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Managing Conflicts in Financial Services - Australian Fund Market1
John Moutsopoulos, Clayton Utz
July 2005
 

Financial Services Reform

Many participants in the Australian fund market have always been subject to general obligations to avoid conflicts as a matter of common law, arising out of the fiduciary relationship between a particular participant and their client.

Recent international experience with conflicts of interest - particularly that of the United States in 2002 with respect to research analysts within investment banks - led the Australian Government to consider its own regulatory framework for managing conflicts. The result is the recent amendment of the Australian Corporations Act 2001 to impose a specific conflicts management obligation on all providers of financial services in Australia who hold an Australian Financial Services Licence (AFSL).

Typical financial services providers include fund managers (such as hedge fund managers), investment managers, investment advisers, custodians, brokers, analysts, banks and other financial institutions which are required to hold an AFSL unless they qualify for a licensing exemption.

Generally, any person who carries on a business of providing financial services in Australia will be required to hold an AFSL issued by the Australian financial services regulator, the Australian Securities & Investments Commission (ASIC). However, there are a large number of exemptions from this requirement. A key exemption exists for certain foreign financial service providers that wish to provide financial services to wholesale clients in Australia. This is considered further in paragraph 3 below.

New Conflicts Management Obligation

From 1 January 2005, the Corporations Act 2001 provides that AFSL holders must have adequate arrangements in place "for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken by the licensee or a representative of a licensee in the provision of financial services." This new regulatory duty extends to all financial service providers generally, whether their clients are wholesale or retail.

There are a number of other licensee obligations which also deal with or relate to conduct potentially affected by conflicts of interest, including the existing general duty to provide financial services "efficiently honestly and fairly". However, the new conflicts management obligation imposes, for the first time, a direct and specific obligation on licensees to have adequate arrangements to manage their conflicts of interest.

Licensing exemption for foreign financial services providers

This licensing exemption takes the form of relief granted by ASIC. The relief must be applied for and, once given, is subject to satisfaction of ongoing conditions. A number of specific entities in a number of specific jurisdictions have the benefit of this relief, including USA, UK, Hong Kong, Singapore and Germany.

The effect of this relief is that, if the foreign provider is able to obtain the benefit of the licensing relief, they will be able to provide financial services (including promoting foreign funds) to Australian wholesale investors (that is, private placement business) without the need to comply with Australian licensing rules, including the new regulatory duty concerning the management of conflicts of interest. The main condition is that the financial services must be provided in a manner that, if they were provided to clients in the home jurisdiction in similar circumstances the financial services would comply as far as is possible with the home regulatory requirements.

Fund Market Participants Affected

Late trading and market timing issues in the US mutual funds industry have recently shaken investor confidence in that marketplace. The underlying concerns behind these issues related to conflicts of interest.

The introduction of the new regulatory conflicts management obligation will have significant implications for licensed participants in the Australian fund market, whether or not these participants already owe similar obligations to their clients as a result of a fiduciary relationship between them.

Examples of Conflicts in the Australian Fund Market

Some examples of typical conflicts of interest scenarios that occur in the Australian fund market include:

  • a company is an investment advisor for two separate clients and has the opportunity to enter into a particular hedging strategy that is suitable for either client;
  • a trustee of a fund which has an interest in maximising management fees in the fund when investors have an interest in minimising the fees they pay;
  • a trustee in a conglomerate group invests in a range of underlying funds where the trustee of those underlying funds is a member of the same conglomerate group;
  • a fund trustee outsource the fund's investment or hedging strategy or custody to a related party;
  • a company is trustee of two separate funds which invest in broadly similar asset classes and has the opportunity to invest in a particular asset that is suitable for either fund;
  • the payment by a trustee of a fund of preferential remuneration to a related company that distributes its fund product.

Policy Statement 181

To assist licensees in complying with the new conflicts management obligation, ASIC has recently issued Policy Statement 181 as well as a supplementary Guide for research report providers (such as research analysts, securities analysts and research houses) which sets out how ASIC expects licensees to manage conflicts of interest that affect their business. In ASIC's view, PS181 and the Guide represents the minimum arrangements licensees need to have in place to comply with the new conflicts management obligation. Licensees whose conflict management arrangements are not consistent with ASIC policy are exposed to a greater risk of regulatory and enforcement action by ASIC.

According to PS181, the 3 mechanisms that providers would generally use in their arrangements to manage conflicts of interest are controlling, avoiding and disclosing the conflict. A licensee must:

  • identify the conflicts of interest relating to their business;
  • assess and evaluate those conflicts; and
  • decide upon, and implement, an appropriate response to those conflicts.
PS181 contains guidelines for licensees to implement each of the above steps, including the following requirements to ensure conflicts management arrangements (ie measures, processes and procedures) are adequate:
  • the arrangements must be documented with compliance monitoring records also kept;
  • the arrangements must be implemented and maintained on an ongoing basis, including by being:
    • approved by senior management;
    • regularly reviewed and, where necessary, updated;
    • overseen by a specific person(s) responsible for their implementation, review and updating;
  • licensee's internal structures and reporting lines should support the licensee's management of conflicts. This includes the requirement that the people who decide what is an appropriate action to take (see step 3 above) where a conflict arises, "should not be significantly affected by the conflicts themselves";
  • licensees need to consider their remuneration practices (including soft dollars) in terms of whether they give rise to conflicts of interest;
  • licensees must make appropriate disclosures to clients about any material conflicts of interest that may affect the provision of financial services to them;
  • in some cases, a conflict of interest may have such a serious potential impact on a licensee or its clients that disclosing the conflict and imposing internal controls will not be adequate. In such a case, the only way to adequately manage the conflict will be to avoid it or refrain from providing the affected financial service.
ASIC has stated that for the purposes of its administration of the law (including in particular PS181), it may take into account compliance with industry standards or practices.
It seems clear that the common law rights of clients who are in a fiduciary relationship with a financial services provider continue to apply as an additional set of safeguards to the new regulatory duty concerning the management of conflicts.

While it is still early days, and the practical approach of ASIC's PS181 and the Guide has not yet been tested, there does seem to be a potential for mismatch between aspects of the new regulatory duty (as interpreted by ASIC) and fiduciary obligations in respect of conflicts.

Different ways to manage conflicts

Possible mechanisms for managing conflicts include:

  • the insertion into the client agreement of an express exclusion clause which circumscribes the extent of the fiduciary's duty to avoid conflicts;
  • obtaining the consent of the client to the conflict after making full disclosure of all material facts;
  • restructuring remuneration or review processes;
  • introducing mechanisms for independent oversight or decision making;
  • establishing "Chinese walls" to prevent inappropriate flow of information between business areas or make other internal structural changes to support the management of conflicts;
  • revisiting the constitution of fund boards and committees;
  • in extreme cases, avoiding the conflict entirely or declining to provide the service.

Conclusion

Conflicts in the Australian financial services industry are inevitable. It is an area that the Australian regulator is interested in and expects licensees to have put in place an effective and fully functioning compliance program to manage conflicts.

Reputation and goodwill is everything in financial services. The new regulatory rule presents an opportunity for some fresh-thinking by financial service providers in the Australian fund market and a reassessment of their pre-existing compliance practices in the conflicts area. A key message for many such financial service providers is that the conflicts crisis in the United States would have been avoided if United States providers had not forgotten the importance of having a culture of fiduciary responsibility.

Chapter 7 of the Australian Corporations Act 2001 includes what are known as the Financial Services Reform (FSR) Act provisions, which were introduced into the Australian Corporations Act by amending legislation. The legislation took effect on March 11 2002, but there was a two-year transitional period that ended on March 11 2004. So for most people the regime has only been in place for the last 12 to 18 months.

The FSR regime regulates:

  • providers of financial services in Australia (this includes all the different type of providers mentioned above whether the provider is foreign or Australian based including both on-shore and off-shore funds promoted in Australia);
  • disclosure in relation to financial products; and
  • financial markets and clearing and settlement facilities.

'This article first appeared in the June issue of the AIMA Journal.

 
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