Understanding Conflicts of Interest in Asset Management (OCC)
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.
