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Client Update: ASIC's guidance on conflicts in vertically integrated funds-management businesses

24 March 2016

In brief: ASIC has released a report looking at the way 'vertically integrated' funds management businesses deal with conflicts of interest. The report summarises the findings of ASIC's recent review of a number of businesses, and sets out some good practice recommendations. Partner Marc Kemp (view CV) and Senior Associate Simun Soljo look at the report.

What is a vertically integrated business?

ASIC focused its review (Report 474 – Culture, conduct and conflicts of interest in vertically integrated businesses in the funds-management industry) on 12 Australian financial services (AFS) licensees in what it referred to as 'vertically integrated' businesses. For the purposes of the review, this was limited to businesses whose operations include at least two of the following functions:

  • investment management;
  • acting as a responsible entity or wholesale trustee;
  • acting as a trustee of a registrable superannuation entity;
  • operating a platform (eg IDPS or IDPS-like scheme); or
  • acting as custodian, which may include investment administration.

It excluded deposit-taking, insurance and financial advice businesses from the review. These commonly form part of vertically integrated financial services organisations in Australia, and so their exclusion is curious. However, the principles set out in the report are likely to be applied by ASIC to all of these businesses.

ASIC considers that 'the vertically integrated business model gives rise to inherent conflicts of interest, and consequently there may be a divergence in many areas of the financial services organisation between the interests of' various parties, including the entities involved, employees, directors, customers, and investors.

The law relating to conflicts

ASIC focused on the obligation of an AFS licensee to 'have in place adequate arrangements for the management of conflicts of interest…' (section 912A(1)(aa) of the Corporations Act 2001 (Cth)), and the obligation of a responsible entity of a registered managed investment scheme under s601FC(2)(c) to:

act in the best interests of the members [of the scheme] and, if there is a conflict between the members' interests and its own interests, give priority to the members' interests… 

 

Directors are also required to disclose material personal interests in a matter before the board, and may not be able to be present or vote on the matter (ss 191-195 of the Corporations Act).

Trustees of superannuation funds and their directors also owe duties to deal with conflicts under superannuation legislation and APRA standards, but they were not expressly dealt with in this report.

ASIC's view is that a conflict of interest is a circumstance where 'some or all of the interests of people (clients) to whom a licensee (or its representative) provides financial services are inconsistent with, or diverge from, some or all of the interests of the licensee or its representatives'.

ASIC also says that 'what constitutes adequate conflicts management arrangements will depend on the nature, scale and complexity of the licensee's business'. The report provides some more concrete examples of the types of practices ASIC considers to be good and bad in implementing this general principle in the context of a vertically integrated business.

ASIC's observations – what is working and what isn't

ASIC observed that, in general, the businesses reviewed had current policies setting out principles for managing conflicts of interest, and that these are updated frequently. It also observed most staff also received some training on conflicts management, and the businesses reviewed understood the need for appropriate information barriers, although the use of these barriers depended on the size of the business.

On the other hand, the 'could do better' list appears somewhat longer. ASIC thought that improvements could be made in a number of areas, including the way:

  • businesses deal with conflicts involved in outsourcing services to related parties;
  • licensees select products for investment menus or approved products lists;
  • licensees link remuneration to compliance training and appropriate behaviour; and
  • boards are structured – including dealing with potential conflicts stemming from multiple and related directorships, and ensuring remaining board members have appropriate knowledge and skill if conflicted directors need to absent themselves. On this point ASIC did acknowledge that most organisations appeared to recognise the importance of avoiding conflicts of interest at the board level.

While ASIC's review was not specifically focused on remuneration policies and practices, it expressed concern that remuneration structures may not adequately consider conduct, compliance training and behaviour as a determinant of remuneration, bonuses or salary advancement. Ominously it said that it may conduct a further review of remuneration practices in the financial services industry as a result of this finding.

Red flags and recommendations

ASIC sets out in some detail what it considers to be good practices in dealing with conflicts in vertically integrated businesses. It notes that the ultimate responsibility for compliance rests with the board.

It reiterates the 'Four Cs' framework for managing conduct risk:

  • communication of expectations about conflicts management;
  • challenge of existing structures and practices that create conflicts of interest;
  • avoiding complacency; and
  • ensuring there are consequences for exemplary and poor conduct within the organisation.

In general, ASIC recommends greater formality of process where there are conflicts or the possibility of conflicts – formal due diligence processes, objective selection criteria, formal agreements on arm's length terms, structural and legal barriers, and ongoing review.

More specifically, for example, ASIC recommends that:

  • board papers demonstrate that management has considered conflicts of interest in formulating a proposal for consideration and board approval;
  • board agenda and committee papers include prompts to identify and consider conflicts of interest;
  • conflicts of interest be a standing item at both board and board committee meetings;
  • employees be responsible for reporting all potential, apparent or actual conflicts of interest to appropriate parties, including the employee’s manager and, except for minor matters or where the manager is affected, designated risk and conflicts management personnel;
  • a formalised due diligence process is conducted in the selection of investments or investment managers, including of related entities and their products; and
  • any revenue sharing arrangement and other terms agreed with a related party be on the same or better commercial terms as they would be with a third party that is not from the group (a requirement imposed in any event by the restrictions on related party transactions under the Corporations Act).

The wash up

It is clear that ASIC will be particularly critical of licensees who adopt generic policies without carefully considering the specific conflicts in their own business, and who fail to thoroughly embed conflict management practices throughout the organisation, and actually implement them.

In some ways, the recommendations set a standard of perfection which few organisations will be able to meet. But this is clearly an area of focus for ASIC, and so licensees may want to reconsider, in light of the report, how they are addressing the issues identified.

One aspect not dealt with by the report is the reasonable expectations of customers dealing with a vertically integrated group – arguably it would not be a surprise to many customers that they may be provided products and services from related parties within the same group. However, licensees will not be able to point to this alone as a reason for using related parties, and will increasingly need to demonstrate on an objective basis how they are complying with their duties to deal with conflicts.

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