The UK Financial Conduct Authority (FCA) released its updated rules on payments for investment research, eliminating payments for corporate access with client commissions. Moreover, the rules go into effect in less than a month, reflecting the FCA’s view that the rules are simply a clarification, and that investment managers should have been following them all along.
The full text of Policy Statement (PS) 14/7 can be found at http://www.fca.org.uk/your-fca/documents/policy-statements/ps14-07.
The FCA is implacable in its aversion to corporate access as a form of research. The FCA received 62 comment letters and met with investment managers, investment banks and corporate issuers prior to issuing its final rules. In the end, the FCA did not make major changes to the proposed rules.
Some respondents argued that the definition of corporate access was too broad. Nevertheless, the FCA held to its definition denoting any service of arranging or bringing about contact between an investment manager and an issuer or potential issuer.
The FCA also pointedly addressed the issue of bundling corporate access with other services, such as conferences or analyst input. Investment managers will need to explicitly disaggregate the research portion and make a ‘fair assessment’ of the charge to pass on to their customers.
It will also scrutinize situations where the corporate access is deemed a ‘free good’. Effectively, investment managers will need to fully justify any other payments made to a broker arranging corporate access as a non-monetary benefit and demonstrate that corporate access is not being subsidized by other payments.
With or without corporate access, investment managers will need to scrutinize unpriced bundled services more carefully. The FCA expanded the final rules to place more emphasis on the need for investment managers to proactively value bundled services, whether or not investment banks are cooperative.
Investment managers should do “fact-based analysis” of bundled services. This would include comparisons to priced services such as independent research (which is often an order of magnitude less expensive). Asset managers are also encouraged to estimate what it would cost them internally to perform the service. Or determine what they would be willing, in good faith, to pay for the service.
The FCA seems unsympathetic to the investment manager lament that investment banks are not forthcoming in providing pricing for their services:
Where an investment manager feels they need information from the broker or third party provider to assist them in a valuation process, we would expect a reasonable level of transparency to be present as part of any commercial arrangement. This could include the nature of a good or service provided, and the extent to which it has been used.
FCA singled out corporate access but is less clear for other forms of research, leaving it up to investment managers to justify whether primary research meets the test. Primary research providers were particularly troubled by the definition that research needs to “present” meaningful conclusions. The FCA stuck to its guns on this point, arguing that the phrase ‘meaningful conclusions’ has been part of the UK’s definition of eligible research since 2006. Moreover the FCA “would not expect an investment manager to accept as substantive research a good or service that only has a purely ‘artificial’ conclusion added by a broker or third party.”
On the plus side, the FCA says it does not intend to rule out “research that is used by the investment manager to feed into their own further research or assessment of investment and trading ideas.” However, it concludes that eligible research must meet its cumulative definition of research, including presenting meaningful conclusions:
In the UK, the ability to use dealing commissions to acquire research is not intended to cover all non-execution related inputs into the investment manager’s decision-making process, but only additional third party research that can met our cumulative evidential criteria.
Those firms hoping the FCA would moderate its position will be disappointed in the published rules, which, if anything, are tougher in their final form. PS 14/7 sends the signal that the FCA will err on the side of less rather than more eligible research, and none of the arguments presented to date seem to have softened their position.
Investment banks will be hardest hit by the new rules. The FCA intends to erase £500 million (US$800 million) in commissions it estimates are spent on corporate access in the UK. Most of that goes to investment banks. However, if the FCA succeeds in pressuring investment managers to put a fair value on bundled investment bank research, the damage could be larger. Priced independent research is generally significantly less than what investment banks have traditionally been paid for their research. Or to use the other metric suggested by the FCA, investment managers could hire a lot of internal staff with the amounts paid for bank research.
The FCA has not only been fielding comments to CP 13/17. From November 2013 to February 2014, it conducted a thematic supervision review examining both asset managers and sell-side brokers to review current market practices and business models linked to the use of dealing commissions. Reading between the lines, it does not appear that this review relaxed the FCA’s perspective. The FCA promises to report on this review later this year.
The Damoclean sword over everyone’s head is the MiFID II, which could result in an outright ban on paying for any research with client commissions. As the FCA puts it, “MiFID II has the potential to impact the ability of portfolio managers to receive third party inducements, which may include research acquired in return for dealing commissions linked to execution services.”
The FCA is a party in the MiFID II discussions, but, judging by PS 14/7, a ban on research commissions would not break its heart.