Conflict resolution

While it might seem obvious that an MP should not accept cash from lobbyists to ask questions in Parliament, some conflicts of interest can be hard to spot and depend on an individual’s role as well as the sector they work in. So how can internal audit help firms to be on guard?

10 July 2013 @ 13:00 in Features.

When the Financial Services Authority (FSA) fined fund manager Martin Currie £3.5m in 2012 for failing to manage a conflict of interest between clients, it was a sign of heightened regulatory scrutiny of asset managers’ approach to managing such issues.

In November last year, the FSA sent the chief executives of every UK asset manager a letter asking them to confirm that their firms had adequate conflict procedures in place. And, under the guise of the new Financial Conduct Authority (FCA), it is now said to be considering multi-million-pound fines for fund managers that use investors’ money to pay investment banks for access to the CEOs of their corporate clients (reportedly up to $20,000 an hour).

But conflicts of interest can occur in all types of organisation. For example, the Financial Reporting Council (FRC) recently announced two investigations into the audit arm of KPMG over possible conflicts. And last October the European Court of Auditors found that a number of EU agencies, including the European Food Safety Agency and the European Medicines Agency, had failed to manage conflict of interest situations adequately.

Sources of conflict

Conflicts of interest can occur in a wide range of situations. They might involve a clash between an employee’s personal interests and those of their employer’s customer or stakeholder. Gifts and entertainment are obvious examples, whether it is a case of a head of procurement being paid to fly around the world to attend a prestigious sporting event by a supplier trying to sell them services, or a local councillor accepting a bottle of champagne from a company and subsequently sitting on a panel deciding whether to award them work. Or it could be an individual holding shares or having another financial interest in a client, supplier or competitor.

Other types of conflict occur between the interests of different clients. This is a particular problem for law firms, which are prohibited by the Solicitors Regulation Authority from acting for a client whose interests clash with those of another client or of the firm itself. As a result, many now have teams dedicated to detecting potential issues.

Concerns over a lack of independence can also be a problem for external auditors. In May, the FRC – which sets ethical standards to ensure their objectivity and impartiality – published its annual report into audit quality inspections. While it highlighted an improvement in the overall quality of external audit work, it also found that firms should reassess the adequacy of their independence and ethics procedures and the training they provide to staff at all levels. In one case, a former executive of an audited organisation rejoined its audit firm as a partner, but failed to dispose of a shareholding in the organisation for several months, in breach of ethical standards.

Whatever the nature of conflicts, there can be regulatory consequences for failing 
to manage them appropriately. Company boards have a statutory duty under the Companies Act 2006 to avoid conflicts of interest, while the UK corporate governance and stewardship codes (overseen by the FRC) place a range of requirements on boards and investors for handling independence and potential conflicts on a “comply-or-explain basis”. The Bribery Act 2010 has increased scrutiny over employees accepting gifts and entertainment. The professions also have their own ethical codes and systems of regulatory oversight.

But legal problems are not the only danger from conflicts of interest – there’s 
also the risk of reputational damage. Angela Robertson, general counsel at Eversheds, notes: “If a law firm takes on a piece of work for a client and a conflict of interest is subsequently identified, it could severely damage or even kill that client relationship. 
In some sectors – particularly those where clients are sensitive around conflict issues – 
it could have repercussions across the industry, because word would get out to others. Obviously there’s a risk of adverse publicity, particularly in the legal press.”

Reducing the risks

How can organisations reduce the risk of conflicts of interest occurring? The starting point is for all conflicts or potential conflicts to be declared or identified so they can be managed appropriately. At Wokingham Borough Council all councillors and senior managers are asked to complete a declaration of any known conflicts of 
interest annually. 

“But this is only as effective as the training and understanding that goes with it,” explains Muir Laurie CMIIA, director of business assurance and democratic services and head of internal audit at the council. 

“I think some internal audit teams think that getting 100 per cent completion of 
those forms is all you need to do. But that doesn’t mean there aren’t conflicts of interest – managers may be unaware of them or knowingly leave them off forms because it might ruin relationships they have with contractors.”

Issues for councils in general are typically around property and procurement for officers and planning for council members. Laurie says that Wokingham runs governance training sessions for newly elected councillors. “If a council member is sitting on the planning committee hearing a planning application from one of their neighbours wanting to build a conservatory in their back garden, should they declare it? They should – and that’s the kind of practical example we try to give.”

In the legal sector, a lot of conflict management relies on processes and technology, explains Robertson. As well as being responsible for conflict management at Eversheds, she previously set up the global conflicts team at Clifford Chance after it had undergone two mergers. “Every single piece of new work for a client, whether new or existing, had to go through the central conflicts team to identify whether there were any legal or commercial conflicts of interest,” she explains.

A law firm needs a good conflicts database containing details of all its current and historic clients and cases, she adds. “You need to be able to identify what work you’ve done for which client over a period of time. You’ve also got to have a good, clear process that everybody is aware of, so that you don’t start acting on a piece of work for a client until you’ve checked with the conflicts team, assuming you have one.” But lawyers must also be trained to understand the importance of giving the correct information to the conflicts team, she adds. “A conflicts system relies on people using it properly and inputting the right information.”

Getting the right culture and governance framework is also an important issue for asset managers – and reflects the FCA’s focus on consumer protection, believes Amanda Rowland, the partner who heads up PwC’s asset management regulation team. 
“If senior management are getting the right information and are fully engaged, and the culture is right within the firm, all of these issues – whether conflicts or anything else that affects consumers and products – will be handled better,” she says.

While she believes that “most firms would say that they were managing conflicts of interest in a way that they felt was appropriate”, the regulatory expectation has shifted and “the level of attention from the regulator has clearly concentrated minds”. Since then, firms have been looking at their written policies and procedures and ensuring they have appropriate control mechanisms for declaring, registering or managing conflicts. 

But there are still grey areas – particularly relating to concerns raised by the FCA over the way asset managers buy research and trade execution services on behalf of clients. “Clearly there’s the potential for conflicts. The question is what’s the best way to deal with that, while at the same time leaving asset managers with access to the best quality research that enables them to make the best decision for their funds and provide the best service for their customers.” The matter is the subject of an ongoing discussion between the regulator and the industry, she adds.

So what’s the role for IAs in terms of managing conflicts of interest? “As part of our internal audit plan, we’ll carry out a review of declarations of interest for officers and members, says Laurie. “We don’t look just at the completion rate, but whether they are consistent with our cumulative audit knowledge and experience. If they aren’t, we can flag it up.” It’s also important for a head of internal audit to lead by example and be very transparent about any perceived or actual conflicts of interest that they face themselves, he adds.

An end to direct assistance

IAs need to be aware of a recent change to Financial Reporting Council standards for external auditors that will affect how the two sets of auditors can work together. “Direct assistance” – where external auditors take IAs into their audit team for a period of time – will now be prohibited. 

It’s a move that has been taken precisely to avoid “conflicts of interest and a lack of independence”, explains Melanie McLaren, executive director of codes and standards at the FRC. “Clearly an internal auditor who is employed by a company has a financial interest in it.”

External auditors will still be able to rely on the work of IAs provided that it has been scoped and managed by the internal audit function and that the external auditor is satisfied that it has been approached objectively and appropriately reviewed. 

There is, of course, an ongoing debate at European level over the possible compulsory rotation of external auditors and restrictions on the consultancy services that they can provide. In the UK, the FRC doesn’t support mandatory rotation, but changed the corporate governance code last autumn to stipulate (on a “comply-or-explain” basis) mandatory retendering of external audit contracts every ten years by FTSE 350 companies. “Our view is that investors deserve the best quality audit,” says McLaren. “In some parts of the market there isn’t a large number of firms capable of carrying out a sufficiently high-quality external audit, largely because of the global reach or sectoral expertise needed.”

In terms of firms’ consultancy work, McLaren says the FRC isn’t in favour of a cap on so-called audit-related services. “We think it would be better to say that there are certain services that can’t be provided (such as advocacy) and then place a requirement on audit committees to satisfy themselves in terms of independence, objectivity threats and safeguards on the other work.”

SOURCE:Charted Institute of Internal Auditors