Contracting out conflict

Contractual techniques may be used to prevent a fiduciary relationship arising in situations that would otherwise clearly give rise to such a relationship, the Federal Court of Australia has confirmed in a recent judgment. Though not binding on English courts, the decision and the reasoning of the Federal Court may influence how other jurisdictions approach the question of the modification or displacement of fiduciary duties by contract, particularly in the context of large financial conglomerates. Any principles to be derived from the decision will have wider application, though its effect in other situations may be limited.

The circumstances

The Australian Securities and Investment Commission (ASIC) brought proceedings against the Australian arm of Citigroup alleging that it had breached its fiduciary duties owed to an advisory client (ASIC v Citigroup [2007] 62 ACSR 427).

Citigroup in Australia, as is the case with large financial conglomerates, operated its business through various divisions and business segments. In order to restrict the flow of information between different departments, structural organisational measures were employed with the different departments operating behind 'Chinese walls'. The private advisory side of Citigroup won a tender to act for T on the proposed takeover of P Ltd.

Later, a public-side employee became aware of rumours in the market and bought shares in P Ltd. ASIC contended that Citigroup, by purchasing the shares, had acted in breach of its 'no conflict' duties owed to T. Citigroup argued that it was never in a fiduciary relationship with T and relied upon the terms of its engagement letter which provided that Citigroup was engaged: 'As an independent contractor and not in any other capacity including as a fiduciary.'

ASIC argued that this did not have the effect of excluding fiduciary duties as to do so would require T's fully-informed consent to permit the dealing in the shares of P. Such consent had not been obtained. Citigroup's answer was that the duty of a fiduciary to obtain fully-informed consent had no application because it presupposes the existence of an antecedent fiduciary relationship. Here, no such pre-existing relationship had been created; this was clear from the terms of the engagement letter.

The court agreed with Citigroup. The question of whether any fiduciary relationship existed was to be determined by the proper construction of the letter in light of all the circumstances. Citigroup was retained as an independent contractor and not as a fiduciary and had never been in a fiduciary relationship with T. The activities between the parties prior to the signing of the letter were not such as to give rise to a fiduciary relationship. The question arises as to whether other professionals can use contractual techniques to exclude a fiduciary relationship with clients in circumstances that would otherwise give rise to such a relationship.

What is a fiduciary relationship?

A fiduciary relationship seems impossible to define with any precision; and, unlike an elephant, you do not always recognise it when you see it. According to Jacobson J in ASIC: 'The distinguishing or overriding duty of a fiduciary is the obligation of undivided loyalty' (at para 289). (See also Millet LJ in Bristol and West Building Society v Mothew [1998] Ch 1 at 18). Jacobson J further observed that the most that can be said is that a fiduciary relationship exists where a person has undertaken to act in the interests of another and not in his or her own interests. Even if this is an accurate statement of the law, it begs the question of when it can be said that such an undertaking has been entered into.

However, there are clearly established fiduciary relationships such as solicitor and client, trustee and beneficiary, director and company, employer and employee, and partners. Similarly, it has long been accepted that financial advisers can owe fiduciary duties to their clients.

In a 1992 consultation paper entitled Fiduciary Duties and Regulatory Rules (Consultation Paper No 124), the Law Commission gave as an example a situation in which an investment bank's advisory department is advising a company which is making a hostile share swap bid for another company but another department of the bank, such as the department managing discretionary share-trading accounts, is selling shares in the bidder. This could be contrary to the interests of the bidder and it may have the effect of depressing the bidder's share price (CP 24 at 2.4.12 s(viii)). This example is similar to the events in ASIC.

Excluding and managing fiduciary duties

Investment banks and others have sought to manage potential conflicts of interest in a number of ways. The focus of this article is on the use of contractual methods and not on the favoured technique of the Chinese wall.

The court in ASIC observed that a Chinese wall is a technique for managing as opposed to excluding conflicts of interest. A discussion of Chinese walls is beyond the scope of this article but it is clear that it will be a question of fact in each case as to whether an information barrier is effective (see the decision of the House of Lords in Prince Jefri Bolkiah v KPMG [1999] 1 All ER 517 where the ad hoc Chinese wall proved inadequate). In ASIC itself there were allegations of information having crossed the wall.

Contractual techniques

Contractual techniques have long been used to manage or modify fiduciary duties. In ASIC, the Australian court approved the findings of the Law Commission (CP 124) which recognised that the question of the scope of any fiduciary duties and, indeed, whether a fiduciary relationship existed, will depend on the all the facts, including the contractual terms between the parties. This view is supported by Kelly v Cooper [1993] AC 205 (at 213-14) (see below).

Consent of the client

A key question in ASIC was whether a fiduciary relationship had arisen prior to the signing of the mandate letter. If it did, then Citigroup was obliged to obtain the fully informed consent of its client in order to vary its duties. After a careful analysis of the facts, the court held that Citigroup was never in a fiduciary relationship with T.

Solicitors and other professional advisers should not be rushing to exclude fiduciary duties owed to clients as a result of ASIC. In a solicitor and client situation, for example, a fiduciary relationship may arise at a very early stage, indeed even before the solicitor is retained. Therefore, any variation would, at the very least, require the fully informed consent of the client. But in seeking to obtain such consent, would a solicitor be complying with his fiduciary duty to act in the best interests of his client? Furthermore, the common law duties of professionals are usually bolstered by rules of professional conduct and these rules may well prevent the exclusion of such duties and place restriction on their variation, even with consent.

Nature of consent

If consent is needed, then whether it has been given will be a question of fact in each case. A fiduciary must give full and frank disclosure of all material facts. The sufficiency of the disclosure will depend on the sophistication of the person from whom consent is sought.

Ideally, any consent should be express and unambiguous. However, it clear from cases such as Kelly that consent can be implied by the circumstances of the situation or implied by trade and custom. But, the trade or custom: '[M]ust be strictly proved. It must be so notorious that everybody in the trade enters into a contract with that usage as an implied term' (per Jessel MR in Nelson v Dahl [1879] 12 Ch 568, 575). In Kelly the Privy Council held that there was to be implied in a contract with a real estate agent a term to the effect that the agent was able to act for other sellers of similar properties. Such a term was notorious and, indeed, it would be impossible for estate agents to carry out their normal business otherwise.

In ASIC, the judge went on to consider the issue of consent and opined that, on the facts of the case, informed consent would have been implied from T's knowledge of Citigroup's structure and method of operations. T knew that Citigroup was a large financial conglomerate which did not act exclusively for T. T also knew that Citigroup had a proprietary trading desk. T accepted that Citigroup could trade for third parties or for itself so long as it did not use T's confidential information. So this was a relationship where trade and custom would have implied consent. But the test of notoriety may in many other situations be very difficult to satisfy.

Avoiding conflicts

Fiduciary duties are by their nature uncertain. It may well be difficult to assess when a conflict has arisen and, if so, whether it has been effectively managed. For this reason, it is no surprise that regulators of professional bodies produce rules to complement the common law. Solicitors, for example, must comply with the Solicitors Code of Conduct 2007. In the context of financial firms, the Financial Services Authority has recently updated its rules with effect from 1 November 2007 in order to comply with the Markets in Financial Instruments Directive. In brief, the new rules require firms to have in place from the outset arrangements to manage conflicts, rather than relying on disclosure and consent.

A topical area concerns duties owed by directors to companies, now codified in Pt 10 of the Companies Act 2006. Section 175, which is not yet in force, states that a director must avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the interests of the company. A director in such a situation would need to obtain the fully informed consent of the company, and this should be obtained from the company by way of a resolution of the members. However, ss174 (4) and ss175 (5) allow for the potential conflict to be authorised by the directors if the company is a private company provided there is nothing in the constitution to invalidate such authorisation. If the company is a public company, the constitution must include a provision allowing directors to authorise the matter.

Practical effect of ASIC

The finding in ASIC that no fiduciary relationship had arisen depended on the particular facts. In any event, the judge would have implied the client's consent to the dealing in the shares. The effect of the judgment might be more limited in other professional situations where a fiduciary relationship is likely to have arisen at a very early stage and where consent to a variation in fiduciary duties will not be readily implied.

The benefits of excluding a fiduciary relationship are clear: fiduciary duties are vague and imprecise and greater certainty can be achieved by having the relationship governed by the terms of the contract. The practical response to ASIC for reluctant potential fiduciaries would be to exclude fiduciary duties expressly and clearly by contract as soon as practicable. However, in the event that a fiduciary relationship has already arisen, it is prudent to insert a further clause whereby the client expressly consents to what would otherwise amount to a breach. But bear in mind, if you are a fiduciary you must be acting in the best interests of the client in seeking such consent.