FCA Issues Consultation Paper on "Payment Optionality for Investment Research"
Commentary by Mark Highman
In a Consultation Paper, the UK Financial Conduct Authority ("FCA") requested comment on proposed rules to allow for the "bundling" of payments for third-party research and execution services, subject to proposed guardrails.
The FCA stated that the rules currently prevent UK asset managers from purchasing research with bundled payments (whereby payments for execution and research are combined) except subject to conditions that few advisers can meet. As a result, the FCA contends that research payments are typically a direct charge to an asset manager’s overall profit, which has resulted in a diminution of the purchase of research, primarily to the detriment of smaller advisers and their clients.
In the Consultation Paper, the UK is considering allowing advisers to pay for research by bundling the payment for that research. In so doing, clients would be charged the costs of research rather than the adviser. (Payments through such bundled services were historically permitted in the UK, but were prohibited by MIFID II, which was incorporated into the UK MIFID.) The FCA stated it wants "to give UK buyside firms – asset managers and others – greater flexibility on how they can purchase investment research."
Comments on the Consultation are due by June 5, 2024.
Note: For more detail on the FCA Consultation Paper, please see Norton Rose Fulbright's coverage in Global Regulation Tomorrow.
Commentary
Significance of Proposal for U.S. Broker-Dealers
The FCA’s Consultation Paper on Payment Optionality for Investment Research is a significant proposal, as it would enable U.S. broker-dealers to provide securities research to UK asset managers under a soft dollar arrangement, and thus fall within the exclusion from regulation as an investment adviser under the U.S. Investment Advisers Act of 1940 (the "Advisers Act"). The FCA Consultation Paper references similar legislative initiatives in the EU. If adopted, these proposals would collectively enable U.S. broker-dealers to provide securities research to UK and EU asset managers without being subject to regulation as investment advisers under the Advisers Act.
Payment for Research in the United States: A Brief Recap
- Section 202(a)(11) of the Advisers Act excludes from the definition of an "investment adviser" a broker-dealer that provides investment advice, including securities research, that is solely incidental to the firm’s broker-dealer business and that receives no "special compensation" for this advice.
- Historically, U.S. broker-dealers provided research to customers under a "soft dollar" arrangement in which payment for research was part of the payment for effecting securities transactions for the customers (so-called "bundled" payments). As soft dollar arrangements do not involve any "special compensation" for research, broker-dealers providing research under a soft dollar arrangement were excluded from regulation as investment advisers under the Advisers Act.
- MiFID II, however, required EU asset managers ("MiFID Managers") to "unbundle" payments for research from transaction fees by requiring cash payment for research (so-called "hard-dollar" payments). This requirement extended to U.S. sub-advisers to MiFID Managers, which were contractually required to pay for research.
- Receipt of hard dollars for research is "special compensation" that brings a broker-dealer outside the exclusion from the definition of an "investment adviser," and within the scope of regulation as an investment adviser under the Advisers Act.
- As a result, U.S. broker-dealers providing research to MiFID Managers and their U.S. sub-advisers, and non-U.S. broker-dealers providing research to U.S. sub-advisers to MiFID Managers, were required to (i) register as an investment adviser or fall within an exemption from registration and (ii) comply with fiduciary requirements applicable to investment advisers, including disclosure and consent requirements applicable to investment advisers effecting securities transactions as principal or as agent with an advisory client.
- In order to address this issue, the SEC issued a temporary no-action letter in 2017 permitting broker-dealers to receive hard-dollar payments for research from MiFID Managers and their U.S. sub-advisers without being subject to regulation as an investment adviser under the Advisers Act.
- The SEC letter was extended in 2019, but the SEC let the relief lapse in July 2023.
- As a result, (i) U.S. broker-dealers that provide research to MiFID Managers or their U.S. sub-advisers for hard dollars, and (ii) non-U.S. broker-dealers that provide research to U.S. sub-advisers to MiFID Managers for hard dollars, are subject to regulation as investment advisers under the Advisers Act.
Impact of FCA Proposal
The FCA Proposal, if adopted, would permit UK asset managers to pay for research through soft dollar arrangements in which payments for research is "bundled" with payment for trade execution services. This would enable U.S. broker-dealers to fall within the exclusion from regulation as an investment adviser under the Advisers Act, as the broker-dealers would not receive "special compensation" for research.
The FCA Consultation Paper specifically addresses the following issues of particular note:
(i) Commission sharing arrangements (or "CSAs"): In the United States, these arrangements are more accurately referred to as "client commission arrangements." Under a client commission arrangement, a customer pays a broker-dealer commissions to effect a securities transaction and agrees that a portion of the commission revenue will be allocated to pay for securities research, which may either be provided by the broker-dealer effecting the customer’s securities transactions or another broker-dealer that provides securities research. The FCA Proposal permits use of client commission arrangements to align with payment arrangements in other jurisdictions, including the United States. See FCA Consultation Paper, Sections 2.7 and 2.28.
(ii) Trading commentary produced by a broker-dealer’s sales or trading desk: The Proposal provides that short-term trading commentary and advice linked to trade execution would be an "acceptable minor non-monetary benefit" for a UK asset manager. See Sections 4.29-4.32 and 4.46 of the Proposal.
Contractual Provisions
The Proposal would impose certain conditions on UK asset managers that pay for research through bundled commission payments, including the following contractual provisions with research providers:
- an agreement with research providers on the methodology for calculating and separately identifying the cost of research; and
- a structure for the allocation of payments between research providers, which is intended to align with "payment allocation structures typically used in other jurisdictions (e.g. CSAs)." See FCA Consultation Paper, Sections 4.38 and 4.39.
Firms may need to revisit customer agreements to address these requirements.
Comments
Comments are due on the FCA Consultation Paper by June 5, 2024. U.S. broker-dealers may consider submitting comments to the FCA as to how the Proposal would affect provision of research to UK asset managers.