The Financial Services Authority (FSA) has published its long awaited consultation paper on bundled brokerage and soft commission arrangements (CP176) (www.practicallaw.com/A29873). Paul Myners highlighted concerns about the conflicts of interest and market distortions arising from the use of these arrangements two years ago in his report on institutional investment (www.practicallaw.com/A16174). In July 2001 the FSA agreed with the Treasury that it would review how well the current regulatory regime addresses these issues. CP176 sets out the results of the FSA's review and its proposals to strengthen the regulatory regime in relation to soft commission and bundled brokerage arrangements.
Bundled brokerage arrangements involve the supply by a broker to a fund manager of a package of services, including trade execution and other services such as the provision of research materials or access to the broker's own investment analysts, for a single price. There are no specific regulatory rules on bundling although bundled arrangements need to comply with a number of general FSA rules, such as the conduct of business rule on inducements (COB 2.2, FSA handbook of rules and guidance).
Under a typical soft commission arrangement, a broker agrees to pay for certain goods and services which are supplied directly to the fund manager (usually by a third party rather than the broker or one of its associated companies) in return for which the fund manager agrees to direct a certain level of business to the broker.
The FSA's Conduct of Business Sourcebook creates a specific regime for soft commission arrangements. The principal provisions are that:
A soft commission agreement must be in writing.
The broker must agree to provide best execution.
Soft commission can only be used to acquire certain goods and services that will assist in the supply by the firm of investment management services to its clients.
The broker must obtain the client's prior consent to soft trades for his portfolio, and provide periodic disclosure of commissions paid and the value of softed services received.
In CP176 the FSA identifies four areas of concern with the use of soft commission and bundled arrangements under the current regime:
Lack of transparency. The use of commission by fund managers to obtain goods and services makes it difficult for customers to identify what services they are paying for and how much they are paying for them.
Over-consumption of additional services. Because fund managers are not paying for services out of their own resources and because the amount they spend is unlikely to be subject to effective scrutiny by their customers, there may be a tendency for fund managers to buy more services than are strictly necessary and to pay more than is necessary.
Excessive dealing. Both fund managers and brokers have an incentive to maximise trading volumes; the former to obtain softed or bundled services and the latter to obtain commissions. This may result in excessive dealing in a customer's portfolio at the expense of fund performance.
Quality of trading decisions and execution. Fund managers may, under current arrangements, be incentivised to select brokers on the basis of the generosity of their softing or bundling arrangements rather than the quality of their trade execution.
The FSA concludes that normal market mechanisms constitute a weak control on the use of bundled and softed services and that the existing regulatory regime does not effectively address the problems.
The FSA is proposing two main reforms to the current regulatory regime, which apply equally to bundled and softed goods and services:
Limiting the goods and services that can be bought with commission under soft or bundled arrangements. The FSA proposes that the restriction should apply to market pricing and information services, which are, in the FSA's view, categories of service for which demand is reasonably certain. According to FSA-commissioned independent research carried out by OXERA (Oxford Economic Research Associates), these services account for between 50% and 57% of soft commission credits. The FSA considers that this exclusion would cover a range of technology services offered by third party providers, whether supplied to fund managers on a stand-alone basis (for example, dedicated terminals) or integrated with in-house systems.
Other services that the FSA considers fall into the category of services for which demand is reasonably predictable are: custody services, the provision of computer hardware and dedicated telephone lines and the payment of fees for seminars and publications. The FSA is consulting on whether the restriction should also apply to these services.
Limiting the ability of fund managers to pass-through automatically to customers' funds the cost of any services other than trade execution. This proposal focuses on those goods and services that may be purchased with commission (that is, that are not excluded as above) including, in particular, investment research. The FSA proposes that where a fund manager buys goods or services with a customer's commission, either on a bundled basis or under soft commission arrangements, he must determine the cost of the goods and services and rebate an equivalent amount to his customer's fund (instead of passing through automatically the costs to customers' funds). A fund manager may still buy goods and services other than trade execution for a customer with commission but he will be accountable to that customer for the amount spent. The fund manager could, of course, recover the costs of any such services from the customer either by way of an increase in the management fee or under a separate agreement for the provision of the services.
The FSA recognises that there may be some practical difficulties in valuing the goods and services purchased with commission. Bundled services, in particular, which are provided by a broker in-house, would not normally be separately priced. The FSA considers that, although not required by its proposals, an effect of the proposals may be to encourage the provision of services by brokers on an unbundled basis.
The FSA regards the proposals in CP176 as complementary to those in its recent consultation papers on best execution (CP154) and investment research (CP171) (www.practicallaw.com/A27314 and www.practicallaw.com/A28636; see also feature article "Analysts' research: Avoiding conflicts of interest", this issue). Together, they represent a significant challenge to existing ways of doing business for both the buy-side and the sell-side in the financial services industry. In particular, the proposal to require fund managers to rebate non-execution costs to customers' funds is controversial. Fund managers will be most obviously concerned by the proposals, which would entail a direct increase in their cost base. There may be an incentive to operate from other jurisdictions where soft commission arrangements continue to be permitted. Full service brokers will be concerned about the source of funding for research. In particular, fund managers who are effectively required to bear the cost of research may increasingly demand an execution-only service. Both brokers and fund managers may also doubt the practicality of being able to ascribe a cost to the different constituents of a bundled execution service.
Mark Kalderon is a partner and Umesh Kumar is a senior associate at Freshfields Bruckhaus Deringer.
CP176 "Bundled Brokerage and Soft Commission Arrangements" is available at www.fsa.gov.uk/pubs/cp/cp176.pdf. Comments on the proposals are requested by 29 August 2003.