Samantha: Hello, this is Samantha Shares.
This episode covers Understanding Conflicts of Interest in Asset Management.
The following is an audio summary version of that document.
This podcast is educational and is not legal advice.
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And now the OCC summary.
Today we're diving deep into conflicts of interest in asset management.
Even though this guidance is primarily directed at banks, these
principle-based guidelines provide an excellent framework for credit unions
as well when managing conflicts in their asset management activities.
Managing conflicts of interest properly isn't just about checking regulatory
boxesâit's fundamental to maintaining trust with your clients and protecting
your institution's reputation.
Let's start by understanding what exactly constitutes a conflict
of interest in asset management.
According to the OCC handbook, "Conflicts of interest arise whenever a bank
engages in self-dealing and in any situation where a bank's ability to act
in the best interests of its account beneficiaries or clients is impaired."
The handbook explains that "Self-dealing occurs when a bank, as fiduciary,
engages in a transaction with itself or related parties and interests."
At the heart of fiduciary responsibility is the duty of loyalty, which the handbook
describes as "the most fundamental duty owed by a fiduciary to the
beneficiaries of a fiduciary account."
This involves administering the trust solely in the interest of the
beneficiaries and avoiding transactions that involve self-dealing or that
create conflicts between the trustee's fiduciary duties and personal interests.
So what are some common examples of conflicts of interest?
The handbook identifies several scenarios where conflicts may arise:
When a bank or its affiliate engages in a transaction with a fiduciary account.
For example, when a bank exercises investment discretion and places
fiduciary funds in an obligation of the bank or an affiliate.
Or when a bank places fiduciary assets in a proprietary investment product
managed by the bank or an affiliate.
Another common scenario is when a bank exercises investment discretion and
allocates fiduciary brokerage business to an affiliated broker-dealer, or
delegates investment discretion to organizations from which the bank receives
a direct or indirect financial benefit.
The handbook also mentions that conflicts arise when a bank doesn't
deal fairly with customers or collects fees that aren't disclosed, aren't
authorized, or are simply unreasonable.
Even employee compensation plans can create conflicts if they give
employees incentives to act against the best interests of fiduciary clients.
Let's talk about the specific types of risks that conflicts of interest present.
The handbook identifies four main categories: compliance risk, operational
risk, reputation risk, and strategic risk.
Compliance risk is obviousâconflicts of interest in fiduciary activities
are prohibited by numerous laws and regulations, except
under certain circumstances.
Improper conflicts can result in regulatory sanctions
and costly litigation.
Operational risk stems from potential misconduct by directors, officers,
and employees who administer asset management activities.
This includes improper use of inside information, improper transactions between
related parties, improper acceptance of gifts, or acceptance of co-fiduciary fees.
Reputation risk is particularly damaging for fiduciaries.
As the handbook notes, "A bank's reputation can be negatively affected
if the bank engages in, or appears to engage in, improper conflicts of
interest or self-dealing with respect to its asset management activities."
The expectation that a fiduciary acts in its beneficiaries' best interest is at the
core of the business, and damaging that trust can have far-reaching consequences.
Finally, strategic risk occurs because improper conflicts can undermine a
bank's growth and income strategy.
Many institutions rely on fee-based asset management as a stable
source of revenue, which depends on maintaining a satisfied customer base.
Now, let's talk about what proper risk management looks like when it comes
to handling conflicts of interest.
The handbook outlines several key components.
First, effective board and management supervision is essential.
The board of directors should adopt and promote an appropriate
corporate culture, including a code of ethics that sets expectations
for ethical behavior and compliance with banking and securities laws.
Second, institutions need comprehensive policies that address various
types of conflicts of interest that might occur in their specific
asset management activities.
These policies should reflect the bank's strategic direction, risk
tolerance levels, and ethical culture.
For example, banks are required to adopt policies addressing brokerage placement
practices, use of material inside information, and methods for preventing
self-dealing and conflicts of interest.
They also need policies for fair and equitable allocation of securities
when receiving orders for the same security at approximately the same time.
Third, an institution needs robust processes to implement these policies.
This includes processes for identifying potential conflicts in advance,
analyzing whether such activities are properly authorized, and monitoring
for relevant changes in circumstances.
The handbook emphasizes that "Even when authorized by applicable law, the
sale or transfer of an asset from a fiduciary account to a related party or
interest poses significant reputation and litigation risks to a bank fiduciary."
Such transactions should be approved by the board of directors
or a committee responsible for overseeing fiduciary activities.
Fourth, personnel need to be qualified and properly trained.
Management should recruit, develop, and retain qualified staff and
provide sufficient training and oversight to ensure employees
understand their obligations regarding conflicts of interest.
And fifth, effective control systems like audit and compliance functions are
necessary to assess the effectiveness of processes to manage conflicts of interest.
These systems should provide timely, accurate, and relevant information
about the nature and scope of actual and potential conflicts.
Let's discuss some specific scenarios that often create conflicts of interest
and how institutions should handle them.
One common situation involves self-deposits of fiduciary funds.
The handbook notes that "The primary supervisory concern with the
self-deposit of fiduciary funds is that a bank may fail to fulfill its
duties of undivided loyalty and care to fiduciary account beneficiaries
if the bank's interests conflict with those of its fiduciary clients."
While regulations permit self-deposit of funds awaiting investment or
distribution, banks must set aside collateral to secure deposits in
excess of FDIC insurance coverage.
Another important area involves proprietary investment products.
When a bank fiduciary invests in mutual funds or other products
sponsored or managed by the bank or an affiliate, there's an inherent
conflict because the bank benefits from fees generated by these products.
The handbook advises that "Before investing assets of a particular
account in a proprietary investment product, a bank fiduciary should
ascertain that all such conflicts are properly authorized and disclosed
in accordance with applicable law."
Brokerage allocation is another sensitive area.
The handbook states that "Allocating fiduciary business to a broker based
on the broker's deposits or other relationships with the bank, including
business referral arrangements, is an impermissible conflict of interest."
The handbook also addresses soft dollar arrangements, where a bank
receives research and brokerage services from broker-dealers in
exchange for directing client transactions to those broker-dealers.
This creates a conflict because the bank is using client assets to benefit itself.
The handbook advises that such arrangements must comply with the
safe harbor provisions established by securities laws and regulations.
Employee conduct is another critical aspect of managing conflicts of interest.
Banks should implement policies and procedures designed to prevent
employees from improperly benefiting from the bank's fiduciary activities.
This includes prohibitions on accepting gifts or bequests from fiduciary
clients and proper oversight of personal securities transactions.
Let me highlight a few key principles for handling these conflicts:
First, authorization.
Many conflicts of interest are permissible if properly authorized by applicable law,
which can include federal, state, or other jurisdictions' laws, the terms of the
governing instrument, or a court order.
The handbook emphasizes that "Mere authorization of a conflict of interest
by applicable law does not make a particular decision by a fiduciary
appropriate, prudent, or in the best interest of the fiduciary account."
Second, disclosure.
Even when conflicts are authorized, full disclosure to
interested parties is essential.
As the handbook notes, "Even if not required by applicable law, full
disclosure of conflicts of interest and fees related to investments in funds from
which a bank receives fees is considered a safe and sound banking practice."
Third, fairness and reasonableness.
Any fees charged must be reasonable, and transactions must be fair to
the fiduciary accounts involved.
For example, when discussing fees, the handbook states that "if a bank's
compensation for acting in a fiduciary capacity is not set or governed by
applicable law, the bank may charge a reasonable fee for its services."
And fourth, best interest of the client.
All decisions must ultimately be made with the best interest of the client in mind.
The handbook emphasizes that "A bank fiduciary exercising investment discretion
that makes a long-term investment in a self-deposit is engaged in prohibited
self-dealing unless the investment is authorized by applicable law."
Let's talk briefly about proper oversight of conflicts of interest.
Banks should conduct thorough due diligence before entering into any
arrangement that could create a conflict.
The handbook advises that "Before entering into such arrangements, the
arrangements should be reviewed by legal counsel and approved by the
committee of the board of directors responsible for fiduciary oversight."
Ongoing monitoring is equally important.
The handbook states that "These arrangements should be reviewed
periodically to ensure that they are properly authorized under applicable
law, disclosed in accordance with applicable law, and do not impair
the bank's ability to properly exercise its fiduciary duties."
Effective management information systems are also essential.
According to the handbook, "A bank's MIS and related processes should provide
adequate information to alert staff to potential and actual conflicts of
interest and self-dealing activities and ensure that exceptions to applicable
law, including bank policies, are reported to the appropriate officers,
employees, and supervisory committees."
And of course, a robust audit program is vital to ensuring that controls
and processes are working properly.
The board of directors must assess whether audit programs are adequate
to determine if conflicts of interest are managed in accordance with
applicable law and bank policies.
So what happens when a bank identifies a potential conflict of interest?
The handbook advises that "A bank's risk management processes should require that
exceptions to bank policy or exceptions that are in excess of the bank's risk
appetite are identified and escalated to a designated committee of the board
of directors responsible for fiduciary oversight or a designated senior
manager for resolution or approval."
Before we wrap up, I want to emphasize that managing conflicts of interest
effectively is not just about complying with regulationsâit's about maintaining
trust with your clients and protecting your institution's reputation.
The handbook acknowledges this when it states that "A bank's reputation as a
fiduciary or provider of asset management services may also affect deposit accounts,
loan relationships, corporate clients, and other banking relationships."
Improper conflicts of interest can undermine client trust and
have far-reaching consequences for your entire organization.
In conclusion, conflicts of interest are inherent in asset management activities,
but they can be managed effectively with proper authorization, disclosure,
oversight, and a commitment to acting in the best interest of clients.
By implementing robust policies, processes, and controls,
institutions can navigate these complex issues successfully.
This concludes the summary.
If your Credit union could use assistance with your exam, reach out to Mark Treichel
on LinkedIn, or at MarkTreichel.com.
This is Samantha Shares and we Thank you for listening.