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Thursday, 25th April 2024 |
| Chinese walls must be assessed |
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| Financial institutions and their clients need to ensure that conflicts of interest are managed to the highest standards. Kevin McHugh outlines some questions a client can ask about its financial institution’s conflicts of interest policy. |
Potential conflicts of interest occur every day for financial institutions and their customers. It is very common, for example, to see cases of a bank providing services to several companies from within the same sector in circumstances where the interests of any given company may not be consistent with the interests of another company which is a customer of the same bank. Equally it is common, for example, to see one arm of a bank providing a customer with corporate finance advice while another arm supplies finance. It is not difficult to envisage circumstances where the interests of the company and of the bank will vary.
Risks arising from conflicts
The risks for both customer and institution of conflicts of interest are considerable.
A customer carrying out, for example, an acquisition wants to get and to be seen to get the best possible independent advice. Conflicting interests on the part of its advisors may adversely affect it’s ability to achieve this.
For the institution there are risks of reputation damage and of loss of custom. The courts can also, in appropriate cases, require the institution to account for any profits it makes or to pay damages in respect of any loss made by its customer. For the customer prevention is better than cure.
Given these risks there are obvious incentives to avoid conflicts arising in the first place. As a practical matter, however, this is easier said than done. In many cases a customer will go to a given institution precisely because of the expertise it has gained by dealing with multiple customers in the same sector .
Equally customers may prefer to choose a financial institution which offers multiple services precisely because of its range of services and expertise. In these and many other cases avoidance of conflicts may not be a practical option.
Clients’ rights
A client faced with an advisor with conflicting interests and wishing to consider his rights has to take account of several legal issues.
Under common law conflicts of interest must be avoided unless the informed consent of the clients involved has been obtained. It is difficult in practice for an institution to be certain that informed consent is obtained. In a large institution there are practical difficulties in knowing about all possible conflicts, much less in fully explaining them to all interested parties. European law and Stock Exchange rules apply a slightly less rigorous standard by requiring only that all reasonable measures be taken to avoid a conflict and that clients be fairly treated where conflicts do arise. It remains to be seen which standard the courts will apply in practice, but even under the less rigorous standard the onus on the institution is considerable.
The most common mechanism for addressing conflicts is through Chinese walls arrangements. It is worth noting that Chinese walls need to be of a high standard if they are to satisfy the courts and the regulatory authorities. In three cases in the UK the courts have expressed doubts about whether Chinese walls could ever be impregnable. UK regulatory authorities put the onus on the institution to prove the effectiveness of its arrangements. It is likely that the UK precedents and attitudes would be influential if a test case arose in Ireland.
Obviously the specific legal position of a client will depend on all the facts but the general attitude of the courts and the regulators holds institutions to a high standard.
Assess the management of potential conflicts
What questions should a client ask in order to assess the quality of the arrangements his chosen institution has in place? Obviously the specific questions will vary depending on the facts but the following questions, which are not comprehensive, provide general guidance:
1. Does the institution have a formal Chinese walls policy?
2. Has the institution specifically assessed where significant conflicts of interest may arise?
3. Does the institution physically segregate different business areas?
4. Does the business identify specific individuals (or classes of individuals) entitled to enter specific areas? How does it enforce this policy? How are staff entering the premises outside hours (including contractors, cleaners etc) controlled? What staff are entitled to access multiple business areas (this might include, for example, auditors, compliance staff, legal staff, support staff and senior managers).
5. Does the business operate a clean desk policy? Are files which are not in use locked away? What procedures are in place to prevent unauthorised file access?
6. Does the business operate IT access controls to limit access to information? Who has access to the information relevant to your company? How are these controls enforced?
7. Does the company use code words and number copies of documents ?
8. Have both the institution and all relevant staff signed confidentiality agreements?
9. What procedures are in place to protect against information being passed on when a staff member leaves a given business area?
10. Does the institution have a process for taking on new clients? Who evaluates whether conflicts would occur and what action should be taken in cases of potential conflict? Who evaluates whether changed circumstances with existing clients gives rise to conflicts?
11. Are there specific competing clients for which the institution will not act? If so will this restriction apply to staff who leave the business unit involved? How long will the restriction continue?
12. Who decides how to respond where conflict does occur? Does the institution have a policy of disclosing conflicts to each of the clients involved? How much is disclosed in this process? When does this disclosure occur?
Summary
Management of conflicting interests is difficult for customer and institution alike. The risks where the issue is mismanaged are considerable. It is sensible therefore to address the issue comprehensively as early in the relationship as possible and to keep the matter under ongoing review. |
Kevin McHugh is Director of Compliance and Risk of Goodbody Stockbrokers
and is the author of ‘Regulation of Investment Capital Markets’,
published by Blackhall Publishing (price ?75 hb, ?45 pb).
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| Article appeared in the October 1999 issue.
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