New York, NY – In the past few months, many journalists (ourselves included) have extolled the various virtues of Commission Sharing Agreements (CSAs) and their near cousins, Client Commission Arrangements (CCAs). However, very few have focused on negative consequences that adopting CSAs might have on the money management community. Below we provide an overview of these issues:
1. Reduced Competition
The first negative consequence we need to discuss is not really a result of CSAs, but rather it is a result of the rapid move to unbundling the execution from the research decisions. In the US, many money managers have quickly reduced their number of trading counterparties – from 260 to 60, 300 to 30 or 250 to 20 execution partners – under the belief that they would be focusing their business with a smaller number of “best execution” providers.
It is hard to argue that the broker that was 299th on a money manager’s list was probably there because of the quality of the research they provided, not the quality of their execution capabilities. However, it not so easy to make that argument with the 65th broker, the 35th broker, or the 25th broker.
In addition, this rapid consolidation of execution into the hands of a smaller and smaller number of brokers, might not benefit money managers over the intermediate to long term as reduced competition could lead to a number of adverse consequences, including rising execution costs.
It also must be noted that a number of the largest brokers that are benefiting from this consolidation of execution providers are also in direct competition with the buy-side through their own asset management divisions, through their proprietary trading desks, or through their growing hedge fund operations. Increased consolidation enables these firms to see a greater percentage of the buy-side clients’ flow – a development that could be beneficial for the sell-side and detrimental for the buy-side.
2. Falling Research Quality
It is also clear that the proliferation of CSAs will lead to a deterioration in the quality of research from some previously high quality research brokers. This assertion seems somewhat contradictory as the market generally believes that good research providers will be rewarded under CSAs with more research commissions.
However, this view overlooks the actual economics of the research business. Today, many of the world’s top investment analysts work at large integrated investment banks that derive revenue (and profits) from a wide range of business activities. It is this diversity of business that enables these firms to afford the best and brightest – even if these firms’ research businesses cannot support themselves purely from their equity capital markets businesses.
Unfortunately, the use of CSAs could lead some second tier execution firms to lose a significant amount of their execution revenue (although they would maintain their research revenue). And while it would be easy to say that these firms should just “close down” their trading desks – such a move could have devastating consequences to their overall business as many investment banks compete on the basis that they can also make markets in the stocks they finance or bring public. In other words, the squeeze on the trading business would have a knock on effect for the whole company.
But, some might argue that this should have no impact on the good research they produce. This, however, is not the case. The revenues and profits lost from trading (and other related businesses) actually supported the salaries, bonuses, infrastructure, and other related costs of running a high quality research business. The loss of these profits would be felt by the analysts – and impact that could prompt many of the best analysts to leave for greener pastures.
Subsequently, the consolidation of execution partners caused by unbundling and the use of CSAs would lead, in some cases, to the deterioration in research quality at many second tier and boutique brokers and investment banks.
3. Negotiating Disadvantage
Probably the single greatest negative consequence that using CSAs could have on the buy-side is the severe disadvantage it puts them at when negotiating with their brokers over the value of their research. This is due to the asymmetry of information (some call this information leakage) that exists between the two parties.
We have been asked by numerous buy-side executives if we can help them determine if they are paying the right amount for their research they are getting. When asked why they need our help, we learn that they know they are paying the “right” amount for many alternative research services because these services have an actual rate card.
Unfortunately, these same firms have no such idea when it comes to research that is sold in a “bundled manner” – including the research provided by many bulge bracket CSA brokers. These buy-side firms only know what they paid last year in total commissions — purportedly to receive execution and research services. Consequently, it is very difficult for the buy-side to determine how much they should actually pay for these bundled research services.
The CSA broker, on the other hand, in is a very different position because they know what everyone else pays for their service (including their most appropriate peers). In addition, the broker knows what the buy-side firm is paying for other alternative and third-party research that they are being asked to pay for through the CSA mechanism.
As a result, the CSA broker has a distinct advantage when negotiating with their buy-side clients over how much they should be paid for their research. This means that buy-side firms will probably continue to overpay for their sell-side research – at least until this asymmetry of information is resolved.
Comment by Bill George:
First, I want to thank Integrity Research ResearchWatch for referencing my “Request for Rulemaking on Disclosure and Transparency in Client Commission Arrangements” in your article on Sunday March 11, 2007 titled “Where Has Commission Disclosure Gone”.
Then, let me say that your Sunday March 18, 2007 article “The Dark Side of CSA’s for the Buy-Side” mentions many of the problems with Commission Sharing Arrangements (CSA’s) and Client Commission Arrangements that I see, and it outlines some of the issues that motivated me to file my “Request for Rulemaking” with the SEC.
However, I am commenting here to mention a couple of my other concerns about CSA’s and CCA’s, not mentioned in your article, which I believe will negatively impact buy-side fiduciaries, and which will also negatively impact independent research, third-party and regional brokerage firms, and clients whose investment advisors use institutional full-service brokerage firms.
In general, I believe that without the mandate (and enforcement of the mandate) to unbundle and price proprietary services in institutional brokerage arrangements the new definitions for CSA’s and CCA’s will provide greater opportunities for the kinds of conflicts of interest and fraud that have been the subject of the brokerage and investment advisory scandals and prosecutions for the last seven, or so, years.
Commission Sharing Arrangements
Under the provided-by clause in the old definition of Commission Sharing Arrangements, the broker “providing” independent research to an advisor was obligated to pay the producer of the research for the specified research before the research was delivered, and the investment advisor could not be contractually obligated to reimburse the broker for “providing” the research (the ‘obligation’ was a gentleman’s agreement). This forced a very high level of due-diligence and caution on brokerage firms that wanted to provide execution and independent research to institutional advisors. Such brokerage firms are understandably very cautious and selective about which independent research providers they will prepay. The new definition of Commission Sharing Arrangements does not address the issue of prepayment to research producers. Will the new definition of Commission Sharing Arrangements encourage the same level of due-diligence and protection for the use of institutional clients’ brokerage commissions that the old definition encouraged?
Client Commission Arrangements
The new definition of Client Commission Arrangements, particularly those arrangements that will be structured as described in the SEC’s recent No Action Letter,* is even more problematic. In its revised form this “No Action Letter” specifically emphasizes that the executing broker has no liability to pay for the research institutional advisors request. Further, this new definition of Client Commission Arrangements mentions that investment advisor ‘directed’ research payments will be paid out of a “pool” of excess commissions generated by the advisor’s trading with the executing broker. Without a stipulation that the value of the proprietary research provided by the executing broker must be identified and disclosed, how can institutional clients, investment advisors and regulators know that brokerage commission payments are being appropriately allocated between: the costs of execution, the costs of proprietary research qualifying for the safe harbor of Section 28(e) provided by the executing broker, the value of other proprietary services provided by the executing broker, and the commission pool from which independent research producers might be paid? Without the identification and pricing of proprietary services this new definition of Client Commission Arrangement allows clients’ brokerage commissions to be treated a fungible resource for the executing broker until whatever commission is left-over gets allocated to the “Client Commission Pool”.
I have worked for brokerage firms which, under investment advisor ‘directed’ brokerage arrangements, were part of the “selling group” for initial public offerings and secondary underwritings. Typically, the “selling concession” earned by me and my employer for selling the offering took eight months to a year to be paid by the full-service broker who was the investment banker in the deal. Reflecting on the time value of money should cause one to wonder if ‘slow payment’ to independent research providers will negatively affect the viability of the independent research business.
Another concern should be that under the old interpretations of client commission arrangements the providing broker was liable for the invoice. Under the new definition the investment advisor directs the executing broker to pay the invoice and the advisor is ultimately liable for the payment for research and is also liable for co-fiduciary clients’ directed payments (commission recapture directed by pension advisors to pay for plan services).
Because third-party brokers typically only offer execution and invoice payment, they have no conflicting goals (they don’t pay themselves for proprietary services) and their activities are transparent and documented by the costs of execution and by the invoices they pay. The new definition of Client Commission Arrangements places the investment advisor in the position of negotiating with the full-service broker on behalf of independent research providers and fiduciary clients’ who require directed brokerage payments to pay for appropriate plan services. Is it reasonable to assume that investment advisors will have the integrity, or the will, to negotiate for the exclusive benefit of their clients when such negotiation might reduce the value of favors the full-service brokerage firm will exchange with the advisor?
Is the Securities and Exchange Commission prepared to immediately reassign its substantial independent research payment audit resources from a third-party brokerage focus to focus on auditing investment advisors’ direction for independent research and directed brokerage payments, and will there be better opportunity to detect fraud under the new regimen.
The concerns mentioned in your article and the additional concerns mentioned in this comment are some of the more important reasons why I filed my Request for Rulemaking on Disclosure and Transparency in Client Commission Arrangements with the Securities and Exchange Commission.