Conflicts of Interest

NATURE OF “THE CONFLICTS CRISIS”

By ′the Conflicts Crisis′, I mean the series of events, primarily in the US, which have caused a crisis of confidence in the way the financial sector in particular manages conflicts of interest. These events have included issues about corporate conduct, and the reliability of corporate accounts, seen in the collapse of Enron, WorldCom, Parmalat and Arthur Andersen. It has involved concern about the reliability of investment recommendations, where some of the world’s largest investment banks have been found to have recommended stock which they knew to be of poor quality. And it has been seen in recent revelations of abuses in the wholesale insurance markets, potentially involving bid rigging and other serious abuses.

These issues are commonly characterised as a failure to manage conflicts of interest. But some conduct described in this book could perfectly well be classified as fraud, false accounting or corruption. Why does the usual characterisation focus on conflicts of interest? First, it seems to me, because the underlying conflict is often what motivates the conduct. Second, because the legal controls applying direct to the conduct – the criminal law banning fraud, false accounting or corruption, have not proved sufficient to control it, so people want to try to focus on the root cause. But in recognising the good sense behind addressing this series of unfortunate events as conflicts of interest, we need also to recognise its weakness. In particular, it must not allow us to believe that the underlying problem is simply poor systems and controls, and that the solution lies solely in improving them. The underlying problem is not poor systems and controls, but the combination of the incentives which conflicts create, the willingness of some to abuse their position, and the need to improve safeguards to prevent abuse or mitigate its effect.

In considering the appropriate response to the conflicts crisis, we need also to recognise its nature as a crisis. In my view, its nature as a crisis derives from four factors things. First is the scale of the impact. This brought it home that conflicts were not just the way of the world, but something that mattered fundamentally. Second was that it was recognised as a systemic issue. This is, because, even if the conduct is not endemic, many of the underlying conflicts are, and so could bring about repeat crises unless they are effectively tackled. The third is, not only were internal controls found inadequate to prevent abuse, but so also was the external control environment, in the form of auditors and rating agencies, which were found to be conflicted too. Finally, the scale of the impact was exacerbated by the way market forces operated. Not only had they proved inadequate to prevent abuse, but they then created a rapid correction, seen most vividly in the demise of Arthur Andersen, which has had lasting negative effects.

THE REGULATORY RESPONSES, AND THEIR PROSPECTS OF SUCCESS

The regulatory response, particularly in the US, has been wide ranging with:

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disciplinary, penal and redress sanctions for many of those involved;

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extensive new systems and controls;

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a renewed emphasis on senior management responsibility, reinforced in a particularly uncomfortable way through uncompromising sign off procedures;

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increased disclosures, to assist market forces to operate in more timely and effective ways. As this work shows, regulatory responses in other jurisdictions have varied. In my view, this is both legitimate and sensible. This is not because the crisis did not happen in those jurisdictions, still less because a similar crisis could not. Rather, it is because different jurisdictions have different markets, different legal and control systems, and different cultures, so need different remedies. These different regulatory regimes have another benefit: that they allow different approaches to be tried, and each market to learn from the experience of others. A possible drawback of regulatory harmonisation work is to standardise controls across markets, which may work differently in different contexts or even not be needed in some.

Will these regulatory interventions prove adequate to avoid another conflicts crisis? In their favour it could be said that:

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they tackle the problems which emerged in a wide-ranging and
intensive way;

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they tackle both opportunity, by improved systems, and motive, by the disincentive of enforcement action;

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they try to create better, less abrupt, market disciplines, through
improved disclosure; and

+          they have already restored confidence to a considerable degree. But this does not in my view mean that another crisis cannot occur. First, fundamental conflicts continue. Indeed, in one form or another, they are inevitable. They arise whenever one person has power to secure his own interests at the expense of his duty to someone else – and this is almost universal in the financial services industry. Second, conflicts are widespread, going beyond the traditional investment banking and securities market, as we have seen recently in the insurance world. Third, systems and controls can only go so far in combating powerful commercial incentives. If the incentive is sufficiently powerful and widespread it will corrupt or overcome the control.

THE CHALLENGE FOR THE FUTURE

So what will make the difference? Can we hope to eliminate conflict abuse, or only to prevent it reaching crisis proportions? If we can, in my view it can only be through:

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recognising that similar problems can arise in a number of areas, not just in those where they have arisen in the past: the current focus on conflicts of interest in the hedge fund industry is a good example of this recognition;

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a healthy scepticism and effective self-protection by the user
community, so that market forces can work constructively;

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a constant vigilance on the part of market participants, and a
willingness to ′whistle blow′ where serious problems arise;

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prompt and, if necessary, regular action by the enforcement authorities, to provide a credible disincentive, to match the powerful incentive which the conflicts create.

I hope, by sensitising people to conflicts, and how they may be managed, this volume will contribute to this important task.