Following the recent release of ASIC Report 474, AFS Licensees have been put on notice by ASIC to re-examine and improve their conflict of interest management practices.
ASIC raises the bar on best practice conflicts management
1. Findings from ASIC Report 474
The report examines compliance practices among AFS licensees to maintain ‘adequate arrangements’ in respect of managing conflicts of interest as such conflicts commonly arise through group entities entering into related party transactions.
In preparing the report, ASIC comprehensively reviewed the practices of 12 AFS licensees who are vertically integrated structures in the funds-management industry. ASIC found that conflicts management policies were generic and high-level in nature. ASIC also stated that only a few organisations appeared to specifically consider and address the key conflicts of interest of their organisation and address how those conflicts should be managed.
Further, it noted that conflicts management policies and procedures were notably deficient in the areas of outsourcing, product selection, remuneration and board membership.
2. A duty to manage conflicts
Under amendments made to the Corporations Act in 2004, AFS licensees have been obliged to maintain ‘adequate arrangements’ in respect of conflicts management policies.
ASIC has provided guidance in this area in Regulatory Guide 181 (RG181) Management of conflicts of interest by AFS licensees. RG181 states that ‘to be adequate, conflicts management arrangements must successfully identify conflicts of interest and control the effects of those conflicts on the provision of financial services so that the quality of those financial services is not significantly compromised.’
Further, it states that ‘arrangements that are not monitored and enforced are unlikely to be adequate.’ Since RG181, ASIC has only prosecuted one AFS licensee for non-compliance with the ‘adequate arrangements’ test.1
The case was pre-GFC and examined conflicts management practices against the backdrop of insider trading allegations. The Federal Court found that, on a question of the adequacy of information barriers (or ‘Chinese walls’), the AFS licensee had discharged its duty to provide adequate conflict management arrangements under the following criteria:
physical separation by departments;
procedures for dealing with crossing the Chinese wall;
monitoring by compliance officers; and
The Court also found that ‘adequate arrangements require more than a raft of written policies and procedures; they require a thorough understanding of the procedures by all employees and a willingness and ability to apply them to a host of possible conflicts.’
While this statement places a duty on all employees to actively practice the policies and procedures implemented by management, ASIC’s recommendation on best practice in this area expands upon the court’s findings.
3. Good practice recommendations
ASIC has expanded upon RG181 in its recent report and has provided thorough recommendations on what the regulator’s view of ‘adequate arrangements’ looks like.
What constitutes adequate conflicts management arrangements will depend on the nature, scale and complexity of the licensee’s business. However, ASIC has left AFS licensees under no illusions about what it regards as good practice conflicts management and identifies the following as eight key characteristics that need to be embedded into an organisation’s conflicts management processes:
Conflicts management policies and procedures should be approved by the board.
Conflicts of interest should be a standing item at both board and board committee meetings, with meeting participants being required to declare relevant interests and duties at meetings.
Boards should consider any material contracts with related parties. Agreements with related parties should be reviewed by legal and compliance advisers before being presented to the board for approval.
Financial services groups should have a risk management team that is independent of the business teams, and provides regular reporting on operational risk (which covers complying with conflicts management obligations) to the audit and risk committees.
There should be a formalised mechanism to review conflicts and escalate significant issues.
On a day-to-day basis, employees must be responsible for reporting all potential, apparent or actual conflicts of interest to appropriate parties, including the employee’s manager.
Conflicts management committees should be used on an ad-hoc basis to deal with complex or structural issues.
A periodic review of open conflicts of interest should be carried out to ensure that the context has not changed and the measures taken to manage the conflicts remain adequate.
4. What happens to AFS licensees who fail to implement adequate arrangements?
As well as significant investor and creditor or losses, a failure to adequately manage the inherent conflicts of interests that arise in a vertically integrated funds management business may result in significant breaches of the Corporations Act and inflict serious reputational and financial damage on the organisation.
Management of conflicts remains a focus for ASIC. In the two months since ASIC released its report, it has requested enforceable undertakings from two AFS licensees for failing to have in place adequate conflict of interest management arrangements. ASIC noted in its 2016 strategic outlook report that it ‘remains concerned about the culture of financial services businesses.’
5. What should you be doing?
ASIC’s spotlight is now well and truly focused upon management of conflicts of interests by the financial services sector. AFS licensees should review their current conflict of interest management arrangements and the culture within the organisation to comply. They should also enforce them against the guidance contained in RG 181 and the recommendations flowing from ASIC’s latest report – not only to ensure they are meeting ASIC’s expectations, but to ensure they are appropriately managing this risk to protect their organisation from the serious consequences of failing to do so.