The global investment banking community should be concerned by an Australian action against Citigroup over proprietary trading, argues James McConvill

The Australian Securities and Investments Commission (ASIC) recently announced that it is taking action against Citigroup’s Australian arm. ASIC alleges that Citigroup has breached, among other things, new rules in Australia requiring investment banks to manage conflicts of interest.

ASIC’s action places a big question mark over a fundamentally important component of modern investment banking worldwide: proprietary trading, that is, banks trading in shares for themselves rather than their clients. Accordingly, one US business commentator has said: “Investment banks around the world will be watching this case closely.” One UK corporate lawyer believes that the case has “far reaching implications for investment banking.”

Let’s make this simple: Citigroup was involved in a conflict of interest. The investment bank’s proprietary trading desk purchased a significant number of shares in Patrick, Australia’s largest port cargo handler, and at the same time was advising logistics company Toll Holdings in relation to that company’s impending multi-billion dollar takeover offer for Patrick. The conflict arises because as a purchaser of Patrick shares, Citigroup wanted the share price to go up, but as adviser to Toll, it had an interest in Patrick’s share price remaining stable so that the takeover target wasn’t too expensive for its client.

Citigroup, like many other investment banks, has in place separate divisions: its finance division works to finance transactions; its advisory division provides advice to clients about takeovers and similar transactions, and its proprietary trading division is involved in buying and selling shares and other securities simply to make money for the bank. Traditionally, investment banks were simply involved in financing and advising on deals, but over the last twenty years or so, they have made a significant amount of money from proprietary trading.

But the important thing to point out about this arrangement is that the banks completely separate their proprietary trading ‘desk’ from their financing and advising arms. While the financing and advisory arms may share information between them, the idea is that the proprietary trading people in the bank are removed from all that; they play a different type of ball game.

While the proprietary trading people may work in the same building as the financing and advisory people, they are separated by a Chinese wall not a physical wall (although sometimes it does go that far), but an understanding that certain information belongs to a particular circle of individuals within an organisation, and is not to be shared with individuals outside the organisation. There is a ‘circle of trust,’ so to speak.

ASIC argues strongly that Citigroup, as a financial service provider in the Australian market, has breached one its general legal obligations, which is to “have in place adequate arrangements for the management of conflicts that may arise wholly, or partially, in relation to activities undertaken … in the provision of financial services.”

This obligation was introduced into the Corporations Act last year, as one of a suite of corporate governance changes made through the government’s CLERP 9 legislation.

Interestingly, regulators in the US and the UK have recently introduced (or revised) similar conflict management rules to crack down on conflicts within full-service investment banks. Conflicts of interest in investment banks became an issue earlier this decade as it was found that many reports prepared by ‘sell-side’ research analysts in the large investment banks (most famously Merrill Lynch) lacked objectivity due to being influenced by the banks’ trading and financial activities. The big problem involved research analysts preparing overly positive reports about companies who were also paying the bank for the provision of corporate finance services.

Australia’s new conflicts of interest obligation was also introduced in response to this concern about the integrity of research reports. So up until the Citigroup action, the major concern of regulators in the US, UK, and Australia, in relation to investment banks, concerned the independence of research analysts, not proprietary trading. Proprietary trading was obviously known about, given that it is a key part of modern investment banking, but was not expressly raised as a problem by regulators in the context of conflicts of interest.

In fact, in a policy statement released in 2004 which attempts to clarify the new obligation of investment banks to manage conflicts of interest, not once does ASIC raise proprietary trading as an example of an activity needing to be managed (through disclosure and internal controls), let alone one that should be avoided. But ASIC’s position has obviously changed. ASIC’s media announcement about the Citigroup action makes clear that it wants investment banks to avoid proprietary trading when this could raise conflicts with their ‘traditional’banking activities. It considers the management obligation to have an application beyond the practices of research analysts.

This is why ASIC’s case against Citigroup, while taking place ‘down under,’ has global implications for investment banking- and particularly for investment banks in the US and UK. If ASIC proves successful in establishing that Citigroup’s proprietary trading activities violates the new management obligations on conflicts, US and UK regulators may assess whether existing rules on conflicts of interest can be used to launch an assault on proprietary trading. However, particularly in the US, conflict rules appear to limited to the activities of research analysts. So conflict rules having more general application (like Australia’s rules) may be adopted.

It is to be hoped that the Australian Federal Court will decide that Citigroup did indeed manage its conflicts, and comply with its obligation, through mounting effective Chinese walls which separated the bank’s financial activities from its trading activities. But if the Court sides with ASIC that the Citigroup should have gone further and avoided any conflicts arising from its proprietary trading, trouble may be ahead for full-scale investment banks across the globe.

The big winners out of all this will not be the corporate regulators, but rather boutique investment banks that have stayed clear of proprietary trading and focused on more traditional corporate advisory and financing services. Postmodernism may be about to hit the investment banking community. Watch out!

James McConvill is principal of The Corporate Research Group and a senior lecturer at La Trobe Law School, Melbourne