Conflicts of interest are high on the FCA’s agenda, and are likely to remain so in future.1 They are a clear priority in the FCA’s 2019/20 business plan, and have also been flagged as an important area of concern in recent Market Watch publications. This blog outlines the conflicts that may arise for asset managers in the areas of personal account (PA) dealing, order allocation and outside interests in investee companies, and sets out some ideas to consider when deciding how best to manage these.
Why conflicts of interests are a crucial cause for concern
Conflicts of interest can arise in almost all aspects of a financial services firm’s relationship with its customers and the market, including for example in product design and distribution, investment strategy, order handling and allocation, and external relationships. In recognition of this, the FCA has adopted a principles and outcomes based approach as opposed to a detailed prescriptive regime. Consequently, there is an expectation that firms should monitor continuously any potential or crystallised conflicts between their interests and those of their clients.
Asset management firms have a particular responsibility in this regard because they are often in possession of inside information and have the potential to influence the market through the manner in which they trade and employ voting strategies. This puts the onus on asset management firms to be pro-active in undertaking self-assessments to identify existing and new potential sources of conflicts. Once conflicts are identified, it is important that firms are able to demonstrate to the FCA that steps have been taken to manage them appropriately. In particular, the FCA expects robust frameworks that not only identify conflicts but also analyse them at a sufficiently granular level, implement appropriate controls, and monitor compliance with those controls rigorously. In short, the FCA is looking for firms to move beyond a prescriptive tick-box approach to managing conflicts.
The FCA’s recent Market Watch 62 outlined a number of concerns the FCA identified from a review of wholesale broking firms’ systems and controls for PA dealing. These concerns will also be relevant for asset managers. Common failings the FCA identified included:
- employees not being conversant with the firm’s PA dealing policy despite having signed attestations stating that they were;
- deliberately circumventing the policy;
- not declaring external accounts;
- trading in breach of the firm’s PA dealing policy;
- trading in their personal accounts in a manner which was contrary to the professional recommendations they had given clients; and
- front-running client orders or following client orders.
Some employees also reportedly believed that not being fully versed with the firm’s PA dealing policy provided them with a defence against breaches.
The following procedures, amongst others, may help to overcome the above control weaknesses:
- all staff investment accounts required to go through a formal process of approval when being opened;
- staff required to request permission before trading internally or externally;
- adequate records of all staff trades being maintained;
- close monitoring of staff trades to ensure there has been no trading in stocks in which the firm has inside information; and
- periodic monitoring on all staff trades to determine whether there were any conflicts with concurrent client trades.
Whilst the FCA’s rules in COBS 11.7 and 11.7A will be a useful starting point, a number of other sources set out the regulator’s expectations. The FCA’s 5 Conduct Questions (which the FCA is extending to asset managers), Principles for Businesses, and the Individual Conduct Rules (COCON 2.1)2 require firms to integrate personal integrity and customers’ best interests into all their business activities. Overall, the regulatory emphasis is on firms developing a proactive control culture rather than pursuing a tick-box approach.
Whilst the conflicts inherent in PA dealing are often focussed on in asset management circles, those inherent in order allocation are highlighted less frequently. However, the consequences of not managing these conflicts are equally serious, as evidenced by the recent multi-million pound fine paid by an asset manager for allocating favourable orders to higher fee-paying funds as opposed to lower fee-paying funds. This practise is also known as “cherry picking”. In this case, the FCA found that the firm had neglected to manage conflicts of interests fairly.
Asset managers need to ensure they have proper procedures in place to monitor trades that are allocated to clients or funds after they have already been dealt in the market. Ideally, procedures must require permission to be sought prior to allocating the trade in this manner. When monitoring such trades, all relevant factors must be taken into account whilst deciding whether a client’s interests were compromised, in the favour of the firm, a staff member or another client. There should be adequate records for all instances. Reflecting the FCA’s Principles for Businesses, SYSC 10 and COCON 2.1 rules, cases of misallocated orders are likely to attract scrutiny of the conduct of all parties involved.
Conflicting interests in investee companies
If inadequately managed, conflicts of interests have the potential to create adverse perceptions of a firm among investors. Recently there has been heavy market scrutiny of common board memberships between asset managers and their investee companies and the potential conflicts this can give rise to in a range of possible areas including asset selection.
Asset managers need to ensure that any potentially conflicting interests in investee companies are recorded and disclosed to investors. Firms’ monitoring frameworks therefore need procedures in place to identify these and ensure that investment is limited in companies in which the conflicting interest may carry potential harm to investors and reputational risk for the firm. Importantly, the FCA expects asset management firms to foster a culture in which investment managers promptly reveal conflicting outside interests in investee companies to the firms’ Compliance and Audit functions.
Implications for asset managers
Managing conflicts of interests appropriately will be a still greater priority now that the Senior Manager and Certification Regime applies to all authorised firms. The FCA has heavily scrutinised inadequate conflicts management within PA Dealing and order allocation and this trend is likely to continue. Firms with a culture that is seen to drive poor conduct and overly prescriptive procedures that are not regularly complied with, or regularly reviewed and updated, are running substantial regulatory risk. Moreover, given the rising importance of environmental, social and governance issues, the reputational impact of any regulatory censure or action due to inappropriate management of conflicts could be severe.
Consequently, in order to manage conflicts effectively, firms should consider employing a combination of:
- an extensive monitoring framework to identify and monitor conflicts of interests prevalent in all parts of the business;
- a pro-active recording of identified existing or potential conflicts and the steps taken to mitigate or manage them; and
- a holistic board-led approach which prioritises and monitors a good conduct culture and associated behaviours at all levels of the firm.
1 The obligation to manage conflicts of interests appropriately is enshrined in Principle 8 of the FCA Principles for Businesses and SYSC 10. Most recently the FCA has stipulated in its 2019/20 business plan that conflicts of interests are a sectoral priority for wholesale financial markets and firms that design and sell retail investment products. The business plan also states the FCA’s intention to continue to monitor the outcomes and reductions in harm from the various rules imposed by MIFID II, including more work on conflicts of interests in the wholesale market. MIFID II imposed stricter requirements on firms to manage or prevent conflicts where possible.
2 These have replaced Principles for Approved Persons from December 2019 for all solo regulated firms
This publication has been written in general terms and we recommend that you obtain professional advice before acting or refraining from action on any of the contents of this publication. Deloitte LLP accepts no liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication.