Use of dealing commission – acquisition of research

The ability of regulators to cause a stir has never been in doubt. But seldom have they been so electrifying as with the recent developments over Use of Commission. With accusations flying back and forth, there is a growing risk of being killed in the rush. Certainly accuracy has been an early casualty of this battle.

At the risk of being a bore, it is worth repeating recent developments. As long ago as last July, the FCA published its promised Discussion Paper (DP14/3), setting out its thinking on radical steps to tackle the opacity of the long-standing structure for acquiring investment research as a benefit linked to execution commission payments to brokers. Although the industry had no desire to reopen this debate, the context for the FCA discussion was the MiFID II directive, which was by then already confirmed and indicating a much tougher approach to permitted ‘inducements’. In the discussion paper, FCA recognised that commission sharing agreements had some benefits, but was critical of the way that most firms actually used them.

In its December Advice to the European Commission on the Level 2 material for MiFID II, ESMA rejected commission sharing agreements on the grounds that the allocation between clients was unfair, being still tied to the volume of transactions . In place of CSAs, ESMA proposed that the Commission adopt requirements that would permit the acquisition of investment research by only two possible mechanisms, one of which was a simple purchase by the firm at its own expense. The ESMA-proposed alternative would be the use of a ‘research payment account’ into which clients would make direct payments and from which the acquisition of research would be funded. In comparison with the current structure of acquiring research through commission payment, research payment accounts should, in theory, enhance transparency at no additional cost to the client, who might reasonably expect the level of execution commission to be reduced commensurately. The drawback, of course, lay in the detail. A firm using an RPA would be required to negotiate a research budget with each and every client, some of whom might decline to cooperate. Furthermore, possibly due to differences in client money protection mechanisms across the EU, ESMA remained silent on the matter of appropriate protection for money held within an RPA. ESMA also commented “The proposal makes clear that there should be no payment for third party research linked to the payments made for execution of orders. This will address the potential inducements and conflict of interest issues that currently exist for portfolio managers when they receive third party research linked to execution arrangements with the broker. The proposed approach will also create more transparency over spending on research to improve outcomes for consumers.”

So what is the problem? If it were really just a single problem, we would be practically there. The problems are:

The requirements tagged on to the use of the RPA option.

Negotiations with every client, as well as retrospective reporting to them, looks hugely labour-intensive, and therefore expensive, and also contains inherent difficulties associated with the inevitable inconsistency of the outcome of negotiations with large numbers of clients. If some will not pay their fair share, what is to happen? Is it that the firm is required to pay the short-fall into the RPA? We should be told.

And what about client money?

However unwelcome it may be, it remains a possibility that an RPA will be a client money account. If that is right, many firms not previously accustomed to holding (or even permitted to hold) client money, could be tipped into this arduous area, at the same time as suffering a dramatic change in prudential status, with significant capital implications. On the other hand, FCA may take the other tack and permit an RPA to be treated as the firm’s own money, albeit subject to restricted use.

And then there is the issue of interpretation.

This one has recently lit the blue touch-paper. It is said that FCA has misinterpreted ESMA’s Advice. FCA has clearly indicated (in FS15/1, its feedback statement relating to DP14/3 and to ESMA’s Advice) that it takes the view that collecting money from clients for the RPA may not be through a transaction-linked commission. It is also said that other regulators around Europe see no such restriction and that that proves that FCA has got it wrong and that its position would be damaging to the competitiveness of the UK industry. Does this view stand up to scrutiny?

First, consider what ESMA has said, as quoted above. I suggest that it is pretty clear that they intend that “there should be no payment for third party research linked to the payments made for execution of orders.” Whether they have achieved that in their drafting is another question, but their intention seems clear. Secondly, if there is any scope for doubt over whether ESMA intends Level 2 to prohibit the use of transaction-based collection for the RPA, it is important that that should be resolved now, before the European Commission makes any decision on the question, so that there is an opportunity for the industry to press for a re-think before it is too late. Thirdly, will the FCA be deliberately super-equivalent, by gold-plating, if no such prohibition is introduced at the European level?

In FS15/1, FCA has indicated an inclination to apply some potential super-equivalence. It has pointed out, pretty reasonably really, that if these measures are introduced through MiFID II and affect only MiFID firms, there would be a marked disparity with non-MiFID firms, including UCITS managers and AIFMs. The impact of such a distortion would be a rather unseemly rush for the exit from MiFID. The different treatment would be short-lived, unjustifiable and create perceived competitive advantage. Therefore FCA expects to apply the same measures to UCITS manager and AIFMs, whether the EU imposes that on them or not. But the more fundamental super-equivalence question is what FCA will do if the EU does not impose a ban on funding the cost of research through execution commission? Given what it has already said in both DP14/3 and FS15/1 about the merits of that prohibition, it would be a significant U-turn for FCA to abandon that position.

However, FCA does not have a totally free hand in the area of super-equivalence; it is only available where minimum harmonisation applies and FCA has to seek leave from HMT to deploy it. Would the FCA apply and would HMT agree? Given that FCA has explained its view that the prohibition should not create a competitive disadvantage relative to jurisdictions where no such ban applies, it is entirely possible that it would press ahead with this measure and, perhaps depending on the political flavour post-election, HMT might be minded to concur. There are many variables in this prediction, including the outcome of the general election, whether the MiFID II legislation will permit super-equivalence and whether there might be some form of EU plan for further measures, foreseeable at that time. All that we can say is that this significant super-equivalence cannot be ruled out.

So, where are we? Assume the worst case, which is, in many ways, the most probable, i.e. that the only permitted ways of acquiring research are by buying it from the firm’s own P&L or through an RPA, which may not be funded via execution commission. Assume also that the client money rules are not applied and that money held in an RPA is on the firm’s balance sheet. In that scenario, the RPA is virtually a dead letter. Why, after all, would any firm apply the RPA requirements when they could take the alternative route, raising fees by the equivalent amount and volunteering a degree of transparency to their clients according to taste? This option also has attractions if RPAs do become client money accounts. The firm can volunteer equivalent transparency while buying research through its P&L, or it could offer a more tailored version of that disclosure; there is no limit to the options available under that approach. The only client loss associated with it would be client money protection, which may or may not be an issue, recognising that the amount of cash involved will be relatively modest and the risks low.

Whatever the outcome, when the rules are made in mid-2016, firms’ boards will have 6 months in which to change their business models to comply. Most boards will welcome early briefings of this material change to their relationship with their clients. However unclear the position may be today, we know that material change is in the wind and boards will be choosing from a wide spectrum of options.

Oliver Lodge

March 2015

OWL Regulatory Consulting is the adviser to the investment industry on matters of regulation.