Conflicts of interest and the duty to manage them

By Michelle Levy
Banking Financial Services Royal Commission Funds Insurance Superannuation Financial Services

In brief

Written by Partner Michelle Levy

Back in 2004, the Corporations Act 2001 (Cth) was amended to include an additional obligation for Australian financial services licensees to have in place adequate arrangements for the management of conflicts of interest that may arise in relation to the activities undertaken by the licensees in the provision of financial services. Conflicts were an afterthought, coming a couple of years after the Financial Services Reform Act (Cth) in 2001. At the time, it didn't seem to be a particularly onerous obligation, and so it has proved. The regulators and various enquiries and committees have criticised financial services providers for letting conflicts of interest get in the way of their customers' interests, but the Corporations Act obligation to have adequate arrangements for managing conflicts is a poor basis for requiring licensees to put their customers' interests first.

What does ASIC say about how conflicts of interest are managed?

In ASIC's recent report into culture, conduct and conflicts of interest in vertically integrated businesses in the funds management industry (ASIC Report 4740), ASIC said the conflicts management policies it reviewed for 12 licensees were generic and not 'tailored to meet the specific challenges and circumstances of each individual business' and that the 'policies appeared to have been completed to satisfy a compliance obligation, rather than to change the behaviours and conduct of the business as a whole.'

What does the law require?

The finding is not really surprising given the way the obligation is expressed and what, in my experience, is a very poor understanding of what a conflict is. To the first point, Australian financial services licensees are not required to avoid or prevent conflicts of interest but merely to have 'adequate arrangements to manage them'. This might be especially confusing for those licensees who are also trustees or who otherwise owe fiduciary duties to their clients. They may well think that this statutory duty displaces their equitable duty not to have a conflict and, for licensees that are not fiduciaries, they may well ask what conflict. And that brings me to the second and more serious issue. It can be very hard to identify a conflict where they exist and it is even harder where they do not.

A conflict of interest presupposes a prior duty

A person has a conflict of interest or duty, at law, only when they owe a duty to another person. A trustee is the most obvious example, the trustee owes a duty to their beneficiaries and equity protects the beneficiaries' interests by preventing the trustee acting where they have a conflict between the trustee's duty to beneficiaries and the trustee's duty to another person. In our world, the most acute example of conflicting duties is the conflict between the duties of a professional trustee (the trustee of a superannuation fund or the responsible entity of a managed investment scheme) and their duty to shareholders. Similarly, the professional trustee may have a conflict between their duty to beneficiaries and their personal interest in maximising their fees.

But all of this gets very murky when the licensee does not have any particular obligations to clients or customers. If I don't owe you a duty, how can I have a conflict of duty or interest when I deal with you? I am perfectly free to pursue my own interests. That is why the law does not impose a duty to avoid conflicts, nor to manage conflicts, on the parties to a contract. And that is also why a duty to have adequate arrangements to manage conflicts does not work independently of a separate duty towards the licensee's clients or customers.

So, in short, if the regulators and Government want to upgrade the importance of managing conflicts, they need to start with articulating the duties. The law already does this for trustees, REs, custodians and financial advisers. But it does not do so for banks and the rest of the financial services industry.

Conflicts of interest in the UK

Things have progressed further in the UK. The FCA released a consultation paper on implementing MiFID II late last month (yes, this was post Brexit). It says that financial services firms will be required to:

have effective organisational arrangements, not only to manage but also to prevent conflicts of interest. [MiFUD II] strengthens the content and quality of disclosure when these arrangements fail, and introduces new requirements on firms to assess and periodically review, their conflicts of interest policy. It requires senior management to receive on a frequent basis – and at least annually – written reports on the situations contained in the conflicts of interest record.

These obligations are not merely an afterthought, the FCA says:

The effective management of conflicts of interest is a central tenet of the financial services regulatory framework in the UK.' And it is a central tenet because financial services providers have a duty to the clients.

The principles that apply to financial services businesses say that: 'A firm must pay due regard to the interests of its customers and treat them fairly'. Because they have an obligation to have regard to customers' interests and to treat them fairly, there is potential for the interests of the customers and the interests of the firm to diverge and it makes sense to impose the further obligation to 'manage conflicts of interest fairly, both between itself and its customers and between a customer and another client.'

Firms are also required to identify conflicts of interest that may arise in the course of providing services to customers and they are told very plainly when that might be the case. And they will be strengthened when MiFID II commences in the UK on 3 January 2018. After this time, the definition of conflict of interest will include circumstances where:

the firm or that person is likely to make a financial gain, or avoid a financial loss, at the expense of the client; the firm or that person has an interest in the outcome of a service provided to the client or of a transaction carried out on behalf of the client, which is distinct from the client's interest in that outcome; the firm or that person receives or will receive from a person other than the client an inducement in relation to a service provided to the client, in the form of monetary or non-monetary benefits or services.

How does it apply in Australia?

There is no similar definition in the Corporations Act applying to financial services licensees. There is an extremely difficult articulation of when a superannuation trustee has a conflict in the Superannuation Industry (Supervision) Act 1993 (Cth). But for the most part, that definition relies on the general law and works only because trustees have a duty to exercise their powers in the best interests of their beneficiaries.

My point is that a duty to avoid or manage a conflict of interest requires, first, a clear articulation in the law of the duties owed by the licensee to their customers and clients. Without that, the duty to have in place adequate arrangements for managing conflicts will always be imperfect.

Using disclosure as a stick

And then, because it is interesting, this is what a firm will be required to tell its customers and clients about conflicts when MiFID II commences: A firm will be required to include in 'all disclosures' a specific description of the conflicts of interest that arise for the firm in dealing with the client, the steps undertaken to mitigate those risks, and the risks to the client and, where the firm is unable to avoid a conflict of interest, they will be required to say that the firm's organisational and administrative arrangements to prevent or manage the conflict are not sufficient to ensure that the risk to the client's interests will be prevented.'

Now, that is an incentive to put in place a really good, and tailored, plan for managing conflicts.