Recommendation no. 10. Handling of certain types of conflict of interest

Recommendation no. 10. Handling of certain types of conflict of interest Adopted by the board of the Norwegian Securities Dealers Association on 8 April 2014. 1

1. Introduction In banks 1 that provide investment services, conflicts of interest, among other things, may arise between credit departments in the corporate segment and the investment services operations, especially the Investment Banking 2 (IB) operations. This may particularly be the case when investment services are provided to loan customers, where the bank may be in the situation that it must safeguard its own and the customer s conflicting interests, or the conflicting interests of customers. Conflicts of interest may also arise in those cases where the IB operations assist market players that have purchase, sales or merger interests in the bank s customers. The growing market trend for companies debt-capital financing to be increasingly in the form of negotiable bond loans at the expense of traditional bank loans indicates that greater attention must generally be paid to the banks handling of conflicts of interest. The objective of this recommendation is to: provide directions as to how possible conflicts of interest may be revealed and handled; help the banks to organise their investment-service operations and establish routines in a way that reduces potential conflicts of interest; provide examples of possible conflicts of interest that may arise between a bank s provision of credit and provision of investment services, especially in relation to IB operations, see annex 1. This will help to strengthen the confidence in the bank s overall operations among the bank s customers and the confidence in the financial market in general. Banks are advised to reveal and deal with possible conflicts of interest before they undertake any legal or other obligations to the customer in question. The bank should not normally sign any mandate agreements or send over a draft of such agreements, accept and take part in beauty parades or a request for a proposal (RFP) or receive sensitive information from potential customers until the conflict of interest issue has been clarified. The bank may nonetheless receive information on a potential assignment that is necessary to clarify any conflict of interest provided the potential customer is informed that any assignment will be conditional on internal approval. The general conditions related to the handling of inside information are not covered by this recommendation, since these are regulated separately in laws and regulations and by the banks internal routines. However, it is underlined that any measure to handle conflicts of interest pursuant to this recommendation requires the market abuse regulations to be complied with at all times. The recommendation will also, in so far as it is appropriate, apply to investment firms that are not a part of a bank. 1 Below, bank is used for banks that provide investment services. 2 That part of the operations that provide advice and preparations in connection with an enterprise s capital base, both equity and debt capital, as well as advice relating to M&A. 2

The Norwegian Securities Dealers Association s standard no. 3 concerning The relationship between corporate departments and analysis departments. Handling of conflicts of interest and requirements relating to the contents of recommendations, including analyses applies in addition to this recommendation. 2. Legal basis 2.1 The regulation of conflicts of interest According to section 9-11 subsection 1 no. 2 and section 10-10 subsection 1 of the Securities Trading Act, an investment firm, including banks that provide investment services, is to be structured and organised in such a way as to minimise the risk of conflicts of interest between the firm and its customers or between the firm s customers, and the firm is to take all reasonable steps to identify such conflicts of interest. According to section 9-23 of the Securities Trading Regulations, an investment firm must assess whether the firm could achieve a financial gain at the customer s expense, whether the firm has a different interest than the customer as regards the result of the provision of the investment service or execution of the transaction, whether the firm has financial or other grounds to prioritise the interests of another customer or other groups of customers ahead of the customer s interests and whether the firm conducts the same type of activity as the customer. In addition, according to section 9-24 of the Securities Trading Regulations, a firm shall have written guidelines for handling conflicts of interest that as a minimum include the identification of possible conflicts of interest and a description of the routines/measures for handling these. These guidelines must be adapted to the firm s size and organisation as well as the nature, extent and complexity of the firm s operations. 2.2 Relationship to the duty of confidentiality The starting point is that conflicts of interest must be handled in compliance with the prevailing rules concerning the duty of confidentiality in relation to the exchange of customer information in a group and in accordance with the rules concerning information barriers (Chinese walls). According to section 10-9 of the Securities Trading Act, employees, officers and persons with determinative influence in an investment firm shall treat as confidential any information about the affairs of others which may come to their knowledge in the course of their work, except as otherwise prescribed in law or regulations made pursuant to law. The same applies to anyone that performs work for the investment firm even if the person concerned is not employed by the firm. According to section 18 of the Commercial Banks Act, officers, employees and auditors of a commercial bank are obliged to treat as confidential any information which comes to their knowledge by virtue of their position concerning the bank or a customer thereof or another bank or its customer, unless they are obliged to disclose information pursuant to this or any other Act. 3

The duty of confidentiality pursuant to these provisions applies to any party outside the bank but not within the bank, cf parliamentary bill (Proposition to the Odelsting) 15 (1996-97) pp. 61 and 88 as regards the Securities Trading Act. However, this does not mean that information may be freely exchanged between the bank s various departments. To ensure the necessary independence between the bank s different departments, the banks must, according to section 9-24 subsection 3 letter (a) of the Securities Trading Regulations, have procedures for the proper exchange of information between different parts of the firm, as well as procedures and systems for the management of information that ensure the requisite security and confidentiality, cf section 9-7 subsection 2 of the Securities Trading Regulations. If the introduction and implementation of procedures for, among other things, the proper exchange of information fail to ensure a sufficient degree of independence, the banks must initiate such further or alternative measures as are necessary and appropriate to achieve such independence, cf. section 9-24 subsection 4 of the Securities Trading Regulations. In those cases where there is inside information, the persons in a bank that possess such information shall not give it to unauthorised persons. When dealing with inside information, they must demonstrate due care so that the information does not come into the possession of unauthorised persons and is not misused. Since banks are regularly in possession of inside information, they must have routines for the secure handling of inside information, cf. section 3-4 of the Securities Trading Act. If inside information is exchanged, the bank must also ensure that recipients of such information are correctly added to a list in accordance with section 3-5 subsection 1 of the Securities Trading Act, and it must also be documented that the recipients have been made aware of the duties and responsibilities this involves, as well as of the criminal liability associated with the misuse or unwarranted distribution of such information, cf. section 3-5 subsection 3 of the Securities Trading Act. The persons in the bank that are to be regarded as unauthorised in relation to the information possessed by the bank s credit departments and IB operations will depend on the bank s overall need to exchange information between different departments to comply with its regulatory obligations, including in relation to the capital adequacy regulations and securities trading legislation. For example, in the case of the sale of products where banks take a credit risk in relation to customers, such as in derivative trading and other FX business, there will often be a need for access to the bank s internal rating of the customer in question in order to ensure the correct pricing of the credit risk and thus a satisfactory return on the bank s capital. Such an exchange of information between the bank s credit department and the relevant derivatives and FX brokers is not to be regarded as a breach of the duty of confidentiality or other information barriers provided the objective of the exchange of information is to ensure the correct pricing of the credit risk and the bank has established and complies with adequate internal routines. The exchange of information between two different departments of the same bank will be legitimate when the objective is to comply with the law s requirements regarding the discovery of any conflicts of interest and this is done in accordance with adequate routines (including the Engagement Committee routines, see item 3.2.1 below) and the rules governing the proper handling of information. 3 3 In connection with this, reference is made to section 15-5 of the Banking Act Commission s proposal regarding a new Act on Financial Undertakings and Financial Groups (Finansforetakslov), according to which a financial undertaking may disclose information on a customer relationship to another financial undertaking in the same financial group if this disclosure is required to comply with management, control or reporting requirements for the company in the financial group determined in or pursuant to an Act. 4

2.3 Geographical scope Several of the rules concerning the organisation of the operations, including the duty of confidentiality and handling of conflicts of interest, have not been made directly applicable to banks and investment firms that provide investment services in Norway through a branch. In this regard, reference is made to section 9-26 of the Securities Trading Act. However, these rules are based on the common European regulations, including the Markets in Financial Instruments Directive (MiFID), which will be implemented in these banks and investment firms country of residence (provided these banks and investment firms are established within the EEA area). This means that the general principles established by the Securities Trading Act must be presumed to apply to those branches that are members of the Norwegian Securities Dealers Association, so it is assumed that the principles and guidelines stated in this recommendation, with references to Norwegian laws and regulations, may also be applied to these branches. 3. Identification of conflicts of interest 3.1 Identification Attempts should be made to reveal conflicts of interest through preliminary investigations as early as possible in the process, for example by the following: investigations into a potential customer/transaction based on publicly available information and knowledge about the customer, for example from previous projects; checks with potential customers as to whether there are any conflicts of interest relating to the firm, associated persons or owners; a check of conflicts within IB, in which one or more managers that know about other activities that are ongoing in the IB department are asked about any conflicts; a check on conflicts with other departments in the bank, for example with the account executive, provided this complies with the proper handling of information. Such a check on conflicts will especially be natural if the assignment is initiated by the account executive. Examples of typical questions to account executives may be whether there has been a breach of covenants or loan agreements, whether the bank has stipulated a requirement that the funds are to be used to repay debt to the bank, whether there is a conflict between the customer and the bank, etc. In some cases, it will be necessary to involve several of the bank s departments in order to satisfactorily reveal possible conflicts of interest. 3.2 Handling of conflicts of interest 3.2.1 Exchange of information 5

If conflicts of interest are revealed, the person(s) responsible for deciding on the relevant assignment must ensure that the way in which these are to be handled is considered and that the follow-up activities which are agreed on are documented. In order to reveal any further conflicts of interest between the bank s various operations, it must be possible for there to be an exchange of information between these operations as regards customers and the nature of assignments, etc. This may also entail a need to exchange sensitive information between the various affected departments, i.e. between relevant persons within the bank. Such an exchange of information may take place provided it is to relevant persons on a need to know basis and in accordance with further stated routines. A recommended tool for revealing conflicts of interest in relation to other departments of the bank, and for deciding how, if possible, to deal with these, may to establish a committee consisting of the heads of departments, including those outside the IB department, for example called the Engagement Committee (EC). It is important that such a committee and its members are regarded as authorised to receive and handle the sensitive information, including inside information. Checks on conflicts that have been carried out should be documented in so far as possible. The presentation of the issue, proposal and decision on how to handle any identified conflicts of interest must therefore be documented. Should some time elapse between the preliminary check and the materialisation of the assignment, for example if there are postponements due to market conditions, it should be routinely assessed whether there is a need to conduct a new check on any conflicts of interest and whether changes have taken place that may affect the execution of the assignment. 3.2.2 The EC s organisation, tasks and procedures The members of the EC may vary from bank to bank (depending on the internal organisation) and from case to case. The members should represent the bank s affected credit departments and the relevant division(s) within the bank s IB department and Markets department(s), depending on the assignment in question and the customer(s) involved. Compliance should be entitled to attend and be kept continuously informed about EC meetings. In each case, the EC should always consist of persons with the authority to decide whether the bank is to take on the assignment in question provided the necessary measures to limit any revealed conflicts of interest are implemented, and they must have the authority to determine how any conflict of interest may/shall be resolved. The individual bank should establish an internal routine for what is possibly to be presented to an EC. All commercial assignments linked to possible transactions that may be price-sensitive in relation to the securities market, for example because they may include the handling of inside information, cf. section 3-2 of the Securities Trading Act, or that may entail a significant conflict of interest should be dealt with by the EC before the firm binds itself legally or in any other way, and normally at the latest before a draft mandate agreement is sent out. Commercial decisions on transactions should always be submitted to an EC with regard to cases which entail the handling of or which involve (i) inside information or, (ii) an obligation 6

for the IB or Market Department, or (iii) if the assignment may mean that the bank incurs/increases or sells/reduces an ownership position in a financial instrument or other asset. The EC may also be used in other important cases or where a possible assignment is so complex that there is a need for a wider discussion between the firm s professional departments; in the sense of departments which would otherwise be separated by physical or other information barriers. It is the account executive s or project manager s responsibility to present the cases that should be submitted to the EC. If the account executive or project manager is in doubt, this person s manager, or possibly Compliance, should be consulted. The EC should thus, in so far as this is in accordance with other instructions issued by the bank: assess the customer or customers in question; assess the individual assignment and the obligations that the bank is to undertake, including any reputational considerations; assess any payment and any commercial risks linked to the assignment; assess any market, counterparty or credit risks that may result from the assignment and decide whether it can recommend that the bank undertakes such risks (based on the handling of a conflict of interest); ensure that no conflicts of interest exist or may arise and, if this cannot be avoided, decide how such conflicts of interest should be dealt with. Compliance should be consulted in such an assessment; ensure that all relevant companies/financial instruments are registered on the bank s watch list for the continuous follow-up of conflicts of interest, at least when the transaction means that the bank has or may in future have price-sensitive information in its possession. Should the nature of a transaction or assignment change along the way so that the transaction or assignment differs significantly from that which was submitted to the EC, the transaction or assignment should be submitted to the EC for re-assessment before the bank undertakes obligations to the customer in question in relation to the changed project. This is among other things in order to reveal any new conflicts of interest. The project manager is to prepare and send over a draft decision to the person appointed as responsible for convening the relevant members of the EC. Annex 2 to this recommendation contains an Example of a draft decision. The head of the bank or the person he/she appoints in his/her place is to convene a meeting and send a copy of the draft decision to the committee s members. Should the draft decision contain inside information, all the recipients are to be added to the bank s insider list when the draft decision is sent out. The committee members are in such case presumed to be aware that they are on such a list. If Compliance is not a member of the EC, Compliance must nonetheless be informed of any draft decision that is to be dealt with by the EC. The EC members are to assess the individual draft decision with the aim of revealing and discussing any conflicts of interest relating to their own department (and anything else that the member knows about). If the conflict is of major importance, the member should discuss this with the relevant project manager and Compliance before the EC meeting. 7

The assessment must be documented. Compliance should receive a copy of such documentation in order to be able to follow up its regulatory tasks. If the case is of an unusual nature or there is any disagreement in the EC, the documentation must be sent to the persons who actually attended the meeting. Otherwise, documentation is only to be sent to the project manager, who is to keep a copy in the project folder. 4. Examples of possible handling of conflicts of interest 4.1 Consent from the customer Provided the bank can inform the customer of a possible or existing conflict of interest without coming into conflict with the duty of confidentiality provisions, see item 4.3 below, the conflict of interest may be remedied by the customers involved expressly consenting to the execution of the assignments. 4.2 Separate deal team In those cases where the bank takes on competing assignments, the IB department should establish separate deal teams 4. A clear and documentable division should be established between the different teams, for example in the form of: physical separation the teams are to be located in different premises with strict access controls, including in connection with the attendance of external and internal parties at meetings; technical separation the teams are completely excluded from each other s IT systems, documentation and other internal and external communication; organisational separation the various teams report solely to the IB department s senior management; routines and internal controls. 4.3 Duty to state any conflicts of interest According to section 10-10 subsection 2 of the Securities Trading Act, if the measures taken to minimise the risk of conflicts of interest are not sufficient to protect the customer s interests in a satisfactory manner, the bank is to tell the customer of possible conflicts of interest. The bank cannot carry out business on behalf of the customer until the customer has received such information. In addition, section 9-25 of the Securities Trading Regulations states that the information is to be given in writing and be sufficiently detailed for the customer to make an informed choice with regard to the investment service or the ancillary service to which the conflict of interest relates. The information shall take into account the expertise, knowledge and experience of the customer. Such information to the customer may be used to handle both conflicts of interest that are transaction-specific and conflicts relating to the bank s general operations. That means that if the bank has identified a general conflict of interest that cannot be handled without harming a customer s interests, the customer may be notified of this in advance and before the situation becomes relevant, for example in the guidelines for handling conflicts of interest or in some other way. 4 In these cases, situations may arise in which conflicts of interest must be stated, refer to item 4.3 below. 8

If special conflicts of a more important nature arise in connection with a transaction and the customer has not previously been informed that his/her interests cannot be protected in a satisfactory manner, the customer must be notified separately before the bank carries out the transaction in question. The objective of this provision is to enable the customer to understand the nature of the risk linked to the possible conflict of interest so that the customer can make an informed decision as to whether he/she nonetheless wants the assignment to be carried out by the bank in question. General wording stating that there may be possible conflicts of interest will not comply with the duty to provide information. The rules concerning the duty of confidentiality always take precedence over the duty to provide information. This must be assessed in each case. If the bank has inside information that is relevant to the assignment, particular care must be shown with regard to fulfilling the duty to provide information. 4.4 Statement of roles and interests in documentation In those cases where the bank has several roles or interests linked to an assignment, the bank s different roles must, in so far as possible, be stated in relevant information to potential investors. If the bank is the lead manager for share issues in which all or some of the issue proceeds are to be used to repay debt to the bank, the bank must ensure that this factor is properly reported in relevant information to potential investors. 4.5 Competing assignments If the bank is, at the same time or within a short period, asked to take on lead manager assignments for several customers within the same industry and it will be natural to focus on the same investor group, there may be a potential conflict of interest in that some customers may be unfairly preferred. This will especially be the case if one assignment has a higher fee structure than the other(s). In such cases, the bank must clarify the situation with the affected customers. 4.6 Rejection of assignments In those cases where a conflict of interest cannot be kept to a minimum through the measures pursuant to section 9-11 subsection 1 no. 2 of the Securities Trading Act and the matter cannot be remedied through the duty to provide information pursuant to section 10-10 subsection 2 of the Securities Trading Act, the bank must refrain from accepting the assignment in question. In such cases, the bank should inform the potential customer as quickly as possible and return any information it has received on the assignment in question without being asked to do so. 9