their members (ie their borrowers and savers). A society cannot therefore be owned or controlled by an outside institution or major shareholder.³ Society boards and management have a special responsibility to protect the interests of their members through the highest standards of corporate governance.

2.17

Although societies are not publicly quoted, they should have regard to the UK Corporate Governance Code⁴ or the Combined Code⁵ as appropriate when they establish and review their corporate governance arrangements.

2.18

A building society’s directors are elected by its members. Subject to certain exceptions, any natural person may be elected as a building society director (section 60 of the 1986 Act). Members have the right to nominate any candidate for election. Unless that person is subject to a prohibition order made under section 56 of the Financial Services and Markets Act 2000 (as amended) (FSMA), the board⁶ cannot refuse to accept a candidate’s nomination because the board does not regard that person as fit and proper.

2.19

Prior to the election, the board should take reasonable steps to establish whether there are any facts or matters concerning the candidate’s fitness and propriety which the members should be aware of. If there are, the board should bring them to the members’ attention before the election takes place. The PRA will not vet candidates for election.

2.20

A person elected as an executive or non-executive director of a building society must not exercise a controlled function⁷ unless the PRA gives its approval (sections 59 and 60 of FSMA). The PRA will not approve a director unless it is satisfied that he meets, and will continue to meet, the Fit and Proper Test for Approved Persons (see the Fit and Proper Test for Approved Persons sourcebook in the Handbook (FIT)). An approved person⁸ must also comply with the requirements of the Statement of Principle and Code of Practice for Approved Persons sourcebook in the Handbook (APER).

2.21

Part VII of the 1986 Act contains requirements relating to the management of building societies.

2.22

Every building society must have at least two directors and one of the directors must be appointed chairman (section 58 of the 1986 Act). The chairman should not hold an executive position in the society. This helps to separate strategic direction from the day to day management of the business and helps the chairman to take an independent view of management issues. It also protects against undue concentration of power.

2.23

Every building society must have a chief executive (section 59(1) of the 1986 Act). The chief executive should be a member of the board.

2.24

A small building society may not need as many executive directors as a large building society, but every society should have at least one.

2.25

Given the mutual status of building societies, a clear majority of directors on a society’s board should be non-executive. Non-executive directors should not be given the expectation that they will remain on the board until retirement. They should serve for a fixed term, both initially and for any subsequent term. The appropriate ratio of non-executives to executives will vary with the scale, nature and complexity of the society’s business.

2.26

It will rarely be appropriate or desirable for a chief executive or other executive director to remain as a non-executive board member after his or her retirement.

2.27

The board should have an appropriate range of skills and experience to control and direct the society’s activities effectively. The composition of the board should be reviewed at regular intervals to ensure that its management and other resources are at least adequate for the society’s current business and the business it proposes to undertake.

2.28

When a director is to be appointed under a formal service contract, the board should consider carefully the terms of the contract it offers. When it does so, it should take into account (for example) the need to attract and retain directors with appropriate experience, knowledge and skill; the need to preserve the board’s freedom of action; the potential cost of the contract proposed; the period of notice the society will have to give, and the potential liability it will incur, if it terminates the contract other than for misconduct. The objective should be for notice or contract periods of one year or less.

2.29

The Building Societies (Accounts & Related Provisions) Regulations 1998 (SI 1998/504) (The Accounts Regulations) require a building society to give particulars of its directors and chief executives service contracts in its annual Report and Accounts. If there are no service contracts, the building society should say so.

2.30

Every building society must have a secretary (section 59(2) of the 1986 Act). The secretary should ensure that board procedures are followed and regularly reviewed. He should also provide guidance on the boards responsibilities and how they should be discharged.

2.31

Part VII of the 1986 Act places restrictions on certain types of dealing between a building society and its directors. For example:

1. (a) it requires a director, who is interested in a contract with the society, to declare that interest to the board (section 63 of the 1986 Act); and
2. (b) it prohibits a building society from entering into an arrangement, by which a director will acquire a non-cash asset of more than a certain value from the society, unless the society has approved the arrangement by resolution at a general meeting.

2.32

A building society should maintain written procedures and controls which ensure compliance with these restrictions.

2.33

The 1986 Act also restricts a building society’s ability to make loans to a director or a person connected with a director (section 65 of the 1986 Act). In the circumstances, it would be inappropriate for a building society to follow its usual loan procedures when a director or connected person makes a loan application. The responsibility for approving such loans should not rest with staff members, even if the loan falls within a normal staff mandate.

2.34

A building society should have written procedures for dealing with loan applications from directors or persons connected with them and every director should be familiar with them. Those procedures should include consideration by the board, or a board committee, before any loan application is approved. That review should have regard, for example, to the terms of the proposed loan and whether it is permitted by the 1986 Act.

2.35

Every building society is required (by section 71 of the 1986 Act) to keep accounting records which:

1. (a) explain its transactions;
2. (b) disclose, with reasonable accuracy and promptness, the state of its business at any time; and
3. (c) enable the directors and the society to properly discharge their respective duties under the 1986 Act and article 4 of the IAS Regulations⁹ (if applicable).

2.36

The accounting records should contain:

1. (a) day to day entries of all sums received and paid by the society;
2. (b) day to day entries of every transaction which will, or may reasonably be expected to, give rise to assets or liabilities of the society; and
3. (c) a record of the society’s assets and liabilities and, in particular, the assets and liabilities of any class specifically regulated under section 6 (the lending limit) and section 7 (the funding limit) of the 1986 Act.

2.37

The Accounts Regulations set out specific legal and regulatory requirements about the form and content of the financial statements which a building society and its directors must produce. A building society should ensure that the documents it presents to its members are understandable and balanced so that they report the society’s setbacks as well as its successes.

2.38

The Accounts Regulations and the 1986 Act require a building society to disclose to its members, by its annual report and accounts:

1. (a) the interests of the society’s directors;
2. (b) the interests of its chief executive (on the matter of service contracts) and other officers (on the matter of options to subscribe for shares or debentures);
   
   1. (i) individual directors’ remuneration;
   2. (ii) particulars of service contracts for the directors and chief executive;
   3. (iii) current and past directors’ additional retirement benefits; and
   4. (iv) directors’ interests in the shares or debentures of a connected undertaking.

2.39

In the interests of transparency, a building society should also explain whether it adheres to some or all of the UK Corporate Governance Code or the Combined Code as appropriate and, if so, in what respects.

2.40

Paragraphs 9 to 14 of Schedule 9 to the Financial Services (Banking Reform) Act 2013 (which insert sections 115A to 115C into the 1986 Act) contain provisions relating to website communications by a society, including;

1. (a) that a person is deemed to have agreed to access a document, information or facility on a website if the person has been asked individually and has agreed to do so: or has been asked and the society has not received a response within 28 days. A person may revoke the agreement;
2. (b) the above does not apply to certain communications including Schedule 16 Statements and Transfer Statements;¹⁰
3. (c) a person has a right to receive a hard copy of any document received by other means (eg, electronic communications); and
4. (d) an intended recipient may agree with a society to receive a document in a way that is not by hard copy or by electronic means.