Tuesday, 25 June 2013 11:35
Technical Update: Ethics and Financial Planning
Ethics is becoming an important topic for Financial Planners but what are the legal obligations?
In this timely Technical Update feature, lawyer Philippa Hann of Clarke Wilmott looks at why ethics is more than "doing the right thing" but asks where do morality and the law overlap?
Financial Planners need to consider in what types of circumstances does the law require them to have a conscience and to not act in their own best interests? They also need to know where the law steps into ethical dilemmas. It can be a minefield and getting it right requires careful consideration.
Many countries, notably Germany, France and Italy, impose an overarching duty on parties to a contract to act in good faith but duties vary from country to country. The English and Welsh legal system's approach to this concept of acting in good faith was encapsulated by Lord Justice Bingham in Interfoto Picture Library Ltd v Stiletto Visual Programmes Ltd  1 QB 433 at 439] which is covered in more depth below.
Ms Hann looks at the background to recent and historic cases on this topic and what ethical obligations mean for Financial Planners and wealth managers. The article is a condensed version of the speech given by Ms Hann at the IFP's Ethics & Practice Standards CPD workshop in April.
Ethics: Legal requirements in handling ethical dilemmas
Although a fairly nebulous concept it is generally accepted that ethics is about "doing the right thing but where do morality and the law overlap? In what circumstances does the law require you to have a conscience, to not act in your own best interests? Where does the law step into ethical dilemmas?
The requirement to act in good faith
Many countries, notably Germany, France and Italy, impose a clear duty on parties to a contract to act in good faith. The English and Welsh legal system's approach to this concept was detailed by Lord Justice Bingham in Interfoto Picture Library Ltd v Stiletto Visual Programmes Ltd  1 QB 433 at 439]:
"In many civil law systems, and perhaps in most legal systems outside the common law world, the law of obligations recognises and enforces an overriding principle that in making and carrying out contracts parties should act in good faith.
This does not simply mean that they should not deceive each other, a principle which any legal system must recognise; its effect is perhaps most aptly conveyed by such metaphorical colloquialisms as 'playing fair', 'coming clean' or 'putting one's cards face upwards on the table.'
It is in essence a principle of fair open dealing... English law has, characteristically, committed itself to no such overriding principle but has developed piecemeal solutions in response to demonstrated problems of unfairness."
This refusal to accept the principle of good faith has been echoed by other judges as describing it as "inherently repugnant to the adversarial position of the parties when involved in negotiations" and "unworkable in practice". The approach of the judiciary has historically been to protect the rights of the parties to pursue their own self-interest. The perceived fear of accepting a vague and subjective duty of good faith into English and Welsh contract law, is that it would create uncertainty for the parties to the contract. If the contracting parties cannot rely on the black letter of the contract to understand what their obligations are and when a contract might be enforced, this may lead to the very unsatisfactory result of an uncertainty as to whether a contract should take effect and may give rise to the potential for this uncertainty to be used as a negotiating tactic or to unfairly prejudice one party.
There are, of course, exceptions to the general rule that good faith will not be implied into the required conduct of the parties, the most obvious being the duty to act of the utmost good faith where insurance contracts are involved.
However, the requirements of disclosure have been changed to some extent by the operative provisions of the Commercial Insurance (Disclosure and Representation) Act 2012 coming into force in April this year. These have changed the disclosure requirement from a duty to volunteer information, to a duty to take reasonable care to not make a misrepresentation during contractual negotiations (in other words to answer the insurer's questions fully and accurately).
A fiduciary requirement
A duty of good faith is also implied into employment contracts and other fiduciary contracts. Although contracts between financial advisers and Financial Planners do not always fall into this category, the courts have previously said, when an adviser undertakes to provide advice to a client that may be sufficient to tip the relationship into the fiduciary category. The effect of this is that the adviser must act in good faith. "He must not make a profit out of his trust, must not place himself in a position where his duty and his interests conflict; he may not act for his own benefit or for the benefit of a third person without the informed consent of his principal." This is not an exhaustive list but it does encapsulate the main duties of a fiduciary.
The fiduciary principles all stem from the obligation of loyalty between the fiduciary and his principal (client). This duty of loyalty is a strict requirement and means that a fiduciary cannot place himself in a position where his duty to one client conflicts with his duty to another. Nor can he allow any conflicts between himself and the client or even put himself in a situation where there is a real possibility that a conflict will arise. The requirement not to make a profit does not prevent a fiduciary charging a client on a commercial basis but it does mean that a fiduciary should not make money from the relationship except through reasonable payment and with the client's informed consent. Any profits made outside these rules must be disgorged to the client.
Of course many fiduciary type duties are already imposed on financial advisers and planners by the Conduct of Business Sourcebook. The duty to communicate in a way which is clear, fair and not misleading (COBS 4.2), to only be remunerated through adviser charging and not to solicit or accept any other commission, remuneration or benefit of any kind (COBS 6.1) and to manage conflicts of interest (COBS 12.2.3) all reflect fiduciary duties.
A European dimension
Of course the legal system here is not an island and our membership of the European Union means that European principles have crept into our laws. The Unfair Terms in Consumer Contracts Regulations 1999, for example, import a statutory duty of good faith into contracts between businesses and consumers. These regulations were directly parachuted into UK law from Europe and, at the time, were hailed as one of the most far reaching pieces of legislation relating to the protection of the consumer yet seen.
In 2008 the OFT used this legislation to attack the bank charges written into a number of major banks' standard terms of business but the case was unsuccessful at trial. The judges avoided the need to interpret the standard terms by a good faith standard by categorising the charges as a price of the contract in respect of which bank clients could shop around. The result of this interpretation was that the charges fell outside the scope of the regulations. This was perhaps a reflection of the judicial resistance of the time to imposing good faith requirements on the parties to a contract.
Although the specific requirements for good faith differ across Europe the broad principles are the same and include obligations: To inform the other party, where reasonable, of
all important points that they would not discover on their own;
To observe moral and ethical standards of behaviour where they are not already implied by local law; and
Not to break off negotiations without reasonable cause
The requirement to approach contracts with an ethical mindset is alien to traditional English and Welsh contract law, but, given the impact of Europe on our legislation and particularly that governing the financial services industry, it is unlikely to remain a foreign concept for long.
Future of good faith in financial services
In July 2012 John Kay published his report into equity markets in response to a Secretary of State for Business, Innovation and Skills' request that he review whether equity markets in the UK were effective in creating and sustaining "the competitive advantages in global markets which are necessary to maintain our prosperity." The government published its response in November last year.
He concluded that whether and how people invest their savings depends on trust and confidence in those they choose to manage these funds, and in the businesses they support. "Trust and confidence are the product of long-term commercial and personal relationships: trust and confidence are not generally created by trading between anonymous agents attempting to make short term gains at each other's expense."
The absence of trust and confidence has resulted in a culture of short termism and therefore, rather than a financial services culture based on trust, it is currently based around transactions and trading. This means a focus, not on what the assets might generate in cash and earnings over their lifetime, but on what someone else will pay for it. Thereby promoting short term success over longer term investment and rewarding those who are perceived to be successful over brief periods.
The proposal in the review was that all participants in the equity chain should have a fiduciary duty imposed upon them. This, he suggests, should include, "anyone who manages other people's money or advises on such investment." As outlined above, this is an onerous duty with the highest requirement for trust and confidence. In order to avoid confusion and debate as to the exact duties of a fiduciary Professor Kay proposes the following principle:
All participants in the equity investment chain should observe fiduciary standards in their relationships with their clients and customers. Fiduciary standards require that the client's interests are put first, that conflict of interest should be avoided and that the direct and indirect costs of services provided should be reasonable and disclosed. These standards should not require, nor even permit, the agent to depart from generally prevailing standards of decent behaviour. Contractual terms should not claim to override these standards.
And in order to achieve maximum compliance the Government has asked the FCA to consider the extent to which the current regulatory rules comply with this standard and, therefore presumably, which do not.
Certainly within the financial services industry, and realistically beyond, the requirement for parties to a contract to behave ethically seems inevitable. The resultant effect on the rights and obligations on those advising clients are likely to be even more far reaching than the current regulations already require.
Financial advisers and planners will need to be very aware of the possibility for conflict between them and their client, or indeed another client, and to have in place failsafe procedures to identify and prevent potential such conflicts from putting them in breach of their fiduciary duties. For example where an adviser or planner acts for members of the same family and gains confidential information about them which he is not authorised to share, he may not be able to comply with his duty to act in each client's best interest, without breaching the confidence of the other.
Ethical conundrums which are already affecting financial advisers and planners will come sharply into focus if and when they become a legal requirement.