Regulation of Conflict of Interests and the Impact of the Current Reforms - Coursework Example

CRITICALLY EXAMINE THE REGULATION OF CONFLICT OF INTERESTS WITHIN FINANCIAL INVESTMENT FIRMS UNDER THE MIFID AND CONSIDER THE IMPACT OF THE CURRENT REFORMS Name Institution + City Professor Course Date Submitted Critically Examine the Regulation of Conflict of Interests within Financial Investment Firms under the MiFID and Consider the Impact of the Current Reforms Conflict of interest refers to a scenario that has the capability to undermine the impartiality of an individual because of the probability of a clash between the public interest or professional interest and personal self interest. In such situations, a person’s responsibility to a second person limits his ability to carry out his responsibility to a third individual. Outcome 3.3, 3.1 and 3.2 in Chapter 3 outline the schemes and controls that one must have in place to enable him determine and analyze potential conflicts of interests (Oostwouder 2008, 60). Outcome 3.2 lays the controls and systems that one needs to recognize “Own Interest of Conflict”. These are appropriate to the complexity and size of one’s practice in addition to the nature of work one undertakes. Outcome 3.3 outlines the controls and systems that one needs to identify “Client Conflict of Interest”. Rule 5.01 within the 2007 Code requires that one needs to make arrangements for the efficient management of the whole firm and provide identification of possible conflicts of interest (Oostwouder 2008, 60). In order for investment firms to meet obligations under MiFID in relation to conflict of interest, they must identify the circumstances that may result in conflicts of interest that entail material risk of damage to their client’s interests (Baker 2009, 353). They must establish appropriate systems and mechanisms to handle such conflicts. Additionally, they need to maintain the identified systems in order to curtail damage to interest of their clients through identical conflicts. Investment firms need to appreciate hat conflicts of interest can come up in the course of their transactions with any of their clients when the transaction involves provision of MiFID investment activity or service to a client. For comprehensive understanding of management of conflict under MiFID, it is necessary to have a complete knowledge of the nature of MiFID activities and services (Ramlogan & Persadie 2011, 39). MiFID services and activities include execution of orders on behalf of a client. Dealing on own account is another MiFID service and activity. In addition, there is portfolio management as a MiFID service. Another service that subscribes to the list of MiFID services is transmission and reception of orders in relation to financial instruments. Furthermore, investment advice and Operation of Multilateral Trading Facilities are the other services that fall under this category. Finally, placing a firm’s financial instruments without its commitment is another service (Droutsas 2012, 70). MiFID regulations on managing and preventing conflict of interest apply in all cases regardless of the clientele type the service is offered. The rules remain whether the client is a retailer, an Eligible Counterparty or a professional. Investment firms categorize the range of conflict of interest that can affect them into two classes. Foremost, there are the conflicts of interest that arise between relevant persons and the client. In this case, a relevant person refers to a partner, a manager, a director or any other equivalent of the firm (Droutsas 2012, 70). It could also mean an employee of the corporation as well as any other natural person whose products and services are placed under the control and at the disposal of the firm. The person must be involved by the firm in the provision of investment activities and services (Williams 2006, 514). Further, the relevant person could be any natural person tied as an agent under an agreement to outsource for the purpose of provision of investment activities and services or directly involved in the provision of the essential services and activities of the firm’s investment. In an event that the relevant person is an outsourcee, the law provides that the party becomes compliant with the MiFID policy by making it a condition of the agreement to outsource. In this context, partner refers to partner of the partnership, and not joint venture partners (Williams 2006, 514). MiFID Policy manages specific conflicts of interest in investment firms. There are three areas that are generally considered in this situation. Foremost, MiFID prevents and manages conflicts of interest that may be associated with inducements. Under MiFID, the term “inducements” cover a wide range of payments. It includes commissions, fees and other monetary benefits received or paid by an investment firm in relation to carried out MiFID services and activities. A payment that does not belong to the inducements category may still bear risks of material damage to interest of a client. Such payments still offer a relevant situation of conflict of interest and must be managed. For instance, an internal bonus arrangement for employees of an investment firm based on performance degrees may prompt a member of staff to favor one patron over another (Cheffins 2008, 70). MiFID prevents conflict of interest in the sector of inducements by providing three conditions for payment. It provides that all commissions, fees and other non-monetary payments by an investment firm or any relevant party to a person acting on behalf of third party or the third party itself are prohibited unless three fundamental conditions are met. Foremost, there must be a method of calculating the inducement and this needs to be disclosed to the client. This must done in a way that is understandable, accurate and comprehensive prior to providing the services. Existence of the inducements must be known on time and its nature, amount or whether it is non-monetary must be communicated clearly (Cheffins 2008, 70). Secondly, inducements need to be paid to enhance the quality of service to the client. This must be communicated on time and the party paying on behalf of the investment firm needs to communicate this on time to avoid conflict of interest (British Columbia 2009, 196). Finally, the inducement that an investment firm makes to its clients should not impair the firm’s duty to take action in the best interest of the client. An investment firm has the right to disclose essential arrangements related to commissions, fees and other non-monetary payments to the client in a summary form. It needs to signify that it is willing to disclose further details to the client upon request. The summary disclosure must contain sufficient information to enable the patron to relate a particular payment to a MiFID service or activity (Rollings 2007, 1968). The client needs to know the products to which the service relates and be able to make informed judgment on whether or not to ask for more detailed information on commissions, fees and non-monetary benefits offered. In order to prevent cases of conflict of interest, MiFID outlines some of the inducements that are acceptable in transactions between an investment firm and its clients. Other than the aforementioned commissions, fees and non-monetary benefits, MiFID recognizes proper fees as the other alternative mode of payment (British Merchant & Hubbard 2006, 675). Proper fees are necessary and enable an investment firm to provide investment services such as settlement and exchange fees, custody costs legal fees and regulatory levies. Proper fees cannot, by their nature, give rise to conflicts with the investment firm’s duties to act fairly, truthfully and competently according to the clients’ best interest. Other than controlling and managing inducements to ensure elimination of conflicts of interest, MiFID regulates non-independent research (British Virgin Islands 2011, 76). Whenever an investment firm produces and disseminates information or research suggesting or recommending an investment strategy that does not fall under MiFID’s definition of investment research, such publications are referred to as “Marketing Communication” (Chittenden, Foster & Sloan 2010, 560). Such information relate to a single or a number of financial instruments admitted to regulated markets or trading. Additionally, the publications are often intended for distribution to and are usually likely to be accessible by a large portion of the population. In order to prevent conflict of interest, MiFID laws and regulations require that such non-independent researches put forth by investment firms be marked as marketing communication (Cornish & Phillips 2008, 490). In addition to marking such publications as marketing communications, they should contain prominent and clear statement it is not prepared in harmony with the legal guidelines put in place to promote autonomy of investment research (Yates & Devries 2012, 465). The investment firm also needs to make it clear that such publications are not subject to any form of prohibition on dealing ahead of the distribution of the investment research. Finally, MiFID has the mandate to control and prevent conflict of interest by managing personal transactions and personal account dealing. An investment firm is required to develop, implement and maintain sufficient arrangements targeted at preventing relevant persons from conducting certain activities that could allow manifestation of conflict of interest. The relevant persons may not engage in activities that have the capacity to give rise to situations of conflict of interest. Additionally, the relevant persons may not have access to confidential information or inside information related to clients and transactions for and with clients by virtue of activities carried out by the relevant person on behalf of the investment firm. According to MiFID, inside information refers to information that is precise in nature that has not been made public and directly or indirectly relates to a single or a number of issuers of financial instruments (Pinto 2014, 23). If such information is made unrestricted, it would probably have significant effect on the prices of related derivative financial instruments and the financial instruments. For this reason, MiFID prohibits information such as engaging into a personal transaction that meets albeit one of the following criteria: The relevant person is prohibited from engaging in the transaction under the European Union Market Abuse Directive It involves improper disclosure and misuse of confidential information It is likely to conflict or conflicts with commitment under the regulatory system or MiFID that the investment firm is subject to (Avgousleas 2005,65) Relevant persons are not allowed by MiFID regulations to advise or procure for the investment firm other than in the proper manner according to his employment and contract agreements. No persons acting on behalf of the investment firm may enter into a transaction in a designated investment (Alfred 2009, 76). MiFID sets criteria that describe personal transaction that would mean a breach to contract terms and conditions. It offers an explanation that a personal transaction refers to a commercial transaction in a designated investment conducted on behalf of or by a relevant person when the relevant person acts out of the scope of he should carry out in his capacity as the firm’s employee. Such a transaction is carried out for the relevant person or any person with whom the relevant person has family relationship or close links. Additionally, the transaction could be carried out on the account of a person with whom the relevant person has indirect or direct material interest upon a successful outcome of the trade other than commission, fees and other non-monetary benefits. As much as MiFID does all it can to thwart and control conflict of interest in investment firms, there are certain circumstances under which the restrictions on personal transactions does not apply. Foremost, there are the personal transactions conducted under unrestricted portfolio management service. The exclusion applies where there is no prior communication related to the transaction between the relevant person and the portfolio manager. MiFID regulations do not also apply to personal transactions in unit’s equivalent joint investment schemes or UCITS (Simon 1996, 789). This is where the relevant person or any other individual for whose account the commercial transaction are executed are not whatsoever involved in the management of the scheme. Investment firms ensure that all persons covered in the personal transaction directly or indirectly are aware of the restrictions provided for in MiFID on personal transactions. The policy provides that internal measures be implemented in relation to disclosure and personal accounts. Firms also place measures that ensure they are promptly informed of any personal transactions that their employees and partners engage in. investment firms place stringent measures that inform their systems either through a notification of the transaction or laying down efficient procedures that identify such transactions (Weiss 2006 678). MiFID cannot be effective unless the investment firms take the step to ensure they curtail conflict of interest associated with personal transactions. They, therefore, keep records of personal transactions it is notified of or that it identifies. It avoids mistakes done by such transactions by keeping clear records of decisions taken in terms of prohibitions or authorizations in addition to disciplinary actions taken against offenders (Weiss 2006 678). For a long time, English law has had a tradition of ascertaining high standards on persons many regard as fiduciaries. Fiduciaries include any businesses and professionals whose clients entrust the conduct of their affairs. The duties imposed on these fiduciary institutions are onerous. This flows from the principle that fiduciaries owe a duty of loyalty to their clients. Investment institutions are as such fiduciaries (Banks 2012, 23). From the discussion of the manner in which MiFID manages and prevents conflicts of interest, it is evident that fiduciaries must not place themselves in scenarios where their own interests conflict with those of its customers. MiFID avoids situation where investment firms profit from their position at the expense of its clients (Ferrarini & Moloney 2012, 580). Investment firms owe undivided loyalty to its customers. MiFID Policy acknowledges this and labors to avoid a situation where this duty towards one or a portion of the customers conflicts with the duty it owes other clients. This is the undivided loyalty rule. Therefore, if followed, MiFID does a commendable job in ensuring it eliminates conflict of interest. Impact of MiFID The impact of the initial MiFID released in 2007 directive was significant within the operational areas of processes, people, organizations and systems. Within the two year period preceding the transposition financial institutions began training for their workforce, there existed conflict of interest. Further, Information Technology applications and organizations were modified to conform to transparency requirements of MiFID. Additionally, the modification enabled reporting to be done to both regulatory authorities and market participants. Other than these initial impacts of MiFID, there were other effects of the second phase of MiFID released in 2011. It had impacts on a select group of market participants including Retail and Private Banks, Investment Banks, Market Makers, Exchanges and Broker Dealers (Ferrarini & Moloney 2012, 580). In an assessment of the impacts of MiFID II on these market participants, some interesting findings cropped up. This task looks at some of the impacts of the regulation on Private Banks, Exchanges, Investment Banks and Retail Banks. Investment Bank In the assessment, operational diagrams show that Investment Banks have loads of work to do in order to bridge the gap that results from the change of situation with MiFID II. A wide range of services and financial services of an investment bank are potential targets of MiFID II. This is due to the nature of investment banks of intensive cross-border business models and diverse clientele portfolio. As a result of the nature of investment banks, MiFID touches on several operational areas ranging from reporting applications and crossing systems to fiduciary policies and Know Your Customer (KYC) processes (Veselinovic & Albreht 2008, 80). Investment Banks provide several intricate services and products such as Portfolio Management and financial advisory that have direct relation with some of the enhancements of MiFID II topics. These services and products have direct relation to conflict of interest, inducements and segregation of clients’ assets. Investment Banks must implement some significant changes to conform to the regulations of MiFID II. This is especially so in the Organizational Requirements and Conduct of Business domain. Retail and Private Banks Financial institutions such as private banks and retail banks have the obligation to focus on their existing customers. Under the revised MiFID directive, the customers of such banks have the right to receive the most protection. MiFID directive provides for stringent requirements in terms of transparency, disclosure and communication. However, some of the changes provided for in the revised MiFID might have insignificant impacts on the private and retail banks. Such proposals include the New Market Structure requirement among other requirements. In the event that a private or retail bank has outsourced their order execution capability, the revised MiFID stops being a concern to such a financial institution. For instance, in an event where a bank has introduced an Organized Trading Facility, MiFID ceases to be a major concern (Davies, Worthington, Micheler & Gower 2012,89). MiFID does not, therefore, have an effect on such a financial institution. Similarly, dynamics experienced in the transparency domain benefit retail banks and private banks due to the introduction of ARM (Approved Reporting Mechanism). As a result of availability of this service, there arise improvements in costs and quality. By and large, the efforts to close the revised MiFID gap for private and retail banks are fundamentally limited to Organizational Requirements and Conduct of Business (Forde & Kennedy 2007). These two domains have strengthened retail customer protection. Additionally, the domains have induced interest changes for services and products such as portfolio management and investment advice. Exchanges Existing exchanges such as Multilateral Trading Facilities and Regulated Markets have received considerable attention in the MiFID directive. There are significant alignment market surveillance rules and organizational requirements for execution venue to detect market abuse and ascertain continuity (Tricker 2012, 654). Additionally, Approved Reporting Mechanism and Approved Publication Arrangement for reporting of transactions introduce further requirements to people, systems, organizations and processes within operational model of a particular Exchange. Coupled with enhanced Best Execution Requirements, Exchanges have a great deal of a task to conform to the requirements of MiFID. An assessment of the impact of the MiFID specifications indicate that the regulations impact the financial industry on varied scales depending on the industry segment. This is because all industry segments have specific guidelines and regulations at international and national level (Beale & Chitty 2010,576). Ascertaining the effects of MiFID on any particular industry first considers detailed assessment of the rules and regulations of the industry. Reference List OOSTWOUDER, W. (2008). The implementation of the MiFID in the Netherlands: mission accomplished? European Company Law. 5, 58-67. BAKER, L. C. (2009). Monitor and manage: MiFID and power in the regulation of EU financial markets. Yearbook of European Law. 27, 349-386. STAIKOURAS, P. K. (2014). A novel reasoning of the UK Supreme Court decision in "Lehman Brothers": the MiFID segregation rule from the angle of financial intermediation and regulation theory. The Journal of Business Law. 2014, 97-120. DROUTSAS, D. P. (2012). 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