by:Investment Management and Securities Industry Practice
Changes to the use of dealing commission rules, including a ban on “softing” of corporate access services, reflect the FCA’s continuing objective to ensure that investment managers control the costs that they pass on to their customers.
On 2 June, the UK Financial Conduct Authority (FCA) brought into effect revised rules on its use of dealing commission regime (colloquially, the “soft commission” regime) to clarify existing expectations under the regime rather than creating new requirements. The revised rules (i) clarify the criteria determining the characteristics of qualifying research that can be “softed” (technically, paid for with dealing commissions) (substantive research), (ii) create a presumption that a good or service is not substantive research where the criteria are not met, and (iii) give guidance on FCA’s expectations where firms purchase such research in a bundled package with other goods and services that cannot be paid for with dealing commissions.
These changes follow a consultation paper published by the FCA in November 2013, which set out the proposed scope of the amendments and sought feedback. The main issues arising from the consultation and final updated rules were published by the FCA in a policy statement in early May 2014.
Before considering the changes, it is helpful to review the use of dealing commission regime. Investment managers are required by the FCA to act in accordance with the regime when they execute customer orders that relate to shares. Investment managers are banned from using dealing commissions to pay for any goods or services that are in addition to the actual cost of executing their customer orders. By way of an exemption, investment managers are allowed to pay higher commissions on behalf of clients to acquire execution‑related and research goods and services, provided that those goods and services reasonably assist the investment manager in the provision of its services to customers and do not impair its duty to act in the best interests of customers. These rules are buttressed by robust customer disclosure requirements.
Amending the Exemption Permitting the Use of Dealing Commissions and the Criteria for “Substantive Research”
In its consultation, the FCA proposed to amend the criteria determining the characteristics of a good or service that is directly related to the execution of trades on behalf of an investment manager’s customers and the characteristics of exempt research and to create a presumption that a good or service is not exempt where the criteria are not met.
The proposals were viewed by some respondents to the consultation as resulting in “strict liability”, namely that, even where an investment manager took reasonable steps to determine that the content of a good or service was “substantive research”, they could still be in breach of the proposed revised rules in contradistinction to the status quo.
The FCA’s response was to retain, not discard as proposed, the existing requirement that an investment manager must have reasonable grounds to be satisfied that a good or service paid for with dealing commissions will reasonably assist it with the service provided to its customers. The revised second and third limbs of the exemption read as follows:
- Receipt of such good or service does not, and is not likely to, impair an investment manager’s duty to act in the best interests of its customers.
- The good or service is either directly related to execution of trades or amounts to the provision of substantive research.
The FCA does not consider the removal of a “reasonableness” requirement from the second and third limbs of this test to represent a significant change. In practice, however, this will likely result in additional recordkeeping and paperwork.
The Evidential Criteria for Substantive Research
The FCA proposed some changes to the existing evidential provisions that clarify the characteristics of exempt research, now labelled as “substantive research”. As before, the FCA will expect substantive research to add value to investment decisions, represent original thought, and have intellectual rigour. The main change wrought by the FCA is that qualifying research should also “present the investment manager with meaningful conclusions based on analysis or manipulation of data”. The FCA has stressed that the reference to “meaningful conclusions” is not a new addition and has been part of the rules since they were first introduced. Further, the FCA states that its intention is not to limit a conclusion to a “buy” or “sell” recommendation, noting that “a conclusion can include a summary and statement of opinion, or making a reasoned deduction or inference, provided that the research contains this in itself”. FCA notes, however, that it would “not expect an investment manager to accept as substantive research a good or service that only has a purely ‘artificial’ conclusion.”
In the United States, similar to the UK, physical items, such as computer hardware, that do not reflect the expression of reasoning or knowledge and mass‑marketed publications are not eligible for purchase using soft dollars. However, traditional research reports analysing the performance of a particular company or stock, discussions with research analysts, and meetings with corporate executives to obtain reports on the performance of a company are eligible.
Corporate Access Services
The FCA’s findings from its thematic supervisory work on conflicts of interest between investment managers and their customers in 2012 found evidence that some managers were either failing to monitor compliance with the soft commission regime and/or were off reservation in deeming certain goods and services to be exempt research. FCA found that firms were unable to demonstrate how brokers arranging for access to company management or providing preferential access to initial public offerings constituted research or execution services. FCA has no issue with corporate access per se but rather considers that arranging access to corporate management should not be paid for with dealing commissions; instead, it should be regarded as a core cost of business and be funded from the firm’s own resources or separately charged to clients.
Under the revised regime, “corporate access services” are enumerated in the list of examples of goods or services that do not qualify as exempt, joining well-established categories, such as valuation and performance measurement of portfolios, order and execution management systems, and seminar fees. Accordingly, investment managers can no longer pay for corporate access services out of dealing commissions. The FCA defines “corporate access service” as “a service of arranging or bringing about contact between an investment manager and an issuer or potential issuer”.
Some respondents to the consultation paper believed this definition to be too wide, suggesting it might encompass the arranging of any potential contact between an issuer or potential issuer and an investment manager. The FCA, however, continues to believe it is appropriate. Where corporate access is provided alongside substantive research (e.g., where an investment manager attends investor conferences arranged by a broker), the FCA expects the investment manager to take steps to identify and disaggregate the substantive research element from the corporate access element.
Bundled Goods and Services
Under the revised rules, where a good or service received by an investment manager comprises substantive research as well as elements that are not substantive research, the investment manager must disaggregate the two to ensure that it pays only for the substantive research elements from dealing commissions. In response to the consultation, the FCA makes it explicit that mixed‑use assessments are equally applicable to nonpriced bundled goods and services. Whilst the FCA will fight shy of mandating methodologies for firms, it will expect investment managers to show evidence of their processes and the basis of their judgements.
Guidance on Acting in Customers’ Best Interests
In new guidance, the FCA states that an investment manager should not pass on a charge to a customer that is greater than the cost charged by a broker for the same.
More Reform Likely
The above changes represent a further waypoint in the FCA’s continuing and evolving regulation of soft commission. The FCA continues to consider whether the regime is fit for purpose in the longer term by engaging with its constituency of authorised firms, independent research firms, other service providers, and corporate issuers; framing its work within the context of implementing the recently revised second Markets in Financial Instruments Directive, known as “MiFID II”; and engaging with other international regulators through the International Organisation of Securities Commissions. The FCA will report on that work later in 2014 and will indicate whether further reform is appropriate and, if so, will align the timing of such reform with its domestic implementation of MiFID II in late 2016/early 2017 in order to minimise the uncertainty and potential cost of any changes for firms.
In terms of the outcomes‑focused regulation espoused by the FCA, the revised regime should ensure that it is interpreted correctly as a narrow exemption allowing the investment manager to pass on only costs directly related to the execution of trades or the provision of substantive research to its customers. The FCA wants to see investment managers applying a similar level of scrutiny to payments for goods and services using client dealing commissions, as they would if they were spending their own money. Investment managers should be aware of these changes and review the revised rules in detail if they have not already done so. They should review their current practices against the revised regime and take steps to ensure they are compliant going forward. In practice, the burden of compliance may prove greater than that envisaged by the FCA.
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. Strictly, the findings were those of the FCA’s predecessor, the Financial Services Authority.