Conflicts of Interest MiFID and the General Law

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1 slaughter and may Companies Briefing Paper Act 2006 September 2008 Conflicts of Interest MiFID and the General Law Much has been said and written in recent years about the conflicts of interest that can arise between financial institutions and their clients. However, in our view there has not been sufficient consideration of how the general law and regulatory rules interact in this area at the level of customer contracts and engagement letters. This briefing paper analyses the law and applicable rules in the UK and makes some recommendations about the way forward. 1. Background English law has had a long tradition of imposing high standards on persons regarded as fiduciaries. Broadly, a fiduciary includes any professional or business to whom those using their services entrust the conduct of their affairs in the interests of those users. The duties imposed on fiduciaries are onerous, flowing from the principle that a fiduciary owes a duty of loyalty to its customers, and include the rules that: > a fiduciary must not place itself in a position where its own interests conflict with those of its customer (the no conflict rule); > a fiduciary must not profit from its position at the expense of its customer (the no profit rule); and > a fiduciary owes undivided loyalty to its customer and therefore must not place itself in a position where this duty towards one customer conflicts with a duty that it owes to another customer (the undivided loyalty rule). In the context of financial services, these rules of law can apply to many categories of business, such as financial advisers, agency stockbrokers, asset managers and custodians. They are of particular interest and concern to investment banks carrying on a wide range of these activities. It is also the case that it would in practice be impossible for a modern financial services firm to discharge its fiduciary duties if these rules were to apply in full, without modifications. At the very least, the rules have to be modified to permit the firm to charge for its services and to act for more than one customer where customers interests might be in conflict (for example, where a firm acts for a number of customers who may be competitors in the same business sector). Sometimes such modifications may be implied by law from the nature of the business; but, in most cases, a financial services firm will seek to modify the application of fiduciary duties by contract with its customers, to allow for such matters as: > keeping knowledge of a customer s affairs behind a Chinese wall and permitting other parts of the firm to carry on business, for certain purposes, in a manner that would otherwise be inconsistent with fiduciary duties;

2 > receiving commission or fees from product providers, counterparties or intermediaries; and > dealing for its own account or the account of other customers in securities dealt in on behalf of the customer in question. One way, in theory, for a firm to achieve these goals is to try to contract out of fiduciary duties altogether by stipulating that the firm owes no such obligations and that the customer does not rely on the firm to advise it or to exercise discretion in its interests. This may be possible in certain markets and with certain types of customer. However, this is not a very feasible general business model and, indeed, as a matter of contract law it is not a happy way of documenting a relationship where customer reliance is present and is mutually understood to be so. Apart from a limited number of cases involving professionally-knowledgeable customers (e.g. J.P. Morgan Chase v Springwell Navigation Corporation 1 ) the more usual course of action is for a firm to obtain customer consent to what might otherwise be a breach of fiduciary duty. Thus it can be seen that customer consent is a primary tool for managing a firm s fiduciary duties. Without this tool, a modern financial services firm would find it impossible to avoid incurring liability for breach of fiduciary duty in many day-to-day circumstances. In parallel to the general law, the system of regulation in the UK established under the Financial Services and Markets Act 2000 ( FSMA ) imposes duties flowing from the general principle that firms must treat their customers fairly. These include duties not to accept unreasonable inducements from third parties, to manage conflicts fairly and to deal, and allocate transactions, in a way which is fair to all customers. The UK regulatory system also requires that, where appropriate, customer consent be obtained for particular actions which a firm may wish to take (for example, using a customer s investments held in custody). Until the implementation of MiFID 2, there was little or no tension between the approach of the statutory rules and the contractual and other techniques traditionally used by financial services firms to mitigate their fiduciary duties. MiFID has changed that fundamentally. Article 19(i) of MiFID provides: when providing investment services to clients, an investment firm [must] act honestly, fairly and professionally, in accordance with the best interests of its clients In the case of management of conflicts of interest, this principle leads MiFID to lay primary emphasis on a firm having systems and controls to prevent conflicts arising or affecting the interest of customers. In contrast to the position in the UK prior to the implementation of MiFID, the MiFID approach allows customer consent to be used only as a tool of last resort, when systems and controls have failed to prevent a conflict arising. Consent, in such a situation, is intended to be ad hoc and not general. The firm informs the customer of the set of facts giving rise to a conflict and the customer is then at liberty to discontinue the firm s engagement or to proceed notwithstanding. This briefing paper explores in more detail the similarities and differences between MiFID and the general law in this area and suggests ways of reconciling the two approaches, since neither can be ignored at the expense of the other. Compliance with MiFID requirements will not absolve a firm from discharging its fiduciary duties; conversely, techniques which a firm may employ to mitigate fiduciary obligations will not in themselves necessarily mean that it is meeting its MiFID requirements. 1 [2008] EWHC A separate Slaughter and May briefing paper is available on the Springwell case. 2 The Markets in Financial Instruments Directive, 2004/39/EC. 2 slaugh ter and may

3 2. MiFID requirements on conflicts and how they differ from fiduciary law The relevant provisions of MiFID, as implemented in the UK by SYSC R in the FSA Handbook, identify the following possible conflicts (at a minimum): Where the firm or some person connected with the firm: (1) is likely to make a financial gain, or avoid a financial loss, at the expense of the client; (2) 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; (3) has a financial or other incentive to favour the interest of another client or group of clients over the interest of the client; (4) carries on the same business as the client; or (5) 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. The list set out above is similar to the list of fiduciary duties; but there are subtle and important differences. For one, there must be disadvantage (or the possibility of disadvantage) to the client for the MiFID provisions on conflicts to apply. This is made clear by SYSC G, which reproduces the terms of Recital 24 to the MiFID Implementing Directive 3 : 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. For example, the first situation listed in paragraph (1) above is where a financial gain is made or a financial loss avoided at the expense of the client. The fiduciary obligation, on the other hand, is more stringent; it is that the fiduciary may not make a profit from its position as such. This can be illustrated by reference to the case of dealing errors, where an investment manager may mistakenly buy securities for the account of a client but in breach of the investment limits agreed with the client. If the manager sells down the holding to restore the agreed limits a profit may be made in a rising market but for whose account is that profit? If the securities are re-sold before formal allocation to the client, then the firm could argue that the profit is not made at the expense of the client, because the client was not supposed to become the owner of the surplus securities in the first place. However, the position under fiduciary law is clear. Unless the client expressly consents to it, the firm cannot retain any profit it makes from its position as investment manager, even in respect of dealing mistakes. It is not enough, for example, for a firm which absorbs any losses arising on dealing errors to claim that its retention of profits means that the position is neutral in the long run. Again, under MiFID there is a conflict between the interest of clients where one client may suffer a possible loss from another s possible gain or avoidance of loss. Fiduciary law is arguably stricter. In a case where the consequences could be severe the courts may intervene to prevent possible conflicts where there is only the remotest possibility of a loss or disadvantage to another client /73/EC. 3 slaugh ter and may

4 However, although it generally requires that loss or the potential for loss be shown as arising from an actual or potential conflict, MiFID sometimes goes further than fiduciary law in regulating possible conflicts by imposing requirements which may not be mitigated (whereas, as discussed above, the requirements of fiduciary law may generally be mitigated by consent). One such area concerns inducements (COBS 2.3 in the FSA Handbook). The basic rule is: A firm must not pay or accept any fee or commission, or provide or receive any non-monetary benefit, in relation to designated investment business... The exceptions to this sweeping prohibition are relatively narrow. Apart from fees, or commissions or benefits passing directly between the firm and the client or the client s agent, and proper fees arising in the course of providing services (such as custody costs, settlement and exchange fees, which by their nature should not give rise to any conflict) only fees, commissions or non-monetary benefits which meet the following tests are permitted: > there must be no impairment of the firm s compliance with its duty to act in the best interests of the client; > there must be full disclosure to the client of the existence, nature and amount of the fee, commission or benefit or the method of calculating the amount; and > the payment of the fee or commission, or the provision of the benefit, must be designed to enhance the quality of the service to the client. By contrast, fiduciary law allows a fiduciary and its client to agree to the firm (for example) receiving a wide range of commissions or benefits, although this liberty is qualified by the need for the fiduciary to avoid an actual conflict unless the client specifically consents to that. The difficulty will be to establish how specific the consent must be in such a case. This turns largely on the disclosure made by the fiduciary. The recent case of Hurstanger Ltd v Wilson 4, in the Court of Appeal, held that whether or not sufficient disclosure has been made for informed consent to be given by a principal depends on the facts of each case. The Court quoted with approval from the leading textbook on agency, Bowstead & Reynolds 5 : Consent of the principal is not uncommon. It must it be positively shown. The burden of proving full disclosure lies on the agent and it is not sufficient for him merely to disclose that he has an interest or to make such statements that would put the principal on enquiry: nor is it a defence to prove that had he asked permission it would have been given. As to whether an agent must disclose the amount of commission, Bowstead & Reynolds is again quoted by the Court: Where [the principal] leaves the agent to look to the other party for his remuneration or knows that he will receive something from the other party, he cannot object on the ground that he did not know the precise particulars of the amount paid. Such situations often occur in connection with usage and customs of trades and markets. Where no usage is involved, however, the principal s knowledge may require to be more specific. 4 [2007] 1 WLR th Edition slaugh ter and may

5 Thus, in Hurstanger, a vulnerable and unsophisticated borrower who approached a broker to arrange a loan was entitled to full disclosure of the commission which the broker was to receive from the lender. The Court observed: A statement of the amount which the broker is to receive from the lender is necessary to bring home to such borrowers the potential conflict of interest. In this latter type of case the fiduciary law obligation matches the MiFID requirement for commission disclosure, but in other usage and custom cases the obligation may not be so stringent. 3. Legal and regulatory restraints on excluding fiduciary liabilities The exclusion of pure fiduciary liabilities is not within the scope of the Unfair Contract Terms Act 1977 (because the Act applies to liability for breaches of contract or negligence). On the other hand, the Unfair Terms in Consumer Contracts Regulations could apply to a standard exclusion clause in a contract with a consumer 7 :...if, contrary to the requirement of good faith, it causes a significant imbalance in the parties rights and obligations arising under the contract, to the detriment of the consumer (reg 4(1)). Schedule 2 to the Regulations sets out a non-exhaustive list of the types of term which could be regarded as unfair. Terms mitigating or avoiding fiduciary duties or liabilities are not expressly covered by the list; nor does there seem to be any implication that they are covered automatically. Therefore such terms have to be assessed on an ad hoc basis, having regard to all the circumstances of the contract. It is suggested that terms which seek no more than to allow a firm or its group to operate its reasonable business model should not generally be considered unfair. Conversely, terms which are designed to allow the firm to exploit its position to the detriment of the consumer (e.g. by amending the contract or increasing charges in an unreasonable manner) may be unfair under the Regulations. The requirements of COBS 2.1 in the FSA Handbook ( Acting honestly, fairly and professionally ) are more difficult to apply to fiduciary exclusion clauses. COBS 2.1.2R forbids a firm to exclude or restrict any duty or liability it has to a client under the regulatory system (requirements arising in or under FSMA). Whilst this rule would not apply to the exclusion of fiduciary duties, COBS 2.1.1R(1) contains the more general requirement that: A firm must act honestly, fairly and professionally in accordance with the best interests of its client... FSA guidance in COBS 2.1.3G provides that, in the case of a retail client, a firm will not be in compliance with this rule if it seeks to exclude or restrict any duty or liability (including a fiduciary duty or liability) unless it is honest, fair and professional for it to do so. It is difficult to make any useful general observations about this provision, except to restate what has just been said above: that a term with the purpose of allowing a firm or its group to operate its reasonable business model should not usually offend against a rule of this nature. 6 SI 1999/ A consumer is defined for these purposes as any natural person who, in contracts covered by these Regulations, is acting for purposes which are outside his trade, business or profession. 5 slaugh ter and may

6 4. Can MiFID obligations be reconciled with traditional mitigation techniques? An investment firm has no option but to comply with MiFID requirements as implemented in the relevant rules. However, a duty to obey the rules is primarily owed to the rule-maker, even if (as FSMA does in certain circumstances) the law enables a person who has suffered loss as a result of a breach of the rules to sue the investment firm. It does not follow from the existence of such a remedy that a firm is contractually obliged to its customer to obey the rules which apply to it. Of course, it is always open for the contract between a firm and its customer to provide, either expressly or by implication, that the firm will comply with these rules. However, it is not necessarily advisable for firms to agree to such provisions, particularly in the light of the imprecision in the drafting and regulatory interpretation of the relevant rules. Moreover, it is not illogical for the contract between the firm and its customer to be drawn up on the basis that fiduciary duties are agreed not to arise or that the client consents to certain breaches (subject always to the disclosure point discussed above), even if FSA rules provide for a different approach. (But note that the rules require information to be given to customers about many regulatory matters, including a firm s policy on conflicts of interest.) In summary, the contract may modify or exclude fiduciary duties or the consequences of breaches of fiduciary duties, so as to deprive the client of remedies under contract or fiduciary law, even though the firm is nevertheless under a regulatory obligation to conduct itself towards its client in a way which appears consistent with there in fact being fiduciary or contractual duties. An example might be where the contract allows the firm to benefit from commissions or other fees paid by third parties but where FSA rules prohibit such benefit unless certain stringent conditions are met. A breach of the regulatory rules may give rise to regulatory action and/or allow a customer to claim for breach of statutory duty; but the customer would, subject to the operation of the Unfair Terms in Consumer Contracts Regulations 1999 where applicable, not then have a claim in contract or in fiduciary law. It is conceded above that contractual provisions may track regulatory requirements. This is in fact the case with many agreements (e.g. the Model Terms of Business for managers and brokers published by the IMA). If that is the commercial objective, then it remains to be considered whether there are potential fiduciary obligations or liabilities which need to be addressed. In conclusion: > A firm must comply with regulatory requirements derived from MiFID concerning conflicts of interest; > A firm must also identify potential fiduciary duties and liabilities and, where it is reasonable to do so, exclude or limit them; > MiFID requirements are in tension with some of the contractual techniques, such as informed customer consent, used to manage fiduciary obligations; > It is essential to continue to use these contractual techniques, where appropriate; but > The FSA s rules must be complied with, although it is not necessary (or indeed advisable) to contract to do so. London One Bunhill Row, London EC1Y 8YY, United Kingdom T +44 (0) F +44 (0) Paris 130 rue du Faubourg Saint-Honoré, Paris, France T +33 (0) F +33 (0) Hong Kong 47th Floor, Jardine House, One Connaught Place, Central, Hong Kong T F Brussels Square de Meeûs Brussels Belgium T +32 (0) F +32 (0) Please note that this Briefing Paper is published to provide general information and not as legal advice. For further information please contact your usual adviser at Slaughter and May. yc4.indd908