November 16, 2012

Conflicts of Interest Between Asset Managers and Their Customers: Identifying and Mitigating the Risks

As part of its ongoing review into the investment management industry, the Financial Services Authority (“FSA”) has recently published two important documents: first, its findings regarding managers’ failures to manage conflicts of interest properly, and, second, the fine imposed on Savoy Investment Management Limited for suitability failures.

Conflicts of Interest

The FSA’s findings on conflicts of interest are important and need to be considered carefully by all managers, including both portfolio and fund managers (i.e., all firms that have FSA permission to manage investments), not least because all managers are required by the FSA to consider their policies and procedures and to certify to the FSA by 28 February 2013 that they are in compliance with the rules. We have added our recommendations following each specific finding.

The FSA’s findings of failures fell into six groups.

    1.  Compliance Issues

The FSA found that many firms had poor procedures for identifying conflicts of interest. As a result, the FSA’s preferred structure is for firms to ensure that the responsibility for identifying conflicts rests not only with the compliance function but also with the business. Information on this process should, as a matter of course, be provided to the boards of the firms.

Recommendation: Firms, especially larger ones, should have specific identified individuals in both the compliance and business functions with responsibility for identifying and managing conflicts. This person should either be on the board of the manager or have an agenda item at board meetings.

    2.  Commission Sharing Arrangements

The FSA has strict rules in its Conduct of Business Sourcebook (“COBS”) on the use of dealing commissions by investment managers. In effect, managers may use such commissions only for execution services or investment research, and there is extensive guidance in the COBS rules as to what counts as an execution service or research.

The FSA found that, although managers were aware of these rules, too many managers had given insufficient thought as to whether the services received really constituted either execution services or research.

Recommendation: The FSA has been warning firms both officially and unofficially about improper use of dealing commissions for some time, and it is reasonable to suppose that enforcement action may follow for firms that continue to get this wrong. Managers really should consider these arrangements carefully and conservatively and get independent advice if necessary to support their arguments for compliance.

    3.  Gifts and Entertainment

Considerable attention was given to the issue of corporate hospitality in light of the Bribery Act. Given the general view at the time, supported by the Ministry of Justice, that reasonable corporate hospitality is acceptable under that Act, the FSA now seems to be finding that firms have ceased giving sufficient attention to this issue and, in particular, to the issue of whether entertainment presents potential conflicts of interest.

Recommendation: Firms need to have a more sophisticated policy than simply saying that all hospitality under a certain amount is acceptable. Policies need to distinguish between types of hospitality (relevant conferences, sporting events, etc.) and provide answers to common questions. Will travel and accommodation be acceptable? How frequently may a supplier offer hospitality? Is it acceptable to receive hospitality without the presence of the supplier’s own staff?  Finally, sign-off at certain levels should be made by both the business and compliance.

     4.  Equal Access to All Investment Opportunities

The FSA rules require managers to allocate trades and investment opportunities between different clients and funds on an equitable basis. Whilst the FSA found that most firms had adequate procedures to deal with this, it did find that some managers were unable to justify allocations of certain trades. The FSA cites various egregious examples of customer detriment in its document, although these will probably not be very helpful to firms on a day-to-day basis.

Recommendation:  Identifying potential conflicts in, for example, allocating investment opportunities between different funds with similar but not identical investment policies is the first step. Deciding how to allocate those opportunities will depend on the facts of the case, but it is essential that the reasons for such allocation are noted at the time and are made available to compliance.

    5.  Personal Account Dealing

Personal account (“PA”) dealing has a long history in the regulatory rules, and firms now generally have satisfactory procedures. The FSA did, however, find inconsistent implementation of these procedures, stating that firms with good controls took care to explain to employees the conflicts of interest behind the PA trading controls and to impose significant restrictions such as requirements to trade only as long-term investors and the imposition of maximum trading frequencies.

Recommendation: Firms that have only general PA dealing requirements should revisit them to see whether they are consistent with the FSA’s general guidance. Such policies may be consistent probably only where the risk of client detriment is low – for example where the manager manages RE funds only.    

    6.  Correction of Errors

Firms face potential conflicts of interest when committing errors and then deciding how to allocate the cost of those errors between the firm itself and clients. The FSA found that some firms relied on exclusion of liability clauses from the management agreement not to compensate clients or even to inform them about any errors.

Recommendation: Notwithstanding and contractual provision, the client’s best interests rule will continue to apply. Even where a manager can contractually impose the cost on the client (and not inform it of the error), the FSA may still take the view that the firm is in breach of the FSA rules. Firms should, therefore, be very cautious of this approach.

Savoy Investment Management Limited

On the basis of the FSA’s findings, Savoy seems to have been in fairly clear breach of the FSA’s suitability requirements, and a reduced fine of £590,000 is probably not that exceptional. What is interesting for investment managers is the implied repeated warning to firms to ensure not only that they collect sufficient client information at the outset of the relationship but that the firm has a sufficiently robust system to collect and update information on an ongoing basis and to ensure that trades entered into on behalf of clients are consistent with this information. It is probably reasonable to assume that the FSA will be investigating this carefully with firms over the medium term.