Soft Dollar Rules Proposed in U.K.; ‘Not Dissimilar’ U.S. Outcome Expected
On March 31, the U.K. Financial Services Authority issued a new consultation paper, CP05/5, proposing new soft dollar rules.
The rules take a two pronged approach:
First, the rules define what types of products are "execution" and "research" and are therefore eligible to paid for by commissions. The rules also specify a number of "non-permitted" services that must be paid for in hard dollars (such as custody not incidental to execution, computer hardware, phone lines, and portfolio performance measurement and valuation services).
Second, the rules set forth the principle that advisory clients ought to know how their commissions are being spent. To that end, the rules indicate that compliance with the disclosure code developed by the U.K. Investment Management Association (which effectively "unbundles" full-service commissions on paper) will satisfy the rule. The IMA’s disclosure code requires advisers to provide clients, on an annual basis, with a description of their procedures for managing clients’ costs. On a semi-annual basis, advisers will have to provide client-specific information on how the client’s commissions have been generated and how they have been spent, breaking out commissions paid for execution and research. Clients also will receive information on the adviser’s firm-wide trading patterns.
To facilitate advisers’ preparation of this information, the London Investment Banking Association issued a companion Statement of Good Practice that encourages U.K. brokers to provide U.K. advisers with relevant information.
The FSA did not propose to mandate compliance with the IMA code. Advisers that choose not to use the IMA’s disclosure code "should be able to demonstrate why they believe that the level and content of disclosure to their clients is sufficient and appropriate," said the FSA. The regulator noted that some commenters had expressed concern that the IMA disclosure may be too detailed for retail clients. The FSA also noted that some U.K. advisers may voluntarily provide the IMA disclosure to their non-U.K. clients. "[T]his is a commercial decision for investment managers to agree with their clients," said the regulator.
The proposed rules would apply only to equity trades, not to fixed income trades. The FSA said it may revisit the application of the rules to the fixed income market if it finds evidence of similar soft-dollar related conflicts of interest in that market.
So: Why is this all relevant to U.S. advisers?
Most directly, the FSA’s rules will apply to U.S. advisers that happen to be registered with the FSA (or, as the FSA puts it, "authorised" to carry on investment management business in the U.K.). The rules apply to all activities conducted from U.K. offices, and, in accordance with the general territorial application of FSA rules, seem to apply to a FSA-authorized firm’s activities for U.K. clients conducted from the adviser’s non-U.K. offices.
More broadly, however, the rulemaking is likely to influence the SEC’s Soft Dollar Task Force, which has been closely watching what the FSA has been doing.
In fact, the FSA’s proposal noted that it continues to have discussions with the SEC staff on soft dollar issues "and on ways we might be able to co-ordinate our efforts" in the area. "We believe that they are looking at outcomes that are not dissimilar to our own," the FSA added. "[H]owever, we do not think that implementation of our own programme and the SEC’s are dependent on each other."
Comments on the proposal are due May 31. The FSA said it plans to adopt final rules over the summer, to be effective January 2006.
Of particular note: The rulemaking responded to comments received on the FSA’s November 2004 policy statement (PS04/23), which addressed the sorts of products and services are "execution" and "research" eligible to paid for by commissions. The FSA stuck to its original definitions: To be execution, the services 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. To be research, the output (written or oral) must represent original thought, have intellectual rigour (not merely state what is commonplace or self-evident), and involve analysis or manipulation of data to reach meaningful conclusions.
The March 31 proposal clarified a number of issues raised in PS04/23:
Custody. Despite requests from commenters that custody be treated as execution, the FSA added custody services (other than those that are incidental to the execution of trades) to list of "non-permitted investments."
Newspapers and magazines. The FSA added publicly-available information, such as mass media and specialist journals, to the list of "non-permitted investments."
Post-trade execution analysis. According to the FSA, the issue of post-trade analytics prompted the greatest number of comments. Many commenters urged the regulator to allow software that helps an adviser analyze the quality of its executions after-the-fact as "execution," payable in commission dollars.
Unfortunately for those commenters, the FSA said that it was not convinced that post-trade analytics should be treated as execution. While acknowledging that there are "arguments both ways," the FSA concluded that "clients are better served" by not including post-trade analytics in the execution category. However, the regulator indicated that post-trade analytics could meet the criteria for research if it assists in the making of investment or trading decisions. The FSA noted that it had not specified post-trade analytics as a "non-permitted service."
Data feeds. The treatment of pricing services, data feeds, and other information services also received significant comment. The FSA declined to put these services definitively in the "research," "execution," or "non-permitted" buckets. "Because of the diversity of these systems and their usage, we do not believe it would be helpful or appropriate for us to state what category they, or part of them, fall into to," said the regulator. As a result, it will be up to the adviser to decide whether those sorts of services are research, execution, or non-permitted, based on the principles laid out by the FSA. The regulator said that it expects advisers "to be able to justify this decision if asked by their clients or by us."
While truly raw data feeds, such as price feeds or historical data that has not been manipulated or analyzed in any way, may not be treated as research, "data that has been manipulated into some form of output may be research," provided the tests for what "research" are otherwise met. the FSA said. It also asked for comment on whether raw data feeds could be classified as "execution."