Speaking at the conference of National Association of Pension Funds (NAPF) a year ago, John Tiner stated “there does seem to be a consensus that softing and bundling lack transparency with regard to cost, and that fund managers have not been properly accountable to their clients in the past. But there is less consensus on how to solve these problems.” The publication of the Conduct of Business Sourcebook (Use of Dealing Commission) Instrument 2005 (final rules) appears to have finally resolved the outstanding issues, putting an end to several years of discussion and revision on the practices of soft commission arrangements (softing) and bundled brokerage (bundling). The final rules restrict the use of dealing commission so that investment managers are allowed to use it only to purchase goods or services related to the execution of trades or the provision of research. To ensure greater transparency of such arrangements, the investment managers will also be required to make prior and periodic disclosure to their customers of the arrangements entered into. The Financial Services Authority (FSA) has worked along side the industry and now relies on the industry, to a great extent, to determine the most appropriate means of addressing these issues within the parameters set out by the FSA.
Although different regulatory treatment previously applied to softing (receiving products or services which are paid for by another person) and bundling (including miscellaneous costs in the cost of execution of trades on behalf of a customer), the FSA proceeded on the basis that the two practices had similar economic effects and reviewed them together. The problems with softing and bundling initially came to light as a result of Paul Myners’ review of institutional investment in the United Kingdom (UK). He was concerned that the lack of customer focus on commission costs provides an ‘artificial bias’ for fund managers to choose brokers based on additional services they could acquire from them through the use of commission deriving from the customers’ funds. The inherent conflicts of interest involved raised doubts about the ability of fund managers to achieve best execution for their customers.
Clearly concerned about the risk to their statutory objectives of consumer protection and market confidence and, perhaps, initiated by the United States Securities and Exchange Commission’s own investigation into ‘soft dollar’ arrangements, the FSA undertook a detailed review of softing and bundling resulting in Consultation Paper 176 (CP 176) of April 2003. In that paper, the FSA identified four areas of concern over bundling and softing:
- This practice enabled fund managers to finance some of their management expenses by charging their customers for commission in a way that was unnecessarily opaque.
- As the commission costs were subject to less scrutiny by customers, the FSA believed that fund managers were more likely to ‘over-consume’ additional services; overtrade in order to generate sufficient commission flow and/or to select brokers who offered generous bundling or softing terms but who could not necessarily achieve best execution.
- Customers and competitors did not have sufficient market power to control fund managers’ behaviour in this area.
- Given their similar economic effects, it was agreed that, in regulatory terms, treating bundling and softing differently was inappropriate.
Consequently, the FSA concluded that market controls were weak in this area and proposed to adopt the following measures to address this market failure:
- To restrict the goods and services that can be purchased with commission, whether under soft or bundled arrangements.
- (Radically) in the case of services that could still be bundled or softed, to rebate any commission amounts exceeding the value of the execution of trades to the customer.
CP 176 stimulated a lively debate and a wide range of opinions. The general consensus was that transparency and accountability for fund managers’ expenditure of commission charged to their clients could and should be improved. However, most respondents expressed reservations about the rebate proposal. They considered that it did not take fully into account the broader structural impacts of change and could have unintended adverse consequences for UK fund management and equity trading. To achieve increased transparency and accountability, the FSA considered that three complementary changes were necessary:
- Fund managers’ use of commission should be limited to the purchase of ‘execution’ and ‘research’.
- Fund managers should give their clients better information about the respective costs of execution and research, and the overall expenditure on these services.
- Fund managers should be encouraged to seek, and brokers to provide, clear payment and pricing mechanisms that enable individual services to be purchased separately.
The FSA appreciated that it was for the FSA itself to act on the first of these changes by clarifying what activities should be covered by the terms ‘execution’ and ‘research’ (this was subsequently considered and set out in PS 04/23, November 2004). On the second and third changes, the FSA was persuaded to allow the industry to develop an industry-led solution, based on enhanced disclosure proposal put forward by the Investment Management Association (IMA) in partnership with the London Investment Banking Association (LIBA) and the National Association of Pension Funds (NAPF). This enhanced disclose proposal had two elements to it:
- To modify the existing IMA/NAPF Disclosure Code so that fund managers will be required to provide information to their fund management clients, on a fund-by-fund basis, of the amounts of commission spent on execution and research.
- To issue good practice guidelines (known as a ‘Statement of Good Practice’ by LIBA) for brokers to identify the execution and research component of dealing commission.
Subsequently in May 2005, the FSA published its draft rules addressing its concerns on soft commission and bundled brokerage arrangements and in July 2005, it issued its final rules. The aim of the FSA’s new rules, together with the industry proposals, is to:
- limit fund managers’ use of dealing commission to the purchase of ‘execution’ and ‘research’ services
- require investment managers to disclose to their customers details of how commission payments have been spent and what services have been acquired with them
- embed in the commercial relationship between fund managers and brokers incentives to secure value for clients for execution and research spend
- promote competition between those who produce investment research by removing the regulatory distinction between research services provided by brokers along with execution (i.e. bundling) and research services provided by third parties (i.e. softing).
The final rules have been applauded as a successful joint venture between the FSA and the industry and it is hoped that due to the concerted efforts, the rules will be successfully implemented by the industry and will result in the transparency and accountability that was felt to be lacking. The new rules and guidance will come into force from 1 January 2006 with a transitional period. Firms are allowed to continue to comply with the existing soft commission rules until the expiry of any existing soft commission agreement or 30 June 2006 (whichever is earlier).
Scope of the new rules
As a result of the new rules in COB 7.18 on the use of dealing commission, all references to “soft commission” in the FSA’s Sourcebooks will be made redundant. The new rules will apply to investment managers, and not to brokers. Having said that, brokers remain subject to the inducements rule in COB 2.2.3R and Principle for Businesses 1 requiring a firm to conduct its business with integrity. COB 7.18 will apply to investment management transactions carried on in the UK irrespective of the location of the customer.
In summary, COB 7.18 prohibits an investment manager from executing customer orders through a broker for a commission in return for receiving goods or services, unless certain conditions are met. The conditions are that the investment manager must have reasonable grounds to be satisfied that the goods and services:
- are related to the execution of trades on behalf of the investment managers’ customers, or constitute the provision of research
- will reasonably assist the investment manager in the provision of its services to its customers and do not, and are not likely to, impair compliance with the duty of the investment manager to act in the best interests of its customers.
Consequently, dealing commission can now be used only for the purchase of goods and services that relate to the execution of trades or the provision of research. Key to this regime are the definitions of the execution of trades and the provision of research. Where the goods or services relate to the execution of trades, the investment manager should be satisfied that they are linked to the arranging and conclusion of a specific investment transaction (or series of related transactions) and they are provided between the point at which the investment manager makes an investment or trading decision and the conclusion of that investment transaction. The FSA has further clarified that post-trade analytics may not be included on a blanket basis in the goods and services which could be acquired with commission. However, the provision of information about how well a broker conducted a particular transaction or series of transactions for an investment manager could be a service within the execution parameter.
Conversely, where the goods or services relate to the provision of research, the FSA believes that ‘originality’ is an essential component of research, which can be purchased with dealing commission. The goods or services that relate to the provision of research must be capable of adding value to the investment or trading decisions by providing new insights that inform the investment manager when making such decisions about customers’ portfolios. It is not enough to merely repackage information that has been presented before, produce information that is commonplace or supply data that has not been analysed or manipulated to provide meaningful conclusions. The FSA has also confirmed that raw data feeds (i.e. price feeds or historical price data that have not been manipulated or analysed in any way) will not be permitted as research services. Crucially, however, the final rules will not apply to research generated internally by the investment manager. The FSA has also provided an indicative list of goods and services that cannot be acquired with dealing commission (e.g. computer hardware, membership fees of professional associations and employees’ salaries).
As is evident from the high-level wording of the new section, the new provisions give investment managers discretion to make reasonable judgments. This principle-based rule-making approach was largely supported by the industry as it was regarded as a practical approach, which would allow investment managers the discretion to determine whether the definitions have been met within defined regulatory parameters. The FSA expects investment managers to be accountable to their customers through the process of explaining these judgements to them in the context of enhanced disclosure under the IMA Disclosure Code. Given that this enhanced disclosure proposal was promoted by the industry, it is likely that it will be effectively policed by the industry, and in so doing ensure accountability. The FSA is yet to determine how performance of the final rules will be measured and is due to meet IMA, NAPF and LIBA before the end of 2005 to discuss this issue.
The final rules represent an overhaul of the previous position as it now limits the investment managers’ use of dealing commission to the purchase of goods and services related to execution and research, in line with the FSA’s initial first proposal. The severity of the FSA’s initial second proposal (to offer a rebate to customers), however, was diluted in the final rules to a mere request to improve transparency by providing customers with better information as to costs incurred for the purchase of execution and research services. The investment manager will be required to make in a timely manner adequate prior and periodic disclosure to its customers of the arrangements for the receipt of goods or services that relate to the execution of trades or the provision of research. The FSA suggested that this could be achieved by, for example, changing the firm’s terms of business. In assessing the adequacy of disclosures made by an investment manager, the FSA will have regard to the extent to which the investment manager adopts disclosure standards developed by industry associations.
What does this mean for an institutional investor? Essentially, it will mean more protection and potentially cheaper dealing costs. The final rules empower the institutional investor as the use of dealing commission arrangements have to be made clear to him, thereby ensuring he makes an informed choice when transacting with an investment manager. It also focuses on achieving best execution for the institutional investor by limiting the scope of factors that may influence the investment manager’s choice of broker, which is ultimately reflected in the execution of trades carried out on behalf of the institutional investor.
What does this mean for an investment manager? Initially, the potential of increased costs as dealing commission may no longer be used to purchase “non-permitted” goods and services, which may remain essential to the investment manager’s business. The investment manager will have to consider how to account for these costs to ensure they remain profitable. It is generally accepted that the investment manager can (and probably will) levy the costs by increasing their management fees. Although this liability will eventually fall to the institutional fund, the enhanced disclosure regime and the fact that investment management accounts are required to be transparent will ensure that the institutional investor will be fully aware of the charges resulting from the transaction and can query these, if need be, with the investment manager. As a result, neither transparency nor accountability is compromised.
In addition, the FSA is currently consulting on the disclosure of dealing commission arrangements in the context of retail investment funds. These funds include authorised unit trusts and open-ended investment companies (OEICs), investment trusts and the managed funds of life assurance companies. Following the FSA’s initial review, it was agreed that the benefits of mandating disclosure of bundled and softed arrangements directly to retail investors would be very limited, and would not justify the likely cost to investment managers. This is because most retail investors have little or no knowledge of the way securities are traded or the kinds of arrangements that exist the in wholesale market to be able to understand the information. Further, due to lack of commercial influence it is unlikely that a retail investor will be able to use the information to challenge the behaviour of the provider, and to secure improvements if necessary. As a result, the FSA could not see a strong case for compulsory disclosure to all retail investors. The FSA has, however, indicated that there are other disclosure-based measures that may be more appropriate in the retail market.
Two proposals were put forward:
- Firms will be required to publish any disclosure in respect of retail investments and to make it available on request.
- An individual or a body should act as an investor representative of retail investors by considering the disclosures on their behalf and interacting with the investment manager where necessary.
The investor representative will be expected to have a sufficient degree of expertise, authority, independence and sufficient incentive to perform this task. The FSA is currently consulting for suitable candidates in respect of each investment vehicle. The following persons and bodies have been identified as suitable:
- For collective investment schemes, the depositary or trustee.
- For investment trusts, the independent directors of the company.
- For with-profits funds, the committee or person appointed to review compliance with the PPFM.
- For unit-linked funds, the with-profits committee, the actuarial function, or the independent directors of the company.
The consultation on these proposals will end on 6 January 2006. Final rules and guidance are likely to become effective from 1 July 2006.