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27 March 2009
Conflicts of Interest
Financial Market Supervisory Authority Report
'Distribution compensation' is the term used to describe practices whereby banks or independent asset managers receive benefits from the originators of financial products in exchange for their distribution services. Such distribution compensation may consist of direct or indirect financial benefits (eg, rebates), payments in kind or services such as access to the results of studies or analysis. Where the distribution partners also have loyalty duties towards their clients, conflicts of interest can arise.
The Financial Market Supervisory Authority recently published its report on these issues. The report follows a discussion paper drafted by the former Federal Banking Commission which evaluated ways to identify possible conflicts of interest and the protection of clients from the consequences of these conflicts. The further question of who should benefit from distribution compensation was also addressed.
Conflicts of Interest
It is often difficult for clients to assess the evolution of their assets because this evolution depends on numerous factors (eg, the choice and implementation of investment strategy), and because the client has no appropriate benchmark available with which to compare his or her assets' performance. According to the Federal Banking Commission, the risk of the existence of conflicts of interest which the client cannot identify is particularly high in asset management because all activities – whether related to the provision of advice, portfolio management or brokerage – are invoiced jointly. Additionally, the client is often unable to distinguish factors relating to the asset manager's performance from those related to general market evolution. Clients and asset managers or banks have unequal access to information: institutions know more about the financial products, while their clients know more about the background of their assets. For clients, it is often impossible to ascertain where the asset manager or bank's interests diverge from their own, and whether the bank or asset manager is aware of this divergence.
Investment advisory services
Banks usually provide advisory services on investments free of charge for small and medium-sized investors, in the hope that the client will subsequently use their brokerage services. Thus, regardless of the bank's intentions, it is in its interests to offer advice which will satisfy the client's short-term aims but ultimately lead the client to consider making further purchases and sales (for which a brokerage agent will be required) in the medium and long term.
In 'execution-only' services, the investor gives precise selling or buying orders to a broker or bank which executes them against compensation related to the transaction. The Federal Banking Commission does not consider there to be any specific conflicts of interests inherent to such operations, except where clients require other services from the broker or bank (eg, research or investment advice services).
Internal conflicts of interest within banks
Banks face conflicts of interest not only between the positions of their clients and the positions of the originators of financial products; they also often face internal conflicts of interest between different business units or employees. From a regulatory point of view, such internal aspects are very difficult to regulate since these conflicts often arise out of informal, hidden or unconscious mechanisms. Problems arise where all elements of the supply chain of products – from origination to distribution – are the responsibility of the same bank. Indeed, according to the discussion paper, the more diversified a bank is, the more likely it is to face internal conflicts of interest. Thus, banks offering asset management services only are less subject to conflicts of interest than full-service banks. Indeed, where an institution's asset-management activity is considered to have priority over its production of financial products, that institution is likely to be less tempted to sell its own products to the client.
According to the Federal Banking Commission discussion paper, such internal conflicts of interest mainly arise in full-service banks. The client advisers and portfolio managers of such banks might be induced to sell financial products created by the bank. This may be harmful to the bank's clients if the products of the bank are more expensive or of lower quality than those of competitors. However, the need to compete in the market should mean that banks have no interest in creating more expensive or lower-quality products. Nevertheless, home products remain favoured, in particular due to informal incentives (eg, sales or advice documents are easily available to the client advisers or portfolio managers).
While 'execution-only' relationships qualify as either a mandate or sale agreement depending on the circumstances, under Swiss law asset management contracts and investment advice contracts are clearly subject to the rules on mandate agreement. The agent is therefore obliged to: (i) submit, upon request and at any time, a full report accounting the performance of his or her obligations; and (ii) deliver whatever has come into his or her possession in the course of the performance of the mandate to the client.
In March 2006 the Federal Supreme Court ruled that this second obligation applied to compensation received by an asset manager because he undertook certain specific operations in the course of the mandate. The client can waive such rights to delivery in favour of the agent only if fully and accurately informed of the compensation. The court specified that the agent's second obligation did not apply to compensation received during the execution of the mandate, but which was not directly linked to it. However, the difficulty in ascertaining where to draw this line has given rise to extensive discussion among legal commentators.
A certain number of banks have adapted their contracts and general terms and conditions in order to inform their clients of the potential existence of compensation and conflicts of interest, thus enabling their clients, via different systems, to identify the compensation. In most cases the client must agree that his or her right to that compensation is waived.
Regulatory law and self-regulation
The Federal Banking Commission's practice established a general duty of information and loyalty of banks on the basis of the requirement for unquestionable commercial activities provided by the Federal Banking Act. The discussion paper also mentions the self-regulated client information rules of the Association of Asset Managers. More precise rules on the information to be provided to investors regarding distribution compensation can be found in the Collective Investment Schemes Act and in the Securities Exchanges and Securities Trading Act.
For collective investment schemes, a duty of loyalty obliges the holders of an authorization to inform on all costs linked to the management of the collective investment through the 'total expense ratio'. Additionally, only the compensation foreseen in the documents relative to those products can be credited to the holders of an authorization when buying or selling a product, whether for themselves or for third parties.
For securities dealers (and most of the banks authorized in Switzerland are also regulated securities dealers), Article 11 of the Securities Exchanges and Securities Trading Act imposes a duty of information, diligence and loyalty. This includes the obligation to inform on the risks linked to a particular operation, taking into consideration the knowledge of the client. These obligations are detailed by the Code of Conduct for Securities Dealers of the Swiss Bankers Association and have been recognized by the Federal Banking Commission as minimum standards.
The Federal Banking Commission's investigations revealed no clear distortion of discretionary asset management through distribution compensation, since asset managers have only an indirect effect on the choice of products. The duty of loyalty required by both civil and regulatory law also suppport this conclusion. However, because most financial products are proposed and sold by distribution partners ('pushing') rather than requested by the clients ('pulling'), possible conflicts of interest remain. Hence, the discussion paper proposed a series of possible measures.
The first option would be to rely on the civil law rules. The advantage of this approach is that civil law procedures apply to any distributor, irrespective of whether it is a regulated financial intermediary. However, the global trend is for regulatory measures to apply in addition to civil law. Furthermore, the evidence collection necessary for civil law proceedings can be very costly.
The discussion paper excludes both the total prohibition and the obligation to transfer to the client all distribution compensations.
Additional transparency requirements
The discussion paper notes that transparency offers a limited solution since small and medium-sized investors often have neither the knowledge nor the market power to react to an increased level of information.
However, additional transparency requirements are considered by the discussion paper as a means to raise awareness of conflicts of interest, thereby increasing understanding and the trust in the distribution system. Several possibilities are considered:
However, additional transparency requirements would create problems if they were to be imposed upon the producers of financial products.
On the other hand, transparency information at the point of sale can be provided by product or by class of products, either at the date of the transaction or subsequently, whether freely volunteered or upon demand. However, such information obligations, especially if product specific, would impose a high burden upon the seller.
Organizational measures in relation to conflicts of interest
Such measures, aimed mainly at avoiding internal conflicts of interest, would be difficult to implement given the differences in size and structure of the entities involved. Regulators and self-regulators have excluded such measures in view of this difficulty.
Financial Market Supervisory Authority Report
The Financial Market Supervisory Authority decided to increase transparency at the point-of-sale level by including a section on asset managers' compensation in the newly released circular on the assets management framework rules (in force since January 1 2009).
The asset manager must lay down in writing the nature, conditions and elements of his or her compensation, as well as specifying who exactly benefits from the compensation. The asset manager must also clearly indicate to the client the possible conflicts of interest that might result from compensation paid to third parties. The calculation parameters or the values range of the services obtained from third parties must also be disclosed to the clients, by product category, so far as is possible. Upon request, the asset manager must indicate the level of compensation already received (eg, finder's fees), as far as those can be related to a specific client. In addition, the Swiss Bankers Association must align its self-regulatory rules on asset managers' compensation to those in the Financial Market Supervisory Authority's recent circular.
For further information on this topic please contact Christophe Rapin or Christophe Petermann or Clemens Streit at Pestalozzi Attorneys at Law by telephone (+41 22 737 1000) or by fax (+41 22 737 1001) or by email (firstname.lastname@example.org or email@example.com or firstname.lastname@example.org).
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