New York, NY – In the past few years there has been considerable discussion about the appropriate use of the equity commissions generated from clients’ accounts to pay for investment research (aka “soft dollars”). Consequently, both the FSA and the SEC have put out various rulings in recent years to clarify what money managers can purchase with client commissions. However, one very interesting issue that has been ignored by the market place is the inconsistent way the regulators have dealt with “management access” in these deliberations.
Appropriate Use of Client Commissions
Both the FSA and SEC agreed that client commissions should be limited to purchase execution and research services. The primary difference between the two regulators was the definition of what comprised research and execution.
The FSA provided three criteria to help ascertain whether a product or services could be paid with client commissions. This includes:
- Original Thought – adds value by providing “new insight” to an investment manager in making an
- Intellectual Rigour – provides analysis or commentary that states more than what is “self evident;”
- Analysis/Manipulation of Data – provides “meaningful conclusions” based on analyzed research.
The definition used by the SEC, on the other hand, was set forth in Section 28(e) of the Securities Exchange Act. According to the SEC, a person provides research services if he / she:
- furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities; or
- furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts;
The SEC noted that an important common element defining, “analyses,” and “reports” is that each reflects substantive content – that is, the expression of reasoning or knowledge. Thus, in determining whether a product or service is eligible as “research” under Section 28(e), the money manager must conclude that it reflects the expression of reasoning or knowledge and relates to the subject matter identified in Section 28(e)(3)(A) or (B).
In this regard, the SEC felt that traditional company research reports analyzing a particular company or stock, certain financial newsletters and trade journals (if they relate to the subject matter of the statute), quantitative analytical software and software that provides analyses of securities portfolios, and certain seminars or conferences could also be defined as “research services” under the defintion outlined in Section 28(e).
Does Management Access Qualify As Research?
Based on these definitions, it seems quite surprising that neither the FSA nor SEC found it concerning that many money managers consistently say that the one service they value most that is provided by investment banks is access to company managements.
It is clear to us that setting up meetings with company executives does not reflect the expression of reasoning or knowledge, it does not include original thought, it does not reflect intellectual rigor, nor does it include the analysis and manipulation or data.
In fact, most sell-side management access programs are little more than professional concierge services where buy-side investors can sign up for one-on-one meetings with corporate executives. In some circumstances, the sell-side provides investors access to company executives they could never meet on their own. These programs merely save time for the largest investors who could easily set up many of these meetings for themselves.
This does not mean that investors are not receiving valuable insight, reasoning and knowledge from these meetings. They are getting considerable input from the company executives who participate in these meetings. Unfortunately, the executives are not the ones being paid for their expertise. Instead, the sell-side firms are the ones being paid (and quite handsomely I might add) for merely setting up these meetings.
Thus, we acknowledge that management access is valuable to the buy-side. However, it is also clear to us that based on the FSA and SEC definitions, management access does not qualify as research. As a result, it is unclear how investors can justify using their client’s commissions to pay for this service.
Cannot Stand on its Own
In fact, we suspect that some regulators have seen the problem of using client commissions to pay for management access. A few years ago at a conference in the UK, a senior FSA official was asked about the appropriateness of defining management access as “research” due to the issues outlined above. This FSA official noted that management access could be paid for with commissions in the context of the entire suite of research services provided by the investment bank.
In other words, management access could not be defined as research in its own right, but rather it had to be bundled with other obvious research services (like research reports, conferences, and access to analysts) to meet the standards established by the regulators.
Unfortunately, any other answer would have been devastating for the buy-side as this would have forced them to pay for this valuable input to their investment process out of their own fees rather than using their client’s commissions. In addition, the sell-side could also have been hurt by such a move as many buy-side firms would have paid them considerably less in commissions if they could not define management access as research.