Conflicts of interest is generally seen as a necessary, but often ignored, aspect of investment firms’ compliance processes. This must change when firms start to apply the requirements set out in the MiFID II implementing regulations.
Investment firms operating under the EU Markets in Financial Instruments Directive (MiFID) are already required to consider and manage potential conflicts that arise between the firm and its clients, or between individual clients. This must include establishing and maintaining a detailed policy, taking steps to manage conflicts and, where that is not possible, disclosing them to clients.
With effect from January 2018, MiFID II must be implemented by firms. On an initial review, firms could be forgiven for thinking that very little is changing in relation to conflicts – certainly, the basic components remain largely similar to the current position.
A firm must still take in account situations where it:
- Will make a financial gain or avoid a loss, at the expense of a client;
- Has an interest in the outcome of a service provided to, or transaction carried out on behalf of, a client that is different from the client's interest;
- Has a financial or other incentive to favour the interest of one client or group of clients over the interests of another client;
- Carries on the same business as the client; or
- Receives an inducement from a third party in relation to a service provided to the client that is different from the standard commission for that particular service.
So what is changing?
Although the basic framework stays the same, there is a lot more detail in the requirements that will come into force under MiFID II. For example, MiFID II now requires firms to consider all risks, rather than just “material risk” as is currently the case. There is also an express recognition that firms are relying too heavily on disclosing, rather than managing, potential conflicts – this must now be avoided. Furthermore, where MiFID requires firms to describe how it manages conflicts and explain “such of” a list of steps “as are necessary and appropriate”, MiFID II will oblige firms to address how it will “prevent or manage” conflicts and cover “at least” each of these listed factors. The implementing rules also include a requirement that firms must review their policies, and provide a report to senior management on conflicts, at least annually.
Whilst these changes sound minor, the cumulative effect is that firms will need to look in a lot more detail at their policies, take much more detailed steps when seeking to identify and manage potential conflicts, and carefully review (and expand) the disclosures included in documentation.
New processes for corporate finance firms
In addition to the changes outlined above, there is a raft of new measures directed specifically at corporate finance firms. These changes, which are set out in articles 38 to 43 of the proposed implementing regulations, set out additional conflicts processes for firms offering corporate finance services, such as underwriting, pricing or placing of securities. MiFID II is far more prescriptive and detailed than the existing requirements specifically applying to UK corporate finance firms set out in Chapter 10.1 of SYSC.
When consulting on the implementing measures, ESMA made it clear that it saw specific risks arising from this sector and that it did not consider the existing powers to be sufficiently broad. The types of risks it identified included that firms may recommend an equity raising to repay borrowings from other parts of the same bank; encourage restructuring options that generate higher fees; or favour another client (or group of clients) of the sales desks when allocating shares under a placing or inviting bidders to join a syndicate.
Underwriting and Placing
Before accepting a mandate, firms must provide the issuer with a specific list of information, including the arrangements that are in place to prevent and manage conflicts, and the job titles and departments of the individuals involved in the provision of providing advice. This is intended to ensure issuer clients can make an informed decision.
Firms must ensure that the pricing of an offering does not promote the interests of other clients, or the firm’s interests, in a way that might give rise to conflicts. In addition, a firm must prevent or manage a person that is responsible for providing services to the firm’s investment clients, and which may be involved in the pricing of the offering.
As a result of these provisions, corporate finance firms will need to consider carefully how they offer their services and how they interact with other parts of the firm (or group); and also implement much more detailed policies on conflicts and deal allocations.
In reviewing your conflicts of interest processes in readiness for MiFID II compliance, the key take-away points are:
- Ensure that your existing procedures are sufficiently robust and expand them as necessary.
- Review and, as necessary, expand your register of conflicts (in particular to include all potential risks if you have only listed "material" ones).
- Provide conflicts training to staff to refresh their understanding on identifying conflicts and the correct policies and procedures to follow.
- Ensure procedures are set up so the conflict policy is reviewed at least annually, and preferably coincides with the compliance team's annual report back to the management board.
- Tighten up policies and procedures on disclosing conflicts so that disclosures are only made when strictly necessary, and not used as a default option.
- Ensure disclosure templates are updated with the level of detail required by MiFID II.