Guarding against conflicts of interest. Where do we stand?

See discussions, stats, and author profiles for this publication at: http://www.researchgate.net/publication/242680158 Guarding against Conflicts of Interest: Where do we stand? ARTICLE DOWNLOAD VIEWS 1 22 1 AUTHOR: Alessandra Chirico European University Institute 4 PUBLICATIONS 0 CITATIONS SEE PROFILE Available from: Alessandra Chirico Retrieved on: 16 September 2015 ECMI Policy Br ief No. 11/ Febr uar y 2008 Guarding against Conflicts of I nterest: Where do w e stand? Alessandra Chirico* C onflicts of interest are ubiquitous in the financial services industry, but this does not mean that regulators are prepared to accept conflicts as an unavoidable fact of life. Taken together, the MiFID, UCITS and Market Abuse Directive represent a significant step forward in creating a European regulatory framework for avoiding, managing and disclosing conflicts of interest in investment and ancillary services. In particular, the MiFID provisions on investment research are presented, in this Policy Brief, as an example of ‘good regulation’. Hence, there seems to be no need to call for further regulation in this field. What really matters now is the way the newly enacted MiFID provisions are interpreted by regulators and applied by firms. Nevertheless, there still needs to be put forward more pervasive legislative intervention in the case of conflicts of interest affecting the activity of credit rating agencies, whose multiple users have divergent interests. Investors and regulators are interested in well-researched, impartial assessments of credit quality, whereas issuers primarily seek favourable ratings. This distinction should allow the Commission to gain a better insight into the incentive structures, including possible conflicts of interest and disincentives to perform proper due diligence, faced by credit originators, credit rating agencies and other market participants. Introduction Addressing conflicts of interest helps to promote investors’ protection and maintain market integrity. In the absence of adequate arrangements to cope with conflicts, market intermediaries whose interests conflict with those of a client or an investor may have an incentive to put their own interests ahead of those of the latter. As a result, confidence in the market intermediary or even in the market in general, may be seriously undermined. Indeed, while not all conflicts of interest may result in harm to particular clients or diminish market integrity, all conflicts increase the risk of these outcomes, both in terms of the likelihood and the impact of such outcomes. Conflicts of interest, and potential conflicts, are “ubiquitous” in the financial services industry.1 Although the potential for conflicts to arise is likely to be greater in large organisations providing a range of financial services, even the smallest firm which, for example, is paid to act as an intermediary for a client, can have interests that conflict with those of its client. But whilst the existence of conflicts is inherent in the business models of some firms, this does not mean that regulators (or market participants) in general are prepared to accept conflicts as an unavoidable fact of life. On the contrary, regulators constantly seek to reach a balance between investor protection and market integrity on the one hand and prudential stability on the other hand, “while at the same time not unnecessarily handicapping market players that are immersed in a complex and highly competitive business environment”.2 Nowadays, conflicts of interest are becoming very common in the activities of market intermediaries because of the different roles played by an intermediary or companies within the same financial group as the market intermediary. A classic conflict due to multi- 1 According to Michel Prada (2007), Chairman of the Autorité des Marchés Financiers. 2 Ibid. * Alessandra Chirico, Ph.D. is Head of Research at the European Capital Markets I nstitute ( ECMI ) and a Research Fellow at the Centre for European Policy Studies ( CEPS) in Brussels. She can be reached by phone on + 32 2 229 39 58 or by email ( alessandra.chirico@ceps.eu) . Valuable comments from Karel Lannoo, Rym Ayadi and Burçak I nel are gratefully acknow ledged. Papers in the ECMI Policy Brief series provide insights into regulatory initiatives that affect the European financial landscape. They are produced by specialists associated w ith the European Capital Markets I nstitute, w hich is managed and staffed by the Centre for European Policy Studies ( CEPS) in Brussels. Unless otherw ise indicated, the view s expressed are attributable only to the author in a personal capacity and not to any institution w ith w hich she is associated. Available for free downloading from the CEPS website (http:/ / www.ceps.eu) © Copyright 2008, Alessandra Chirico. All rights reserved. 2 | Alessandra Chirico capacity is posed by the co-existence of credit and equity activities with the same client. Trading for own account, together with managing assets on behalf of third parties is another source of conflict which may give rise, for instance, to front running. Multi-capacity is, per se, a potential source of conflict of interest. From this perspective, recent developments in the financial industry have probably increased the risks: concentration of firms, development of conglomerates, disintermediation and transfer of risks to the markets raise new and complex issues that regulators and market participants must grapple with. EU legislators are also keenly aware of the problems arising by the expanding range of activities that many investment firms undertake simultaneously and the consequent increased potential for conflicts of interest between those different activities and the interests of their clients. They have acknowledged the necessity to provide for rules to ensure that such conflicts do not adversely affect the interests of the market intermediaries’ clients.3 Indeed, it is not easy to address the issue of conflicts of interest from a regulatory point of view. On the one hand, the industry constantly develops new arguments to defend industrial, technical, organisational and financial arrangements which give rise to possible conflicts of interest. And these arguments may be persuasive from a cost-efficiency point of view: saving costs by sharing the same systems for different purposes, combining different skills to improve the quality of services to the client, using commercial networks to diversify the products offered, etc. Regulators, on the other side, can use different tools to deal with these issues. Broadly speaking, in response to them, some changes to the regulatory framework have been progressively introduced. On the sell-side, there are new rules and guidance concerning the management of conflicts of interest around the production of investment research;4 on the buy-side, new rules address conflicts between the buy-side’s own commercial interests and the interests of their clients that were often exacerbated by arrangements in which commissions were used by fund managers to acquire goods and services in addition to execution, now commonly known as ‘soft’ commissions and bundled 3 This is clearly spelled out in Recital 29 of the Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments (MiFID). 4 The above rules and guidance closely follow the principles published in 2003 by the International Organization of Securities Commissions (IOSCO). While not legally binding on member states or the EU as a whole, IOSCO principles are nevertheless of persuasive force. They represent an attempt by IOSCO member regulators to reach consensus, at the level of principle, on important securities regulatory issues, as to further implement consistent rules. brokerage arrangements. Because these practices were not transparent, market forces on the buy-side were weak, and investors had insufficient information to judge whether they were getting value for money on ancillary services provided along with trade execution. Against this background, the present Policy Brief aims to shed light on the existing regulatory regime governing conflicts of interest in financial services in Europe, focusing, in particular, on the MiFID provisions on investment research (presented as a case study of ‘good regulation’). The overall preliminary assessment turns out to be a positive one, despite the shadows still surrounding credit rating agencies and the potential for conflicts inherent in their activity. 1. Different typologies of conflict of interest: Coping with a multi-faceted phenomenon As emphasised at the outset, conflicts of interest are common in the activities of market intermediaries because of the different roles that an intermediary or companies within the same financial group as the market intermediary play. A conflict arises when the interests of a market intermediary may be inconsistent with, or diverge from, those of its clients, investors or others. As clarified in the MiFID Level 2 Directive, “the circumstances which should be treated as giving rise to a conflict of interest should cover cases where there is a conflict between the interests of the firm or certain persons connected to the firm or the firm's group and the duty the firm owes to a client; or between the differing interests of two or more of its clients, to whom the firm owes in each case a duty. It is not enough that the firm may gain a benefit if there is not also a possible disadvantage to a client, or that one client to whom the firm owes a duty may make a gain or avoid a loss without there being a concomitant possible loss to another such client”. 5 More in particular, a conflict (or a potential conflict) arises when the market intermediary, in the provision of services and activities to its clients: • • • 5 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 a client or group of clients over the interests of another client; Recital 24, Commission Directive 2006/73/EC of 10 August 2006 implementing Directive 2004/39/EC of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms (emphasis added). Guarding against Conflicts of I nterest | 3 • • carries on the same business as the client; and/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.6 As a result, there may be different situations arising between: i) the financial institution and one of its clients, ii) a Relevant Person and a client,7 iii) two or more clients of the financial institution in the context of the provision of services by the latter to those clients and iv) a vendor linked to the institution and a client. In addition to these typologies of parties involved in the transactions, especially within a multi-service financial institution, conflicts of interest may arise in a variety of different functional situations. Areas of concern, as outlined in Table 1, mainly include: • • • • 6 the provision of investment research (where a firm provides investment research in relation to an entity or group to which it also provides corporate finance advisory services);8 proprietary trading (where a firm trades its proprietary positions in a security when at the same time it has information about future transactions with clients in relation to that security); portfolio management (where the value of financial instruments in the portfolio of one client can be influenced by transactions in those instruments for the account of other customers; where the asset manager organises transactions between the portfolios of two of its customers; or where the knowledge about certain transactions for one portfolio opens opportunities for so-called ‘front running’ for the account of other portfolios); corporate finance (where a firm has provided corporate financial advice to one corporate client See Art. 21 of Commission Directive 2006/73/EC, entitled Conflicts of interest potentially detrimental to a client. 7 “Relevant Person”, as defined in Art. 2 (3) of the Commission Directive 2006/73/EC of 10 August 2006, means any of the following: a) a director, partner or equivalent, manager or appointed representative (or where applicable, tied agent) of the financial institution; b) a director, partner or equivalent, or manager of any appointed representative (or where applicable, tied agent) of the financial institution; c) an employee of the financial institution or of an appointed representative (or where applicable, tied agent) of the financial institution; as well as any other natural person whose services are placed at the disposal and under the control of the financial institution and who is involved in the provision by the financial institution of regulated activities or d) a natural person who is involved in the provision of services to the financial institution or its appointed representative (or where applicable, tied agent) under an outsourcing arrangement for the purpose of the provision by the financial institution of investment services and activities. 8 See section 3.1.1 below, The case of investment research. • and subsequently, when that corporate client becomes a target of a bid, the firm also seeks to act for the bidder; or where a firm provides corporate finance advice in relation to the same target to clients who are direct competitors of one another); and personal account dealing (where an employee of a firm engages in personal account dealing with securities and the firm has a client with an interest that potentially conflicts with such dealing). A well-known source of conflict can be found in the systems of remuneration of asset managers and, more specifically, in inducements, where the interest of the client conflicts with the interest of the service provider. The most typical example is the so-called ‘churning’ of the portfolio, where transaction frequency is higher than would be in the best interest of the client in order to generate transaction fees for the financial institution.9 There is also a more complex version, where several service providers act in a coordinated way as to advise, market and sell products to their clients, while using kickbacks or soft commissions in a way that is detrimental to these clients.10 In general, one can see that the more different services an institution provides, the more it will be confronted with conflicts of interest. Typical examples would include the firm that also offers order execution services and therefore has an incentive to execute all transactions for the account of its clients itself even though alternatives might be better for the investor, or has an incentive to choose transactions it can execute itself over alternative transactions that would require other intermediaries. The same, of course, is possible when the financial institution is a market-maker in certain financial instruments, or when the financial institution internalises client orders. Deciding to invest for the account of an individually managed portfolio in collective investment schemes sponsored or managed by the same financial group is another example or, to further complicate matters, deciding to invest for the account of one collective portfolio in another collective investment scheme managed or sponsored by the same asset manager. 9 A financial intermediary that is managing assets for clients – whether retail or wholesale – may easily exploit its agency relationship by engaging in excessive trading, which creates higher costs and may lead to portfolio sub-optimisation. Commission-based compensation for the intermediaries is the usual cause of churning. 10 It should be acknowledged that a financial institution that offers asset management to individual clients or that manages the portfolios of collective investment schemes essentially offers its clients its knowledge and skills to make and execute investment decisions. Consequently, the financial service of asset management cannot effectively benefit the investor without the portfolio manager enjoying some margin of discretion. Hence, “an asset manager will necessarily be confronted with conflicts of interest” (see Kruithof, 2005, p. 12). Table 1. Main typologies of conflicts of interest Firm vs client conflicts A firm trading its proprietary positions in a security when at the same time it has information about future transactions with clients in relation to that security. An employee of a firm engaging in personal account dealing with securities where the firm has a client with an interest that potentially conflicts with such dealing. A firm having information in relation to distressed assets where the firm trades proprietary positions in those assets. A firm being the syndicate agent for a financing arrangement for a client where the firm's corporate finance team is looking to advise another firm targeting that client. A firm receiving substantial gifts and entertainment (including non-monetary gifts) that may influence behaviour in a way that conflicts with the interests of the clients of the firm. A firm providing advice to a corporate client in relation to a debt issuance and advising other clients as to the pros and cons of investing in the debt. A firm providing corporate finance advice to one corporate client and subsequently, when that corporate client becomes a target of a bid, the firm is also seeking to act for the bidder. A part of a multi-service financial institution being used by another part of the same institution which owes fiduciary obligations. Client vs client conflicts A firm providing investment research in relation to an entity or group to which it also provides corporate finance advisory services. A firm acting as a discretionary portfolio manager for more than one client or fund. A firm providing corporate finance advice in relation to the same target to clients who are direct competitors of one another. A firm providing advisory and financing services to one client with respect to a bid and seeking to provide financing services to another client regarding the same bid. Source: Financial Services Commission – Gibraltar (2007). 2. The position taken by the EU to regulate conflicts of interests As pointed out by Michel Prada (2007) at a meeting of European Financial Regulators, “no prior legislation has ever addressed conflicts of interests in the same depth as the MIFID which is, in principle, a fully harmonising Directive, so that member states are only partially allowed to add more stringent provisions”. Nevertheless, for the sake of completeness, one should not forget other EU Directives that also address the issue of conflicts of interest. ii) Undertakings for Collective Investment in Transferable Securities Directive (UCITS) of 1985.12 Provides that the UCITS management company is structured and organised in such a way as to minimise the risk of UCITS’ or clients’ interests being prejudiced and tries to avoid conflicts of interest and when they cannot be avoided, ensures that the UCITS the company manages are fairly treated. Reference is here made to: i) Market Abuse Directive (MAD). Prohibits the misuse of inside information (likely to have a significant impact on the price of a financial instrument) and, more precisely, requires the disclosure of information about research sources and methods and conflicts of interest that may impact on the impartiality of the research.11 11 See Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation. Insider dealing and market manipulation were previously dealt with by the Insider Dealing Directive (89/592/EEC), which is no longer in force, and the Investment Services Directive 93/22/EEC. Both the Insider Dealing Directive and a separate Directive on market manipulation served the same objective: to ensure the integrity of European financial markets and to enhance investor confidence in those markets. However, the former, if measured against the number of successful prosecutions for insider dealing within the EU, has not been a success. There are inconsistencies in the way the Directive has been transposed into national legislation. Furthermore, this Directive was developed at a time when most equity market trading was domestically based. This is no longer the case with the development of remote screens and the overall increase in cross-border trades. This consequently has raised issues in terms of cross-jurisdiction enforcement. (For a more thorough assessment, see response by the UK Financial Services Authority to the Committee of Wise Men on the Regulation of Securities Markets, September 2000). 12 As subsequently amended by Directive 2001/107/EC of the European Parliament and of the Council of 21 January 2002. iii) Investment Services Directive of 1993.13 Contains almost exactly the same provisions as the UCITS Directive in its Arts 10, fifth indent (“each investment firm shall be structured and organised in such a way as to minimise the risk of clients’ interests being prejudiced by conflicts of interest between the firm and its clients or between one of its clients and another”) and 11 (1), fifth indent (each investment firm shall try to avoid conflicts of interests and, when they cannot be avoided, shall ensure that its clients are fairly treated”).14 The new MiFID regime is built upon a fiduciary duty. Art. 19 (1) requires investment firms, when providing investment services and/or, where appropriate, ancillary services to clients, to “act honestly, fairly and professionally in accordance with the best interests of its clients”. Similarly, the UCITS Directive sets forth comparable requirements for collective portfolio management.15 3. Market Abuse Directive (MAD). Prohibits the misuse of inside information (likely to have a significant impact on the price of a financial instrument) and, more precisely, requires the disclosure of information about research sources and methods and conflicts of interest that may impact on the impartiality of the research.16 v) Undertakings for Collective Investment in Transferable Securities Directive (UCITS) of 1985.17 Provides that the UCITS management company is structured and organised in such a way as to minimise the risk of UCITS’ or clients’ interests being prejudiced and tries to avoid conflicts of interest and when they cannot be avoided, ensures that the UCITS the company manages are fairly treated. vi) Investment Services Directive of 1993.18 Contains almost exactly the same provisions as the UCITS Directive in its Arts 10, fifth indent (“each investment firm shall be structured and organised in such a way as to minimise the risk of clients’ interests being prejudiced by conflicts of interest between the firm and its clients or between one of its clients and another”) and 11 (1), fifth indent (each investment firm shall try to avoid conflicts of interests and, when they cannot be avoided, shall ensure that its clients are fairly treated”).19 The position taken by the EU to regulate conflicts of interests As pointed out by Michel Prada (2007) at a meeting of European Financial Regulators, “no prior legislation has ever addressed conflicts of interests in the same depth as the MIFID which is, in principle, a fully harmonising Directive, so that member states are only partially allowed to add more stringent provisions”. Nevertheless, for the sake of completeness, one should not forget other EU Directives that also address the issue of conflicts of interest. Reference is here made to: 13 iv) See Council Directive 93/22/EEC, as repealed by Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments. 14 For a comparison with the UCITS provisions, see footnote 15 below. 15 See Art. 10 (2), UCITS Directive. “The management company must act independently and solely in the interest of the unit-holders”; and Art. 5h, Directive 2001/107/EC of the European Parliament and of the Council of 21 January 2002 amending Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with a view to regulating management companies and simplified prospectuses. Notably, the above provision lists principles a management company shall respect, i.e.: (a) acting honestly and fairly in conducting its business activities in the best interests of the UCITS it manages and the integrity of the market; (b) acting with due skill, care and diligence, in the best interests of the UCITS it manages and the integrity of the market; (…) (d) trying to avoid conflicts of interests and, when they cannot be avoided, ensuring that the UCITS it manages are fairly treated, and (e) complying with all regulatory requirements applicable to the conduct of its business activities so as to promote the best interests of its investors and the integrity of the market. The new MiFID regime is built upon a fiduciary duty. Art. 19 (1) requires investment firms, when providing investment services and/or, where appropriate, ancillary services to clients, to “act honestly, fairly and professionally in accordance with the best interests of its clients”. Similarly, the UCITS Directive sets forth 16 See Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation. Insider dealing and market manipulation were previously dealt with by the Insider Dealing Directive (89/592/EEC), which is no longer in force, and the Investment Services Directive 93/22/EEC. Both the Insider Dealing Directive and a separate Directive on market manipulation served the same objective: to ensure the integrity of European financial markets and to enhance investor confidence in those markets. However, the former, if measured against the number of successful prosecutions for insider dealing within the EU, has not been a success. There are inconsistencies in the way the Directive has been transposed into national legislation. Furthermore, this Directive was developed at a time when most equity market trading was domestically based. This is no longer the case with the development of remote screens and the overall increase in cross-border trades. This consequently has raised issues in terms of cross-jurisdiction enforcement. (For a more thorough assessment, see response by the UK Financial Services Authority to the Committee of Wise Men on the Regulation of Securities Markets, September 2000). 17 As subsequently amended by Directive 2001/107/EC of the European Parliament and of the Council of 21 January 2002. 18 See Council Directive 93/22/EEC, as repealed by Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments. 19 For a comparison with the UCITS provisions, see footnote 15 below. 6 | Alessandra Chirico In particular, the required proper management of conflicts of interest lies at the heart of maintaining fair, orderly and efficient financial markets. Towards this end, MiFID requires firms to put in place arrangements to identify, manage and mitigate risks arising from conflicts. The key, of course, is how effective these arrangements are.24 comparable requirements for collective portfolio management.20 Coupled with this fiduciary duty, on the one hand multi-functional financial institutions offering investment services are required by virtue of MiFID to “maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps designed to prevent conflicts of interest from adversely affecting the interests of its clients”.21 On the other hand, management companies of UCITS have to be “structured and organised in such a way as to minimise the risk of UCITS’ or clients’ interests being prejudiced by conflicts of interest between the company and its clients, between one of its clients and another, between one of its clients and a UCITS or between two UCITS”.22 In this way, EU financial regulation reinforces the mere fiduciary duty of ‘treating customers fairly’ by elevating it to a regulatory norm applicable to all financial institutions. As a consequence of the transposition of MiFID into national law, in addition to contractual remedies enforceable under applicable national private law if this duty is breached, the compliance with the above principles can now also be supervised and breaches sanctioned by the national public supervisory institutions.23 3.1 Given the broad range of activities covered by MiFID – investment advice, individual portfolio management, execution of orders on behalf of clients, dealing on own account including market-making, marketing communications, investment research, underwriting and placement with respect to all financial instruments including units in collective investment undertakings and derivatives – it is highly relevant for the purposes of this Policy Brief to attempt an initial assessment of the likely impact of MiFID’s provisions on the management of conflicts of interest. MiFID tackles the issue of conflicts of interest generally with a three-fold approach by requiring investment firms to: i) take all reasonable steps to identify relevant conflicts of interest arising in the course of providing investment or ancillary services; ii) maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps designed to prevent conflicts of interest from adversely affecting the interests of their clients; and iii) where those organisational arrangements to manage conflicts of interest are not sufficient to ensure, with reasonable confidence, that risks of damage to client interests will be prevented, the firm shall clearly disclose the general nature and/or sources of conflicts of interest to the client before undertaking business on its behalf.25 20 See Art. 10 (2), UCITS Directive. “The management company must act independently and solely in the interest of the unit-holders”; and Art. 5h, Directive 2001/107/EC of the European Parliament and of the Council of 21 January 2002 amending Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with a view to regulating management companies and simplified prospectuses. Notably, the above provision lists principles a management company shall respect, i.e.: (a) acting honestly and fairly in conducting its business activities in the best interests of the UCITS it manages and the integrity of the market; (b) acting with due skill, care and diligence, in the best interests of the UCITS it manages and the integrity of the market; (…) (d) trying to avoid conflicts of interests and, when they cannot be avoided, ensuring that the UCITS it manages are fairly treated, and (e) complying with all regulatory requirements applicable to the conduct of its business activities so as to promote the best interests of its investors and the integrity of the market. 21 See MiFID, Art. 13 (3). 22 UCITS Directive 2001/107/EC, Art. 5f (1) (b). 23 The European legislator seems to have taken the view that in order to protect the investor, a regulatory standard requiring investment firms to act in the interest of their clients was necessary because the normative content of this rule offers the investors additional protection. However many commentators have expressed their concerns about the enforcement of the duty of loyalty towards investors. What should be further done is “to provide investors all over the EU with uniform appropriate The requirements under MiFID remedies and evidentiary rules applicable to this norm geared at addressing the real concerns posed”, as breaches of the general rule in Art. 19 (1) MiFID will offer the investor only the remedies already available under national private law, “meaning in most continental legal systems only compensation of damages, making this loyalty principle also virtually unenforceable in practice”. See Kruithof (2005, pp. 30-31). 24 It is worth noting, however, that actual or potential conflicts of interest may still arise where such arrangements are in place and firms should monitor their effectiveness and appropriateness on an ongoing basis. Firms must put in place policies that limit the possibility of conflicts arising between employees, officers and agents of the firm and the firm’s clients. Such policies would cover, for example, dealing on the part of staff and restrict outside interests such as directorships of other companies. 25 See MiFID, Art. 18 (2). It is worth underlining that the obligation applies on a home state basis. This means that Guarding against Conflicts of I nterest | 7 Similarly, Art. 39 MiFID Level 1 requires regulated markets: i) to have arrangements to identify clearly and manage the potential adverse consequences, for the operation of the regulated market or for its participants, of any conflict of interest between the interest of the regulated market, its owners or its operator and the sound functioning of the regulated market, and in particular where such conflicts of interest might prove prejudicial to the accomplishment of any functions delegated to the regulated market by the competent authority; and ii) to be adequately equipped to manage the risks to which it is exposed, to implement appropriate arrangements and systems to identify all significant risks to its operation, and to put in place effective measures to mitigate those risks. The Level 2 implementing Directive (notably Arts 21 to 23, which provide elaboration of the principles set out in Arts 13 (3) and 18 of the Level 1 Directive) specifies that the relevant conflicts of interest are those that arise in the course of providing investment services, including where the conflicts arise in connection with any other activity of the investment firm or its group. MiFID therefore encompasses inter alia conflicts arising from banking, insurance and UCITS management activities, whether they are performed by the investment firm itself or an affiliated entity. The implementing Directive also requires the investment firm to establish and implement an effective conflicts of interest policy that is appropriate to the size and organisation of the firm and the nature, scale and complexity of its business and takes into account the structure and business activities of other members of the group.26 The content and the structure of the policy are likely to vary from firm to firm. For example, a firm that provides products and services on a multiple product or services basis (e.g. dealing and brokerage, advisory, private banking and custody), may need to structure its policy to take into account the possibility of conflicts arising between departments undertaking different services and provide for their respective independence. In addition, the firm is required to keep records of the activities performed by it in which a conflict has arisen or may arise. Firms may comply with the recordkeeping requirement by maintaining a record of the updated policy for a period of five years. firms are only required to comply with the obligation as implemented in their home state, regardless of whether they operate under the single passport on a cross-border basis or through local branches in other EEA member states. 26 See Commission Directive 2006/73/EC of 10 August 2006, implementing Directive 2004/39/EC, Art. 22(1). Disclosure to clients, pursuant to Art. 18 (2) MiFID Level 1, may be made in a durable medium and must include sufficient detail (taking into account the nature of the client) to enable that client to take an informed decision with respect to the investment or ancillary service in the context of which the conflict of interest arises or may arise. In particular, where the client is a retail client it may be necessary to provide greater detail of the conflict than if the client were a professional client or an eligible counterparty, in order to enable the client to make an informed decision on whether to go ahead with the business. The written disclosure should be clear, fair and not misleading irrespective of the client’s categorisation. Most notably, disclosure should only be used where all methods of managing a conflict of interest have been tried and have been deemed as insufficient. It should not be seen as a method of managing a conflict in itself, but rather as a solution of last resort. There are, in fact, significant concerns about the inadequacy of and overreliance on disclosure, especially general disclosures of potential conflicts, behind which investment firms might be tempted to hide misconduct.27 In order to avoid such misconduct, the so-called Principles of Corporate Governance set forth by the OECD advocate not only full disclosure, but also an explanation by parties of how they are managing any conflicts of interest. Far from being simply aimed at providing volumes of information, disclosure should be aimed at increased transparency. Rating agencies, analysts and investment banks should avoid conflicts of interest that could compromise the nature of their advice. The above principles explicitly acknowledge that auditors also have duties to respect: they should be accountable to shareholders and exercise due professional care when conducting an audit. Auditors should be wholly independent and not be compromised by other relations with the company. Finally, a further key requirement is the need to ensure an appropriate level of independence between persons engaged in different business activities involving a conflict of interest entailing a risk of damage to the interests of a client. The Directive, in fact, sets out a series of organisational measures to ensure the requisite degree of independence in appropriate cases, such as the separation of supervision or remuneration between different activities. 27 On this point, the UK FSA (2006) made it clear that “an overreliance on disclosure without adequate consideration as to how conflicts may appropriately be managed is not permitted”. 8 | Alessandra Chirico Box 1. Issues to be covered in the conflicts of interest policy As a tool to manage conflicts of interest, the conflicts of interest policy shall cover the following areas: (a) it must identify (…) the circumstances which constitute or may give rise to a conflict of interest entailing a material risk of damage to the interests of one or more clients; (b) it must specify procedures to be followed and measures to be adopted in order to manage such conflicts. For the purposes of paragraph 2(b), the procedures to be followed and measures to be adopted shall include such of the following as are necessary and appropriate for the firm to ensure the requisite degree of independence: (a) effective procedures to prevent or control the exchange of information between relevant persons engaged in activities involving a risk of a conflict of interest where the exchange of that information may harm the interests of one or more clients; (b) the separate supervision of relevant persons whose principal functions involve carrying out activities on behalf of, or providing services to, clients whose interests may conflict, or who otherwise represent different interests that may conflict, including those of the firm; (c) the removal of any direct link between the remuneration of relevant persons principally engaged in one activity and the remuneration of, or revenues generated by, different relevant persons principally engaged in another activity, where a conflict of interest may arise in relation to those activities; (d) measures to prevent or limit any person from exercising inappropriate influence over the way in which a relevant person carries out investment or ancillary services or activities; (e) measures to prevent or control the simultaneous or sequential involvement of a relevant person in separate investment or ancillary services or activities where such involvement may impair the proper management of conflicts of interest. If the adoption or the practice of one or more of those measures and procedures does not ensure the requisite degree of independence, Member States shall require investment firms to adopt such alternative or additional measures and procedures as are necessary and appropriate for those purposes. Source: Commission Directive 2006/73/EC of 10 August 2006, Art. 22. In being required not only to identify, but also to actively manage conflicts of interest under MiFID, investment firms shall face additional costs and operational challenges. Typical activities that firms are currently undertaking in compliance with MiFID requirements include: i) creation and maintenance of a conflicts database; ii) documented procedures regarding management of conflicts; iii) additional terms and conditions in client documents and the conflict of interest policy; and iv) maintenance of insider lists and implementation of Chinese walls (with subsequent intervention on the IT infrastructure). The highest figure, in terms of costs, relates to the setting up of separate legal and organisational entities within a large firm to ensure their complete independence.28 It is worth emphasising, against the depicted background, that the above changes are particularly acute in the case of structured products, where the financial instruments provided to clients are often specifically tailored to the client’s needs. The specialist nature of these products usually means that analysts and traders within the same firm have a close working relationship and investment research is often triggered by trading strategies. Applying the MiFID rules on conflicts of interest in these areas has been considered likely to require radical restructuring of current business models themselves. Members of the British Bankers’ Association (BBA), London Investment Banking Association (LIBA) and International Securities Market Association (ISMA) have indicated that in areas such as structured products, the liquidity in the markets is so limited that a client is likely to be unwilling to act on the research in the absence of the certainty that the firm holds the fixed income securities to which the research on structured products relates.29 The link between investment research and trading activities within the same institution has been at the core of numerous studies at the international level (IOSCO, in primis) and has led to the regime under MiFID, described in detail below. 3.1.1 The case of investment research: An example of ‘good regulation’ The ready availability of various types of financial information ensures appropriate pricing, helps issuers to raise debt and equity capital in primary markets and ensures deep and liquid secondary markets for financial instruments. Hence, financial analysts who prepare investment research play an important role in the financial information ‘ecosystem’ that nourishes financial markets. Analysts synthesise raw information 28 LECG (2005), MiFID Implementation: Cost Survey of the UK Investment Industry, where the highest cost driver for firms requiring substantial changes (approximately 13% of the industry) amounted to £2,000,000. 29 British Bankers’ Association (BBA), London Investment Banking Association (LIBA) and International Securities Market Association (ISMA) (2004), Response to CP 205: Conflicts of Interest, Joint response. Guarding against Conflicts of I nterest | 9 into more readily digestible research pieces. In turn, the research will be used by investors to help them make their investment decisions, or by intermediaries to produce investment research, investment advice or marketing communications. In its Communication on investment research, the European Commission (2006) notes that the “regulation of investment research and of the financial analysts who create it therefore needs to be sensitive to, and appropriate for, the many roles research plays. It is also of prime importance to ensure that any such regulation limit as little as possible the flow of information of potential value to investors”. As a result, research analysts face a variety of potential conflicts that can impair their objectivity. They may be exposed to interests of the firm, or of certain groups of clients, that conflict with the interests of those to whom the research is directed. Some examples of such interests include those of issuers in disposing of their securities, and of corporate financiers in attracting and keeping issuance – and placement-related business. The firm itself, if it is a proprietary trader, will have an interest in selling financial instruments. Where the firm conducts agency business such as equities broking on a commission basis, it will have a commercial incentive to generate orders. All these interests can impair an analyst’s objectivity.30 The provisions that specifically relate to investment research are contained in the Level 2 MiFID implementing Directive and apply to investment firms that produce or arrange for the production of investment research intended or likely to be subsequently disseminated to clients or to the public under their own responsibility or that of group members. The expression ‘investment research’ is to be read as a sub-category of the type of information defined as a recommendation in the Market Abuse Directive (MAD), as regards the fair presentation of investment recommendations and the disclosure of conflicts of interest, but it also applies to financial instruments as defined in MiFID. Recommendations of the type so defined, which do not constitute investment research as defined in the latter Directive, are nevertheless subject to the provisions of MAD, as to the fair presentation of investment recommendations and the disclosure of conflicts of interest. In order to qualify as investment research, such recommendations must: i) contain pieces of research or other information recommending or suggesting an 30 When analysts are compensated by underwriting departments, there will be a strong conflict of interest potential. It will be most acute if the IPO market is highly profitable relative to brokerage because it will induce analysts to bias their reports in favour of issuers. In a soaring market, the short-term payoff for an analyst may outweigh the benefits of investing in a long-term reputation, being tempted to promote hot issues to expend the firm’s reputational rents. investment strategy, explicitly or implicitly, concerning one or several financial instruments or the issuers of financial instruments, including any opinion as to the present or future value or price of such instruments, intended for distribution channels or for the public; ii) be labelled or described as investment research, or otherwise presented as objective or independent, and iii) not constitute investment advice (i.e. the provision of personal recommendations that are presented as suitable for the recipient, or based on a consideration of the circumstances of that person).31 Where the provisions consequences: i) apply, there are two The investment firm must ensure that it implements all the organisational measures set out in the MiFID implementing Directive in relation to analysts and other persons whose responsibilities or business interests may conflict with the interests of recipients of the research (see Box 2). Those measures require effective separation between business functions that serve different client or business interests. ii) Investment firms should take other specified steps designed to ensure the objectivity of the investment research. Importantly, the firm must prevent certain dealings in financial instruments by relevant persons who have knowledge of the timing or contents of relevant investment research that is not public; as well as certain personal transactions contrary to outstanding recommendations. There are also restrictions on the acceptance of inducements in relation to investment research, the promising of favourable research coverage, and on who may review drafts of investment research and for what purposes.32 The measures and arrangements adopted by an investment firm to manage the conflicts of interests that might arise from the production and dissemination of material that is presented as investment research should be appropriate to protect the objectivity and independence of financial analysts and of the investment research they produce. Those measures and arrangements should ensure that financial analysts enjoy an adequate degree of independence from the interests of persons whose responsibilities or business interests may reasonably be considered to conflict with the interests of the persons to whom the investment research is disseminated. 31 See Commission Directive 2006/73/EC of 10 August 2006, Art. 24. 32 A noteworthy example on how to structure a conflicts of interest policy with regard to investment research is offered by Deutsche Bank in its Policy for Managing Conflicts of Interest in Connection with Investment Research, 2007 (http://www.db.com/en/downloads/Europe_Compliance_GMPo licy.pdf). 10 | Alessandra Chirico Box 2. Specific requirements for financial analysts Member States shall require investment firms (…) to have in place arrangements designed to ensure that the following conditions are satisfied: (a) financial analysts and other relevant persons must not undertake personal transactions or trade (…) , on behalf of any other person, including the investment firm, in financial instruments to which investment research relates, or in any related financial instruments, with knowledge of the likely timing or content of that investment research which is not publicly available(…); … (c) the investment firms themselves, financial analysts, and other relevant persons involved in the production of the investment research must not accept inducements from those with a material interest in the subject-matter of the investment research; (d) the investment firms themselves, financial analysts, and other relevant persons involved in the production of the investment research must not promise issuers favorable research coverage; (e) issuers, relevant persons other than financial analysts, and any other persons must not before the dissemination of investment research be permitted to review a draft of the investment research for the purpose of verifying the accuracy of factual statements made in that research, or for any other purpose other than verifying compliance with the firm's legal obligations, if the draft includes a recommendation or a target price. Source: Commission (Level 2) Directive 2006/73/EC of 10 August 2006, Art. 25 (2). The requirements that apply to the production of research also apply to the substantial alteration of investment research produced by a third party. However, a firm that simply disseminates research produced by a third party is not bound by the consequences mentioned above, provided that the disseminating firm does not substantially alter the research and verifies that the producer of the research is subject to requirements, or has established a policy, equivalent to the requirements of the MiFID implementing Directive. As regards disclosure of research conflicts, the MiFID supplements the regime in the Market Abuse Directive by requiring: i) disclosure where organisational arrangements are not sufficient to ensure, with reasonable confidence, that risks of damage to client interests will be prevented; and ii) disclosure of the conflicts of interest policy of the investment firm. It is intended that the MiFID and the Market Abuse Directive should operate together seamlessly. The field of ‘recommendations’ within the meaning of the MAD Directive (where produced by an investment firm) should exclusively contain investment research or marketing communications for MiFID purposes. Recommendations of an investment firm that do not constitute investment research must be clearly identifiable as marketing communications and must contain a clear and prominent statement that (or, in the case of oral recommendations, to the effect that) they have not been prepared in accordance with standards designed to promote the objectivity of investment research. 4. The main loophole in the MiFID regime on conflicts of interest: Credit rating agencies As already outlined, research analysts must comply with restrictions on their activities and compensation in order for a firm to prevent and/or manage conflicts of interest. Yet, paradoxically, no such rules govern credit rating agencies (CRAs), despite the fact that the smooth functioning of global financial markets depends upon reliable, unbiased assessments of investment risks, as provided by these agencies. Ratings are widely used by investors as a guide to the creditworthiness of the issuers of debt, and in financial covenants. As a result, CRAs play a major role not only in the pricing of debt securities, but also in the regulatory process.33 It may well happen, in fact, that regulators co-opt rating agencies as informationproducing agents for regulatory purposes. This way, when ratings become not just a tool for investors but the very foundation for regulation, they are extremely powerful and conflicts of interest risk becoming sharper. Conflicts of interest can arise from the fact that there are multiple users of ratings whose interests can diverge, at least in the short term. On the one hand, investors and regulators are interested in wellresearched, impartial assessments of credit quality whereas issuers, on the other hand, primarily want favourable ratings. Because the latter pay to have their securities rated, there is a fear that credit agencies may bias their ratings upwards in order to attract more business. Even though, in principle, a CRA’s duty is to consistently provide ratings that are independent, objective and of the highest possible quality, the August 2007 financial market turmoil gave evidence of malpractice. In the recent subprime lending crisis, credit rating agencies have come under increasing fire for their supposed collusion in favourably rating junk Collateralised Debt Obligations (CDOs) in the subprime mortgage business. Loan originators have 33 It is worth recalling that regulators use credit ratings as well, or permit these ratings to be used for regulatory purposes. This is the case under the Basel II agreement of the Basel Committee on Banking Supervision and the Capital Requirements Directive (CRD) with regard to certain approved CRAs, called External Credit Assessment Institutions (ECAIs). Guarding against Conflicts of I nterest | 11 been responsible for packaging subprime mortgages as securitised instruments, and marketing them as collateralised debt obligations on the secondary mortgage market. As a result, credit rating agencies have been called to a special meeting by the world’s securities regulators (IOSCO) to explain how they rate structured financial products based on mortgage assets. This move shows that serious concern over the potential for conflicts of interest between the agencies and the issuers whose securities they rate has risen to the top of the agenda for regulators.34 The Securities and Exchange Commission (SEC), for instance, has opened a formal investigation into whether the creditrating agencies improperly inflated their ratings of mortgage-backed securities because of possible conflicts of interest.35 4.1 Regulating CRAs in Europe: Should the Commission re-evaluate its light-touch approach? Already at the aftermath of the Enron collapse, the reliability of CRAs was discussed at the Oviedo ECOFIN meeting in April 2002, and at the European Securities Committee meetings in May and September 2003. In February 2004, even before the failure of all major CRAs to anticipate the Parmalat default, the European Parliament passed a resolution calling on the European Commission to submit by 31 July 2005, its assessment of whether and how CRAs should be regulated, and in particular, of the need for legislative measures. The Commission called on CESR for advice on this matter. In response, CESR released a consultation paper in November 2004 and issued its final advice to the Commission on 30 March 2005. Despite the European Parliament’s initial preference for pervasive regulation, the Technical Advice recommended a non-legislative solution, based on CRA self-regulation through the adoption of individual codes of conduct formulated along the lines of the IOSCO code. 34 Recent criticisms have in particular addressed the overly positive opinions issued by agencies on the creditworthiness of mortgage-related securities (based on underlying assets now in severe distress due to the subprime meltdown). They point to the fact they are often paid for by the issuers of such securities. Ratings are usually requested – and paid for – by the issuers themselves. In these cases, they are based on both publicly available data and information that are not accessible to the public but which are voluntarily disclosed by the rated entity (e.g. by means of interviews with senior financial officials of the rated entity). 35 At a hearing before the US Senate Banking Committee in September 2007, the SEC Chairman, Christopher Cox, said the Commission was examining whether the credit agencies had “compromised their impartiality” when they simultaneously rated various mortgage-backed securities and provided advice to Wall Street investment firms about how to package them so as to gain higher credit ratings. Later on, in January 2006, the European Commission argued that existing financial services Directives applicable to CRAs (Market Abuse, Capital Requirements Directive and MiFID) – combined with a comply-or-explain approach by the CRAs on the basis of the IOSCO code – provided the way forward in this area. Hence, through these policy initiatives, CRAs have been incorporated into the financial market regulatory landscape.36 It has to be emphasised, however, that MiFID and its implementing measures are not tout court applicable to the rating process of credit rating agencies, whenever the rating process itself does not involve the firm undertaking investment services and activities or providing investment advice as defined in the Directive. In other words, the issuing of a credit rating will normally not result in the credit rating agency also providing ‘investment advice’ within the meaning of Annex I to the MiFID. Nevertheless, credit rating agencies should be aware of the precise limits of the rating activity they carry out in order to continue to operate outside MiFID regulation. For the purposes of the definition under MiFID, in fact, ‘investment advice’ is a personal recommendation made to a person in his capacity as an investor or potential investor, presented as suitable for that person. This means that the recommendation must be based on a consideration of the specific circumstances of that person, and must constitute a recommendation to take one of the following sets of steps: a) to buy, sell, subscribe for, exchange, redeem, hold or underwrite a particular financial instrument; or b) to exercise or not to exercise any right conferred by a particular financial instrument to buy, sell, subscribe for, exchange or redeem a financial instrument.37 As a result, whenever a CRA negotiates together with the issuer how to structure a product in order for the issuer to get better ratings, it provides the issuer with personal recommendations relating to a specific financial instrument, constituting investment advice. In particular, if credit rating agencies also provide these services on a professional basis, they should require authorisation under MiFID. Only in such cases, the MiFID provisions regarding conduct of business and organisational requirements (including management of conflicts of interest) will apply to the firm and its undertaking of investment services and activities.38 36 European Commission (2006), Communication from the Commission on Credit Rating Agencies, (2006/C 59/02). 37 See Art. 52, Commission Directive 2006/73/EC of 10 August 2006. 38 Where, for example, a credit rating agency provides investment services (such as investment advice) to clients that 12 | Alessandra Chirico Yet, in light of the recent market turmoil, one may wonder if this is enough? As already outlined, CRAs provide ratings to investors on structured finance, while, at the same time, they provide advice to banks on how they should structure their lending to get the best ratings. The allegation – made clear by many commentators – is that analysts may give unduly favourable ratings to induce issuers to pay additional fees for other services,39 not that they give unduly unfavourable ratings to persuade issuers to pay for the ratings. According to Frank Partnoy, Professor of Law at the University of San Diego Law School, “the securities analyst conflicts are ‘pull’ conflicts in which the analyst dangles the prospect of favourable ratings to obtain future fees, whereas the rating agency conflicts are ‘push’ conflicts in which the agency threatens the issuer with unfavourable ratings to obtain current fees”.40 This situation is even more difficult to assess, also because there is a general lack of transparency in the fee structure charged by CRAs. Concerns centre on the quality of credit ratings provided by credit rating agencies. Credit rating agencies must base their ratings on a diligent analysis of the available information and control continuously for the integrity of their information sources. This means that credit ratings must be regularly updated, if necessary. Credit rating agencies must also be more transparent about the way in which they arrive at their ratings. In addition, it is important that credit rating agencies are independent and entirely objective in their approach. In particular, the position of credit rating agencies must not be compromised by the relationships they have with issuers or by the access they have to inside information of issuers. It is important that credit rating agencies are prevented from using this information for other activities. fall under the MiFID, the provisions on conflicts of interest will apply to protect the interest of those who receive these services. The provisions on conflicts of interest may require an appropriate degree of separation of investment services from the credit rating process, so that ancillary services may not interfere with the quality and objectivity of credit ratings. 39 Although the provision of ratings is their core activity, many credit rating agencies make use of their expertise in risk assessment to provide other financial services (e.g. investment advice) to issuers (either directly or through related entities). Credit rating agencies are also increasingly involved in the assessment of the risks associated with assets held by financial institutions which are subject to capital adequacy requirements. In the case of the provision of ancillary consulting services, the credit rating agency would be in the position of “auditing its own work,” raising conflicts of interest similar to those in accounting firms when they provide both auditing and consulting services. Furthermore, providing consulting services creates additional incentives for the rating agencies to deliver more favourable ratings in order to further their consulting business. 40 See Partnoy (2005). Reassuringly, in a recent note provided by the Economic and Financial Committee on the current financial markets situation, a call for “a better insight into the incentive structures, including possible conflicts of interest and disincentives to perform proper due diligence, faced by credit originators, credit rating agencies and other market participants” was put forward.41 The EU will thus give high priority to scrutinising the role of credit rating agencies, with a particular focus on structured finance instruments, conflicts of interest and transparency of rating methods.42 These items are also currently featured on the agenda of the EU-US Financial Markets Regulatory Dialogue both at Commission-US authorities and at CESR-SEC levels. Finally, what should be borne in mind is that the selfregulatory approach is not sufficient. Principles and codes of conduct must be implemented in practice on a day-to-day basis. CESR has been given the major task to monitor compliance with the IOSCO code and to report back to the Commission on an annual basis. The ratings industry should thus be aware that the Commission may have to take legislative action, if it becomes clear that compliance with EU rules or the code is unsatisfactory and damaging EU capital markets. That time may have already come. 5. A final assessment of the overall regime The common denominator of the conflicts of interest regime is again that of strengthening investors’ protection. With this in mind, investment firms will need to be very proactive in identifying potential conflicts and managing them through rigorous processes that maintain investor confidence. As some recent examples have spectacularly demonstrated, the costs of failing to manage conflicts, in loss of reputation, as well as direct costs, can be substantial. And the impact of the loss of market confidence is no less significant. This is why each financial institution has been made responsible for ensuring that its systems, controls and procedures are robust and adequate to identify and manage any conflicts of interest that may arise, and to ensure, as far as practicable, that those arrangements operate effectively. In practice, this responsibility rests with the firm's senior management. The rationale for senior management involvement is that the obligation has a key role in a firm’s regulatory responsibilities and is a principles-based obligation, and needs, therefore, to be 41 See Council of the European Union (2007). At the moment, work is being pursued and first conclusions should be released in spring 2008. 42 Guarding against Conflicts of I nterest | 13 applied flexibly and in a way that is appropriate to the relevant firm's business model.43 As recommended by the Financial Services Authority in the UK, senior management of a firm should: i) be fully engaged in conflict identification and management; ii) take a holistic view of conflicts risk and conflict mitigation within the full range of business activities for which they are responsible; iii) have policies and procedures that aim to achieve a consistent treatment of conflicts of interest throughout their organisation; and iv) receive management information on the extent of, and mitigation of, conflicts of interest in their business in order to assist them in controlling their business effectively. Through compliance with the new, stricter legal requirements on conflicts of interest, financial services firms may adequately meet the market’s expectations that they observe proper standards of market conduct and act with due skill, care and diligence in their activities. Moreover, supervisory authorities will expect firms and their staff to ensure that they take steps to manage conflicts appropriately. This is fundamental not only to investors’ protection, but also to maintaining efficient, orderly and clean markets. The message, as emphasised by many regulators, including the UK FSA, is that failure to manage risks properly is now, more then ever, likely to result in disciplinary action being brought against individuals as well as firms and that should serve as a powerful deterrent. 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