Identifying and mitigating the risks
All investment management firms need to pay very careful attention to a recent paper issued by the UK’s Financial Services Authority (FSA) concerning the management of conflicts of interest between asset management firms and their customers. The paper was published on 9 November, 2012, and required action by each investment manager’s governing body1 and chief executive officer by 28 February, 2013.
The paper, which can be found on the FSA website2, followed from a series of thematic reviews at various FSA-authorised investment management firms which clearly left the FSA unhappy about the approach that many firms are currently taking in relation to conflicts.
Not only do many firms have an inadequate framework for management of conflicts, but the regulator also found that a number of firms were actually in breach of its existing rules. A number of FSMA Section 1663 skilled person reviews have been commissioned following these thematic reviews and enforcement action is being considered where more serious issues have been identified.
Many of the criticisms in the paper concern rules that the FSA clearly believed were well-understood and applied by the industry and there is a sense of surprise and disappointment in the regulator’s findings. It may be that the current deluge of regulatory changes affecting investment managers has caused attention to be diverted from their “day job” but the FSA is making it clear that it is not prepared to accept any excuses. The direct tone of the paper makes it clear that a new era of vigorous enforcement is imminent.
While many of the firms that were reviewed by the FSA had policies covering different aspects of conflicts management, the FSA was very concerned that most of the firms could not demonstrate that the policies were properly applied or effective. The FSA’s principal fear is that firms might be incurring inappropriate costs on behalf of their customers in contravention of FSA rules and principles.
The main issues addressed by the FSA’s paper
At the heart of the FSA’s findings is its perception that poor management of conflicts results from an inherent cultural failing and not having the right attitude towards serving customers’ best interests. The paper refers to senior management failing to convince the FSA that they understand that they have a “sense of duty”. The FSA’s paper highlighted five substantive areas for investment managers to focus on whilst reviewing their overall conflict procedures:
- Purchase of research and trade execution services – only a few firms exercised the same control over payments for research and trade execution services on behalf of customers, as they would if the payment were being made from the firm’s own resources. Further, firms did not regularly review whether services were eligible to be paid for using customers’ commission. Such conflict management arrangements should be the subject of regular governing body review.
- Gifts and entertainment – many firms set their gift and entertainment policies in line with market practices without any further considerations. The FSA clearly expects to see a more thoughtful and calibrated approach to this topic, which recognises some of the wider conflicts which can be created by gifts and entertainment. It is not just a question of following perceived market practice, or assessing how expensive the gift or entertainment is, but whether the objectivity of decision making and the duty to act in the interest of the firm’s customers might be compromised by the gift or entertainment.
- Equal access to investment opportunities – in particular, firms should ensure that one client is not favoured above another, whether through greater access to limited investment opportunities, by means of allocation policies or in cross-trading between clients. The FSA also noted that where individual portfolio managers are given significant leeway in investing their portfolios this may result in information and ideas not being shared for the benefit of all clients. Firms should re-evaluate the extent to which there is a discrepancy between how they market their services for customers and the reality of how portfolios are managed within their firm.
- Personal account dealing – the FSA concluded that although personal account dealing arrangements were generally found to be satisfactory, care should be exercised to ensure that there are clear procedures in place with adequate restrictions on permitted trading and ongoing monitoring in compliance with the rules.
- Allocating the costs of errors made by the manager – the FSA singles out the hedge fund manager sector in particular as being one which tends to rely on contractual clauses in their customer contracts excluding liability on their part for any errors or omissions except in the case of gross negligence. The FSA frowns upon the use of such clauses to justify not reporting errors to customers or to avoid collecting information about the costs borne by customers in respect of such errors.
These are all familiar matters to investment managers, so the paper should be read as a reminder of best practice in these areas which firms will be expected to benchmark themselves against. The FSA threatens to take disciplinary action against firms which fall below the required standards.
This should not cause any surprise, as acting in a client’s best interests is a fundamental requirement, and conflicts management is a prerequisite to this. It is frequently left to legal and compliance departments to address these issues, but conflicts recognition and management should also be within the skill set of every portfolio manager. The FSA believes that better controls and standards are achieved where business line management work together with legal and compliance to design conflicts controls.
Global regulatory focus
The issue of failing to identify, monitor and mitigate conflicts of interest in a manner that meets regulators’ expectations is also a hot topic in the United States of America. On 21 February, 2013, the Securities and Exchange Commission (SEC) published its examination priorities for 2013, which covers a wide range of issues at financial institutions; including investment companies, hedge funds and private equity funds.
The SEC states that its market-wide priorities for the upcoming year include: fraud detection and prevention; corporate governance and enterprise risk management; conflicts of interest; and technology controls (emphasis added).
As the SEC notes, conflicts of interest, when not eliminated or properly mitigated and managed, are a leading indicator and cause of significant regulatory issues for individuals, firms and sometimes the entire market.
Over the past several years, the SEC has identified conflicts of interest as a key focus of its risk-based strategy, and an integral part of its assessment of which firms to examine, what issues to focus on and how to examine those areas. Conflicts of interest are a particularly important challenge for large and complex financial institutions.
Due to these firms’ extensive affiliations and the dynamic nature of their businesses, conflicts are constantly arising and changing. The SEC will focus on specific conflicts of interest, steps registrants have taken to mitigate conflicts and the sufficiency of disclosures made to investors. The SEC’s staff will also be looking at the overall risk governance framework that firms have in place to manage conflicts on an ongoing basis.
Concerns for UK affiliates of offshore managers
The FSA’s paper highlights concerns that the regulator has with investment managers that are part of a larger global organisation. The FSA stated that they “saw evidence” that affiliated UK managers “had governance arrangements that did not meet our requirements regarding conflicts management”.
The issues cited in this area related to governance and organisation and specifically noted that in some cases:
- Senior management in the UK did not exercise sole or “meaningful control” over the authorised manager’s conflicts management and other compliance responsibilities; and
- Individuals based overseas at the parent entity were making decisions on the investment manager’s core practices.
The message is clear, the FSA is concerned that in some cases where the authorised entity is a subsidiary of an overseas parent, compliance oversight and decisions on certain “core practices” are being taken outside the FSA’s jurisdiction and that no approved person in the UK is taking responsibility for compliance with the FSA’s rules.
The specific language of the FSA’s paper makes it clear that several of the entities reviewed were affiliates or subsidiaries of non-UK managers and different weaknesses were highlighted for different managers.
Therefore, all entities that control a UK hedge fund manager should carefully review the FSA’s guidance in this area.
The role of directors
As a result of this increased regulatory focus, alternative investment funds, and more specifically their boards of directors, will need to ensure that they have adequately addressed the issues at hand. Most pressingly directors will need to ensure that they are being provided with the appropriate information by investment managers to fulfil their duties.
Directors should be actively enquiring about conflicts of interest policies at the manager, including how these conflicts are managed and disclosed, along with the mechanism through which they are reported to the directors.
Directors also have an important role to play in helping investment managers meet their requirements concerning conflicts of interests. They can assist by demonstrating that both the fund and its investment manager take conflicts seriously and that they are managed properly. Directors can help to demonstrate a culture of transparency that will benefit the investment management firm. Their documented processes can provide additional evidence that the investment manager is adhering to conflicts of interest policies established at the firm level.
Principle 8 of the FSA’s Principles for Businesses requires that a firm must manage conflicts of interest fairly, both between itself and its customers, and between a customer and another customer. In summary, funds, and their directors, as customers of investment managers, can have an important role to play in helping investment managers to demonstrate that a robust conflicts culture exists across their business, while also representing the interests of the funds’ investors and meeting regulatory expectations.
To address the deficiencies noted above, the FSA has placed accountability for management of conflicts squarely on the board of directors and the chief executive officer. The FSA is requiring the boards of all investment management firms to review the paper and assess their arrangements for managing conflicts.
Upon passing a resolution that the firm’s arrangements will ensure proper conflicts management, the chief executive officer must provide the FSA with a written attestation that the arrangements are effective and will ensure compliance. Firms had until 28 February, 2013, to provide this attestation to the FSA.
It goes without saying that this attestation must be treated with the utmost seriousness. The FSA takes a very serious view of firms and individuals that affirm that they are in compliance with particular requirements but are later found wanting during an FSA visit.
The FSA has stated many times that it will hold senior management to account for compliance failings at their firms and by requiring the chief executive officer to attest to compliance is signalling how seriously it will deal with any failure to demonstrate that the firm has a proper framework for managing conflicts.
Although the FSA paper identifies a number of core conflicts, these are not exhaustive and each firm will have to give proper consideration to its own actual and potential conflicts when assessing the effectiveness of its procedures.
The FSA plans a second round of visits in 2013 and will use the attestation responses received to guide the selection of firms for follow up visits. The significance of the FSA’s concerns should not be underestimated and it is clear that enforcement action is likely to be brought against any investment management firm that is found wanting at this stage.