The Financial Conduct Authority ("FCA") has published its policy statement on Changes to the use of dealing commission rules PS 14/7, which covers the issues arising from the FCA's consultation paper CP 13/17, published in November 2013 and also includes the final revised rules which are made by way of changes to COBS 11.6 of the FCA Handbook1. The revised rules come into effect on 2 June 2014.
Asset managers including AIFMs authorised under the Alternative Investment Managers Directive (AIFMD) and UCITS managers (together the "Asset Managers") should review the revised rules, and amended COBS 11.6 guidance, to satisfy themselves that any goods or services purchased with dealing commissions are permitted and meet the criteria for "execution-related" and "substantive research" goods and services. This will involve an assessment of the types of research and other services to establish whether such research provides meaningful analysis and conclusions which inform trading decisions before allocating dealing commissions to pay for it. Any existing internal policies and procedures to allocate costs between the Asset Manager's account and the customers' accounts will need to be reviewed in light of the revised rules and adjusted if necessary to reflect the revised rules and guidance.
1. Background to the changes
The changes to the dealing commission rules are the result of much activity by the regulators in this area over the last few years, including the FCA's thematic review into conflicts of interest between asset management firms and their customers and a Dear CEO letter requiring CEOs of asset management firms to attest that firms' arrangements ensured conflicts of interest were effectively managed in compliance with the FCA Handbook.
The revised rules have been introduced as a result of the FCA's perceived relaxation by Asset Managers of established market practices and standards and, accordingly, a need to clarify what services may be paid for out of dealing commissions. The FCA's thematic supervisory work (carried out from June 2011 - February 2012) found that a majority of Asset Managers had inadequate controls and oversight when acquiring research goods and services from brokers or third parties in return for dealing commissions. In addition Asset Managers were often unable to demonstrate how items of research met the exemption to the dealing commission rules and how they did not impair an Asset Manager's duty to act in the best interests of customers.
2. The current regime
The use of dealing commission regime under COBS 11.6 limits the goods and services that Asset Managers can purchase from executing brokers using their customers' dealing commission to trade execution and research services meeting specified criteria. Consistent with rules on inducements and conflicts management it also requires prior disclosure to be made to customers concerning the receipt of goods or services relating to the execution of trades or provision of research.
Such goods and services purchased must assist the Asset Managers in providing its services to its customers and not impair its duty to act in its customers' best interests.
3. Changes to the regime
Overall, the revised rules largely follow the main elements of the proposals made in CP 13/17. Although no new requirements are introduced to COBS 11.6, existing expectations under the dealing commission rules are clarified with the intention of encouraging Asset Managers to improve controls over their use of dealing commission.
4. Clarification of cumulative criteria for substantive research
The revised rules set out criteria for establishing when the FCA will consider research to be 'substantive', as follows:
The cumulative criteria to be satisfied for a good/service to be substantive "research":
- It is capable of adding value by providing new insights that inform Asset Manager's decisions about customer portfolios
- It represents original thought, critical and careful consideration and assessment of new and existing facts (not a repeat/repackage)
- It has intellectual rigour (doesn't state the obvious)
- It presents the Asset Manager with meaningful conclusions based on analysis or manipulation of data
If the above criteria are not met the good/service is not permitted research and cannot be paid for with dealing commissions.
The previous rules provided that an Asset Manager, which had reasonable grounds to believe the criteria for research were satisfied, could rely upon this to establish reliance upon the dealing commission rules. However, the ability to rely upon "reasonable grounds" has been removed from the new rules with concerns being raised during the consultation process that there was a risk that a strict liability regime would be created. The FCA has rejected any suggestion of such a strict liability regime as the exemptions were always designed to be narrow and should be construed accordingly.
5. "Meaningful conclusions"
One of the key messages which the FCA wants to convey is that research must present meaningful conclusions based on analysis or manipulation of data in order for it to be purchased with dealing commission.
In response to parts of the industry questioning the need for research to present a meaningful conclusion, the FCA has reiterated that the reference to "meaningful conclusions" is a key feature that distinguishes substantive research from other, more general, information services that should not be paid for with dealing commission. The changes to the rules are not intended to limit a conclusion to a recommendation and will include research that contains opinion or reasoned deduction or inference. The phrase "meaningful" does not mean that the Asset Manager must agree with and follow the conclusions for it to be substantive research. The conclusion, however, must inform any trading decisions made for the customer (including a decision not to trade) for the research cost to be paid for out of dealing commission. If research is received that will not be used (even if it could meet the substantive research criteria) then it will not "reasonably assist" the Asset Manager in providing its service to its customers and should not be charged to customers.
6. "Corporate Access" and Bundled Services
The FCA has added Corporate Access (defined as the service of arranging or bringing about contact between an Asset Manager and an issuer or potential issuer) to the list of services that would not be regarded as substantive research, and introduced new guidance in relation thereto. Where Corporate Access is provided alongside substantive research or is provided under a "bundled" arrangement for example with conferences or field trips arranged by a broker, the Asset Manager should take steps to identify and disaggregate the substantive research from the non-eligible elements such as Corporate Access and make a fair assessment of the charge it should fairly pass on to their customers through dealing commissions. An Asset Manager must pay for non-eligible services other than through dealing commission.
The revised rules seek to ensure that dealing commissions are only used to acquire eligible goods and services and that costs are subject to proper controls. The revised wording of COBS 11.6 reinforces that costs can only be passed onto customers in narrow circumstances where the costs are directly related to the execution of trades or the provision of substantive research. Asset Managers should revisit their internal controls around allocation of costs for the account of their customers and reassess the nature of any goods and services they buy with dealing commission. Any research purchased out of dealing commission must provide meaningful analysis and conclusions which inform any trading decisions (including any decision not to trade).
It will be for Asset Managers to decide on their methodology for valuing the goods and services that they receive and determining how much to allocate for the account of their customers. The FCA has provided some guidance (where no price is provided by the supplier) for Asset Managers, however, this is likely to be an area on which there is likely to be further debate and on which Asset Managers will take different approaches. Key will be for each Asset Manager to have a clear, rational process that emphasises the best interest of their customers. Brokers or other third party research providers will be expected to assist in the valuation process as part of any commercial arrangements as this will aid transparency.
Asset Managers may also wish to update their existing policies and procedures to reflect the revised rules and new guidance. Asset Managers should also ensure any agreements with brokers or research providers properly reflect the definition of research or other services that may be paid for out of dealing commissions. Disclosures to customers should be similarly checked to ensure that they are sufficient.
8. What's next?
As part of the consultation process, the FCA also sought industry opinion on reforming the dealing commission regime. However, the revised rules do not address views expressed on the potential need for wider reform as the FCA intends to publish an update on such issues later in the year. This update will report on the findings of the FCA's thematic supervisory work and discussions with both buy-side asset managers and sell-side broker firms.
Depending on the final requirements in MiFID II, the FCA anticipates that further changes may be necessary to the dealing commission regime. If so, the FCA will align the timing of such changes with the domestic implementation of MiFID II in late 2016/early 2017. The FCA may also need to consider its approach to non-MiFID investment management activity falling under the UCITS Directive or the AIFMD, subject to any wider EU discussions on harmonising standards across these areas of legislation.