22 March 2016

ASIC puts the spotlight on vertical integration

This article was written by Nathan Hodge.

In recent times, ASIC’s position has been that there are benefits to vertical integration, but conflicts needs to be appropriately managed. After completing its surveillance project in 2015, ASIC yesterday released its findings on conflicts in vertically integrated structures in Report 474: Culture, conduct and conflicts of interest in vertically integrated businesses in the funds management industry. The Report outlines common types of conflicts that it saw, contains comments on both good and bad practices, as well as some important commentary on culture.

While issues of vertical integration have tended to be viewed at a group / cross industry level, the Report focuses on these issues at an entity level and specifically excludes deposit-taking, insurance and financial advice businesses. That said, many of ASIC’s comments will be directly relevant to groups containing these entities.

Superannuation trustees will need to consider the Report, together with the results of APRA’s thematic review of conflicts published in 2015.

ASIC’s work on culture

2015 saw ASIC start to discuss the importance of culture from a regulatory perspective, but gave little explanation of what it meant by “culture” or reasons for its importance. The Report explains that, in ASIC’s view, poor culture is both an indicator and driver of “poor conduct” – that is, inappropriate, unethical or unlawful behaviour. Accordingly, when looking at culture, ASIC is looking at more than just a “check box” approach to compliance.

When it considers culture, ASIC states that it looks at the following seven key indicators of culture:

  1. Tone – what is the attitude at the top of the CEO, board and senior management?
  2. Spread – does the tone cascade throughout the organisation?
  3. Business practices – How is the tone translated into business practices?
  4. Accountability – Is there accountability?
  5. Communication and challenge – Is there open communication and effective challenge of business practices, procedures and messaging?
  6. Recruitment, training and remuneration - Is the conflicts management policy supported by recruitment, training and remuneration?
  7. Governance – What is the governance framework?

Conflicts in vertically integrated business structures

Much of the public commentary on vertical integration focussed on cross-selling opportunities. However, the limited scope of the Report means that these types of issues were not canvassed.

The types of conflicts considered in the Report related to conflicts:

  • between product manufacturers whose objective is to sell in-house products, and investors whose interests are to be offered a range of suitable investments. These conflicts can lead to inadequate due diligence and giving priority to related party products.
  • when appointing related party service providers. These conflicts can lead to a lack of service provider assessment, inappropriate criteria being used for the assessment, non-arms length engagement processes and no independent oversight of the service provider.
  • when employee incentives reward strategies that focus on short-term sales targets or which encourage employees to promote or give priority to related party products
  • when a person holds a directorship on more than one group company.

ASIC were concerned that there was inadequate management of one or more these conflicts in some organisations.

Good governance processes

ASIC listed a number of processes which it encouraged AFS licensees to adopt. These included:

  1. Board approval of conflicts policies and procedures
  2. Conflicts being a standing board and committee item
  3. Boards consider material contracts with related parties, with related party agreements being reviewed by legal and compliance prior to board consideration
  4. Having a risk management team separated from the business, and who provides regular reporting on operational risk to the audit and risk committee
  5. Adoption of a formal review and escalation process for conflicts
  6. Employees being responsible on a day-to-day basis for reporting conflicts
  7. Having conflict management committees to deal with complex or structural conflict issues on an ad hoc basis.
  8. Periodic reviews of conflicts, and not just conflict processes
  9. A formalised due diligence process for investment selection and retention which is applied consistently to related and unrelated parties
  10. Adopting the same process, considerations and criteria for outsourcing to related and unrelated parties
  11. Periodic training on conflicts
  12. Adoption and regular updating of conflict of interests registers (in addition, for superannuation trustees, registers of duties and interests)
  13. Periodic formal reviews of cash default options that are with a related party bank

Bad governance processes

The Report provides a number of examples where ASIC considered governance on conflicts to be below standard. These included:

  1. conflicts policies which contained generic and high level information and which were not tailored to the organisation
  2. training on conflicts occurring mainly at induction
  3. remuneration structures which do not take into account conduct, compliance training and behaviour as a determinant of bonuses, salary advancement or other rewards
  4. not monitoring the implementation of proposals by related party service providers
  5. reviews of cash default options occurring only at installation
  6. not addressing how conflicts are managed in the conflicts of interest register

Next steps

We recommend that funds management organisations undertake a detailed review of their:

  • conflicts management policies, processes and registers
  • information barrier processes
  • employee incentive structures.

having regard to ASIC’s comments in the Report, and report the results to the board.

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