In our previous alert, Paying for Buy-Side Investment Research: Will the FCA’s Third Way Ease the US-UK Divide?, we discussed the consultation issued by the Financial Conduct Authority (FCA) on proposed rules on payment optionality for investment research. This had followed the UK Investment Research Review, which contained a key recommendation that the FCA to amend its rules on research unbundling to allow FCA-authorised investment managers more flexibility in how they pay for research.

On 25^th July, the FCA published its final rules as part of its policy paper PS24/9: Payment optionality for investment research (fca.org.uk) (PS24/9). The FCA’s aim is to implement the new rules by 1^st August 2024. As the FCA is introducing an optional form of payment for research, it will be for investment managers to determine both whether and when they wish to use the rules from then. The FCA announced FCA sets out rules and proposals to build up UK wholesale markets | FCA, the rules as part of a package of measures designed to help strengthen the UK’s capital markets and position as a global centre together with revised rules for public offers and admissions to trading, noted in our alert. Historic New Listing Rules Adopted for the UK.

The rules do not return the regime to a pre-unbundling approach but create an exception for investment managers that are willing to use a Commission Sharing Arrangement (CSA) with brokers who are prepared to offer a CSA. The new rules give limited relief to managers that are subject to the rules on research; the rules no longer apply to fixed-income research, which is good for credit fund managers. Private equity managers tend not to use investment research.

As we noted before, the rules should, however, have a positive impact on US brokers, making it possible for them to receive payments from UK managers. The US Securities and Exchange Commission (SEC) no-action letter that had allowed US broker-dealers to receive payments on an unbundled basis expired in July 2023.

The FCA has not proposed equivalent changes to its rules for FCA-authorised alternative investment fund managers (AIFMs), but it intends to consult further in 2024 to ensure consistency between the regimes of FCA-authorised investment managers and AIFMs.

Reconciling the Buy-side Position in the UK With the Sell-side Position in the US?

When the UK implemented the revised Markets in Financial Instruments investment (MiFID 2) in 2018, FCA-authorised managers were given to options for paying brokers for investment research: (a) using their own money; or (b) using their client’s money and making payments via a “research payment account” (RPA) mechanism, which requires the managers to agree on a budget with the client and fund payments for research only from that budget.

MiFID 2 complicated the position governing payment by buy-side investment managers to US sell-side broker-dealers because US broker-dealers may not receive research payments from money managers in “hard dollars” or from advisory clients’ research payment accounts, without putting themselves at risk of an SEC enforcement action based on providing research services unbundled from investment advice.

The SEC issued a no-action letter in 2017 (ahead of the MiFID 2 implementation) with the effect that (a) US broker-dealers could accept research payments from money managers in hard dollars or from advisory clients’ research payment accounts; (b) US investment advisers could continue to aggregate orders for mutual funds and other clients; and (c) money managers could continue to rely on an existing safe harbor in US securities laws when paying US broker-dealers for research brokerage.

The no-action letter was, however, a temporary measure and eventually expired in July 2023, reintroducing the divergence in position between the UK and the United States.

The FCA made it clear in original consultation and appear to have confirmed it in PS24/9 the new rules are designed, in part, to address this divergence, having noted that it is important for UK investment managers “to be able to obtain research from global sources without impediments to remain globally competitive.”

The Rules and Guidance

The FCA’s has sought to meet its objective for bundling payments for research and execution services by including a specific carve-out from the inducement rules, rather than by adding to the list of acceptable minor non-monetary benefits.

Under the amendments to the Conduct of Business Sourcebook (COBS) 2.3B, an FCA-authorised manager will still be able to pay for research using its own money or using an RPA, but a proposed rule will offer a third way: joint payments for third-party research and execution services, provided the manager complies with the rules in COBS 2.3B governing the operation of these payments.

The rules include requirements on the manager connected with the following objectives:

• No free-riders: Ensure that all relevant clients, dealing commissions are used bracket — i.e., individual clients would not be permitted to contract out of commission payments for a search
• Specific strategy: Ensure that a client pays only for research directly materially relevant to the investment strategy in which it is invested
• Procurement: Apply minimum standards when choosing research providers and agreeing on prices for goods and services whenever client dealing commissions are used
• Research budget: Set a research budget for a period not exceeding 12 months, at investment strategy level, and cut commissions to pre-agreed execution-only rates for the remainder of the period once research expenditure has reached such budget
• Periodic disclosure: Provide periodic disclosures to clients describing the nature of research purchased, describing the impact research, strategy, level, and investment art comes during such period
• All in the basis points disclosure: Disclose to perspective existing clients fees that include both investment management fees and research payments using dealing commissions for the prior 12 months, expressed as a proportion of average assets under management for the strategy during the prior 12 months
• Identifiable counterparty: Ensure that the portion of execution costs that can be used by the manager to purchase research is, with a set frequency bracket (e.g., monthly), transferred into a bank account controlled by the manager

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