Identifying and understanding conflicts of interest
Managing conflicts of interest
Systems and controls
Ensuring that regulated firms identify and manage conflicts of interest appropriately is a matter of constant focus for regulators, which makes sense given its central importance to the fair treatment of clients and as it speaks to the firms' integrity. Indeed, in its 'Dear Chief Executive' letter to trust company businesses dated 22 October 2010, the Jersey Financial Services Company (JFSC) stated that "management of conflicts will become a routine topic that we will examine during our on-site examination programme".
Nonetheless, firms would be forgiven for thinking that, beyond that letter, they have limited guidance as to what is expected of them when identifying and managing conflicts of interest. This issue has received greater attention in the United Kingdom: in the enforcement case of FCA v Arch Financial Products LLP,(1) the Upper Tribunal gave detailed guidance on what is expected of firms under the Financial Services Authority's (FSA's) pre-November 2007 rules relating to conflicts of interest. The similarities between the approach in those FSA rules and the requirements of the JFSC Codes of Practice mean that the Arch judgment offers JFSC-regulated firms helpful guidance on how they should manage conflicts of interest.
At a high level, firms must consider their approach to:
- identifying and understanding conflicts of interest;
- managing conflicts of interest; and
- record keeping.
Identifying and understanding conflicts of interest
The starting point is that one size does not fit all: differences in conflicts, clients and firms means that the appropriate approach depends on the context.
A firm must therefore identify what the particular conflict consists of and why it amounts to a conflict. At a high level, the Upper Tribunal classified conflicts of interest as:
- direct conflicts of interest between the firm and its client, where the firm is incentivised by self-interest to act contrary to the interests of its client;
- indirect conflicts of interest and duty between the firm and its client, where some more-or-less remote incentive presents the risk that the firm might be encouraged to act contrary to the interests of its client;
- direct conflicts of interest between clients, where although the firm's own interests are not affected, the firm is involved in acting for clients whose interests conflict; and
- a combination of the above.
Firms might argue that there is an alignment of interests between them and their client which means that there is no conflict of interest (eg, where the firm is co-investing with the client). However, caution must be taken before relying on this argument – how realistic is it to say that, viewed in the round, interests are fully aligned?
Another important matter is whether there is a risk that a client will be disadvantaged if the transaction proceeds and, if so, the extent of the damage that will result.
The seriousness of the conflict must be taken into account, including how direct the conflict is and its duration. In contrast, the value of the transaction will have limited, if any, relevance to whether there is a conflict of interest.
Managing conflicts of interest
Firms should remember that they cannot contract out of their regulatory obligations. Firms will therefore need to satisfy themselves that each conflict of interest is being managed appropriately – relevant matters will include:
- whether the transaction can be justified on a defensible objective basis;
- the quality of the internal review and assessment (the higher the degree of independence or insulation of the decision maker, the better);
- if there is (independent) external review and assessment, this may help to ensure that the conflict of interest is managed properly – however, external review will often not be practicable; and
- continuing review (where there is an ongoing conflict, the matter should be kept under review – for example, to adjust in light of changing circumstances).
One option open to a firm under the Codes of Practice to manage a conflict of interest is disclosure. However, there is a real risk that firms place too much reliance on disclosure that proves to be insufficient. The Upper Tribunal gave the following helpful guidance on when disclosure can help with managing a conflict of interest:
- Generalised disclosure and consent: this has limited value from a regulatory perspective – "the fact that a client knows that a conflict may arise from time to time does not dilute the need to deal with it fairly according to the standards laid down in the rules". This approach to general disclosure is reflected in the standards to which the JFSC holds its own commissioners.(2)
- Specific disclosure and consent: "its value depends on the experience, competence and position of the persons to whom the disclosure is made and whether they have been given sufficient information to give an informed consent so that they are in a position to assess the fairness of the transaction concerned". For disclosure to be effective, it must be made in a timely manner and provide the client with the information which they reasonably require to give informed consent.
- After-the-event disclosure: this will be insufficient in itself (the risk has already arisen), but if the client retrospectively agrees to the transaction, that may have some value. However, there remains a risk of the regulator saying that the firm nonetheless acted inappropriately in running the risk in the first place.
Record keeping is often viewed by firms as a second-order obligation, less important than compliance with more 'substantive' rules (eg, on fair treatment of clients). This is a mistake. As the Upper Tribunal noted in the context of conflict of interest management, adequate record keeping establishes an audit trail (which is necessary if the regulator decides to conduct an on-site examination) and can give "corporate memory".
Firms should also bear in mind the Upper Tribunal's warning that the value of records "will be much diminished if they are not easily accessible, coherent and comprehensible and made soon after the event". This is because the later they are made, the less likely they are to be accurate.
Each firm must therefore ensure that it has appropriate arrangements in place to both make and maintain(3) adequate records in relation to conflicts of interest. These arrangements will, of course, vary between firms. However, all firms can help their staff to maintain adequate records by (for example) designing their template forms to prompt staff to record the required information. That said, firms must ensure that the fact-sensitive nature of conflicts of interest is respected (eg, by avoiding prescriptive 'drop down' lists).
The Upper Tribunal set out its view on "sensible" issues to record in relation to identification and management of conflicts of interest. While given in the context of an investment management firm, those comments nonetheless underscore the high expectations with respect to record keeping. Specifically, the following should be recorded:
- the basic facts about the transaction, including the parties to the transaction and its terms;
- the commercial rationale for the transaction, including how it was valued and priced and why it was thought to be in the best interests of the client;
- the decision-making process for the transaction, stating who participated in the decision-making process and carried out the analysis and on the basis of what material;
- any specific analysis of the conflict that was carried out by the decision makers (or those who supervised them) concerning the nature of the conflict and its management, how significant the risks associated with the conflict were thought to be and the key mitigating factors;
- any relevant independent advice received;
- if disclosure was made to the client or a representative of the client, what disclosure was made and to whom and when; and
- any subsequent review
At a minimum, it is clear that record keeping is not a 'tick box' or 'technical' matter.
In order to ensure that they are identifying and managing conflicts of interest appropriately, firms must ensure that they implement appropriate and robust systems and controls. A key aspect of these will be the overarching conflict of interest policy. As the Upper Tribunal noted:
It is difficult to reconcile the overarching requirement to manage conflicts fairly… without having established a conflicts of interest policy that identifies the type of conflict that the firm is likely to come across in its business and the measures that it has in place to manage those conflicts of interest.
Firms must ensure that they have appropriate governance around the management of conflicts of interest. Each conflict of interest should be considered at a suitably senior level by those who have the appropriate degree of independence.
Firms will need to be clear as to when a conflict of interest should be escalated to the board (whether for its information or decision). A necessary (but not sufficient) part of this will be the conflict of interest register. Boards should use this register as a tool to help them understand and manage the conflicts of interest in their business, which means that they must be satisfied that the register contains sufficient and up-to-date information and is tabled and discussed as a matter of routine.
Ultimately, the guiding principle for managing conflicts of interest is clear: firms must ensure that they are acting with integrity and in the interests of their clients. It is clear that regulated firms are (quite rightly) held to a high standard in relation to conflicts of interest, so the board and senior management must ensure that this is an area to which they apply close and constant scrutiny.
For further information on this topic please contact Daniel Maine at Ogier by telephone (+44 1534 514 000) or email ([email protected]). The Ogier website can be accessed at www.ogier.com.
(1) Further information is available here.
(2) See Paragraph 5.4 of the Commissioners' Code of Conduct for Conflicts of Interest.
(3) To ensure both that it is taking decisions by reference to current information on an ongoing basis and compliance with obligations under data protection legislation to keep personal data up to date.