Unbundling and soft commissions: managing conflicting national standards for brokerage — part one

Alex Viall 22 Sep 2005

Kirkpatrick & Lockhart Nicholson Graham has hosted an informative seminar at its London office on unbundling and soft commissions from a UK and global perspective. This is the first in a series of three articles that will provide an overview of the new rules and explain the reasons behind them.

Philip Morgan, head of the UK financial services at KLNG, opened proceedings with an assessment of the history behind the softing and unbundling debate. He began by clarifying with a definition of the two practices:

· soft commissions — by agreement, a broker pays for goods/services that a third party supplies to the fund manager. The amount the broker will pay is agreed on by the fund manager and is dependent on trading volumes

· bundling or full service broking — a broker, in return for a trading commission, supplies a package of services, such as research, computers and premises. The 'extra services' cannot be purchased separately. Normally extra services are provided on the basis of an understanding of the level of business.

History

Morgan explained that Paul Myners' 2001 report on institutional investment in the UK energised the soft commission debate. Myners identified competitive distortion and concluded that fund managers were passing commission costs to clients but were deriving benefits for themselves from commission. Myners proposed that fund managers should bear commission costs to help competition so that they became an element of the management fee. This approach was criticised for potentially offering an incentive to fund managers to under-trade, which would create its own distortion.
The Financial Services Authority formally joined the debate in April 2003 with consultation paper 176. In summary, this CP concluded that: the value of additional services acquired were opaque to the clients; there were conflicts of interest for fund managers and evidence of over-consumption; there was distortion of competition in selection of broking services; softing and bundling should be treated in the same way in terms of regulation.

The CP proposed limiting the goods and services beyond execution that can be bought with commission. It also suggested that services which could still be bundled/softed would need to be costed so that the fund manager could then rebate an equivalent amount to its customer (this was then dropped in favour of a revised disclosure regime after the costs and practicalities were assessed).

Policy statement

Two years on and the FSA published policy statement 7.18 and applies to transactions in shares, warrants and options. Fixed income securities are not included but this may change in the future. Dealing commission is restricted to the purchase of 'execution' and related 'research' services. New disclosure is required to inform customers of fund managers how their money is being spent. All of this should promote a level playing field in the production of research.

Under this policy statement, non-permitted services include: computer hardware; travel accommodation; entertainment costs; valuation services; direct money payments; custody services; publicly available information.

Execution and research

The proposed rules are not completely prescriptive as to whether an activity is execution or research, but some parameters are given.

A service will be deemed as execution if it is demonstrably linked to the arranging and conclusion of a specific transaction and is provided between the point when the fund manager makes the decision and the point when the trade is concluded. Examples include: booking/processing orders; sales/trading advice on specific transactions; and clearing/settlement services, such as netting of positions to reduce costs. Post-trade analytics (except to a limited extent where analysis relates to a particular transaction or is qualified as original research) are excluded and the position on raw data feeds is still uncertain.

For a service to qualify as research it must: add value by providing new insights; include original thought (not repackaged information); be directly relevant to, and used to assist in, the management of investments for the customer; and involve analysis or manipulation of data to reach meaningful conclusions.

Disclosure

A new disclosure regime has emerged in tandem with the FSA's rules. This is an industry-led solution put together by the Investment Management Association and the London Investment Banking Association, with help from the National Association of Pension Funds. The new disclosure regime comprises the IMA pension fund disclosure code and the LIBA statement of good practice for brokers.

The IMA pension fund disclosure code has level one disclosure annually and level two semi-annually. The former requires disclosure of the fund manager's policies, processes and procedures in management of costs paid on behalf of clients. The latter requires: a breakdown of trading volumes clarifying which were at full rate, other rates or net; allocation of commission between execution and other elements of the service; comparable firm-wide information on the pattern of trading and commission spend for clients; comparisons between the average client commission rate against those across the firm.

Level one disclosure reports are to be issued during 2005, while level two reports to UK pension funds are to be sent by Q1 of 2006 with data collected from 1 July 2005. Level two reports to other funds must be sent by Q3 of 2006. The FSA has made it clear that compliance with the disclosure code should be sufficient for compliance with disclosure rules in COB 7.18, although this rule is fairly broad.

With the final rules published in July this year and effective in January next, there is a six-month transition period when firms can continue complying with existing soft commission rules until the earlier of the expiry of existing soft agreements or 30 June 2006.

Conflicting national standards

COB 7.18 applies to UK-based fund managers subject to FSA rules so that brokers from the UK and other jurisdictions will be affected indirectly. Foreign investment management firms with London offices and international brokers with UK fund managers may have a particular issue.

The jurisdiction of the client is irrelevant so it seems, at present, that international clients in the UK will be subject to the new UK rules, although the FSA is intending to consider further the territorial scope of the new regime as there are concerns that it could have an effect on UK competitiveness and the potential for regulatory arbitrage. The FSA knows that it needs to work closely with the Securities and Exchange Commission, the Center for Economic and Social Rights and the International Organisation of Securities Commissions to create a practical global protocol in this area.

The new requirements for 'adequate' disclosure to clients apply to both UK clients and overseas clients; it is ultimately left to investment managers' discretion to determine the adequacy of disclosure to any particular client.

The Markets in Financial Instruments Directive

The FSA is satisfied that the new UK rules are consistent with this directive and related CESR advice on inducements. Article 21 of MiFID requires that firms seek the 'best possible result' from execution (which does not necessarily mean the best price), and an element of this is a consideration of the commissions paid.

Commission — recapture/directed

On customer's instructions, a fund manager can direct a proportion of trades to a specific broker; the broker then gives a commission rebate which directly benefits the customer or his intermediary. These arrangements can continue under the new UK rules, subject to the prohibitions on inducements in COB 2.2.3 (there may be cross-subsidy issues here but it could lead to greater competition on commission rates). Disclosure of such an arrangement, including whether the manager has contracted out of best execution as a result of the arrangement, must be made under the IMA disclosure code.

Commission — sharing:

Here the executing broker agrees that part of the dealing commission it earns will be redirected to one or more third parties, nominated by the fund manager as payment for research services provided to the manager. FSA's view is set out in PS04/23 where it expresses concern about possible conflicts if the commission-sharing agreement contains specific obligations on the volume of business that the manager would send to the broker.

Agreements can enable fund managers to make separate decisions on providers of execution services and research. The FSA has concluded that commission-sharing agreements are not inappropriate if: the manager's clients understand their nature and purpose; commission flows are properly disclosed; the agreement does not create conflicts of interest for the fund manager.

Please note that this is an interpretation of the seminar and has not been approved by the speaker.

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The views and the opinions expressed in 'hot topics' are that of the individual authors and not necessarily those of the Securities & Investment Institute.