Conflicts of Interest
The term ‘conflict of interest’ has neither been clearly defined by legal scholars nor by those of neighbouring disciplines such as economics or other social sciences. A very broad definition would include any collision of diverging interests of different persons. This would lead to an understanding of conflicts of interest as any legal interaction between different persons where the interests of the participating parties openly diverge, even if this antagonism is necessarily inherent in a transaction. This is the case, for example, in reciprocal contracts like sales contracts, where one party aims for the highest price possible whereas the counterparty aims for the lowest. In those cases the contradicting interests are unavoidable and natural, and legal provisions attempt to ensure a fair adjustment of the colliding interests by defining certain boundaries within which the parties may act, enabling the parties to negotiate autonomously. A further uniform regulatory programme to govern these conflicts appears unnecessary and also impossible, as any of these conflicts of interest calls for its own specific solution.
However, specific provisions are needed for conflicts of interest that arise, for instance, in the case of self-dealing of agents, board members or universal banks catering to customers with opposing interests. The same applies to agents who simultaneously serve two or more principals with clashing interests such that the agent would be required to carry out opposing actions. These conflicts of interest, in a narrow sense, constitute fundamental challenges for today’s modern service economy. They arise out of the growing complexity of economic and societal processes, leading to an ever-stronger specialization and division of labour. More and more tasks are assigned to third parties and it becomes more and more difficult to monitor and control these third parties. Lack of knowledge, time and/or financial means prevent an adequate supervision of experts and specialized service providers. The individual is forced to trust the specialists working for him. Typically, it is inherent in their profession to administer third party interests, and they promise to put aside their own interests as well as to refrain from arbitrarily privileging foreign interests. Numbering among these specialized individuals or entities are, for example, banks, lawyers, estate agents as well as members of boards of directors or supervisory boards. But also legal guardians and will executors are not free from such conflicts of interest.
Typical cases in which conflicts of interest arise are especially: (1) conflicts between one’s own and foreign interests; (2) the collision of opposing interests of different third parties, both of which have to be respected by the intermediary (often a collision of duties). Such a conflict may occur in regard to parties on (a) the same side of the market as well as on (b) opposing market sides. A third category which exhibits particu- *larities and might necessitate specific solutions is (3) conflicts of interests arising in the context of organizations.
2. Underlying rationale for regulatory approaches
Regulatory approaches for managing conflicts of interest revolve around the idea that someone who is entrusted with managing the business of another person and has authority over this person’s assets should protect the interests of that person. This principle has grown into an enforceable duty—the duty of loyalty. The concept and the foundation of the duty of loyalty in common law and the parallel civil law concept (in Germany called Interessenwahrungspflicht) differ. The duty of loyalty stems from trust law and was further developed under the doctrines of equity. It is the nature of a trust that the trustee becomes the legal owner of an asset which he has to administer and that he must act in the interest of the equitable owner or beneficiary. The trustee has to refrain from exposing himself to any conflict of interest which would negatively affect the beneficiary. This concept has been conveyed to other relationships of confidence or trust such as agency or the relationship between company directors and their company. In contrast, the civil law concept of such a duty is typically based on contractual obligations. However, such a duty can also arise due to professional regulations or the status as a company organ. Despite such dogmatic differences, the various concepts of a duty of loyalty share a common core: the person who is obliged to protect another’s (ie the principal’s) interests is prohibited from advancing his or her own interests or the interests of a third party to the detriment of the principal.
3. General legal developments
Regulating conflicts of interest (in the narrow sense) has been the subject of far-reaching developments in many areas of law within the past years. Both the common law duty of loyalty and the corresponding civil law duty were initially shaped, for the most part, by the courts. This ex post and case-by-case approach towards regulating conflicts of interest appears, however, to have subsequently been regarded as inadequate in a number of areas, leading to an increase in ex ante regulation by legislators and regulators.
For example, the European Union has adopted a large number of provisions in the field of capital markets law concerning conflicts of interest. International organizations such as OECD and IOSCO have been dealing with conflicts of interest and their effects in a number of areas and have submitted proposals for their regulation. General provisions on conflicts of interest are contained in the Principles of European Contract Law (PECL), UNIDROIT Principles of International Commercial Contracts (PICC) and the Draft Common Frame of Reference (DCFR) (the latter contains further provisions such as, for example, on consulting situations).
Because of the implementation of the directives adopted by the EU, various new provisions on conflicts of interest have been introduced into the national legal systems. Based on this development, these provisions span many different acts and areas of law and have for the most part developed independently with the result that they lack a uniform regulatory concept. While in some areas, such as the law of capital markets, very detailed rules have been introduced, specific rules on conflicts of interest in other areas such as the law of estate agents have not or have only marginally been subject to changes. The increasing conceptual changes concerning the regulation of conflicts of interest are therefore only followed in singular areas of law.
Looking at the legal systems in Europe with regard to the legal treatment of conflicts of interest, the noticeable differences between German and English law are especially striking. While German law, in principle, approaches the problem in a formal way, English law basically takes a more material approach. The material approach centres on a material concept of conflicts of interest and analyses the actual case at hand individually to determine whether the requirements for the application of the rules on conflicts of interest have been met. Conversely, the formal approach attempts to describe those situations where one can typically assume the existence of a conflict of interest using formal criteria (eg in the case of self-dealing).
4. Concepts and rules for regulation
To regulate conflicts of interest, the duty of loyalty has been concretized and divided into several more specific duties. These duties can be categorized into four functional groups: (1) organizational duties, (2) duties of notification, (3) duties of omission and (4) special rules for groups of companies on group structures and the principles of good conduct. Every rule is accompanied by special sanctions.
Organizational duties become ever more important for preventing the emergence of conflicts of interest. The MiFID (Dir 2004/39) and its implementing directive (Dir 2006/73) (especially Art 21) contain detailed rules on the organization of investment companies such as the duty to establish informational barriers within the company in certain situations, so-called Chinese walls.
Duties of notification are important when a person obliged to protect third party interests is unable to avoid a conflict of interest. The notification enables the principal to evaluate the risk posed by the conflict and to act accordingly. In contrast to a number of European directives (eg Art 18 MiFID), PECL, UNIDROIT PICC and DCFR do not expressly stipulate a duty of notification. Nonetheless, they introduce the concept indirectly, as a principal may not avoid a contract if the agent had disclosed the conflict of interest beforehand and the principal failed to object. However, duties of notification are not always suitable to resolve conflicts of interest. Findings in behavioural economics suggest that individuals systematically underestimate risks and are convinced that they are able to manage situations of conflicts of interest appropriately. Thus, a self-confident intermediary faced with a conflict might not regard the conflict as noteworthy and hence will not see any need for notification. Furthermore, the effectiveness of a duty of notification depends on the ability of the principal to correctly evaluate the communicated information and to adjust his actions accordingly. Therefore, notifications have to be, at minimum, timely, correct and complete.
Another approach to regulating conflicts of interests is found in duties to refrain from acting, ie an intermediary facing a conflict of interest has to abstain or withdraw from a particular transaction. As this is a severe restriction, the possible benefits have to be balanced carefully with the possible negative consequences. Therefore, legislatures are often reluctant to impose duties to refrain from acting (however, such rules can be found, for example, in the DCFR). In the case of board members, an existing duty to refrain may lead to the loss of voting rights or a prohibition to vote. In special cases, board members may even be obliged to remain absent from a particular meeting. Finally, the duty to refrain can mean that the person concerned has to resign or be removed from office.
Due to the growing number of associations or corporate groups, comprehensive group-wide regulatory approaches gain importance. A complete separation of conflict situations within companies or a corporate group seems questionable and has rarely been chosen as a solution. A legal comparison with the developments in the United States provides corresponding evidence. The Class-Steagall Act of 1933 introduced an institutional separation of commercial and investment banking (it was later revoked in 1999). The so-called Volcker rule—enacted in a slightly weakened form (due to a number of exceptions) in the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Pub.L. 111-203, H.R. 4173)—has a similar thrust as it generally prohibits a banking entity from engaging in proprietary trading, or acquiring or retaining any equity, partnership or other ownership interest in a hedge fund or a private equity fund or sponsoring a hedge fund or private equity fund. Other countries that had not enacted such a separation do not appear to have fared worse than the United States.
One solution for conflicts of interest within corporate groups, however, might be a central committee for conflict management consisting of representatives of the companies belonging to a group. Its purpose would be to identify conflict situations and to propose solutions to the management. This would require unlimited access to information as well as a high reputation of the committee within the group. Additionally, a high standard of independence and a hierarchical position immediately below the top management level would be necessary.
In order to enforce these duties and penalize failures to adhere to them, many provisions stipulate sanctions. The principal may have the right to avoid the contract (PECL, PICC, CFR) or the contract may be (at least provisionally) void (for more details, especially concerning PECL, PICC and DCFR, see representation). In the latter case, the principal may approve of the contract; otherwise he has the right to claim damages from the intermediary. It may also be possible that the principal is allowed to choose that the intermediary be obliged to fulfil the contract. Moreover, if the intermediary profits from his conflict of interest, he is often forced to disgorge the profits. Disregarding a prohibition against voting in a board meeting usually voids the vote of the concerned board member. This may even impact the resolution had the outcome been different without the vote. Finally, professional intermediaries are subject to numerous public and criminal law sanctions as well as professional and occupational bans.
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