Australia: Managing Conflicts of Interest in Financing Transactions

The recent action by ASIC against Citigroup, and ASIC's release of a Discussion paper on managing conflicts of interest in April, have sparked new debate in the banking industry on this issue. For example, on Friday 26 May 2006, Jeremy Cooper, Deputy Chairman of ASIC gave a presentation to the Securities and Derivatives Industry Association on the importance of investment banks considering conflicts of interest and noted that there are inherent risks in relying on Chinese walls to manage conflicts.

This article will not consider the mandatory obligations of financial services licensees to manage conflicts of interest but will focus on a number of issues that arise with respect to managing conflicts of interest in general financing transactions.

While most people have an intuitive grasp as to what is meant by a conflict of interest, it is important to take note of the particular features which give rise to a conflict of interest in the legal sense.

The Australian Butterworths Encyclopaedic Australian Legal Dictionary offers the following definition of "conflict of interest":

"A situation where the interest, principal, right, advantage or position of one individual or business entity, whether directly or in being represented by another, comes into discord, challenge, dispute or harm with those of another."

Unfortunately, this definition does not provide much insight into whether a particular situation involves a conflict of interest for any party to that transaction, as the type of conflict described will apply to most financing transactions. For example, a borrower will want to be able to carry on its business and deal with assets with as much freedom as possible while its lender will want to ensure that it has the appropriate covenant package and, if required, security to give comfort that the financier will be repaid. While this situation certainly involves a conflict of interests, it does not involve a breach of the financier's duty to avoid, disclose or manage conflicts of interest.

An obligation to avoid or otherwise manage potential conflicts of interest will only arise in particular circumstances. In commercial arm's length transactions, this duty will generally only arise if one party owes the other a fiduciary duty or if there are specific contractual provisions requiring the management of conflicts.

Outside of an express contractual term dealing with conflicts of interest, there are few situations where a financing transaction will give rise to a duty to disclose, avoid or manage conflicts of interest. One such situation is where a fiduciary relationship exists between particular parties. The exact nature of the fiduciary obligations of a particular relationship depends upon the particular circumstances of that relationship. Although this is the case, a fiduciary duty will often involve obligations to avoid conflicts and to act in a manner consistent with the interests and expectations of the party to whom the fiduciary duty is owed.

Courts have not formulated a "standard test" for determining whether a particular relationship is fiduciary in nature. While there are lines of authority suggesting that particular elements are required for a fiduciary relationship, it is precarious to make a determination as to the fiduciary nature of a given relationship without legal advice that takes into account the specific circumstances of the situation at hand. In general though, warning bells should sound where there is an imbalance of power between parties to a transaction and/or where one party gives advice to the other and that other party has not obtained independent advice.

Generally, parties acting in a financing transaction at arm's length will not be characterised as being in a fiduciary relationship, though, there may be certain elements of a particular transaction which result in one party becoming another's fiduciary. For example, a bank acting as a lender may owe a borrower a fiduciary duty if it also acts in an advisory capacity and there is a reasonable expectation by the borrower that the bank would act in the borrower's interests.

Sometimes finance agreements will contain terms which impose obligations to consider potential conflicts of interest. While the following list is not exhaustive, some common contractual terms which may give rise to a consideration of potential conflicts include:

• Prohibitions on the use of information

It is common to find clauses in contracts relating to confidentiality, privacy and permitted uses of information disclosed in a transaction. Many contracts contain provisions that prescribe the manner in which confidential information is to be collected, stored and used. In addition, some contracts may require a party to make special arrangements to protect the confidentiality of certain information. "Information barriers" (also sometimes called Chinese walls or separation arrangements) can be a very effective way to maintain the confidentiality of information where a potential conflict of interest may arise.

• Good faith

Many financing contracts contain express obligations for the parties to act in good faith in negotiating or performing their contractual obligations. A good faith obligation is likely to require the obligor to avoid conflicts of interest. These provisions will generally be binding and enforceable.

The question sometimes arises whether other obligations include an implied duty of good faith. For example, an agency arrangement may be interpreted to require the agent to exercise its duties in good faith and in Shepherd v Felt and Textiles of Australia Ltd (1931) 45 CLR 359, a term was implied into an agency contract requiring the agent to render faithful and loyal service to his principal. Thus, in syndicated financing transactions, the facility agent may be required to act in good faith when performing its contractual obligations.

To date Australian courts have been reluctant to enforce implied duties of good faith in commercial arm's length transactions. Nonetheless it is important to identify if a contract contains an express obligation to act in good faith. Such a contractual obligation may include a duty to avoid conflicts of interest.

Most commercial entities are party to several different contracts with varying obligations. Sometimes a party's obligations to a particular contractual party will conflict with its obligations to another.

The resolution of a conflict between competing contractual obligations often involves careful consideration of the particular commercial and legal circumstances particular to the conflict.

Crossing the conflicts minefield - identify, avoid, disarm

Crossing the conflicts minefield safely involves a three step process:

• Identify

The first and most important step involves familiarisation with the potential situations which could lead to a conflict scenario. For organisations that have specific responsibilities in relation to the management of conflicts, this will often require formal searches at the beginning of a given transaction to identify potential sources of conflict. For other transactions, it is a matter of identifying potential conflicts during the due diligence process. Sometimes it is not possible or practical to identify a conflict until it becomes imminent. The important thing, once real or potential conflicts are identified, is that those conflicts are actioned appropriately.

• Avoid

Once a potential conflict is identified, it is important to consider whether the conflict of interest can be avoided. It is also advisable to have mechanisms in place to facilitate the avoidance of conflicts. Internal conflicts policies are invaluable tools to assist a financier to avoid (or otherwise manage) conflicts.

• Disarm

Sometimes a conflict arises that cannot be managed by identification and avoidance procedures alone. Conflicts can sometimes be managed through disclosure of the nature of the conflict to the affected parties and obtaining their consent to the management of that conflict in a particular manner. For example, there are techniques available for putting into place appropriate information barriers or other separation arrangements. While these measures are fairly common and generally acceptable means of managing conflicts, they are not fail-safe. It is therefore important to adequately supervise and monitor these arrangements to ensure that they remain effective.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.