Fitness and Properness – The Criterion of Conflicts of Interest and Independence of Mind

This is Part III of III of an article series on Identifying and Managing Conflicts of Interest in Regulated Entities.

Click to read Part I or Part II on the significance of identifying and managing conflicts of interest in regulated entities.

Directors of regulated entities are required by statute,[1] by MFSA rules and regulations[2] and by the MFSA’s New Corporate Governance Code[3] (the “Code”) to be suitable, fit and proper persons to ensure the company’s sound and prudent management. The requirement of fitness and properness also applies to qualifying shareholders, senior managers and to key function holders. This article will focus on directors of regulated entities. In 2019, the MFSA published Guidance on the Fitness and Properness Assessment applied by the Authority (the “Guidance”).

The MFSA’s concept of fitness and properness is multidimensional and is composed of four criteria as follows:

1. competence;
2. reputation – integrity and solvency;
3. conflicts of interest and independence of mind; and
4. time commitment.

These criteria must be satisfied not only during an application process but also on an ongoing basis. The MFSA cautions that instances may arise which require the reassessment of the regulated entity’s suitability. While these criteria apply to all directors of regulated entities, this article will focus on the third criterion, that of conflicts of interest and independence of mind.

The Guidance provides that directors should be able to make their own sound, objective and independent decisions and judgements and that conflicts of interest could impact the ability to take sound, objective and independent decisions. This criterion resonates with the concept of unfettered discretion which means that directors cannot validly contract, either with one another or with third parties, as to how they will vote at future board meetings or how they will otherwise conduct themselves in the future. The principle of unfettered discretion applies even if there is no improper motive or purpose and even if no personal advantage is to be gained by the directors under the agreement. If a director does not adhere to the principle of unfettered discretion their ability to take objective, sound and independent decisions may be compromised and could result in a conflict of interest.

The Guidance obliges directors to declare any conflicts of interest that they may have together with the actions that they are taking to mitigate such conflict. If a conflict of interest is identified, the regulated entity must assess the materiality of the risk posed by the conflict of interest. In the event that the regulated entity deems the conflict to be material, it must adopt adequate measures including:

1. performing a detailed assessment of the particular situation; and
2. deciding which preventative and/or mitigating measures will be implemented.

These measures should be included in the regulated entity’s conflicts of interest policy. In relation point ii. above, the Guidance explains that the preventative and/or mitigating measures must be implemented in accordance with the regulated entity’s conflicts of interest policy unless the legislative framework already prescribes which measures must be taken.

The Guidance notes that if concerns exist that could be resolved by the regulated entity taking adequate action, the MFSA could impose additional measures including:

1. prohibition to participate in any meeting or decision-making concerning a particular disclosed interest;
2. resignation of a certain position;
3. specific monitoring by the entity;
4. specific reporting to the MFSA on a particular situation;
5. cooling-off period for the appointee;
6. obligation on the supervised entity to publish the conflict of interest;
7. the application of the “at arm’s length” principle; and
8. specific approvals by the whole board of directors for a certain situation to continue.

It should be noted that a director cannot be considered as suitable if the measures taken by the regulated entity or the imposition of a condition are insufficient to adequately manage the risk posed by the conflict of interest.

Ultimately, the requirement that directors must be fit and proper by, inter alia, having and retaining the ability to make sound, objective and independent decisions and judgements ties in neatly with the requirement that directors are bound to avoid, prevent, mitigate and manage conflicts of interest. Avoiding, preventing, mitigating and managing conflicts of interest is one of the ways in which regulated entities could maintain and enhance good corporate governance. And in terms of the Code, good corporate governance builds mutual trust with stakeholders, creates value for stakeholders, ensures the financial stability of regulated entities and promotes the integrity of the market.

[1] See, for example, article 7(1)(d) of the Banking Act; article 5(1)(d) of the Financial Institutions Act; article 8(1)(e) of the Insurance Business Act; articles 6(1)(a)(i),6(1)(b) and 6(7) of the Investment Services Act; article 43(4)(i)(c) of Trusts and Trustees Act (see also definition of “approved person”); and article 5(1)(c)(iii) of the Company Service Providers Act.

[2] See, for example, Rule 20 of Banking Rule BR/01; Rule 18 of Financial Institution Rule FIR/01; Chapter 2 of the Insurance Rules; Section 3 of the Investment Services Rules for Investment Services Providers; Principle 4 of the Code of Conduct for Trustees; and Title 5 of Chapter 2 of the Company Service Providers Rulebook.

[3] Principles 2.1.3.1.2 and 2.1.3.2.4 of the Code.