As we reported last October, the Financial Services Authority in the UK is challenging the payment for corporate access with client commissions. The FSA’s scrutiny goes beyond corporate access, however, and is raising questions about how well asset managers are managing their use of client commissions generally. The implications could be more far reaching than corporate access.
Between June 2011 and February 2012, the FSA conducted reviews of asset management firms, assessing how well they were managing conflicts of interest. The FSA said the review was prompted by evidence that “some firms no longer saw conflicts of interest as a key source of potential detriment to their customers and had relaxed controls that we had considered to be well-established market norms.” The review resulted in letters sent to senior management at asset managers, and a published summary of findings.
The wording of the summary was harsh:
- “many firms had failed to establish an adequate framework for identifying and managing conflicts of interests;”
- “most of the firms visited could not demonstrate that customers avoid inappropriate costs;”
- “in most cases senior management failed to show us they understood and communicated [a] sense of duty to customers or even that they had reviewed or updated their arrangements for conflicts management since 2007.”
The FSA threatened enforcement actions in some cases, and stated it would conduct a second round of reviews. It also required the CEO’s of the UK’s 195 largest asset managers to attest that they are managing conflicts of interest consistent with FSA guidelines.
Inadequate Commission Management
The FSA has a narrower definition of research than the US Securities and Exchange Commission. In order to be classified as research payable with client commissions, research must contain “original thought, in the critical and careful consideration and assessment of new and existing facts, and does not merely repeat or repackage what has been presented before.” Market data, corporate access and access to IPO’s have challenges meeting the FSA’s criteria for commissionable research.
The FSA’s challenge to corporate access was made in the broader context of lax controls on how asset managers spend client commissions:
We found that few governing bodies [of asset managers] regularly reviewed whether the products and services purchased using client commissions were eligible to be paid for with customers’ funds. In particular, various firms were using commissions to pay for market data services and were unable to demonstrate how these met all of our evidential standards for research services. Firms were also unable to demonstrate how brokers arranging for access to company management or providing preferential access to IPOs, constituted research or execution services.
Corporate access is an issue for the FSA, but it is a symptom of a larger problem: most of the asset managers it reviewed were not prudently managing their clients’ monies. The FSA set a high standard for managing client commissions by comparing the commission management process to the asset manager’s internal procurement policies for its own monies. “Only a few firms we visited exercised the same standards of control over [commission] payments that they exercised over payments made from the firms’ own resources.”
It noted with approval two commission management practices: 1) carefully considering which services represent valuable inputs to the investment process and challenging brokers about paying for other services not considered valuable; and 2) setting a maximum spend on research services and once these limits are reached switching commission rates for the brokers concerned to execution-only rates for the remainder of the commission period. The majority of firms the FSA reviewed, however, “could not demonstrate that customers avoid inappropriate costs.”
Fallout for Corporate Access
Market participants have been sorting out which forms of corporate access potentially meet the FSA guidelines for research. Investment banks have been trotting out lawyers to try to calm nervous asset managers. Corporate access is viewed as a spectrum. Conferences and road trips where asset managers visit corporate facilities are generally viewed as meeting the FSA’s tests for research, given significant involvement from sell-side analysts. At the other end of the spectrum is vanilla ‘diary management’, which is viewed as not meeting the FSA guidelines.
Media attention on corporate access is leading some to question whether corporate access makes sense at all. The Financial Times seems to have latched onto asset management conflicts as a signature topic, similar to the Wall Street Journal embracing insider trading investigations in the U.S.
The FT dug up an investor relations consultant who quoted ‘typical’ figures of $20,000 an hour for access to a chief executive and $15,000 for a chief financial officer. Sounds high to us. We understand the norm in the U.S. to be $10,000 for a CEO, $7,500 for a CFO and $5,000 for others. However, for hard-to-get CEO’s or non-US CEO’s, charges can be higher. Long/short hedge funds have to pay a premium because corporate executives don’t like interacting with short sellers.
In the media spotlight, some in the investor relations community expressed shock and outrage that investment banks were being paid for corporate access. The FT quoted one IR professional apparently innocent to the practice: “One gets annoyed and suspicious when you find out that your resource is effectively being used as a currency by sales teams.” The IR trade association in the UK has called for greater transparency about corporate access payments, and more clarity in the broker’s role in setting up access.
It is unclear whether asset managers will pay fewer commissions for corporate access in the wake of the FSA’s challenge. The latest survey from Thomson Reuters Extel indicates that UK asset managers spend about 30% of commissions on corporate access. Almost certainly, corporate access spending will be shifted to other services. It will be difficult to determine, even for the FSA, whether the diverted commissions will pay for new services or for pre-existing services marked up to compensate for ‘free’ corporate access.
The Bigger Risk
Which leads back to the topic of commission transparency. Does the FSA want to go down this rabbit hole again? In 2005, the Financial Services Authority (FSA) developed a regime requiring greater commission disclosure of execution and research payments, which went into effect the following year. In early 2008, the FSA commissioned a study of the effectiveness of its commission disclosure guidelines, and though the response was mixed at best, it decided to declare victory and move on.
The trade group for the UK asset management industry, the Investment Management Association, appears willing to throw corporate access under the bus, questioning why fund managers are paying “rents” to third parties for corporate access in the first place.
The IMA is quick to say, however, that paying with clients’ money should not be “stigmatised per se.” The IMA is apparently setting up an independent panel to review the topic of commission transparency, and plans to invite neutral parties such as Oxera, the consulting firm which helped to prepare the FSA’s report on commission disclosure in 2008. Reportedly, one concern for the IMA would be a scenario of rising research commission payments triggered by a market resurgence. Given the media attention, it is hard to explain how the cost of a research service doubled just because commission volumes doubled.
Earlier this month, the FT ran a breathless article that UK asset managers are “offloading £1bn of costs a year by bundling them up in opaque client commissions.” Actually £1 billion sounds low. Global equity commissions are north of $20 billion, and EMEA accounts for almost 40% of those commissions.
The source for the FT’s estimates is SCM Private, a small asset manager which has positioned itself as being transparent on client commissions. SCM supplied the FT with detail on which asset managers seemed to be paying the highest commission rates for research and was quoted by the FT claiming that “Fund managers are having their own costs subsidised to the tune of millions of pounds.”
The FT article also quoted the chair of the European Commission’s financial services users group stating that research costs should “come out of the fund manager’s pocket”, not that of clients.
The scrutiny of corporate access seems to be snowballing into something bigger: should research be paid for by client commissions at all? The Financial Times is bird dogging the issue and the IMA seems sufficiently concerned to set up panels.
Missing from the fray is any interest on the part of the UK pension schemes, endowments and the other asset owners. This was the Achilles heel for the FSA’s commission disclosure regime. The FSA created disclosure but the pension funds didn’t pay any attention to it. Ultimately, the asset managers interests are aligned with the investment banks on the topic of commission payments for research. They both want the system to continue. If corporate access needs to be sacrificed at the altar, so be it. We are skeptical the issue will go much further. Pardon us for being skeptical, but we’ve seen this movie before.