The Australian Securities and Investments Commission has released the results of an extensive review of the 'conflict management' practices at vertically integrated businesses in the funds management industry.

The regulator believes that certain models of business may create opportunities for conflicts of interest to arise. The review did not look at deposit-taking, insurance, financial advice and product manufacturing businesses. ASIC says that it may conduct a further review of remuneration practices in the financial services industry. By "vertically integrated businesses" ASIC means those entities that do at least two of the following.

• Manage funds.
• Act as a so-called "responsible entity."
• Superannuation trusteeship.
• Manage a platform structure (an investor-directed portfolio service and/or an IDPS-like structure).
• Investment administration and custody business.

A satisfactory review

The two-stage review involved 12 significant participants in the funds management industry. It drew from other ASIC work on 'conduct risk' and culture in investment banking and elsewhere.

ASIC seems to believe that many organisations take their obligation to manage 'conflicts' seriously, with detailed and tailored policies that appear to be embedded in business practices. These policies come from boards and senior management and cascade down to business units. The report mentions the word 'conflict' 314 times.

The tone at the top

The firms were able to show the regulators that they truly wanted to review and update policies, communication and training in this area. The report, however, contains the customary regulatory gripe that they were often doing so just to please the regulators and not for some higher purpose.

ASIC commissioner Greg Tanzer complained in a press release that some organisations followed a "generic template conflicts policy, with no demonstrated commitment to the conflicts management in the organisation." He went on to reveal that in some cases the conflict in question was so fundamental that the firm should have rejected the piece of business entirely instead of trying to manage it. As ever, ASIC believes that the right tone must come from the very top of every organisation.

The report is much humbler than any report published by ASIC's distant cousin, the British Financial Conduct Authority. It states that its objective is to inform the financial sector about the regulator's "observations of good practice" and does not contain any imperious tables containing very definite pronouncements on what firms ought to be doing.

Chinese walls

ASIC appears to approve of the example of one platform operator and responsible entity of several feeder funds that has structured itself so that none of the funds directly invests in listed or other securities and no member of staff is involved in the selection of listed or other securities. Nonetheless, the entity is aware that the decisions of model portfolio managers might have an effect on market price and might therefore be 'market-sensitive.' In its attempts to deal with the risks it has brought in:  

• restrictions on access to information that could lead to conflicts of interest (e.g. information about trading directions by investment managers);
• prohibitions against the communication of price-sensitive information through information barriers (e.g. communication by custody staff of a large client order to non-custody staff is strictly prohibited); and
• compulsory training for all staff regarding the non-communication of non-public, price-sensitive information.

Another firm that finds favour with the regulator has a fund management arm as well as a custody arm and a separate 'responsible entity' business. Some time ago the firm knew that it ought to set up an information barrier to limit the flow of information from (and within) the fund management arm. Certain staff (e.g. legal) now remain permanently behind the information barrier. Other staff can be allowed ‘over the barrier’ in advance of, or after obtaining, 'inside information.'

The regulator petulantly complains about small firms lacking the resources to set up all these barriers, but the doctrine of proportionality (which all regulators follow and which dictates that no firm should be forced to spend an exaggerated amount of its resources on a task just because it is small in size) ought to take care of such cases and ASIC's complaint appears merely to be the gripe of a died-in-the-wool bureaucrat when confronted with the messiness of everyday life. It complains that small firms 'may' have small premises, leading to difficulty in physically separating different business units. It is also worried that a firm with few people might have have to give some of its employees more than one job and that these jobs might conflict with one another. The phrase 'suck it up' appears to apply here.

In-house product selection  

Regulatory researchers asked the firms how they managed conflicts of interest (if any) associated with the selection of in-house products or managers on platform investment menus or similar approved product lists. Many had policy documents to guide them and these ranged from investment and investment governance policies to conflict management and outsourcing policies. Some policies were vague and ASIC did not like this.

At most firms, the relevant committee and/or board makes the selections, having received recommendations. It says that many, but not all, of the respondents 'purported' to select and assess internal or related funds using the same selection and review criteria they used to select and review external or unrelated funds. It approves of the idea of callling in researchers to look at funds but does not think that an organisation’s conflict management can be up to much if the external research house is not acting independently. Sometimes, apparently, firms commission these firms solely to help their marketing strategies.

Outsourcing services to related parties

All respondents said that they managed "related party dealings" in accordance with their conflict management policies. Most have standard protocols that insist that:

• somebody, somewhere (the report is vague here) should be at least as 'duly diligent' as he would be if the potential service provider was unrelated to the engaging entity;
• the potential service provider should be assessed as at least equivalent to comparable non-related service providers;
• the transaction should be at arm’s length, on reasonable commercial terms;
• someone should keep a record of the arrangement that sets out the "service deliverables" in a service level agreement; and
• there should be some form of monitoring afterwards.

Others go further by insisting that:

• the related parties must have separate representatives and/or legal advisors;
• the firm in question ascertains an independent expert’s opinion to help the directors decide whether the transaction is in the best interests of that entity;
• each related party ought to fill in separate approval papers and then present them to a separate approval committee or board; and
• the "related party dealings" must be recorded on a register or in another database.

Seven directorships for one brother?

Most organisations appeared to recognise the importance of avoiding conflicts of interest on their boards. They claimed to be taking steps in terms of board composition itself — for example, regarding the proportion of independent and unrelated directors. Some of them used committees to manage conflicts of interest and the ways in which their boards considered potential conflicts. This is a sizeable source of concern for ASIC, which expressed sorrow that some organisations did not look at the problem in isolation. It is also worried because most firms appeared not to have any standard procedures in place for reassessing the knowledge or skill of remaining board members in the event of a director being required to abstain from voting because of a conflict of interest.