On 24 February 2015 the FCA announced it had fined Aviva Investors Global Services Limited £17,607,000 for failing to manage conflicts of interest fairly, and that compensation of £132,000,000 was being paid to ensure that none of the funds managed was adversely impacted. The sheer size of this fine serves as a prompt not only to re-examine compliance with existing conflicts requirements under MiFID, but also to look forward to what needs to be done in view of MiFID II's enhanced conflicts requirements by the time implementation arrives in January 2017.
What MiFID II conflicts of interest requirements mean for you
- Assess, review and remediate conflicts of interest policies at least annually.
- Disclosure of specific conflicts of interest must spell out that the firm's own systems and controls are insufficient to prevent risk of damage to clients.
- Disclosures must be in a durable medium, regardless of the nature of the client.
- Disclosures must include a specific description of the conflict and the risks it engenders.
- Consider whether analysts should sit behind a Chinese wall.
The FCA and conflicts of interest
Conflicts have proved to be an important FCA topic of review, comment and enforcement action. Over recent years, the regulator has considered a spectrum of practices across a variety of industries, ranging from the generally satisfactory to outright failures to establish adequate frameworks for identifying and managing conflicts of interest. MiFID II's enhancement of the existing MiFID conflicts provisions will give the FCA further tools to deploy when examining firms' compliance with the essential conduct requirement to identify and manage all conflicts.
Conflicts of interest policies
From MiFID to MiFID II
Ostensibly, there is not a lot of difference between MiFID and MiFID II on requirements for the existence and nature of the policy. MiFID (see Article 22 of the Implementing Directive 2006/73/EC) requires investment firms to "establish, implement and maintain an effective conflicts of interest policy set out in writing and appropriate to the size and organisation of the firm and the nature, scale and complexity of its business." ESMA's proposals for the MiFID II version, set out in their Final Report and Technical Advice to the Commission on MiFID II (published on 19 December 2014) (the "Final Report") recommend that Article 22 of the Implementing Directive is amended by inserting clarificatory and supplemental provisions on the disclosure of conflicts and a requirement to review the conflicts policy on at least an annual basis (see below).
The recent decision and analysis in the Arch Financial v Robert Farrell case should also be considered in the context of reviewing your firm's approach to conflicts of interest in light of the obligations in MiFID II and to ensure that practical arrangements are improved by learning from known poor practice, wherever possible.
Mandatory annual review
Despite industry resistance, on the policy review front ESMA remains resolute that once a year is the minimum frequency, regardless of the size, complexity or nature of the investment firm in question. The Final Report links this annual requirement to revisit a firm's conflicts policy to other, wide structural review requirements, including the requirement that the compliance function report to management at least annually on "the implementation and effectiveness of the overall control environment […] and on the risks that have been identified", as well as the annual review of execution policies. This conflation of the conflicts policy with overall compliance risk reviews tells us the high level of importance ESMA attaches to it.
Disclosure as a last resort
At Article 23(2), MiFID II requires that "Where organisational or administrative arrangements made by the investment firm in accordance with Article 16(3) to prevent conflicts of interest from adversely affecting the interest of its client are not sufficient to ensure, with reasonable confidence, that risks of damage to client interests will be prevented, the investment firm shall clearly disclose to the client the general nature and/or sources of conflicts of interest and the steps taken to mitigate those risks before undertaking business on its behalf."
Again, ESMA's Technical Advice is that Article 22 of the Implementing Directive be supplemented to make it clear that disclosure is a last resort, and adds that the Securities and Markets Stakeholder Group (SMSG) has also emphasised that disclosure remains a "limited tool".
The SMSG is of significance as the SMSG facilitates consultation by ESMA with its stakeholders. It is made up of 30 individuals from 17 Member States, who represent ESMA’s key constituencies (academics, consumers, financial institution employees, financial market participants, SMEs and users of financial services).
As part of "disclosure as a last resort" and the use of Chinese walls, firms should consider any other organisational measures to manage and mitigate conflicts risk.
Contents of disclosures
Should disclosure be the appropriate course of action, ESMA's advice is that it should clearly state that the firm's own organisational and administrative measures have proved insufficient to ensure, with reasonable confidence, that risk of damage to the client's interest will be prevented. Disclosure must be in a durable medium, regardless of the nature or classification of the client, and must include a specific description of the conflict, the risks it engenders, and steps taken to mitigate the risk and take into account the nature of the client to whom the disclosure is being made. The aim is to enable the client to make an informed decision as to whether or not to proceed in light of the conflict.
While ESMA has compromised on its earlier position that research should be entirely unbundled, its advice in the Final Report does recommend amending the Implementing Directive by inserting a new provision that requires the physical separation of analysts and "other relevant persons whose responsibilities or business interests may conflict with the interests of the persons to whom the investment research is disseminated". This somewhat odd Chinese wall requirement is tempered by a proportionality carve-out which allows for appropriate alternative information barriers, but which does not give any indication of what those appropriate alternatives might look like.