The report, which was issued as a “Dear CEO” letter, identifies areas where the activities of asset management firms potentially conflict with the interests of their clients. These cover a range of obligations under SYSC 4 and SYSC 10 and also specific failings under COBS 11 regarding dealing commission and allocations.
The review is said to have been prompted by evidence that the sector had “relaxed’ controls in this area and did not consider conflicts of interest to be a “key source of potential detriment to their customers…”. As the FSA has offered guidance on these topics before it would have expected the rules and principles to be well-established. However, in light of the failings it witnessed a second round of visits is now proposed. Given the fundamental nature of the issues and the current track record of enforcement at the FSA, it is likely that action may well follow.
The FSA had a number of specific observations and recommendations that firms should consider.
Senior Management and culture
The FSA has senior management in its sights. The FSA suggest evidence of poor compliance culture and weak participation in managing and monitoring conflicts of interest at board level. The FSA expects boards of firms to regularly review their practices to ensure compliance; both as a matter of routine and when managing change. Further, the FSA stress that UK subsidiaries of overseas parents need to exercise meaningful oversight of conflicts management and express concern that persons not within the regulator’s ambit were making decisions on core practices.
The FSA encourages a “bottom-up” approach whereby managers of each business department engage routinely with compliance to review conflicts of interest. Indeed, all staff should be alert to the possibility of conflicts and be attuned to the controls in place. Importance is also given to the presence of a non-executive director or otherwise independent persons to challenge processes, where the size and scope of a firm would allow such.
Research and execution services
The FSA found that too few firms were adequately controlling spending on research and execution services. Indeed, the report claims that many were rather more flippant with their customers’ monies than their own. The FSA expects firms to consider which services are valuable inputs to its investment process and to challenge brokers about why it should pay for extraneous services. One reason often cited for using a broker can be access to management; the FSA felt firms were unable to show how corporate access or providing preferential access to IPOs constituted research or execution services. Again, the FSA turns to senior management to provide control; governing bodies should review products and services purchases using client commissions.
Trade allocation and equal opportunity
The FSA found inadequate controls and oversight over the allocation of investment research ideas between customers. The report emphasises the responsibility to share research and provide equal access to all suitable investment opportunities, or otherwise disclose that ideas are not shared between portfolio managers.
Firms reviewed by the FSA were also unable to show that cross trading was always in both customers interest, with inadequate rationale, challenge and oversight seen in such trading. Indeed, the FSA highlights enforcement action against a firm that traded for one fund to ease the liquidity problems of another. This appears to be a re-cycling of the recent Martin Currie enforcement case, an important exemplar of how managers can abuse their fiduciary responsibilities.
Hedge fund managers in particular were considered to be too reliant on contractual limitations in order to avoid reporting the cost of errors to their clients and ultimately liability in cases other than through negligence. The FSA found that firms had not considered whether repeatedly making the same or similar errors might in itself amount to gross negligence.
The FSA found satisfactory arrangements were in place around personal account dealing. These were however, applied inconsistently across staff, sometimes with senior staff excluded from the procedures and oversight. The FSA regarded firms that imposed significant holding restrictions and maximum trading frequencies on their staff as good practice.
The FSA reiterated that firms should consider gifts and hospitality as viewed through the prism of full disclosure – so if an inventory of such had to be published, how would it look to investors? Sensibly, the regulator is placing emphasis on the cumulative impact of gifts where managers receive gifts and entertainment on a regular basis. The scope of the advice extends to issuer-sponsored conferences and research trips, including entertainment provided during these trips.
Action required by Firms
The FSA expects firms that have received a hard copy of the report to provide it with a receipt and attestation to the report by 28 February 2013, using the prescribed wording in the Appendix.
However, the FSA also expects senior management of all asset management firms to read and consider the report’s findings. The not too subtle message here is corporate governance is paramount. A culture of compliance should be set from the top down and tested from the bottom up.
This provides an opportunity for all firms to conduct their own thematic review of conflicts management. Application is as important as documentation and we will be running a series of conflicts-themed training events for clients over the next few months to help firms re-enforce their compliance standards and culture. If required, IMS can provide an independent review and advise senior management accordingly.
For more information on FSA regulations please visit the IMS group at www.theimsgroup.co.uk/group-services/regulation-and-compliance/fsa-authorisation.html