The Financial Services Authority’s (the ‘FSA’) mission to restore investor confidence continues with its most recent ‘Dear CEO Letter’. The watchdog’s focus is now on examining the manner in which firms recognise, control and manage conflicts of interest, having uncovered a number of failings during their thematic review which ended in February of this year.
Although there are well established rules regarding the systems a firm should have in place to deal with conflicts, the review, which was prompted by evidence from the FSA’s other supervisory work, found that firms “no longer saw conflicts of interest as a key detriment to their customers and had relaxed controls previously considered to be well-established market norms”. The FSA’s report communicates the findings of the review to the wider asset management sector and asks CEOs of recipient firms to reply to the report, confirming they have reviewed the report and that their firm is in compliance with the obligations of the FSA Handbook concerning conflicts of interest.
The requiring of what appears to be a written warranty from each firm serves to emphasise the importance the FSA is placing on this matter but it is not without precedence. The FSA followed a very similar course of action in respect of its CASS compliance review. In that instance a similar thematic review of investment companies and insurance brokers found numerous failings in what were believed to be established practices and obligations. As a result, the FSA issued a report on the obligations on firms and requested that the CEO of the recipient firms reply with a written confirmation that the firm was in compliance with the CASS obligations. Having received the replies, the FSA followed up with a further review, and where a firm was found to have wrongly confirmed they were in compliance with the CASS obligations the FSA took significant action (a key example being Blackrock’s fine of £9.5m).
The FSA have stated in this report that they will adopt a similar approach going forward; noting that the responses received in relation to this letter will inform their selection of firms for follow up assessment visits. Where the FSA concludes that a firm has not complied with relevant principles or rules, and cannot justify their approach, they are likely to find that the firm has not met with a number of the FSA Principles (primarily PRIN 6 and 8), as well as multiple SYSC rules requiring firms to identify, manage, disclose and record conflicts as well as maintaining an effective policy in respects of conflicts. Where a firm has replied stating they are in full compliance with the obligations, and are found to be in breach, it is also very likely that the FSA will argue that, despite being on notice, the firm failed to adequately rectify issues and that their supervisory systems are inadequate to indentify and handle failings in their policies.
Regulatory Obligations with respects to conflicts
Firms are subject to various regulatory obligations that require the implementation and maintenance of controls to manage potential conflicts of interest. In summary, these obligations are as follows:
FSA Principles for Business
The FSA Principles recognise that conflicts of interest may arise in practice despite attempts to avoid them. The focus of the Principles is to guide firms to managing them in a way which limits the impact they may have on customers. PRIN 6 requires FSA regulated firms to pay due regard to the interests of their customers and treat them fairly. Treating customers fairly will clearly require a firm to consider how a conflict of interest could cause detriment to its customers and how such conflicts should be managed in order to address that risk. Further to this, PRIN 8 imposes a more specific requirement on firms to manage conflicts fairly.
In accordance with a specific FSA rule (COBS 2.1.1), a firm must act honestly, fairly and professionally in accordance with the best interests of its client. The FSA also has rules on “inducements” to prevent fees, commissions and other non-monetary benefits, provided to or from third parties, unduly influencing a firm from acting in the best interests of its clients. Firms are also subject to FSA rules on order execution and handling and personal account dealing which cover conflicts related issues.
In its SYSC sourcebook the FSA also imposes more detailed rules in relation to the identification and management of conflicts. SYSC requires regulated entities to take all reasonable steps to identify conflicts of interest between:
- the firm, including its managers and employees, or any person directly or indirectly linked to them by control (such as another group company), and a client of the firm; or
- one client of the firm and another client;
that arise or may arise in the course of the firm providing any service to its clients in the course of carrying on regulated activities (such as investment advisory or management services) or ancillary activities or providing ancillary services (SYSC 10.1.3).
In identifying the types of conflict of interest that may arise, a firm must take into account the factors set out at SYSC 10.1.4, namely whether the firm or a person linked to the firm (including a group company) might:
- make a financial gain or avoid a financial loss, at the expense of a client;
- have an interest in the outcome of service or transaction;
- have a financial or other incentive to favour another client or group of clients;
- carry on the same business as a client; or
- receive an inducement from a third party (in the form of monies, goods or services) in relation to services provided to a client, other than a standard fee or commission.
A firm must manage conflicts appropriately, i.e. take reasonable steps to prevent conflicts from causing a material risk of damage to clients’ interests (SYSC 10.1.7). Where this is not possible or sufficient, a firm must disclose the conflict so that the client can take an informed decision (SYSC 10.1.8). However, over-reliance on disclosure without adequate consideration as to how conflicts may be managed is not permitted.
A firm must keep and regularly update a record of conflicts that have arisen and may arise in future (SYSC 10.1.6). A firm must also maintain an effective and proportionate group-wide conflicts of interest policy (SYSC 10.1.10 and 10.1.11). A summary of this policy must be provided to retail clients, although it is best practice to provide this summary (or indeed the policy itself) to other types of clients also.
Identifying specific conflicts
The FSA’s report informs firms of specific areas where they wish for controls to be reaffirmed and having done so it is likely that these areas will form a significant part of their second review. Firms should therefore examine the following issues and take the appropriate steps:
- Spending on research – The FSA has highlighted that firms must have adequate controls for spending on research and execution services. They noted that firms should exercise the same standards of control for research payments that they exercise over payments made on the firm’s account. Further, they expressed that failure to control spending shows evidence of failing to achieve the best interests of a customer and therefore needs to be rectified.
Firms should ensure that they have systems in place to question what services are actually of benefit to their customers and be able to query brokers as to why they should pay for additional services which are not of value to them. Maximum spend rates on research have also been accepted as evidence of protecting customer interests.
- Benefits – If any monetary benefits or non-monetary benefits were to be provided to a firm by brokers, managers or service providers in return for business then, in addition to the significant conflict issues, difficulties under the FSA’s inducements rules may arise. Firms need to take greater care in determining whether the value and/or frequency of gifts and entertainment could give rise to actual or perceived conflicts.
It would be wise for firms to review their policies to ensure that they recognise the true value of such benefits given to employees of the firm, taking into account the true costs incurred by the provider and the value to the individual receiving the benefit. The policy should also ensure that there is an adequate approvals policy, possibly including both direct line managers and compliance staff so as to prevent any concern over objectivity of decisions.
- Equal access – Firms must ensure that they have adequate procedures in place to ensure that when an attractive opportunity is identified by a manager, or information comes to light to make an existing investment less attractive, information flow within the firm is managed to prevent favouring one type of client over another. Additionally firms need to ensure their policy accounts for fair distribution of opportunities which have limited capacity but would suit many different clients being managed on different services, so as to prevent different clients/services benefiting over others.
Further to this where a customer pays for additional benefits which may provide greater access (e.g. direct access to research), this practice should be fully disclosed to other clients so they can consent thereto.
- Personal dealing – Employees dealing for their personal accounts can give rise to obvious conflict between their own interests and those of the firm’s customers. Procedures concerning such dealing should be made clear to employees and impose significant restrictions, limiting an employee’s ability to distort the investment to the detriment of the firm’s customers. The FSA has explicitly stated that it is poor practice to exempt staff, particularly senior staff, without good reason.
- Allocation of the costs of errors – Where a firm makes a mistake whilst handling a customer account, a conflict clearly exists as to who should meet the costs of that mistake. Such a conflict is exacerbated by the fact that the customer may only gain knowledge of the error through the firm informing them.
Firms should have in place systems that allow the capturing of error information so as to assist in preventing similar mistakes and ensuring that there is not a persistent pattern which would indicate negligence. Additionally firms should consider a policy which returns customers to the position they would have been in had the error not incurred, and allows them to retain the profit from a mistake provided it cannot be netted against a loss making error of the same type, or the customer explicitly refuses to accept the trade.
By publishing the ‘Dear CEO Letter’ the FSA is continuing its bold approach to restoring public confidence. The FSA has now put asset management firms on notice of its intent to re-establish the controls it believed were well-established within the market place and reaffirm the importance of conflict management. Those firms which fail to deal with this issue now open themselves up to enforcement action if the FSA finds they have inadequate systems in place to deal with conflicts of interest.
With the FSA’s promise to perform a round of thematic visits on the back of the responses received from the ‘Dear CEO Letter’, firms should work closely with their front line management, compliance staff and legal advisers to confirm that they do have robust arrangements to identify and manage existing and new conflicts, as well as adequate systems to ensure a credible, long-term commitment to serve their customers’ best interests.