Further to its consultation in spring 2024, the UK Financial Conduct Authority (FCA) has confirmed in Policy Statement PS24/9, “Payment Optionality for Investment Research,” that, with effect from today, 1 August 2024, covered FCA-regulated asset managers will have a “new” option to pay for research alongside those already available, i.e., payment for research from a firm’s own resources and from a research payment account. The new option facilitates joint payments for third-party research and execution services, provided that the firm meets the requirements or “guardrails” in relation to its operation.

See our May 2024 LawFlash for a summary of the consultation proposals.

Following engagement with market participants which highlighted challenges facing UK asset managers receiving research from US firms that are registered both as broker-dealers and investment advisors, FCA has decided to add “short term trading commentary and advice linked to trade execution” to the list of acceptable minor non-monetary benefits (MNMBs) for all three payment options, in addition to making some other marginal modifications to the rules governing the area.

On scope, FCA’s changes [1] will not yet be made available to all types of UK asset managers, in particular UK UCITS management companies, full-scope UK alternative investment fund managers (AIFMs), small authorised UK AIFMs, and residual collective investment scheme operators. FCA’s policy intent is to apply the changes to those fund managers to ensure consistency across all of the rules on research and inducements for investment firms and collective portfolio managers, on which it plans to consult in Q4 2024.

Nonetheless, the exclusion of these types of UK asset managers will create complications in the near term where the asset managers or their affiliates may rely on the new optionality for research payments in some cases but not others.

Readers will recall how the revised Markets in Financial Instruments Directive (MiFID II) introduced requirements in 2018 to separate charges for execution from charges for research, thereby “unbundling” the two services. [2] The reform caused considerable friction with payment structures operating in other jurisdictions, particularly the United States.

These changes form part of wider reforms to strengthen the UK’s position in global wholesale markets, facilitate asset managers accessing research globally and make UK asset managers better able to compete on an international scale, and share common features with other jurisdictions, including the European Union and United States. FCA confirms that in designing the new option it had regard to commission sharing arrangements (CSAs), which it describes as “a common operating practice and a frequent firm choice in research procurement.”

FCA seeks to achieve the following outcomes:

• Promoting effective competition among asset managers by introducing a new payment option that is more operationally efficient than research payment accounts (RPAs), and may thereby improve the ease with which new entrants can enter the market and be more scalable for small but fast-growing firms.
• Facilitating the international competitiveness of UK asset managers by introducing an option the features of which are compatible with those that operate in other jurisdictions, and providing operational efficiencies for asset managers with diverse business models to purchase research across multiple jurisdictions.
• Securing an appropriate degree of protection for consumers through guardrails to ensure (1) sufficient discipline around such areas as budgets for research spending, fair allocation of costs to clients, and value assessment; (2) charges to clients are reasonable; and (3) transparency around the firm’s approach and its outcome to clients.
• Preserving the aspects of research procurement approaches introduced under MiFID II that have been beneficial and operated as intended.
• Increasing choice and avoiding unnecessary regulatory costs by introducing a new research payment option while keeping existing options unchanged.

CHANGES MADE IN LIGHT OF CONSULTATIVE FEEDBACK

FCA made the following changes from its proposals:

Budgeting

FCA originally provided examples of how budgeting could be done at the level of an investment strategy or group of clients. FCA has now clarified that there is flexibility to accommodate a level of aggregation that is instead appropriate to a firm’s “investment process, products, services, and clients.” Importantly, FCA believes this should provide sufficient flexibility to accommodate firms with different group structures, procurement processes, investment strategy classifications, investment decision-making, and client bases.

In other welcome changes, FCA now specifies that disclosures on budgets being exceeded should be made as soon as reasonably practicable and can be part of a firm’s next periodic report on costs and charges rather than a separate communication.

Research Provider Disclosures

FCA has amended this guardrail from the consultation version in two ways. First, it no longer requires the disclosure of the most significant research providers. Instead, it requires disclosure of the types of providers from which research services are purchased, accompanied by guidance clarifying that a breakdown according to independent research providers (IRPs) vs. non-IRPs is one way to meet this requirement. FCA has also amended the level of aggregation at which such disclosures are to be made to mirror those of the budgeting guardrail above (i.e., appropriate to a firm’s investment process, products, services, and clients).

These changes address concerns raised by some respondents about providing information that may be either uninformative or commercially sensitive, while still requiring disclosure on the principal services and the broad categories of providers on which clients’ monies are spent. The changes also address a number of responses proposing increased disclosure on the proportion of research procured from IRPs, while providing sufficient latitude by embedding this in guidance. FCA also clarifies some points where its proposals were potentially misinterpreted (e.g., the requirements do not necessitate disclosure of actual amounts paid to research providers).

Price Benchmarking

FCA originally proposed a requirement to undertake benchmarking of prices paid for research services against relevant comparators to ensure charges to clients are reasonable. In the interests of proportionality and flexibility, FCA has dialled this down to require only that firms ensure research charges to clients are reasonable, leaving it to guidance to clarify that benchmarking of prices paid for research services is one means of demonstrating compliance.

Cost Allocation and Disclosure

FCA has amended this guardrail in two ways. First, on fair allocation of costs, it has been flexible about the levels at which costs are allocated, provided these are appropriate to a firm’s investment process, products, services, and clients. This is consistent with the modified budgeting and research provider disclosure guardrails above.

Second, it has given more flexibility on how to estimate expected annual costs to clients. Previously, these estimates were to be based on both the budget-setting and cost allocation procedures and the actual costs for prior annual periods, but firms can now calculate it according to whichever of the two methods is most appropriate.

Separately Identifiable Research Charges

FCA has made a change to the wording of how research costs are to be separately identified within joint payments for research and trade execution. FCA previously required that there be written agreements with research providers. To accommodate a broader range of potential market practices and arrangements, FCA now more broadly requires that arrangements be in place that stipulate how this is done.

GUARDRAILS

We set out below a summary of the key requirements governing the operation of the new option:

• A written policy describing the firm’s approach to joint payments, including with respect to governance, decision-making, and controls.
• An arrangement that stipulates the methodology for calculating and separately identifying the cost of research.
• A structure for the allocation of payments between research providers, including IRPs.
• An approach for the allocation across clients of the costs of research purchased through joint payments, appropriate to the investment process, product, services, and clients of such firm, but ensuring its outcome is fair such that the relative costs incurred by clients are commensurate with relative benefits received.
• Periodic assessment, to be undertaken at least annually, of the value, quality, use, and contribution to investment decision-making of the research purchased and how the firm ensures that research charges to clients are reasonable against relevant comparators.
• Disclosure to clients on the firm’s approach to joint payments, including if and how joint payments are combined with any other payment option, the most significant research services purchased, and costs incurred.
• Operational procedures for the administration of accounts used to purchase research and for the delegation of such responsibilities to others.
• A budget to establish the amount needed for third-party research, reviewed and renewed at least annually, based on expected amounts needed to purchase such research as opposed to volumes or values of transactions.
• It is confirmed that research services are not a factor in assessing best execution, and the best execution rules continue to apply unchanged.

FCA has deleted the current rule treating investment research on small and medium-sized enterprises as an acceptable MNMB. [3] Introduced in 2021, this option for combined payments to purchase research on companies with a market capitalisation below £200 million has had little take-up. Furthermore, the new option for joint payments can apply to research on companies of any size, including the companies captured by the deleted rule. However, FCA is retaining the rule which treats corporate access in relation to companies with a market capitalisation below £200 million as an acceptable MNMB. [4]

ARRANGEMENTS IN OTHER JURISDICTIONS

In the United States, the use of “soft commissions” or “soft dollars” is commonplace, under which payments to broker-dealers for execution and research services are combined or “bundled.” This can include “full bundling” through which research can only be procured from the broker-dealer with which trade execution was undertaken. [5] However, the use of structures such as CSAs is also prevalent; these allow asset managers to pay a broker-dealer for trade execution, yet have the portion of commission allocated for research available to be used to purchase it from a different broker-dealer or IRP.

On the other hand, US broker-dealers must register as investment advisers if they wish to accept payment for research separate from execution commissions because separate payment can be treated as special compensation for the purpose of the Investment Advisers Act of 1940. The Investment Advisers Act provides an exclusion from the requirement to register as an investment adviser if the investment advice provided by the broker-dealer is incidental to the brokerage business and they receive no “special compensation” for providing the advice.

In 2017, the US Securities and Exchange Commission staff issued a no-action letter providing relief to US broker-dealers accepting unbundled payments from EU and UK asset managers for research services. The relief expired in July 2023 and, while evidence of any negative impacts on UK asset managers appears limited, it is important for UK asset managers to be able to obtain research from global sources without impediments to remain globally competitive.

The new framework established by FCA for optionality in payment for research should be welcomed by global asset managers, including those in the United States with UK-affiliated asset managers that have had to address the inconsistencies in regulatory regimes. However, there are certain respects in which the new FCA framework potentially differs from the US framework.

For example, under the FCA framework, an asset manager:

• may not enter into a research arrangement that would compromise its ability to meet its best execution obligations, whereas under US law an asset manager would not be deemed to have breached its best execution obligations by paying higher commission for research if the asset manager determined that the higher commission was reasonable in relation to the value of research and brokerage services in accordance with the safe harbor under Section 28(e) of the Securities Exchange Act of 1934; and
• must allocate costs of research procured using joint payments fairly between clients such that relative costs incurred by clients are commensurate with relative benefits received, whereas, with disclosure, under Section 28(e) an asset manager may assess the reasonableness of research costs in view of its responsibilities to all accounts for which the asset manager has investment discretion even if that means that some clients pay through client commissions for research that is not used in the management of their accounts (i.e., cross-subsidization).

The EU is introducing legislative adjustments to the MiFID II unbundling rules to offer firms greater flexibility on how to pay for investment research services. These include a new payment option to bundle research payments with execution, alongside a number of requirements with which firms will have to comply when selecting such option.

FCA’s new option for joint payments shares certain features with these recent EU proposals (e.g., transparency around the payment option selected by a firm; maintenance and disclosure to clients of a policy to manage conflicts of interest; regular assessments of the quality and value of research; an approach to separately identify charges for research from total charges for investment services; disclosure to clients of costs; the exclusion of sales and trading commentary from relevant requirements).

The EU policy-making process has not yet set out expectations in certain other areas covered by FCA’s new option (e.g., budgets for research spending, an approach to the fair allocation of costs across clients, a structure for the allocation of payments across research providers similar to CSAs) and the EU requirements are also less explicit in certain respects (e.g., cost disclosures to clients are only required upon request and if known).

[1] The new payment option and changes to the list of MNMBs.

[2] Firms receiving research were required to either pay for research from their own resources (the P&L Model) or agree to a separate research charge with their clients using a research payment account (the RPA Model).

[3] COBS 2.3A.19R(5)(g).

[4] COBS 2.3A.19R(5)(k).

[5] Some respondents to FCA’s consultation identified that the new option did not amount to “full bundling,” which does not necessitate calculating what portion of total commission is a charge for research and under which research is acquired only from the firm through which trade execution occurred. FCA agrees that its new option amounts to CSA-like arrangements, whereby the research charge is an identifiable component of total charges for trade execution and research, and it is possible to purchase research from a range of providers. FCA considers full bundling would lead to opacity of prices paid for research services, challenge the ability to compare prices paid across research providers, and not preserve competition in the separate markets for trade and execution.

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