The FCA consultation paper CP24/7 “Payment Optionality for Investment Research” considers the reintroduction of the bundling of research payments with broker’s execution fees
Why should I read this?
The longstanding bundling of payments for research with execution and brokerage services, which had been the global norm, was brought to an end in the UK (and wider EU) in January 2018 by reforms introduced under MiFID II. The changes were introduced to address concerns expressed by European legislators that bundling led to conflicts of interest that might sway the fairness and accuracy of the research. Critics of the proposals at the time said that the outcome would lead to the demise of research generally, and in respect of small cap and start-up firms in particular, which in turn would reduce the amount of capital available for new entrants to the market; predictions which have since proved correct.
Bundling of research with execution remains the norm outside the UK and EU.
Both the UK and EU have since tinkered at the margins with their models of how research is paid for to try to address the issue relating to start-ups, which made it possible for firms to receive research on smaller firms and certain fixed income, currency and commodity instruments on a bundled basis without breaching the relevant rules. Currently, firms have two options in relation to other types of research:
- pay for research from their own resources; or
- pay for research from a research payment account (“RPA”)
The FCA’s consultation paper CP24/7 “Payment Optionality for Investment Research” sets out a third option, which will allow for the ‘bundling’ of payments for third-party research and trade execution, based on the second recommendation of the July 2023 investment research review (“IRR”).
What do I need to know about the FCA proposals?
Under FCA’s proposals, firms that choose to offer bundling to their clients will be required to put in place:
- A formal policy on bundling
- A budgetfor purchasing third-party research and ongoing assessments of value and price
- An approach and structure for allocation of costs to clients and payments to research providers
- Operational procedures for the administration of research payment accounts
- Disclosures to clients on bundled payments, significant research providers and costs incurred
In reality, complying with the proposed requirements associated with ‘re-bundling’ advice will create a not insignificant administrative burden and it remains to be seen how attractive this option will be in practice.
The US model for funding research
The US has two principal laws that govern payment for research provided by sell-side firms to money managers.
- Section 202(a)(11) of the US Investment Advisers Act of 1940 (“Section 202(a)(11)”) establishes a general rule that persons accepting payment for providing advice, analysis, or reports concerning securities (“Investment Advice”) must register as investment advisers. Section 202(a)(11) provides a limited exclusion from the general rule for brokers that provide Investment Advice, provided that the Investment Advice is solely incidental to the broker’s business, and the broker does not receive “special compensation” for its Investment Advice.
- Section 28(e) of the US Securities Exchange Act of 1934 (“Section 28(e)”) offers a safe harbor to a money manager to enable it to pay commission that exceeds the execution-only rate if the money manager determines in good faith that the commission is reasonable in relation to the value of research provided by the broker. The US Securities and Exchange Commission (“SEC”) interprets the term “research” to encompass Investment Advice and analysis and reports on matters such as economics, industries and issuers.
Almost twenty years ago, the SEC adopted a rule that would have enabled brokers to offer fee-based brokerage accounts to customers without having to register as investment advisers. However, an appellate court upheld a challenge to the rule, reasoning that compensation other than commissions constituted special compensation within the meaning of Section 202(a)(11) and that the SEC lacked the authority to adopt an exception to this. Since then, the SEC has taken the position that payments to brokers for Investment Advice other than bundled commissions constitute special compensation, and requires brokers who wish to accept such payments to register as investment advisers.
The practical consequences for a broker who is required to register as an investment adviser are that: (1) the broker becomes subject to a fiduciary duty to the recipient of its Investment Advice, rather than the less rigorous requirement that it provide suitable advice; and (2) the broker is required to obtain pre-trade consent from its customer each time it trades as principal with the customer – a one-time blanket consent is insufficient. The SEC’s staff originally provided temporary relief to enable US brokers and those non-US brokers not registered with the SEC under Rule 15a-6 under the US Securities Exchange Act of 1934 to accept cash payments from EU and UK money managers otherwise prohibited from paying for Investment Advice from brokers with bundled commissions. However the relief expired on July 3, 2023.
The consultation closes on June 5, 2024.
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