In November last year, The UK's Financial Services Authority (“FSA”) published a supplementary policy statement, Policy Statement 04/23, “Bundled Brokerage and Soft Commission Arrangements”, which sets out a range of services and expenses which will no longer be permitted as soft commissions, in a move designed to improve transparency in the fund management industry. It sets out the FSA’s views on “non-permitted services”, “execution” and “research” and discusses the progress made by the industry in formulating a market-based solution to the transparency and accountability issues raised by soft and bundled brokerage commissions.

In the United States, a CFA Centre for Financial Market Integrity paper has been issued almost simultaneously with the FSA Policy Statement, which sets out a code of conduct for global asset managers and recommends a new approach for dealing with commissions from client trades.

Background
In its original Consultation Paper on the subject in April, 2003 (CP176, “Bundled Brokerage and Soft Commission Arrangements”, the FSA identified four main areas of concern:
·The costs of bundling and softing are opaque, so investors lack the information to judge whether or not fund managers are acting in their best interests. Thus, the manager does not account fully to customers for expenditure which their fund bears directly.
·Bundling and softing arrangements can cause conflicts of interest for fund managers over trading decisions and in the routing of business to brokers. A fund manager may be motivated to trade with a particular broker in order to access the broker’s other services, rather than obtain best execution. The result could be excessive consumption of the broker’s other services, such as investment research, over-trading, or poor execution decisions.
· The control over these incentives exerted by normal market influences is insufficient. Customers lack the power to obtain sufficient information to enable them effectively to monitor their fund manager’s expenditure of their assets.
·Bundling and softing are given different regulatory treatment, which is inappropriate, given that they have similar economic effects.

The FSA therefore made two main proposals, on which it consulted the industry:
·To limit the goods and services, beyond trade execution, that could be bought with commission, which would prevent the softing of goods and services for which demand is reasonably predictable; and
·In the case of services which could still be bundled or softed, managers would be required to determine the cost of any non-execution services acquired with commission and to rebate an equivalent amount to customer’s funds.

The FSA set out its findings in Policy Statement 04/13, dated May 2004. This concluded that fund managers’ use of commission should be limited to the purchase of “execution” and “research” and the FSA promised to clarify these terms at a subsequent date. It also allowed the industry time in which to tackle the issues of transparency and accountability, through the development of an industry-led disclosure regime.

The FSA said that by the end of 2004, it wished to see a “credible disclosure proposal that would provide meaningful information to fund management clients on the costs to them of execution and research, together with a timetable for implementation”.

In the supplementary policy statement just published the FSA sets out its views on “non-permitted services”, “execution” and “research”. These are designed to complement the work being undertaken by the industry on transparency and accountability.

“Non-permitted Services”
The FSA’s view is that all those goods and services which it believes are not sufficiently connected with investment management decisions or transactions should be classified as execution or research. These would include:
·Services relating to the valuation or performance measurement of portfolios;
·Computer hardware;
·Dedicated telephone lines;
·Seminar fees;
·Subscriptions for publications;
·Travel accommodation or entertainment costs;
·Office administrative computer software, such as word processing or accounting programmes;
·Membership fees to professional organisations;
·Purchase or rental of standard office equipment or ancillary facilities;
·Employees’ salaries; and
·Direct money payments.

Although the FSA acknowledges that these goods and services are likely to be relevant to the fund manager’s business in a broader sense, they nevertheless will have to be paid for by other means than through trading commission.

“Execution”
The FSA says that it views “execution” as consisting of services provided by a broker which meet two criteria:
·They are demonstrably linked to the arranging and the conclusion of a specific transaction (or series of related transactions); and
·They arise between the point at which the fund manager makes an investment decision and the point at which the transaction is concluded.

The FSA noted a general consensus in the industry that the elements of an execution service that may be recovered through commission charges include broking and processing of orders and related costs arising directly from trading. In addition, a broker may provide active order management, carrying out programme trades and other complex trading strategies and “working” orders in tranches to minimise market impact costs, or could facilitate client orders by trading as principal. All these would be categorised within the “execution” element of commission.

Research
Research should be capable of adding value by providing new insights that inform fund managers when making investment or trading decisions about their clients’ portfolios. Research should not merely repackage what has been presented before, but should represent original thought; should not merely state what is commonplace or self-evident; and should involve analysis or manipulation of data to reach meaningful conclusions. The FSA considers that original written research, whether by brokers or by independent providers, is most likely to fulfil these criteria.

Transparency and Accountability
The FSA had set the industry the challenge of developing a “credible approach” to disclosure by the end of 2004, with a timetable for implementation starting this year. The Investment Management Association (“IMA”) has taken the lead in devising an enhance disclosure regime and has commenced consultation with its members. The FSA says that it hopes that the presentation of information to the client on the use of commission by the fund manager to purchase execution and research services, and on the significance of the figures, will provide the basis for a more effective dialogue between client and manager on the efficiency of the fund manager’s purchasing decisions, which should in turn sharpen incentives and accountability in the relationship between fund managers and brokers.

Consequential Issues

Implications for the terms “soft” and “bundled”
The FSA says that the term “soft commission” to denote a type of arrangement for paying for third-party goods and services will become redundant as a regulatory concept in the UK. The key issue will be whether or not particular goods and services will be “non-permitted”, regardless of how they are supplied.

Commission Sharing Arrangements
The supplementary policy statement also dealt with the issue of commission sharing arrangements. The FSA does not consider that such arrangements are inappropriate, provided that:
·Fund management clients understand their nature and purpose;
·The commission flows generated are properly reflected in the industry’s disclosure regime; and
·They do not create new, unmanageable conflicts of interest for the fund manager.

Scope Issues
The FSA sets out its preliminary thoughts on the territorial scope of the revised regulatory regime and coverage in relation to types of fund management firm and business. It intends to address these points in more detail in due course when it consults on actual rule changes. However, its preliminary view is that its regulatory regime will apply to fund management carried on in the UK, with the disclosure regime being the standard for UK clients’ mandates. The industry must determine whether the UK disclosure regime should or should not apply to non-UK clients.

The FSA acknowledges that the new regime may not be relevant to particular types of investment management firm and activity. It is to give this further consideration in its consultation paper on rule changes.

Retail Fund Governance
The FSA has committed itself to carrying out work on strengthening the corporate governance of retail funds as a means of sharpening the accountability of fund managers. The IMA has carried out its own review in this area and is currently consulting its membership on its findings. The FSA will examine the practical implications arising form the IMA review, releasing its findings and recommendations in the first quarter of 2005.

International Co-operation
The United States Securities and Exchange Commission (“SEC”) has established an internal task force to carry out a review of “soft dollar” arrangements. The FSA is discussing with the SEC on ways in which the two regulators may be able to co-ordinate their efforts in this area.

The Issue From a US Perspective
The United States CFA Centre for Financial Market Integrity has published a paper setting out global and ethical standards for firms managing assets. The paper includes guidelines for the provision of best execution and recommends that asset managers should use standardised performance measurement and use fair market price to value client holdings and should disclose conflicts of interest and disciplinary actions. The paper is currently being consulted upon with a view to a final version being published next year.