14 Sep 2007

Fiduciary relationships, managing conflicts and Chinese walls

by Michael Legg, Nicholas Mavrakis

ASIC v Citigroup is crucial guidance for investment advisory arm of investment banks and other advisers who may be fiduciaries and for financial service licensees.

The decision in ASIC v Citigroup is a landmark judgment on the obligations of the investment advisory arm of investment banks to their clients and how those obligations may be managed. It provides guidance for other advisers who may be fiduciaries and for financial service licensees who are subject to section 912A(1)(aa) of the Corporations Act.


The case concerned the role played by the investment banking division (IBD) of Citigroup Global Markets Australia Pty Ltd in advising Toll Holdings Ltd on a proposed takeover of Patrick Corporation Limited. Citigroup's proprietary trading desk was buying shares in Patrick at the same time the IBD was providing its advice.

As a result of these activities ASIC commenced proceedings in the Federal Court against Citigroup for, inter alia, breaching section 912A(1)(aa) of the Corporations Act as a result of conflicts of interest and duty arising from Citigroup's advisory role creating a fiduciary relationship with Toll.

The Court found that on the facts before it Citigroup owed no fiduciary duties and there was no contravention of section 912A(1)(aa).

The judgment contains important guidance as to when a fiduciary relationship may arise for advisers, how that relationship may be excluded and the meaning of managing conflicts as required by section 912A(1)(aa), including through the use of Chinese walls.

The contractual exclusion of a fiduciary relationship

The Court determined the existence of a fiduciary relationship by reference to the mandate letter between Citigroup and Toll. Relying on accepted High Court authority that parties to a contract may exclude or modify the operation of fiduciary duties, the Court found that the words in the mandate letter that Citigroup was retained "as an independent contractor and not in any other capacity including as a fiduciary" can only be given their plain meaning - a fiduciary relationship was excluded.

Factors creating a fiduciary relationship

The Court stated that "but for the express terms of the mandate letter, the pre-contract dealings between Citigroup and Toll would have pointed strongly toward the existence of a fiduciary relationship in Citigroup's role as an adviser". Those pre-contract dealings included Citigroup holding itself out as an expert adviser and the giving of advice which involved the use of financial acumen, judgment and expertise to further Toll's interests. Therefore caution must be exercised as to the content of terms of engagement and the timing of their provision to the client.

Pre-existing fiduciary relationships and exclusion clauses

As a result of the mandate letter effectively excluding a fiduciary relationship the judgment did not address a number of important questions. Will an exclusion of a fiduciary relationship clause be effective if a fiduciary relationship pre-existed the exclusion clause? Will the clause's effectiveness, or requirements for effectiveness, vary depending upon whether the fiduciary is in an established category or created ad hoc?

ASIC argued that that where the inclusion of a particular term in a putative fiduciary’s retainer agreement would create an actual or potential conflict between the interests of the fiduciary and those of the client, then the "would-be fiduciary" must obtain the informed consent of the client to the inclusion of that term. That meant that Citigroup needed Toll's informed consent for its exclusion clause to be valid.

ASIC relied upon the so-called "solicitor time-charging" cases which state that because a solicitor may be a fiduciary prior to entering into any retainer, a solicitor who wishes to enter into a time charging costs agreement with the client must make full disclosure to the client of all the implications of such an agreement. The Court distinguished the cases on two bases:

  • that the cases are based on a Court's inherent jurisdiction over solicitors; and
  • the relationship was an established category of fiduciary relationship.

It left open, however, whether the principal could be extended to pre-existing ad hoc fiduciary relationships. There is therefore a risk that advisers who cultivate a relationship of trust and confidence prior to excluding a fiduciary relationship may need to seek informed consent.

Informed consent

There is no precise formula as to what amounts to informed consent but at a minimum full and frank disclosure of all material facts is needed. The Court did not need to deal with this issue but made a number of observations.

First, it held that Toll had not given express consent. Citigroup had relied on Custodian and Nominee Appointments that were executed by Toll to retain Citigroup to purchase shares in Patrick for Toll. The Appointments contained express disclosures permitting Citigroup to trade on its own account in securities it had been instructed to buy for a client. The Court found that a consent to proprietary trading and conflicts of interest in a more limited retainer was not consent to an exclusion of the entire fiduciary relationship in an expanded retainer that included advising on the takeover. This finding suggests that if informed consent is required, careful consideration needs to be given to the scope of what a client is being asked to consent to.

Informed consent may be implied. The Court would have found that Toll had impliedly consented because of its experience with takeovers and its CFO's knowledge that Citigroup may trade on its own account so long as it did not use Toll's confidential information. Consent however was not be implied because the practice of proprietary trading in a target's shares was notorious. Rather, the Court found that there is nothing in the relationship of investment banker/financial adviser and client that necessitated proprietary trading in its client's target's shares. However, no evidence on industry practice was before the Court to enable this proposition to be tested.

The sufficiency of disclosure may depend on the sophistication and intelligence of the person to whom disclosure is required to be made. As a result the disclosure by an investment bank that may be sufficient to a corporation frequently involved in mergers and acquisitions may be insufficient for a recently listed company. Equally, the disclosures by financial advisers to individuals may need to be of another order again.

Exclusion clauses and collateral attack

The use of an exclusion of a fiduciary relationship clause may also be open to collateral attack on the basis of mistake, misrepresentation or misleading and deceptive conduct (section 1041H of the Corporations Act) or section 12DA of the Australian Securities and Investments Commissions Act 2001 (Cth)). If a client asks what such a clause means, a careful explanation will be needed.

Managing conflicts of interest

Section 912A(1)(aa) of the Corporations Act provides that a financial services licensee must have in place "adequate arrangements for the management of conflicts of interest" that may arise in the provision of financial services.

ASIC's case was that an adequate arrangement required the elimination of unauthorised conflicts by obtaining express consent. ASIC's Policy Statement PS 181 adopts the approach that some conflicts can only be managed by avoiding them. Further, the CLERP 9 Explanatory Memorandum states that section 912A(1)(aa) "will require internal policies and procedures for preventing and addressing potential conflicts of interest that are robust and effective" [emphasis added]. The Court rejected ASIC's approach as the section uses the word "management" which does not require the elimination of a possible conflict. Of course, one way of managing conflicts would be to eliminate them but section 912A(1)(aa) was interpreted so as to not require that step. The Court made no reference to the CLERP 9 Explanatory Memorandum or the purpose of the legislation.

The Court also observed that adequate arrangements require more than written policies and procedures, it requires a thorough understanding of the procedures by all employees and a willingness and ability to apply them to a host of possible conflicts. Advisers must have a working knowledge of how to deal with conflicts.

Chinese walls

The Court noted that Chinese walls do not eliminate conflicts; rather they are only a technique for managing conflicts which continue to exist. Chinese walls may be used to comply with section 912A(1)(aa) of the Corporations Act.

However, any Chinese wall must be an established part of the organisational structure not created on an ad hoc basis. The Court endorsed recommendations that the type of organisational arrangements that needed to be adopted included:

  • the physical separation of departments to insulate them from each other
  • an educational programme, normally recurring, to emphasise the importance of not improperly or inadvertently divulging confidential information
  • strict and carefully defined procedures for dealing with situations where it is thought the wall should be crossed, and the maintaining of proper records where this occurs
  • monitoring by compliance officers of the effectiveness of the Chinese wall; and
  • disciplinary sanctions where there has been a breach of the wall.

The statutory requirement is to be contrasted with the duty in equity of a fiduciary to eliminate or avoid conflicts. In the fiduciary context a Chinese wall alone is insufficient to avoid breach of fiduciary obligations. Indeed the Chinese wall may hide the existence of the conflict within an organisation which is meant to be avoided.

The Chinese wall may, however, be effectively employed if the client consents to the use of Chinese walls on a fully informed basis as a way in which to avoid breach of the fiduciary's duty of loyalty. Such consent may also be implied.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.