New York, NY – Countless surveys conducted by various organizations in recent months have shown that Commission Sharing Agreements (CSAs) and Client Commission Arrangements (CCAs) are becoming increasingly more widespread in the US as long only asset managers and hedge funds adopt these new arrangements.
In addition, the SEC has recently acknowledged that they are working on various approaches to make it easier for bulge bracket firms to participate in CCAs. However, the SEC’s unwillingness to deal with commission transparency in an meaningful way continues to hinder the buy-side adoption of CSAs and CCAs in the US.
Industry Background
Traditionally, buy-side clients have compensated broker-dealers for their execution capability and their equity research by trading with them, thereby generating “bundled” equity commissions. However, this is changing as an increased number of money managers are looking to unbundle this relationship, enabling them to make separate decisions to purchase research and execution services. As a result, many of these clients are using CSAs and CCAs to pay their research providers.
In the past few years, many bulge bracket firms have refused to participate in their competitors CSA and CCA programs for fear that this would run afoul of certain rules in the 1940 Investment Advisers Act, precluding them from committing capital on trades with the institutional clients who paid them for their research through the CCA program.
SEC Solutions for Bulge Firms To Accept CCAs
Last month, at SIFMA’s annual institutional brokerage conference, Robert Plaze, the associate director at the SEC’s Division of Investment Management, outlined two possible solutions for bulge bracket firms to be paid with CCAs and not create problems with the 1940 Act.
One solution is for broker-dealers to structure their legal relationships so their institutional clients are the investment management companies rather than the funds themselves. This is the approach that Lehman Brothers adopted in their highly publicized “hard dollar” deal with Fidelity.
Plaze acknowledged that this structure would enable the broker providing the research to continue to conduct principal transactions with the mutual fund. Plaze said he expects this approach to be formalized by the SEC in the next few months.
Another approach would work if the research provided by the broker-dealer was “generic”. Plaze said that broker dealers providing this type of research to their clients may still be able to trade on a principal basis with their accounts because the principal-transaction rules would not apply.
Plaze also noted that a new rule proposed by the SEC in September that was aimed at retail brokerage firms might also be applicable to institutional brokers. This rule requires brokers to verbally notify their retail clients that they are taking the opposite side of their trade.
Lack of Transparency Rules Remain
Despite these obvious developments, one significant issue remains which hinders unbundling and the more widespread use of CCAs and CSAs — the lack of commission transparency rules in the US.
The FSA and IMA established regular disclosure rules, that went into effect on January 1, 2006, that forced UK asset managers to report to their pension fund clients how much of their commission assets are being used for research and execution.
We believe strongly that this move created a new mindset where many money managers felt it made sense to “unbundle” their execution decision from their research decision. This changing approach created a need for a vehicle which would enable money managers to leverage their commission dollars to pay for exterenal research services separately from trading — hence the development and widespread use of CSAs. Consequently, approximately 70% to 80% of all UK asset managers currently use CSAs to pay for their external research.
However, since the SEC’s release of its 28(e) interpretive guidance in July 2006, the SEC has consistently avoided proposing any commission disclosure rules, even though a majority of the Commissioners have expressed their strong beliefs that commission trasparency would be a good thing for investors.
As a result, US buy-side investors have been relatively slow to adopt CSAs and CCAs, with only 30% to 40% of investors currently using them. However, it is important to note that many of the firms that have “adopted” CCAs are not aggressively using them to pay for the bulk of their research purchases. Rather, many firms are still experimenting with CCAs.
Next Steps for CCAs
So what is next for CSAs and CCAs? One thing that is likely to encourage buy-side clients to unbundle more aggressively would be for more regulatory pressure in this regard. This would include moves by the Department of Labor or the SEC to mandate more commission disclosure.
In addition, we expect that a number of bulge bracket firms will try to encourage their clients to use them as their CSA or CCA brokers in an attempt to expand their share of the execution pie. As part of this strategy, some bulge bracket firms might even try to offer new and innovative services to convince buy-side clients to do more CSA business with them. This is consistent with Goldman’s Hudson Street platform and more recent rumblings Goldman plans to roll out an “enhanced” CSA offering in Europe.