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News November 15, 2004 Issue

U.K. FSA Draws Lines Around ‘Research’ and ‘Execution’

Last week, the U.K. Financial Services Authority (FSA) released a new Policy Statement 04/23, which divides the world of potentially softable products and services into three categories: "research," "execution," and "non-permitted services." The statement sets forth the FSA’s conclusions about the scope of the terms, but does not contain actual rule text. The FSA is expected to propose draft rules defining the terms by the end of the first quarter of 2005, following the U.K. investment management industry’s development of a related disclosure regime. Comments on the new statement are due by December 17.

Let’s cut to the chase. Under the proposed scheme, "non-permitted" (i.e., not softable) services include:

  • custody (see below);
  • raw data feeds;
  • information that is generally publicly available through the mass media, specialist journals, other publications, and associated subscriptions;
  • portfolio valuation and performance measurement services;
  • computer hardware;
  • dedicated phone lines;
  • seminar fees;
  • subscriptions for publications;
  • travel and entertainment costs;
  • word processing, accounting, and other office administrative software;
  • membership fees for professional associations;
  • purchase or rental of standard office equipment or ancillary facilities;
  • employees’ salaries; and
  • direct money payments.

Execution. The general test: to be "execution," the service must be "demonstratably linked to the arranging and conclusion" of a specific transaction or series of related transactions, and must arise between the point at which the adviser makes an investment decision and the point at which the transaction is concluded. So, for example, sales and trading advice can be execution if attributed to a specific transaction or transactions after the point at which the adviser makes the trading decision (for example, advice on liquidity and negotiation on the terms of a trade).

The FSA said that post-trade analytics, such as software that evaluates execution quality, should not be considered execution "without very strong reasons".

As for custody, the regulator had this to say: "[W]e see no obvious reason why fund managers should use commission on transactions to pay for custody services."

Research. The general test: to be "research," the output must represent original thought, have intellectual rigor, and involve analysis or manipulation of data to reach meaningful conclusions. Original written research (whether proprietary or third-party) is included, as well as discussions between a manager and the author of the research. Interestingly, the FSA said that artificial intelligence could be research: "It is clearly possible that original analysis and meaningful conclusions on investment and trading decisions can be computer-generated."

The policy statement notes that the U.K. investment management industry is continuing its work on developing an acceptable disclosure regime. Back in May 2004, the FSA gave the U.K. industry until the end of the year to come up with a proposal. The recent statement indicates that the FSA is satisfied by the industry’s progress, and is going to hold off publishing proposed rule changes until first quarter of 2005, so that it can reflect the industry’s recommendations.

A few other notes:

  • If you’ve been confused by the British distinction between "bundling" and "softing," take heart: The new terminology focuses on whether a product or service is execution, research, or non-permitted service, regardless of who provides it (which drives the distinction between bundled and softed service).
  • The FSA said that the medium of communication or delivery — paper, electronic, in-person, etc. — is irrelevant in determining whether a service is execution, research, or a non-permitted service.
  • The FSA recognized that its bundling proposals have been focused on institutional managers and said that it would consider whether the changes are relevant to other types of firms. Similarly, it noted that the proposals have related to commission arrangements in the equity markets, but said that in the future it would consider whether to extend their application to other asset classes.
  • The FSA changed its position on commission-sharing arrangements, saying that would not consider them inappropriate if they are understood by clients, adequately disclosed under the industry’s forthcoming disclosure proposal, and do not create new, unmanageable conflicts for advisers.