“Type 2” Conflicts of Interest, Risk Assessment and “Inner Controls”

In his comprehensive taxonomy of conflicts of interest in the financial services industry ,  Professor Ingo Walter of New York University distinguishes between the kind of conflicts  that a firm has with its clients (“Type 1” conflicts) and conflicts between a firm’s clients (“Type 2” COIs).   Because the coverage of the COI Blog is not focused on this (or indeed any) industry we have  devoted little attention to the latter.  However, last week the UK’s Financial Services Authority imposed, in a Type 2 case, what is evidently its largest COI-related fine ever against a firm (Martin Currie), and this seems a good occasion to discuss these sorts of conflicts.

As briefly described in this article  the firm “caused one client to enter into an ill-advised transaction which rescued another client from serious liquidity concerns…  Both of the two … clients focused on making investments in the China market and were managed by Martin Currie from its Shanghai office. In April 2009, Martin Currie caused the rescued client fund to invest around £15m in an unlisted bond issued by an offshore Chinese firm, the FSA said. Martin Currie failed to ensure that the bond’s valuation or the rationale behind the investment were properly scrutinised at the time of the transaction and it proved to be a poor investment for the client, whose fund halved in value over the next two years. While the investment was detrimental to that fund, it had significant advantages for the other client in question, which was facing serious liquidity concerns due in part to its exposure to illiquid investments in a single offshore Chinese entity.”

Note that Type 2 conflicts pose risks not only for financial services firms.  They can also arise in law firms (where such COIs are far more common than are the Type 1 variety), and other contexts, too – e.g., consulting firms that do not fully disclose how commercial relationships with one client can impact the advice given  to others (such as in technology  procurement).

Indeed, it may be non-obvious Type 2 COIs that create the greatest risk for some organizations precisely because they have not been spotted.  And even where these are known they may not be fully appreciated,  because the self interest in Type 2 COIs may be less obvious (though no less real) than in Type 1 conflicts; i.e., those faced with the former may be particularly at risk due to the relative absence of “inner controls.”  For these reasons, all sorts of organizations should at least consider in their risk assessments whether Type 2  COIs could be an issue for them.