Managing conflicts of interest - ASIC's policy proposal

By Randal Dennings and Graeme Howatson.

Key Points:
The ASIC has released a policy proposal paper which sets out what financial services licensees will need to do to comply with the proposed new conflicts of interest provision to be added to section 912A of the Corporations Act. Because 1 July 2004 is a possible commencement date for this new provision, it may be wise for licensees to start planning for any necessary changes to their compliance system sooner rather than later.

On 4 December 2003, the CLERP 9 Bill was introduced into Parliament. The Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003 includes an amendment to section 912A of the Corporations Act which will add an additional duty to the duties of financial services licensees set out in the section.

Proposed section 912A(1)(aa) will require financial services licensees to have adequate arrangements for the management of conflicts of interest that may arise wholly or partially in relation to activities undertaken by the licensee, or the licensee's representative, in the provision of financial services as part of the financial services business of the licensee or their representative.

This new provision was discussed in Management of conflicts of interest in the financial services industry, an article that appeared in the CLERP 9 Special Edition of Corporate Insights. In this article we point out that in order to comply with the existing section 912A(1)(a) duty to ensure that financial services are provided efficiently, honestly and fairly, a licensee must manage conflicts of interest. In other words, proposed paragraph (aa) does not create a new duty, but it will require licensees to address conflict of interest issues in a more systematic way that complies with ASIC guidelines.

The proposed section does not detail what specifically licence holders will be expected to do to manage conflicts. Instead, as the explanatory memorandum released with the Bill points out, the new provision will provide the legislative basis for the ASIC to develop guidance on the management of conflicts of interest.

Since the publication of Corporate Insights, the ASIC has released a policy proposal papertitled Licensing: Managing conflicts of interest. This paper sets out guidance for licensees on compliance with the new provision. It also includes a schedule dealing specifically with conflict issues faced by providers of research reports. In this article, we highlight the main issues dealt with by the paper.

What are conflicts of interest?

Conflicts of interest are circumstances where some or all of the client's interests are inconsistent with or divergent from some or all of the licensees' or their representatives' interests. These include actual or potential and current or future conflicts of interest.

What methods can be used to manage conflicts?

Generally speaking, there are three methods of managing conflicts. These methods are:

• controlling conflicts of interest;
• disclosing conflicts of interest; and
• avoiding conflicts of interest.

Control involves ensuring that, regardless of the presence of conflicts, financial services are provided fairly, honestly and professionally.

ASIC identifies disclosure as a key tool in managing conflicts. Disclosure should be:

• timely, prominent and specific;
• occur before or when the financial service is provided and refer to that specific service; and
• sufficiently detailed to allow the client to understand the potential impact of the conflict on the financial service.

Usually, disclosure is the appropriate way to address conflicts arising from remuneration arrangements, unless these arrangements cause "direct and significant" conflict, in which case they should be avoided and not merely disclosed. Because disclosure should be specific, generic disclosure documents (for example) are unlikely to be satisfactory.

As we have seen, as a general rule, licensees and their representatives are not required to avoid conflicts. The exception to this rule is where the presence of the conflict is incompatible with the fair, honest and professional provision of a financial service.

How are these methods to be implemented?

Part B of the paper sets out specific steps that can be taken to manage conflicts. Paragraph B1 warns that "Arrangements that are not consistent with the proposals in this section are unlikely to be adequate and will expose licensees to a greater risk of regulatory action."

Licensees should have measures, processes and procedures to:

• identify conflicts of interest;
• assess and evaluate conflicts;
• decide on and implement an appropriate response to conflicts; and
• ensure that, regardless of any conflict, the quality of the financial services provided is not significantly affected.

Licensees should ensure that measures, processes and procedures they adopt are:

• approved by the licence owner or senior management of the licensee;
• suitable for the nature, scale and complexity of the licensee's business;
• effectively implemented;
• regularly monitored and reviewed, and updated as needed; and
• overseen by a person or persons who is responsible for their implementation and monitoring.

Licensees should document their conflict management arrangements and keep records of their compliance with these arrangements for at least seven years. ASIC is considering making these requirements licence conditions.

Breaches must be reported and acted on. Systematic breaches will usually mean that conflict management arrangements are inadequate.

The next step

ASIC is seeking comments on this policy proposal paper. A copy of the paper can be downloaded from the ASIC website, and the closing date for comments is 31 January 2004.

Despite the fact that the matters dealt with in this article are only proposed policy, we believe that financial service licensees should be considering now what they may need to do to comply with ASIC's requirements. It is possible that the CLERP 9 amendments, which include section 912A(1)(aa), may come into operation as soon as 1 July 2004. The policy proposal makes it clear that from the date that the amendment commences, it will not be acceptable to have informal or ad hoc arrangements for managing conflicts. Unless your compliance system already includes detailed measures, processes and procedures which are likely to be satisfactory to ASIC, it may be wise to start planning for the necessary changes sooner rather than later.