As promised, the UK’s Financial Conduct Authority (FCA) released last week its consultation paper which proposes clarifications on what is permissible to be paid with commissions, namely that corporate access is not eligible. The clarified rules would also likely nix commission payments for primary research, such as expert networks or channel checks, and reduce mixed-use payments for market data services. The paper is a prelude to the FCA’s broader goal of unbundling commission payments for research.
FCA head Martin Wheatley challenged fund managers’ use of client commissions to pay for investment research in a landmark speech at the end of October. The issue has been percolating since last November when the predecessor to the FCA reported that asset managers were doing a poor job managing conflicts of interest. The report zeroed in on corporate access but raised questions about the larger issue of how well asset managers were managing the use of client commissions spent on research.
The regulatory umbrage prompted the Investment Management Association (IMA), the trade association for UK Asset Managers, to appoint this summer a blue ribbon panel to make recommendations on how client commissions might be better managed. The UK media, led by the Financial Times, has been attacking corporate access particularly and commission bundling generally.
The FCA is adamant that corporate access does not meet its definition of research and is therefore ineligible for payment with client commissions:
We maintain that arranging access to corporate management does not amount to research and so must not be paid for with dealing commission. The arranging service in itself does not provide any analysis or insight, or reach meaningful conclusions. It is difficult to see how, when a bank or broker arranges for an investment manager to meet its corporate clients – by whatever means – they would fulfill the ‘research’ criteria. In most instances it is unlikely to involve original thought, have critical analysis and evaluation of information, and reach meaningful conclusions that are provided to the investment manager.
If the provider of corporate access offers a briefing note or a research analyst’s input before a meeting, this element would be eligible for payment with client commissions. However, only that limited research element, which the FCA says should be ascribed ´a reasonable, fair value by the manager´, is eligible and not the entirety of the arranging service.
The FCA estimates that UK investment managers made aggregate payments for corporate access of up to £500 million (US$800 million) in 2012. It expects these payments to decline in the future as asset managers either absorb the cost of corporate access themselves or charge it more explicitly to customers.
Impact on other research
Consultation Paper 13/17 has a broader reach than corporate access. The FCA re-emphasizes the UK definition of commissionable research which must contain critical analysis and evaluation of information provided. Further, the use of client commissions for research is not permissible for services used by the investment manager in developing or preparing their own research and analysis.
Although CP 13/17 does not explicitly reference primary research, its thrust would make it difficult for UK-based asset managers to justify paying for expert consultations, channel checks, surveys and other forms of primary research with client commissions. First, the providers of these services typically do not include analysis and insight as part of the service, and, second, they are mostly used by asset managers in preparing their own research.
Market data services have been explicitly excluded from the UK definition of research since 2006, but the FCA noted that some asset managers have been paying for most or all of their market data services with client commissions on the grounds that some market data services contain elements of ‘substantive’ research. The FCA would require asset managers to explicitly value the ‘substantive’ component and commission that portion only.
The consultation paper mentions other services that the FCA considers ineligible, such as the purchase of raw data feeds, translation services, and preferential access to IPOs.
Sell side research
The FCA’s prohibition of corporate access hurts sell-side research. In the latest Thomson Reuters Extel survey, 38% of buy-side respondents considered corporate access ‘very important’ when deciding who to turn to for sell-side research and advisory services.
A potential zinger for sell-side research, much of which is not explicitly priced, is contained in the FCA’s injunctions for asset managers the exercise the same level of care with client commissions as they would for internal costs. The FCA directs asset managers to use prices for comparable services as guidelines for commission payments for research. In other words, if an independent research provider charges £40,000 for covering a sector, this should be a consideration in valuing payments for brokerage research.
Most market participants have already begun cutting back commission payments for corporate access. The current paper clarifies the FCA’s position for any in doubt.
While the impact on corporate access is no surprise, the implications for primary research were not as broadly understood. Primary research firms rightly point out that custom research is already transparently priced and that it is used by the fund to benefit investors by generating alpha. They are likely to push back on the FCA’s prescription against paying for services used by the asset managers to develop their internal research.
The bigger issue is whether the FCA will try to abolish altogether the payment for research with client commissions.
Our view is that, even with the proposals in this CP, there remain some inherent flaws in the use of dealing commission to fund research and in the industry structures that have evolved from our rules. These issues may require more forward looking reforms to ensure the investment management sector is fit for the future and maintains a competitive edge as the global focus on transparency increases.
The European dimension
One theory is that the FCA is front-running the EU on the topic of bundled research. As CP 13/17 notes, negotiations to revise MiFID are currently underway, with the main Directive (or ‘Level 1’) expected to be concluded by early 2014. It is possible that the FCA is stirring up the industry to show the EU how damaging banning commission payments would be.
Under any scenario, the FCA will want to be in front of MiFID II to try to manage it from a perspective that is workable for the UK asset management industry. As the FCA puts it: ‘…we have indicated a desire for a collective solution driven both by European reform, but also a domestic debate. By considering all options, including the potential for unbundling to be implemented across the EU through forthcoming reforms under MiFID II, we are confident of developing a solution that will tackle the misaligned incentives, potential for conflicts of interest, and the lack of transparency and controls of costs created by the existing use of dealing commission regime.’
The deadline for comments on the consultation paper is February 25, 2014. The FCA intends to implement the clarifications later in the spring of 2014.
One of the inputs will be the IMA report which is promised for early in 2014. The IMA paper will probably argue against banning commissions, and propose a variety of improvements: improved budgeting, greater transparency, pressure on sell-side for more explicit pricing, better voting/valuation measures.
Meanwhile, the FCA is carrying out a review over the next few months to further examine how firms are managing their conflicts of interest and costs, especially in their use of client commissions. The FCA is reviewing not only investment managers, but also sell-side firms (i.e. the large investment banks), to explore the supply of bundled brokerage services and how the brokers manage conflicts between their different customers. The results of this review will likely be released after the implementation of the changes proposed in CP13/17.
MiFID II is unlikely to come into force before late 2016 at the earliest. However, negotiations on the directive are happening now, which may explain some of the FCA’s urgency on this topic.
The UK asset management industry expects change to the current commission regime. At the conference where Wheatley made his landmark speech, there was a poll of asset managers and the majority expected structural changes.
The FCA may accept the IMA recommendations while still holding the sword of no commissions over the industry’s head if things do not improve; or it may propose to move to an unbundled world over some period of time.
If the FCA chooses to ban commissions for research then it will have to draft a consultation paper, get feedback, finalize the rules and implement an 18 month or longer transition period. So the earliest it would happen would be 3-4 years from now.
Even if the end result were a ban on commission payments for research, commissions for execution would still be allowed. Research would be paid out of the asset managers’ P&L but asset managers would be allowed to raise fees to the asset owners to partly offset the impact.
The FCA estimates that £3 billion (US$ 4.8 billion) was paid by UK asset managers in 2012, of which approximately half was for research. The FCA would like to see this number decline. In a fully unbundled world, it would decline substantially. However, even though CP13/17 is billed as a clarification of existing rules, we expect it will have a measurable impact on research payments through the elimination of the majority of corporate access spending, commission payments for primary research and reduced commission payments for market data.
As we have argued previously, we remain skeptical that the endgame is a complete ban on commission payments for research. For one thing, the US Securities and Exchange Commission has shown zero interest in the topic, and we think it would be problematic for the FCA to ban commissions altogether while the SEC condones what is already a more generous commission regime.
More likely, the FCA is scrambling to maintain leadership on this topic ahead of the EU negotiations for MiFID II. As Wheatlely noted in his October speech, the FCA is looking for a solution that ultimately protects the UK asset management industry, which is a significant part of the UK economy. Some level of reform will be necessary, but we are betting the FCA will stop short of a full ban. At least for now.