Time is running out for you to put arrangements in place to pay for third party investment research. Are you ready for the new rules on inducements in MiFID II?
Paying for research: an innocuous-enough topic in the grand scheme of the establishment and operation of investment funds; at least historically. Not so any more.
Of all the changes to be brought about to the regulatory landscape by MiFID II, some of the strongest reactions in the asset management industry have been generated in respect of the provisions dealing with inducements and the corollary rules on payments for third party research.
But, for managers who want to receive third party research but wish to avoid paying for research from their own balance sheet from 3 January 2018, it is likely time has already run out to receive FCA approval and notify investors to operate a research payment account paid for by a fund.
If you have missed it and are still at the early stages of planning, there are a number of decisions that you will need to make – and policies to implement – in order to reduce the amount of time that the cost for research will sit with you or your delegate managers.
Firms carrying on MiFID business are prohibited from paying to or accepting from any party (other than its client or a person on behalf of its client) any non-monetary benefit in connection with the provision of an investment services or ancillary service.
In the context of investment research, there is an exemption under the new rules for any third party research that is received by a (MiFID) firm providing investment services or ancillary services to clients where that research is received in return for either:
- direct payments by the firm out of its own resources
- payments from a separate research payment account controlled by the firm (provided that the firm meets certain requirements relating to the operation of the account).
For AIFMs and UCITS ManCos a complementary regime requires those firms to comply with modified rules for collective portfolio managers in respect of the operation of a research payment account.
In either case the detailed rules concerning the operation of research payment accounts will require considerable thought and planning and compliant policies and procedures will need to be implemented.
Research payment accounts: five key rules
The rules in respect of the research payment accounts include:
- A requirement that the account must only be funded by a specific research charge to clients, which must only be based on a research budget set and regularly assessed by the firm and which is agreed with, and published for the benefit of, clients.
- The obligation on firms to regularly assess the quality of the research purchased based on robust quality criteria
- an obligation for firms to agree with clients not only the research charge that has been budgeted by the firm but also the frequency with which the specific research charge will be deducted from the resources of the client over the year.
- A need to establish appropriate controls and senior management oversight to ensure the research budget is managed and used in the best interests of the firm's clients.
- A requirement to implement a written policy setting out how the firm will comply with all elements of the rules relating to the operation of the research payment account, and, in the case of an AIFM or UCITS ManCo, a requirement that a written statement of how the firm will comply with all elements of such rules must be published in the Prospectus of the fund.
What should managers do?
At a high level, the options available to managers appear simple enough at face value:
- Pay for the research yourself from own funds; or
- Agree with or disclose to investors a budget for the purchase of research and establish a research payment account to administer the payment of those fees.
However, the fact that unwinding current arrangements with any brokers that may already be bundling research in with execution services is likely to be a complex task. As valuing investment research as an independent service may prove even more difficult, many of the bigger managers who are able to shoulder the cost of research from their own balance sheets have elected option 1.
In so doing they may be looking to leverage the goodwill generated by actively marketing this position. Or they may simply have come to the view that the costs of paying for research directly are not vastly different to the indirect costs of going down the RPA route.
Other managers, however, have chosen to pass the cost on to the investors and establish a research payment account, either out of choice or necessity – after all, the annual cost of research for a fund could be significant, in particular where bespoke research is a key aspect of a fund’s strategy. But choosing to establish a research payment account is only the start.
Further issues to consider
- In addition to the various written policies, procedures and statements required to be given by firms in accordance with COBS 2.3B and COBS 18 Annex 1, firms will also have to work out how their business model interacts with other firms in the chain of manufacturing and distribution. In particular “Host ACDs”, whose arrangements for obtaining and paying for research will vary depending on their relationship with the delegate investment managers /sponsors, will need to assess and implement appropriate policies on a mandate-by-mandate basis.
- As alluded to above, budgeting will also prove difficult in the first instance and will coincide with a need for firms to find the right level of researcher for their needs – particularly given that some of the most senior researchers are likely to command significant fees.
Timing and FCA Applications
In addition to the technical regulatory rules, managers will also need to bear in mind that the operation of a research payment account will, likely cause a new payment to be made from the scheme property of a fund - a “fundamental change” as far as the FCA Handbook is concerned (i.e. a change that requires investor consent at an EGM). Fortunately, certain transitional provisions will allow managers to treat the new fee for a research payment account as a 'significant change' requiring 60 days' notice to investors. This is, of course, in addition to the time allowed for the FCA to approve the application – one month.
So, assuming a manager intends to have a research payment account operational by 3 January 2018 (and thus avoid having to pay for research from its own pocket from 3 January 2018), an application would realistically have needed to have been submitted to the FCA by 2 October (assuming the FCA approval takes one month and assuming the investor notification is to be issued after the FCA approval has been granted - and allowing time to organise the mailing). Every day beyond this that an approval application is not submitted to the FCA is another day that the cost of research must be paid for from your balance sheet.