As the services provided by financial institutions become more diversified and global, so the prospects increase of conflicts of interest and financial institutions falling foul of their fiduciary duties to clients. The picture becomes further clouded as financial institutions increasingly seek to contractually exclude or limit liability that might arise out of these duties.
Helpfully, a recent judgment of the Federal Court of Australia provides a timely reminder of the common law fiduciary duties owed by financial institutions, particularly in the context of proprietary trading.
In Australian Securities and Investment Commission (ASIC) v Citigroup Global Markets (No 4), delivered by the Federal Court on June 28 2007, the plaintiff's allegations raised questions about the way in which financial institutions conduct proprietary trading, but the judgment is of wider interest. The Court considered:
The fiduciary duties owed by financial institutions to their clients.
The importance of being aware of those duties and fully understanding what procedures should be put in place to honour them.
How those duties can be altered, minimized or extinguished.
A firm's fiduciary duties
In simple terms, a fiduciary relationship is one where there is an expectation that one person will act in the sole interests of another, to the exclusion of their own interests. Fiduciary duties commonly arise where someone has undertaken to act for another in circumstances of trust and confidence. The classic example of a fiduciary relationship is that of solicitor and client.
The courts in England and Australia have historically sought to restrain the notion that fiduciary relationships can exist in a commercial context. Commercial relationships are commonly defined by contract, and parties to a contract are entitled (and indeed expected) to consider their personal interests first and foremost – one of the best-known contractual principles being caveat emptor, or "let the buyer beware". Courts have traditionally been reluctant to impose a contrary position.
So the fiduciary element is often absent from a commercial relationship because both parties recognize that the other is acting in its own best interests.
It follows from this that, because commercial relationships are commonly defined by contract, determining the fiduciary duties owed in a commercial relationship cannot be considered in isolation from the contractual relationship between the parties. The full context of a commercial relationship, including any contract, needs to be considered when determining the existence and extent of fiduciary duties.
Fiduciary duties that might arise in the context of services offered by financial institutions include:
The duty to avoid a conflict between the firm's interests and those of its clients.
The duty not to profit from its position, whether or not that profit is made at the expense of the client.
The duty of undivided loyalty – that is, the client is entitled to expect that the firm will look after only the client's interests.
The duty to maintain the confidentiality of information provided by its clients.
It is the first duty, to avoid conflict between the firm's interests and those of its clients, that the Federal Court was asked to consider in ASIC v Citibank.
ASIC v Citibank
Citigroup Global Markets Australia (Citi), the Australian arm of US banking firm Citigroup Inc, provides a variety of financial services to clients through its various business divisions.
The Court heard that Citi, with an eye on its duty to avoid conflicts of interest, had established Chinese walls, or information barriers, to prevent the flow of information between employees exposed to confidential or market sensitive information (private-side employees) and those employees not exposed to such information (public-side employees).
The proceedings arose out of the purchase by a public-side employee (Manchee), who worked on Citi's proprietary trading desk, of a million shares in Patrick Corporation. At the time he purchased the shares, private-side employees were advising Toll Holdings on a proposed takeover bid for Patrick.
Manchee purchased the shares on the last trading day before Toll announced its bid for Patrick. Private-side Citi employees realized that the Citi proprietary trading desk was acquiring large amounts of Patrick shares and, after a conversation between senior private and public-side employees, Manchee was advised not to buy any more Patrick shares. Manchee then immediately sold about 200,000 of the shares he had bought in Patrick.
On the face of it, Citi faced a conflict of interest, because as a purchaser of Patrick shares it wanted Patrick's share price to increase. As an adviser to Toll, however, it had an interest in Patrick's share price remaining stable, so that Toll paid the lowest price possible for its takeover target.
ASIC, the Australian regulator, issued proceedings against Citi contending that:
Irrespective of the fact that the parties had signed a letter of engagement that specifically excluded the existence of a fiduciary relationship, Citi owed fiduciary duties to Toll.
By buying the Patrick shares, Citi placed itself in a position where its duty of loyalty to Toll conflicted with its own financial interests.
Citi had failed to put in place adequate arrangements to manage the conflict of interest. Specifically, it had failed to properly manage the potential conflict by not obtaining Toll's express consent to proprietary trading in Patrick shares.
ASIC also alleged that Citi had engaged in insider trading but did not succeed on these allegations.
The success of each of ASIC's contentions above was dependant upon the existence of a fiduciary relationship.
ASIC argued that the exclusion of fiduciary obligations in Citi's letter of engagement was ineffective because Citi had not obtained the informed consent of Toll.
In response, Citi argued that the duty of a fiduciary to obtain informed consent had no application to its relationship with Toll, because seeking informed consent presupposes the existence of a fiduciary relationship. No such relationship existed, Citi argued, so it was not necessary for it to obtain consent to its removal.
The Court agreed that the effect of the provisions of the letter of engagement was that no fiduciary relationship existed between the parties and that, on that basis, Toll's informed consent was not required.
The Court also noted that the relationship between an investment banker and its client should be distinguished from more traditional fiduciary relationships such as that between solicitor and client, which invariably attract fiduciary obligations, suggesting that in the latter relationship fiduciary duties could only be excluded with the fully informed consent of the client. The Court held that in this case the parties had acknowledged, in the letter of engagement, that they were not in a fiduciary relationship and that "those words mean what they say and should be enforced accordingly".
One of the most curious aspects of ASIC v Citibank is that the regulator claimed that a fiduciary relationship had arisen between Citi and Toll by reason of the letter of engagement, which was the very document that purported to exclude such a relationship. Also, the regulator contended that events pre-dating the execution of the letter of engagement evidenced the existence of the fiduciary relationship. Unfortunately for the regulator, the Court held that, but for the express exclusion of the fiduciary relationship in the letter of engagement, the pre-contractual dealings between Citi and Toll would have pointed strongly towards the existence of a fiduciary relationship. However, because ASIC claimed that the fiduciary relationship arose by reason of the engagement letter alone, the Court declined to take pre-contractual events into consideration. A number of observations can be made about this. The first is that the Court suggests that ASIC might have been more successful with its case had it constructed its arguments differently. Secondly, the judgment emphasizes that in the absence of an explicit contractual exclusion or alteration of the fiduciary relationship, it is possible (by reason of the nature of their relationship and each party's respective position) that a court may find that a financial adviser owes their client fiduciary duties.
Practical implications
Avoiding conflicts
Allegations such as those made against Citi are embarrassing and carry a potential reputational risk. ASIC's case against Citi was heavily publicized both in the Australian and international press. Every aspect of Citi's conduct in relation to Toll became the subject of courtroom debate, cross-examination and, ultimately, a publicly available judgment. About 34 pages of the Court's judgment recounts, in detailed chronological order, the history of Citi's relationship with Toll, the signing of the letter of engagement and the manner in which Citi reacted to and dealt with the conflict issue. Fortunately for Citi, the Court found its conduct to be exemplary. A judgment to the contrary might have been commercially devastating.
ASIC v Citibank reinforces the need for financial institutions to have adequate risk management systems in place to appropriately respond to potential conflicts. The absence of these systems holds the potential to be costly and commercially embarrassing for businesses.
Limiting or extinguishing fiduciary duties
ASIC v Citibank also reminds us that it is possible for financial advisers to contractually modify, or completely exclude, their fiduciary duties through the letter of engagement or any other contractual document that is determinative of the legal relationship between the parties. There is a limit to this, of course – as the Court observed, it is not possible to exclude liability for fraud or dereliction of duty.
When is informed consent needed?
The client's informed consent to the exclusion or alteration of the fiduciary relationship will be required where one party in the relationship is subject to fiduciary obligations before the contract is entered.
This might arise:
in the context of the present transaction (that is, one party acted in a fiduciary capacity in pre-contractual dealings);
by reason of previous transactions (that is, one party has previously acted in a fiduciary capacity to the other); or
by reason of the nature of the relationship, such as solicitor and client.
In these circumstances, the financial institution must show that the client specifically understood not only that the fiduciary relationship was being extinguished or altered, but also the consequent practical implications (for example, in the ASIC case, that the financial institution's proprietary arm may trade in the shares of its takeover target).
Financial institutions must consider from the outset whether consent should be obtained, while also being aware that seeking and obtaining consent amounts to an admission that a fiduciary relationship exists.
When has informed consent been given?
In ASIC v Citibank, the Court held that informed consent could be express or implied.
There is nothing in the relationship between a financial institution such as Citi and its client to suggest that it is an inherent part of the business of investment banking to engage in trading its client's target's shares, but the Court took into account Toll's knowledge of Citi's structure and method of operations, as well as Toll's experience and "core competency" in mergers and acquisitions, and concluded that in this instance informed consent could be implied.
As a matter of risk management, express written consent is clearly preferred. Financial institutions should ideally seek to obtain express written (and informed) consent from all clients, particularly when dealing with smaller or more commercially inexperienced clients.
By James Cooper and Anna Reddick of Barlow Lyde & Gilbert LLP