There is a longstanding regulatory principle (Principle 8) that a firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client. Specific rules give effect to that principle.
Some readers will recall the change of emphasis around conflicts of interest rules that arrived with MiFID II in 2018. The preceding rules required firms to manage ‘material conflicts’ … defined as those conflicts ‘constituting or giving rise to a material risk of damage to the interests of its clients’.
The current rules and guidance require firms to manage ALL conflicts:
“A firm must take all appropriate steps to identify and to prevent or manage conflicts of interest between:
- the firm, including its managers, employees and appointed representatives (or where applicable, tied agents), or any person directly or indirectly linked to them by control, and a client of the firm; or
- one client of the firm and another client
that arise or may arise in the course of the firm providing any service referred to in SYSC 10.1.1R including those caused by the receipt of inducements from third parties or by the firm’s own remuneration and other incentive structures.”
The rules and guidance around what is meant by ‘managing’’ are mostly contained SYSC 10. As the rules arise out of MiFID II, the rules and guidance can apply differently for MiFID optional exemption firms or firms that carry on insurance distribution activities, not least in the allowance of a degree of proportionality – that is to say that firms are expected to manage conflicts in a manner that is proportionate to the type of business done and the type of firm they are. The way the rules apply (as rules or guidance or not applicable) can be found in SYSC 1 Annex 1 3.2CR(1) and the associated Table B.
Notwithstanding those differences in application, the key requirements of rules/guidance/good practice that all firms should be implementing can be summarised as follows:
- Identifying conflicts
- Preventing conflicts
- Disclosing conflicts
- Recording conflicts
The order of these conflict management activities is important. It is absolutely not acceptable to jump straight to disclosure, sit back and think the job is done. The FCA considers that disclosure is a last resort option, to be used only where the conflict in question cannot be prevented – prevention, i.e. removing the conflict entirely, being the optimal and primary management solution.
The types of conflicts that should be identified include those where the firm or a relevant person, or a person directly or indirectly linked by control to the firm::
- is likely to make a financial gain, or avoid a financial loss, at the expense of the client;
- has an interest in the outcome of a service provided to the client or of a transaction carried out on behalf of the client, which is distinct from the client’s interest in that outcome;
- has a financial or other incentive to favour the interest of another client or group of clients over the interests of the client; or
- receives or will receive from a person other than the client an inducement in relation to a service provided to the client, in the form of monies, goods or services, other than the standard commission or fee for that service.
The relevant rule is;
“A firm must maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps to prevent conflicts of interest as defined in SYSC 10.1.3 R from adversely affecting the interests of its clients.”
This implies two steps, first that that the firm removes the conflict if reasonably possible and second that, where the conflict cannot actually be removed, that reasonable steps are taken to prevent the conflict causing any actual detriment to the interests of clients.
As mentioned earlier, disclosure may often be required as a part of the management of a conflict but it is not a substitute for preventing harm and should be considered as a last resort – SYSC 10.1.9A states:
“A firm must treat disclosure of conflicts pursuant to SYSC 10.1.8R as a measure of last resort to be used only where the effective organisational and administrative arrangements established by the firm to prevent or manage its conflicts of interest in accordance with SYSC 10.1.7R are not sufficient to ensure, with reasonable confidence, that risks of damage to the interests of the client will be prevented.”
Disclosure is required where the arrangements made by a firm are not sufficient to ensure, “with reasonable confidence, that risks of damage to the interests of a client will be prevented”.
In that event. the firm must clearly disclose the following to the client before undertaking business:
- the general nature or sources of conflicts of interest, or both; and
- the steps taken to mitigate those risks.
The disclosure must:
- be made in a durable medium;
- clearly state that the organisational and administrative arrangements established by the firm to prevent or manage that conflict are not sufficient to ensure, with reasonable confidence, that the risks of damage to the interests of the client will be prevented;
- include specific description of the conflicts of interest that arise in the provision of
- insurance distribution activities, investment services or ancillary services;
- explain the risks to the client that arise as a result of the conflicts of interest; and
- include sufficient detail, taking into account the nature of the client, to enable that client to take an informed decision with respect to the service in the context of which the conflict of interest arises.
The above comments on disclosure are in addition to the requirements in COBS 6 relating to the provision of information to clients as standard. COBS 6.1.4 requires firms, other than common platform firms, to disclose to clients the manner in which the firm will ensure fair treatment of the client, when a material interest or conflict of interest may or does arise.
A common platform firm should provide a description, which may be provided in summary form, of the conflicts of interest policy. In addition, at any time that the client requests it, further details of the conflicts of interest policy must be provided.
Firms either should or must (dependent on firm type) “establish, implement and maintain an effective conflicts of interest policy that is set out in writing and is appropriate to the size and organisation of the firm and the nature, scale and complexity of its business.”
The content of a conflicts of interest policy is specified in SYSC 10.1.11.
Firms should maintain a record where a conflict of interest entailing a material risk of damage to the interests of one or more clients has arisen or, in the case of an ongoing service or activity, may arise. Note this is also a rule for some firms and guidance for others but would certainly constitute good practice for all firms.
Conflicts in practice
As can be seen from the above summary, the rules/guidance are quite detailed and specific. What could go wrong?
Quite a lot, it would appear. A quick Google search around the theme of ‘conflicts of interest’ throws up some big names that have been fined substantial amounts for failings around conflicts of interest including Standard Life (£31M) and Aviva (£17.6m).
Away from the provider world, an adviser firm was censured and fined £107,200 (after 30 % discount for early settlement) for failings that included breach of FCA Principle 8. Specifically, the firm recommended Amber Financial Investments Limited as a wrap platform for its customers and that customers make investments through Tatton Investment Management, a discretionary fund manager, without disclosing to customers that it had shareholdings in these companies. The fine was in addition to payment of substantial redress to clients affected. But it’s not just about obvious financial interests such as shareholdings. Read on.
Centralised Investment Process (CIP)
Many adviser firms have some sort of CIP, often based around a preferred platform and model portfolios. Does this present a conflict of interest? The FCA believes that it can in some circumstances. Consider this example of ‘poor practice’ in relation to managing conflicts, extracted from FG 21/3.
“A firm’s advice manual states that when advising clients in ill-health to transfer out of a DB scheme, the firm’s PTSs should consider recommending the client should go into drawdown and take ongoing advice. By setting out a process that did not adequately recognise the role of lifestyled/impaired life annuities, it seemed the firm was prioritising an approach that would benefit itself more than the client.”
From the sparse detail, it would appear that there was no evidence of managing the conflict, unlike in this example of ‘good practice’ that is also from FG21/3.
“A firm operated a centralised investment proposition (CIP). The firm would profit from ongoing advice charges and easier administration if they recommended a transfer and their CIP solution.
They wanted to be able to demonstrate that they managed this conflict of interest. If the pre-sale business review function identified that a transfer and investment into the CIP had been recommended when it would not be suitable, the PTS was disqualified from quarterly bonus distribution.”
We get the intended moral of this example but would suggest that it hints at less than 100% effectiveness in terms of managing the (potential) conflict unless we infer the following:
- the fact that there was a pre-sale review process identifying any unsuitable use of the CIP means that the firm’s PROD and investment process clearly identified client types for whom the CIP was and was not intended
- this has been clearly documented and trained out to all advisers
- the firm maintains good management information on when the CIP is used and when alternatives are used instead
- the CIP is not considered by the firm or advisers as a ‘default solution’
- the firm is demonstrably able (in terms of research resource and practice) and willing to provide ongoing service to clients in relation to non-CIP solutions and/or a client’s existing plans that remain outside the CIP, even if this means the client pays any ongoing charges directly
Finally, a quick thought on the stated bonus sanction. The disqualification from quarterly bonus is arguably questionable. As a ‘punishment’ for undesirable behaviour that could well cut across the adviser’s contract of employment, it is potentially dangerous for the firm from a legal/HR point of view. Even if this process is specified in the contract of employment, it remains risky not least because it could be considered arbitrary given that an assessment of suitability can be subjective, especially in the DB transfer world. More immediately to the point, there is no indication in the example of any remedial training for the adviser so as to prevent recurrence of the issue.