FCA calls for the unbundling of research from dealing commissions

Transcription

1 July 2014 FCA calls for the unbundling of research from dealing commissions Introduction On 10 July 2014 the Financial Conduct Authority ("FCA") published a discussion paper (DP14/3) on the use of dealing commission regime. In the paper, the FCA reports on findings from its recent thematic review and suggests ways for firms to improve the way research is purchased under the current rules. The FCA concludes that the unbundling of research from dealing commissions would be the best way to address the conflicts of interest that arise when investment managers use transaction costs to fund external research. Any policy changes will take place in the context of the recast Markets in Financial Instruments Directive ( MiFID II ), which must be implemented by Who does this apply to? Contents Introduction... 1 Who does this apply to?... 1 How did we get here?... 1 What is the issue?... 2 What does the discussion paper say?... 2 How does this fit with MiFID II?... 3 What happens next?... 4 What should firms do now?... 4 The issues raised in the discussion paper will be of interest to investment managers who use dealing commission to pay for research. This includes UCITS management companies when carrying out scheme activity and alternative investment fund managers ( AIFMs ) carrying out investment management functions. It is also relevant to brokers and third party providers of independent research and other ancillary services to investment managers, and to customers of investment managers, including institutional and retail investors. How did we get here? The rules on the use of dealing commission are contained in section 11.6 of the FCA s Conduct of Business Sourcebook ( COBS ) and build on the rule on inducements in COBS 2.3.1R. The rules provide that investment managers can use dealing commission passed on to their customers accounts to acquire only goods and services that are related to (a) the execution of trades on behalf of customers and (b) the provision of substantive research. FCA calls for the unbundling of research from dealing commissions 1

2 In 2012, the Financial Services Authority ( FSA ), the predecessor to the FCA, published a report 1 based on its thematic reviews of asset management firms and their arrangements for managing conflicts of interest, in which it identified that too few firms adequately controlled spending on research and execution services. At the same time, it issued a Dear CEO letter to all investment managers, asking their boards to review their conflicts of interest management in light of the FSA s findings. Each firm s CEO was required to attest that they were satisfied that their firm managed conflicts effectively and was in compliance with the FSA s rules. The FCA published a consultation paper (CP13/17) the following year with proposed enhancements to the use of dealing commission regime, designed to ensure that investment managers make appropriate judgments and control costs on behalf of their clients when using dealing commission to pay for goods and services. Final rules were presented in a policy statement (PS14/7) in May These rule changes were made in the context of a wider review of the regime. The FCA conducted a further thematic review from November 2013 until February 2014, covering both investment managers and brokers. The discussion paper summarises the outcomes of the wider review and outlines potential changes. What is the issue? UK investment managers currently pay brokers an estimated 3 billion of dealing commissions per year, about half of which is spent on research. These transaction costs are borne directly by the investment managers customers. The FCA is concerned about the lack of transparency of costs, the investment managers controls over dealing commissions, and the potential for conflicts of interest, given what the FCA perceives to be the largely unpriced and opaque nature of the research market. The purpose of the wider review was to assess the extent of these issues and determine whether structural reform is necessary to improve the transparency and efficiency of investment managers and the research market. Any reform will aim to ensure that investment managers manage costs appropriately in the best interests of their customers and that competition in the research market is effective. What does the discussion paper say? The FCA summarised its findings as follows: > While some investment managers have improved their governance over how they purchase research with dealing commissions, there are still too few firms applying sufficient rigour in assessing the value of the research services they use. 1 Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks (Nov. 2012). FCA calls for the unbundling of research from dealing commissions 2

3 > There is a lack of price transparency in the market for research due to the way the market has evolved, and the bundled supply of execution and research services by brokers makes price discovery difficult. The FCA concludes that these findings support the case for structural change. The regulator believes that unbundling research from dealing commissions is the most effective way to address the conflicts of interest that arise when investment managers use transaction costs to pay for external research. In the FCA s view, this would lead to more efficient price formation and competition in the supply of research, eliminating the current lack of transparency in the market. Investment managers would need to absorb the cost of research themselves or pass the cost through to investors, for example in the annual management charge. The paper includes a discussion of the concerns that stakeholders have raised about the potential effects of unbundling research from dealing commissions. These include the impact on (a) the level of research coverage in the market, (b) the liquidity of UK mid- and small-cap company shares if dealers react to a fall in revenues by reducing coverage of these sectors, and (c) the competitiveness of UK investment managers internationally. It is the FCA s view that the efficiency benefits of unbundling would outweigh these possible negative impacts. How does this fit with MiFID II? The FCA would prefer to make any changes in conjunction with EU-wide reforms. Earlier this year, MiFID II was agreed by European legislators, although it will not apply until the beginning of The new Directive significantly restricts the benefits an investment manager can receive from third parties in relation to the provision of services to clients. Minor nonmonetary benefits are permitted, so long as they are (a) disclosed, (b) capable of enhancing the quality of service to the client, and (c) of a scale and nature consistent with the investment firm s duty to act in the best interest of the client. The European Commission has been empowered to adopt delegated acts clarifying how these requirements will work in practice, including criteria to assess compliance of firms receiving inducements with the obligation to act honestly, fairly and professionally in accordance with the best interest of the client. The Commission has mandated the European Securities and Markets Authority ( ESMA ) to provide it with technical advice to assist in the development of these delegated acts. Among other things, it has asked ESMA to provide technical advice on the definition and conditions for acceptable minor non-monetary benefits. In its consultation paper published in May 2014, ESMA stated that any research that involves a third party allocating valuable resources to a specific portfolio manager would not constitute a minor non-monetary benefit and could be judged to impair compliance with the portfolio manager s duty to act in their client s best interest. According to ESMA, widely distributed research FCA calls for the unbundling of research from dealing commissions 3

4 or generic economic commentary could be acceptable, but bespoke reports, corporate access or meetings with research analysts should not be deemed a minor non-monetary benefit. In the FCA s view, this means unbundling research from dealing commission arrangements across the European Union, except for the most generic and widely disseminated financial research. The FCA also discusses the possibility of going beyond the EU rules by requiring the unbundling of all research from execution arrangements in the UK. In addition to MiFID II, the FCA supports making similar changes to the inducement rules that apply to investment management activities under the UCITS Directive and the Alternative Investment Fund Managers Directive. If the new regime is not replicated for these other Directives at the EU level, the FCA has suggested that it could make changes through UK implementation. What happens next? The ESMA consultation closes on 1 August The FCA s discussion paper does not contain any formal policy proposals, as the EU reforms are still being formulated. However, the responses that the FCA receives will inform any changes that it makes to the use of dealing commissions regime as it implements MiFID II between now and Comments on the FCA s discussion paper should be submitted by 10 October The FCA will aim to provide feedback on responses in late 2014 or early 2015, after ESMA has provided its final advice to the Commission. The FCA will also interact with other international regulators through the International Organisation of Securities Commissions ( IOSCO ), in recognition of the fact that many investment managers operate globally and would therefore benefit from a cross-border consensus. What should firms do now? Interested parties should review the FCA discussion paper and ESMA consultation paper and may wish to comment by the relevant deadlines. Firms should also consider the FCA s findings and take steps where necessary to ensure that their systems and practices and controls are adequate to comply with the FCA s current rules on the use of the dealing commission. Following are some tips for best practice based on the FCA s findings. Investment managers should: > Review the FCA s Dear CEO letter of November 2012 and check compliance. > Review governance over how research is purchased with dealing commission and ensure sufficient rigour is applied in assessing the value of the research services used. FCA calls for the unbundling of research from dealing commissions 4

5 > Set and manage research budgets that are not influenced by trading volumes and apply budget caps for individual brokers or research providers. > Manage research budgets through Commission Sharing Arrangements ( CSAs ) with brokers and management of execution rates. > Assess research needs based on what will add value for clients and identify which providers can provide those services at the best price, distinct from decisions over where to direct trades. > Negotiate with brokers about the price of research and how much different levels of service should cost. > Consider using independent assessments or proxies such as other priced services in the market to assess the value of research. > Use broker voting processes that ascribe a clear monetary figure to each vote, and link total amounts rewarded a broker to actual services received over a period. Subject these processes to internal challenges and comparisons to ensure consistency. > Avoid using bundled rates without assessing the value of research. Brokers should: > Check payments instructed by investment managers from the CSA balance against a list of pre-approved research providers. > Discuss with investment managers about the price of research and how much different levels of service should cost. > Be transparent about who they are acting for when arranging corporate access and disclose what their role is. Author: Christopher Bernard This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2014 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on and such persons are solicitors, registered foreign lawyers or European lawyers. Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. Contacts For further information please contact: Michael Kent (+44) michael.kent@linklaters.com Nikunj Kiri (+44) nikunj.kiri@linklaters.com Peter Bevan (+44) peter.bevan@linklaters.com Nadia Swann (+44) nadia.swann@linklaters.com Martyn Hopper (+44) martyn.hopper@linklaters.com Carl Fernandes (+44) carl.fernandes@linklaters.com Sarah Parkhouse (+44) sarah.parkhouse@linklaters.com Harry Eddis (+44) harry.eddis@linklaters.com One Silk Street London EC2Y 8HQ Telephone (+44) Facsimile (+44) Linklaters.com FCA calls for the unbundling of research from dealing commissions