Conflicts of interest in the banking sector: prevention and management

Banking institutions often wear many hats: lender, shareholder, securities distributor, advisor, etc. This inherent versatility creates fertile ground for the emergence of conflicts of interest. High-profile cases such as the Enron scandal in the United States and the LVMH v Morgan Stanley dispute in France have painfully highlighted the considerable risks associated with inadequate prevention and management of such situations. Understanding the nature of these conflicts and the mechanisms put in place to manage them is essential for both customers and the institutions themselves.

The concept and issues surrounding conflicts of interest

Legal definition and regulatory framework

A conflict of interest arises when a person or entity is faced with conflicting demands between its own interests and the duties it owes to others, or between the divergent interests of several parties to whom it owes a duty of loyalty. In the banking sector, this typically occurs when the bank's own interests conflict with those of a customer, or when the interests of two different customers conflict and the bank is involved with both. As P.-F. Cuif points out, this is a "situation in which a person's personal interests are in opposition to his duties", a situation which in principle calls for duties to take precedence over personal interests (RTD com. 2005, p. 1).

Awareness of these issues increased in the early 2000s, catalysed by major financial scandals. The regulatory response was significant. In the United States, the Sarbanes-Oxley Act of 2002 introduced stricter rules. In Europe, the Market Abuse Directive (2003/6/EC) was a first step, requiring financial analysts to disclose their interests and potential conflicts of interest.

The Markets in Financial Instruments Directive (MiFID), initially adopted in 2004 (2004/39/EC) and since recast (MiFID 2 - 2014/65/EU), has considerably strengthened the system. Article 23 of MiFID (echoing the spirit of Article 18 of MiFID 1) requires investment firms to take "all reasonable steps to identify conflicts of interest" and, if organisational measures are not sufficient to ensure with reasonable certainty that the risk of damage to clients' interests will be avoided, to "clearly inform clients, before acting on their behalf, of the general nature and/or source of such conflicts of interest".

Transposition into French law

French law has incorporated these requirements, mainly in the Monetary and Financial Code. Article L. 533-10 of this code requires investment services providers (ISPs), a category that includes many banks, to maintain "effective organisational and administrative arrangements" and to take "all appropriate measures to detect, avoid or manage conflicts of interest". The purpose of this obligation is to protect clients against potential harm to their interests as a result of such conflicts. Understanding the bank liability as an investment services provider is therefore essential in this context, as failures in the management of conflicts and ISPs can have serious consequences for the company.

The LVMH v Morgan Stanley case marked a turning point in French case law. The conviction of the bank for having published unfavourable financial analyses on LVMH while advising a competitor (Gucci) underlined the importance of rigorous conflict management, even in the absence of specific regulations as detailed as today. The Paris Court of Appeal (30 June 2006) upheld the conviction on the grounds of civil liability (formerly articles 1382 and 1383 of the Civil Code, now articles 1240 and 1241), demonstrating that breaches of ethics can have significant financial consequences.

Typology of banking conflicts of interest

Conflicts of interest in the banking sector fall into two broad categories.

Disputes between the bank and its customer

These conflicts arise when the bank is likely to prioritise its own interests (commercial, financial) to the detriment of those of its customer. Several scenarios illustrate this tension:

• Financing and advice at odds A bank that finances a company may be tempted to adjust its investment or restructuring advice to preserve its own debt, even if this is not in the client's best interests.
• Home-made products Active promotion of financial products (UCITS, structured products, unit-linked life insurance) designed or managed by the bank or its subsidiaries may create a conflict if these products perform less well or are riskier than external alternatives, but generate more income for the bank.
• Role as shareholder and lender When a bank holds a significant stake in a client company, its lending decisions can be influenced by its interests as a shareholder, blurring the lines between the two roles.
• Asymmetric information The bank often has more information than its customer about the markets or specific products. It may be tempted to use this asymmetry to its advantage, for example by not disclosing all the risks of an investment. The conflict between bank and customer is a complex reality to manage.

Disputes between several of the bank's customers

The bank may also find itself caught between the conflicting interests of two or more of its customers. Its central position and access to confidential information about each of them make these situations particularly delicate:

• Market transactions (M&A) A bank advising a target company on an M&A deal while at the same time financing the potential buyer, or advising both parties, is in a clear conflict of interest.
• Financing competitors Financing two companies that are direct competitors in the same market can pose a problem if the bank uses information obtained from one customer to benefit the other, or if its financing decisions favour one to the detriment of the other.
• Intermediation Advising a client on the acquisition of an asset (property, business) belonging to another client of the bank requires careful management to avoid favouring one of the parties.
• Asset management and financial analysis A bank whose asset management department holds significant positions in a company may see its financial analysis department encouraged to publish favourable recommendations on this company, to the detriment of the objectivity due to other investor clients.

The organisational complexity of large banking groups, with their many subsidiaries and specialised departments, makes the detection and management of these inter-customer conflicts particularly difficult, as J. Stoufflet has pointed out.

Prevention and management solutions and systems

In response to these risks, regulations and professional practices have developed a number of prevention and management mechanisms.

The Chinese Walls

Organisational segregation is the most fundamental preventive measure. Chinese walls" refer to the set of procedures designed to establish a watertight separation between the various departments or activities of a financial institution to prevent the inappropriate circulation of confidential or privileged information. For example, the M&A advisory department must be isolated from the financing or financial analysis departments.

The AFEI/FBF (Association Française des Entreprises d'Investissement / Fédération Bancaire Française) code of conduct on investment research clearly states this principle: "In order to prevent the undue circulation of confidential and/or privileged information [...] the investment services provider must put in place [...] procedures known as 'Chinese Walls'".

This physical and informational compartmentalisation is based on the "need to know" principle: sensitive information is only communicated to those employees whose job imperatively requires it. The effectiveness of these walls depends on the rigour of their implementation and internal control.

Customer information and consent

When organisational measures are not sufficient to eliminate all risk of conflict, transparent client information becomes a legal obligation. Article L. 533-10 of the Monetary and Financial Code requires ISPs to "clearly" inform clients "of the general nature and/or source of these conflicts of interest" before acting on their behalf.

This information must be :

• Prerequisite Before the operation in question is carried out.
• Clear and precise The customer's understanding of the nature of the conflict.
• On a durable base To leave a record for future reference.
• Sufficiently detailed Taking into account the nature of the customer (professional or non-professional), to enable them to make an informed decision.

In some cases, the customer's explicit consent may be required for the bank to act despite the identified conflict.

Specific rules for certain activities

More specific rules apply to certain particularly exposed activities:

• Financial analysis To guarantee the objectivity of recommendations, strict rules govern the independence of analysts (separation from the investment bank, rules on remuneration, control of communications with issuers).
• Investment advice ISPs must assess the suitability of the products offered to the client's profile (knowledge, experience, financial situation, objectives) and, if necessary, warn the client.
• Management on behalf of third parties The obligations have been strengthened to ensure that the manager does not favour the interests of the bank or other clients to the detriment of the principal.

The role of the compliance officer and internal control

The role of compliance officer has become central to financial institutions. They are responsible for :

• Implementing and supervising conflict management procedures.
• Detect risk situations.
• Advising and training employees.
• Ensuring respect for the "Chinese walls".

The internal control system must actively monitor potential conflicts of interest and verify the effectiveness of the measures put in place.

It should be noted that Article L. 511-34, 4° of the Monetary and Financial Code provides for a limited exception, authorising the transmission of confidential information between entities in the same group if this is strictly necessary for the management of conflicts of interest at group level. The question of responsibility and conflicts of interest is complex and requires constant vigilance.

Managing conflicts of interest is an ongoing challenge for the banking sector. If you are faced with a situation where you suspect a conflict of interest has affected your rights, the assistance of a banking lawyer can be decisive in analysing the situation and defending your interests. Do not hesitate to contact our firm for an assessment of your case.

Sources

• Monetary and Financial Code, in particular articles L. 511-33, L. 511-34, L. 533-10.
• Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (MiFID 2).
• Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse.
• P.-F. Cuif, "Le conflit d'intérêts, Essai sur la détermination d'un principe juridique en droit privé", RTD com. 2005, p. 1.
• J. Stoufflet, "Conflits d'intérêts dans l'activité bancaire", Estudios juridicos en memoria del professor Rodolfo Mezzema Alvarez, Ed. Fondacion de Cultura universatoria, Montevideo, Uruguay, 1999.
• Paris Court of Appeal, 30 June 2006, Morgan Stanley v LVMH.
• ACPR Recommendation No. 2011-R-03 of 6 May 2011.
• AFEI/FBF code of conduct on managing conflicts of interest in financial analysis.