In November 2013, the UK Financial Conduct Authority (FCA) published a consultation paper (the Consultation Paper)1 on proposed changes to the rules on use of dealing commission; the key proposed changes included:
- the removal of the “reasonable grounds” test for certain elements of the exemption from the prohibition on using dealing commissions to purchase goods and services;
- a new presumption of breach to the effect that contravention of the criteria for execution service/permitted research may be relied on to establish contravention of the dealing commission rules;
- a new obligation to disaggregate elements that are not permitted research from those that are (with only the latter being able to be paid for through dealing commissions); and
- a prohibition on using dealing commissions to purchase corporate access services.
The FCA stated that the proposed changes were intended to clarify and reinforce the existing rules and “[a]s such, they do not impose new requirements on firms, but provide guidance and clearer drafting”.2
On May 8, 2014, the FCA published a policy statement (Policy Statement)3 setting out the final new rules on the use of dealing commission. The New Rules will take effect from June 2, 2014.
This Update examines the implications of the New Rules for investment managers.
In this update, “Current Rules” refers to the rules in effect up to June 1, 2014, and “New Rules” refers to the rules set out in the Policy Statement and which, as noted above, take effect from June 2, 2014.
Background to the dealing commission rules
Under the dealing commission rules which are contained in Chapter 11.6 of the Conduct of Business Sourcebook (COBS 11.6) of the FCA Handbook, investment managers in the United Kingdom (UK) are prohibited from purchasing goods or services through dealing commissions paid to their brokers and passed on to their customers unless such goods/services are related to the execution of trades or constitute permitted research.
The “reasonable grounds” test
As noted above, UK investment managers are prohibited from using dealing commissions to purchase goods or services, subject to certain exemptions. Under the Current Rules, this prohibition does not apply if:
“the investment manager has reasonable grounds to be satisfied that the goods or services…
(a) (i) are related to the execution of trades on behalf of [its] customers; or
(ii) comprise the provision of research; and
(b) 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.”4
In contrast with the Current Rules, the New Rules provide that the prohibition does not apply where:
“(a) the investment manager has reasonable grounds to be satisfied that the good or service…will reasonably assist the investment manager in the provision of its services to its customers…;
(b) the investment manager’s receipt of that good or service…does not, and is not likely to, impair compliance with the duty of the investment manager to act in the best interests of its customers; and
(c) that good or service either:
(i) is directly related to the execution of trades on behalf of [its] customers; or
(ii) amounts to the provision of substantive research.”5
It seems clear from the wording of the Current Rules (as set out above) that the “reasonable grounds” test applies to all the points that follow it; that is, (i) whether or not a good/service is related to execution or constitutes research; (ii) whether or not it will reasonably assist the manager; and (iii) whether or not it impairs compliance. However, from June 2, 2014 the “reasonable grounds” test will apply only in relation to whether or not a good or service will reasonably assist a manager with its provision of services, whereas the assessment of whether or not a good/service is related to execution or amounts to permitted research will be subject to an objective standard.
Some respondents to the Consultation Paper argued that the removal of the “reasonable grounds” test would effectively mean moving to a strict liability standard which would be a significant departure from the Current Rules. However, the FCA does not believe that the removal represents a significant change to the current regime.6 Respondents also argued that the New Rules would mean that investment managers would have to demonstrate compliance in every single instance (given the objective standard for assessment), which would result in significant operational burden.
The FCA confirms in the Policy Statement that this is indeed the regulatory intention and states that it expects firms to have sufficient systems and record keeping in place to meet and demonstrate compliance with the New Rules. From June 2, 2014, investment managers should keep appropriate records of the basis on which they conclude that a particular good or service paid for through dealing commissions satisfies the relevant criteria.7
The result is that there is going to be, at least in relation to certain aspects of the dealing commission rules, a higher standard of compliance expected of investment managers.
There are specified criteria for assessing whether or not a good/service is related to execution of trades (commonly referred to as “execution services”) or constitutes permitted research. While the criteria themselves under the Current Rules and the New Rules remain largely the same, as noted above, the assessment tests will be different: under the Current Rules, the assessment is in effect made on the basis of “reasonable grounds”, whereas under the New Rules the criteria “must” be met.
In this regard, some respondents to the Consultation Paper sought clarification on the relevant criteria given the proposed objective test. The FCA has provided detailed explanations in the Policy Statement on one of the key criteria for permitted research, namely, “meaningful conclusions”:
- Under the Current Rules, a piece of research may constitute permitted research, “if the research [amongst others] involves analysis or manipulation of data to reach meaningful conclusions.”8
- In contrast, the New Rules now provide that for a good or service to amount to permitted research, “the relevant research [amongst others] must present the investment manager with meaningful conclusions based on analysis or manipulation of data.”9
In the FCA’s view, “conclusion” here is not limited to a “buy” or “sell” recommendation; rather it can include a summary or statement of opinion or making a reasoned deduction or inference provided that the relevant research contains this in itself. However, a purely artificial conclusion will not be acceptable. Further, “present” here also covers research provided in non-written formats (e.g., telephone call); and “meaningful” does not infer that the investment manager has to agree with the conclusion.
The FCA also clarifies10 that third party research may be acceptable as permitted research even if it is mainly used to inform further internal research within the investment manager, provided that such third party research meets the criteria for permitted research. However, if a piece of third party research will never be used at all, even if it could meet the specified criteria, it would not fall within the exemption since it would not “reasonably assist” the manager in the first place.
Presumption of contravention
Under the Current Rules, if a good or service meets the criteria for execution service or permitted research, such compliance may be relied upon as tending to establish compliance with the dealing commission rules.11
The New Rules introduce a presumption of breach. That is, where the specified criteria are not met and the relevant good or service is paid for through dealing commissions, such contravention may be relied on as tending to establish a contravention of the dealing commission rules.12
In relation to permitted research, the Current Rules have no specific provisions for goods/services that contain both elements that meet the criteria for permitted research and elements that do not.
Under the New Rules, where the relevant good or service received by an investment manager comprises the provision of permitted research together with elements that are not permitted research (payment for the former through dealing commissions is acceptable but payment for the latter is not), the investment manager is required to disaggregate those non-eligible elements from those eligible elements.
One of the problems identified by some respondents to the Consultation Paper was that disaggregation would present a significant operational challenge to investment managers since services received by an investment manager are often provided in a bundled form and the pricing is not itemised. In view of such difficulty, the FCA has provided formal guidance in the New Rules on how disaggregation should be applied. For example, an investment manager should make a fair assessment of the value of any non-eligible elements, acting in the best interests of its customers; and where there is no quoted price for certain item, the investment manager may consider what it would be willing, in good faith, to pay for those non-eligible services.
The FCA has refrained from setting out a preferred methodology for assessing mixed-use services (as called for by some respondents during the consultation) and says that such methodology is a matter for firms to decide. On the one hand, the lack of such a “preferred methodology” may present operational difficulties as to how firms should amend/update their procedures. On the other hand, it provides flexibility to managers in enabling them to design their own procedures. The FCA states that, provided a firm’s process is “clear and rational” with a strong emphasis on customers’ best interest, this should be acceptable.
The Current Rules set out, as examples, a list of goods/services that the FCA considers do not meet the criteria for execution service or permitted research.13 Under the New Rules, “corporate access service” has been added to the list. This effectively means that investment managers will be prohibited from using dealing commissions to pay for corporate access.
“Corporate access service” is defined under the New Rules to mean “a service of arranging or bringing about contact between an investment manager and an issuer or potential issuer”.
This definition is the same as the one proposed in the Consultation Paper and some respondents to the Consultation Paper argued that the definition was too broad. However, the FCA believes that the definition is appropriate. It seems that the intention is to have a broad definition in order to capture all forms of meetings between managers and issuers.14
Where a corporate access service is provided as part of a wider event or bundled services, the FCA states that the investment manager should take steps to identify and disaggregate the corporate access service from other services that can be included in dealing commissions and make a fair assessment as to the value of such corporate access service (see discussion above).
Where an investment manager regards a corporate access service as free, i.e., the manager does not ascribe any value to such a service, and if the manager also pays dealing commissions to the broker for execution services and permitted research, the FCA warns that it is important that such a manager have sufficient systems and controls to ensure that they can demonstrate amounts paid to a broker are justified purely in relation to execution services and permitted research. The practical effect seems to be that an investment manager will have to either ascribe a “fair” value to any corporate access services received (regardless of whether or not they are provided for free) or even to obtain corporate access services from a separate broker.
Territorial scope of the New Rules
The FCA states that the New Rules will not affect the existing territorial scope of the Current Rules. This essentially means that the New Rules, as with the Current Rules, apply to UK authorised investment managers only.
In relation to the application of the New Rules to internationally active firms, the FCA notes that it will continue to have regard for the context in which an investment manager operates where it undertakes business internationally.
The role of the sell-side
The New Rules do not impose any obligation on sell-side firms to provide information or otherwise cooperate with investment managers. Some respondents to the Consultation Paper argued that without express corresponding obligations on sell-side firms, it would be difficult for investment managers to comply with the New Rules (e.g., to determine whether or not the specified criteria for permitted research are met (which “must” be met under the New Rules) and to disaggregate non-eligible elements).
Without directly addressing this concern, the FCA says in the Policy Statement that, where an investment manager enters into a commercial arrangement to obtain relevant information from sell-side firms, it expects that a reasonable level of transparency to be present as part of any such commercial arrangement and that it is the investment manager’s responsibility to comply with the regulatory requirements. The FCA notes in the Policy Statement that it has examined the provision of corporate access by brokers and other third parties as part of its thematic review and will provide comments on this at a later stage.
The EU Markets in Financial Instruments Directive is in the process of being completely revised as a new package called “MiFID II”. MiFID II, which is expected to become law in member states at the end of 2016 or in early 2017, contains specific rules on inducements and conflicts of interest, and may have a bearing on the issues set out in the New Rules. The FCA says that it sees its work on dealing commission arrangements “as part of informing this debate on future EU reforms.” The FCA is also engaging with other regulators through the International Organisation of Securities Commissions (IOSCO).
The FCA expects to report back on its wider work on dealing commission arrangements later in 2014.
As noted above, the FCA’s view is that the New Rules are intended to clarify the Current Rules. The FCA is of the view that firms that are already compliant with the Current Rules and have sufficient systems and controls to demonstrate compliance should not need to make material system changes to comply with the New Rules. However, the practical effect of the New Rules is that investment managers will need to consider carefully, and amend if necessary, their systems and procedures in order to ensure that they comply with the newly “clarified” requirements.