CONFLICTS OF INTEREST GENERALLY
Human affairs generally are laden with conflicts of interest. None of us lives in a world of simply owing duties to a single person. Life is multifarious and we are all conscious of the different levels of responsibility we have in relation to conflicts of interest in our private lives. Some of these responsibilities are buttressed by the power of law, some by moral and ethical standards, some by social customs and sometimes we have to make difficult personal decisions.
The same is true in the business world. And over time the boundaries between acceptable and unacceptable behaviour have shifted. Not so many decades ago, trading on inside information was perfectly acceptable; indeed it was the motor for much trading activity. That was in the days of political, social and personal privilege. Increasingly, democratisation has demanded equal rights for all, including immediate general availability of market-sensitive information on publicly traded assets.
The last several decades have witnessed widespread and powerful drivers of change in the business world: the democratisation of the ownership of assets; de-regulation; globalisation; consolidation within and across industries; expansion driven by a search for synergies between different business activities; and price competition. The consequence, in terms of conflicts of interest, has been to increase the area of potential conflicts within business organisations and to diversify the stakeholders to whom are owed the responsibilities to manage the conflicts effectively.
During the 1990s there was a boom in the securities markets, accompanying a period of unprecedented economic expansion. Although the markets generally operated effectively, there were cases of abuse and excess which have been the focus of much attention from regulators and legislators since the collapse of the dotcom boom in 2002. This attention has resulted in the emergence of a new and more sophisticated framework for the management of conflicts of interest. The general structures of this new framework are operative in most of the securities markets around the world and the similarities of the operating requirements will be apparent from the different sections of this book.
There is still work in progress but at this stage it is possible to discuss the main features of the new framework. Before looking at them, let us remind ourselves about the key concern in relation to the conflicts of interest.
The situations where the responsibility arises to manage the conflicts of interest effectively are where there is conflict between the interests of the firm (or
Overview
individual, or relevant associates) and the duty the firm (or individual) owes to the client or between the interests of one or more clients.
Throughout history the common and civil law systems have imposed a particularly high level of care to manage conflicts of interest effectively where there exists a relationship of a fiduciary nature, or of uberrimae fides or otherwise of the “highest character”. In these relationships the core obligation is one of loyalty and this does not permit the entertainment of a conflict of interest. Occupations like lawyers, agents and directors have by virtue of their status been subject to fiduciary obligations. Other activities can have fiduciary obligations imposed upon them in particular circumstances only. Areas where fiduciary obligations may well be owed are, for example, discretionary investment management and mergers and acquisitions work. In these the client has an expectation that the institution will place the client’s interest above the interests of the institution and other clients. There would clearly be a conflict of interest if an investment bank were to act for two potential bidders for a takeover target, at least without the informal consent of both and an effective Chinese wall between the groups carrying out the work.
Outside fiduciary situations, the legal systems have in the historic past imposed duties for control handling of conflicts of interest only rarely. However, with the growth of fair and open markets, legislators and regulators have been expanding the extent to which the management of conflicts of interest should be overseen by prescriptive requirements. In the US, in the aftermath of the Great Depression draconian action had been taken to address the conflicts of interest that could arise between commercial and investment banking. The Glass-Steagall Act of 1933 required separation between commercial and investment banking and this regime lasted until the passing of the Gramm-Leach Bliley Act in 1999. In the UK historically there was until Big Bang in 1986 not only a division between commercial and investment banking, but even between the “broking” and “jobbing” activities of the securities business.
The 1980s and 1990s were the great period of deregulation in the Western world (although, in relation to partnerships, deregulation had arrived earlier, in 1967, with the limit of 20 on the number of partners being abolished by the Companies Act 1967 in the UK, allowing the growth of the major UK international accountancy and legal firms). Market forces were allowed freer rein to dictate the shape of business activities and of business organisations both within states and between states. Economic activity built up a head of steam. “Irrational exuberance” stoked up the dotcom bubble which burst in 2002.
Since the bursting of the bubble both legislators and regulators have developed new constraints in relation to the management of conflicts of interest and this book explains the new framework that has resulted, particularly in relation to accountancy and financial services.
The US-related sections of this book recount the story of developments in the US over the last few years. Many of these developments have been driven by New York Attorney-General Spitzer and the SEC Director of Enforcement Stephen Cutler. Starting off with specific enforcement activity in relation to certain aspects of the securities industry, there has now taken place a widespread overhaul of the controlling infrastructure in relation to the management of conflicts of interest in the securities markets generally. Specific new rule-making, particularly in relation to research analysts and market timing, has been accompanied by a principles-based surveillance of practices generally (see particularly Stephen Cutler’s speech of 9 September 2003 in Charleston, South Carolina and the industry’s top-to-bottom reviews carried out in accordance with the requirements set out in the speech). Eric Dinallo ably analyses this development in his section of this book.
At this stage it is possible to see that it has been accepted that the consolidation and integration of banking services resulting from the deregulation of the end of the last century are to continue to provide operating platforms in the financial markets of the future. And the regulators have engaged in a productive exchange on how conflicts of interest in the banking industry can be managed both within the new specific rules that have been brought into being and also by the operation of a principles-based approach.
In the field of accountancy major changes have been brought about principally as a result of the passing of the Sarbanes-Oxley Act of 2002 which overhauled the previous self-regulatory regime and set up the Public Company Accountancy Oversight Board, which has the power to discipline for violations and impose penalties and limitations on a temporary or permanent basis.
Similar vigilance has been required of the legal profession with the Sarbanes-Oxley Act requiring the SEC to set minimum standards of professional conduct for lawyers “appearing and practising” before the SEC. Also the SEC has stepped up its scrutiny of lawyers and has brought enforcement action against in-house counsel as well as outside counsel.
Regulators outside the US followed with interest the developments in the US post 2002. In Europe and in Asia regulators carried out reviews of activities carried out during the dotcom boom and in certain areas brought in new requirements.
IOSCO has provided a useful forum in which the securities regulators from many countries have sought to co-ordinate their responses to market developments. It was IOSCO which followed up on the research settlement in the US with the publication of internationally applicable principles to govern the relationships of research analysts with other areas of business activity. These principles have been applied in many countries. IOSCO has, in August 2005, announced its intention to carry out its own review of the adequacy of management techniques in the worldwide financial services industry for the resolution of conflicts of interest. its report on this subject, like its other reports, will have substantial persuasive influence when it’s published in due course.
It has been in Europe that a particularly active period for securities regulators has occurred over the last few years. This has been prompted by two stimuli: first, reactions to the excesses of the dotcom boom and, secondly, the European ambition to create a modern and effective single securities market.
Europe has embarked on an ambitious programme of unifying the operation of its securities markets and has taken the political, legislative decisions necessary to do so. One of the central pieces of legislation in this programme is called MiFID – the Directive on Markets in Financial Instruments (Directive 2004/39/EC). Articles 13(3), 18(1) and 18(2) set up a new legal regime for the handling of conflicts of interest in investments firms. These articles are to the following effect:
Article 13(3) “An investment firm shall maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps designed to prevent conflicts of interest as defined in Article 18 from adversely affecting the interests of its clients.”
Article 18(1) “Member States shall require investment firms to take all reasonable steps to identify conflicts of interest between themselves, including their managers, employees and tied agents, or any person directly or indirectly linked to them by control and their clients or between one client or another that arise in the course of providing any investment and ancillary services, or combinations thereof.”
Article 18(2) “Where organisational or administrative arrangements made by the investment firm according to Article 13(3) to manage conflicts of interest are not sufficient to ensure, with reasonable confidence, that risk of damage to client interests will be prevented, the investment firm shall clearly disclose the general nature and/or sources of conflicts of interest to the client before undertaking business on its behalf.”
Following a consultation process carried out by the Committee of European Securities Regulators (CESR) in 2004 and 2005, further proposed flesh has now been put on the bones of Articles 13(3), 18(1) and 18(2) of MiFID by the European Commission. The proposals are still in draft form at the time of writing but are indicative of the current European thinking on the topic. They are clear and self-explanatory and are set out in the Appendix to this book.
Europe has been active in relation to the independence of the audit function. In November 2000, the European Commission had issued recommendations on quality assurance for statutory audit. Then in May 2002 the Commission issued recommendations on fundamental principles of auditors’ independence with the aim of securing EU-wide harmonisation of legal standards on the independence of auditors. Then in March 2004 the Commission submitted a draft for a new directive regarding the work of auditors. Although the Directive is still wending its way through the European legislative process, various member states have already brought into law revisions in line with this proposed new Directive.
In the same way that the regulators in the US overseeing the financial markets have been carrying out recently a thorough appraisal of the management of conflicts of interest in these markets, so too in the UK the Financial Services Authority (the FSA) has been engaged upon a review of practices in this area. The intention of the FSA in carrying out this review has not been to issue new rules or guidance (although, of course, FSA requirements will be subject to change from April 2007 due to MiFID). Rather the intention has been to engage the industry in a productive exchange on how conflicts of interest can be managed in a principles-based way. There have been extensive discussions between the FSA and the securities industry and the dialogue is continuing.
The recent developments in relation to auditors are summarised in the UK section of this book (and the section in this book by ****** provides fascinating insights into the main drivers of change in this area).
With regard to the legal profession, the UK is in the vanguard of developments in the same way that the UK Big Bang of 1986 was a precursor to the deregulation of the securities markets elsewhere (including the enactment of the Gramm-Leach-Bliley Act in the US in 1999). There has been considerable activity centred on The Law Society’s work on conflicts of interest (dealt with in the UK chapter of book) and also in the Clementi Report which the UK government is committed to implementing. This Report opens up the prospect of lawyers now being allowed to work alongside other professionals and other business activities and even operating in companies owned by non-lawyers.
The last few years have witnessed an unprecedented endeavour to create a heightened framework in relation to the management of conflicts of interest in the services industry. This framework has many broadly comparable ingredients in the Americas, Europe, Asia and Australasia, although different jurisdictions have differences of detail. The various jurisdictional sections of this book set out the requirements which are operational.
It is to be hoped that the new heightened framework for the management of conflicts of interest will provide a sufficiently robust set of controls so as to ensure fair dealings and command the respect of users of the markets.
Keith Clark
General Editor
London
August 2005
