Further easing the US-UK Divide: Extending the Buy-Side Investment Research Rules to Fund Managers

In our previous alert Paying for Buy-Side Investment Research: New Rules Ease the US-UK Divide | Insights & Resources | Goodwin we discussed the Financial Conduct Authority (FCA) final rules in its policy paper PS24/9: Payment optionality for investment research (fca.org.uk) (PS24/9). These introduced an optional form of payment for research for the managers of separate accounts (Investment Managers) but, as we noted, not for the managers of funds, including private investment funds (Fund Managers).

On 9^th May, the FCA published a policy paper In https://www.fca.org.uk/publication/policy/ps25-4.pdf (PS 25/4) containing final rules and guidance expanding payment optionality to Fund Managers. The rules and guidance came into force on that date.

Although the payment optionality rules have not returned the regime to a pre-unbundling approach, it has created an exception for Fund Managers willing to use a Commission Sharing Arrangement (CSA) with brokers who are prepared to offer a CSA. Like the rules for Investment Managers, the rules will have a positive impact on US brokers, making it possible for them to receive payments from UK Fund Managers, noting that the US Securities and Exchange Commission (SEC) no-action letter that had allowed US broker-dealers to receive payments on an unbundled basis expired in July 2023.

As with the rules for Investment Managers, the rules for Fund Managers give limited relief; the rules no longer apply to fixed-income research, which is good for credit Fund Managers. Private equity Fund Managers tend not to use investment research.

Reconciling the Buy-side Position in the UK With the Sell-side Position in the US?

When the UK implemented the revised Markets in Financial Instruments investment (MiFID 2) in 2018, the FCA expanded the buy-side investment research rules to authorised Fund Managers, giving them the options for paying brokers for investment research: (a) using their own money; or (b) using their client’s money and making payments via a “research payment account” (RPA) mechanism, which requires the Fund Managers to agree on a budget with the client and fund payments for research only from that budget.

The FCA Rules complicated the position governing payment by Fund Managers to US sell-side broker-dealers because US broker-dealers may not receive research payments from money managers in “hard dollars” or from advisory clients’ research payment accounts, without putting themselves at risk of an SEC enforcement action based on providing research services unbundled from investment advice.

The SEC issued a no-action letter in 2017 (ahead of the MiFID 2 implementation) with the effect that (a) US broker-dealers could accept research payments from money managers in hard dollars or from advisory clients’ research payment accounts; (b) US investment advisers could continue to aggregate orders for mutual funds and other clients; and (c) money managers could continue to rely on an existing safe harbor in US securities laws when paying US broker-dealers for research brokerage.

The no-action letter was, however, a temporary measure and eventually expired in July 2023, reintroducing the divergence in position between the UK and the United States.

The FCA made it clear in original consultation, referred to in PS 25/4, that the extension of the rules to Fund Managers is designed, in part, to address this divergence.

The Rules and Guidance

The FCA has made amendments to Conduct of Business Sourcebook (COBS) 18, Annex 1, an FCA-authorised Fund Manager will still be able to pay for research using its own money or using an RPA, but the revised rules offer a third way: joint payments for third-party research and execution services, provided the Fund Manager complies with the rules in COBS 2.3B, the changes to which we noted in our previous alert Paying for Buy-Side Investment Research: New Rules Ease the US-UK Divide | Insights & Resources | Goodwin referred to in the COBS 18, Annex 1.

The rules impose requirements on a Fund Manager connected with the following objectives:

• No free-riders: Ensure that all relevant clients, dealing commissions are used bracket — i.e., individual clients would not be permitted to contract out of commission payments for a search
• Specific strategy: Ensure that a client pays only for research directly materially relevant to the investment strategy in which it is invested
• Procurement: Apply minimum standards when choosing research providers and agreeing on prices for goods and services whenever client dealing commissions are used
• Research budget: Set a research budget for a period not exceeding 12 months, at investment strategy level, and cut commissions to pre-agreed execution-only rates for the remainder of the period once research expenditure has reached such budget
• Periodic disclosure: Provide periodic disclosures to clients describing the nature of research purchased, describing the impact research, strategy, level, and investment art comes during such period
• All in the basis points disclosure: Disclose to perspective existing clients fees that include both investment management fees and research payments using dealing commissions for the prior 12 months, expressed as a proportion of average assets under management for the strategy during the prior 12 months
• Identifiable counterparty: Ensure that the portion of execution costs that can be used by the manager to purchase research is, with a set frequency bracket (e.g., monthly), transferred into a bank account controlled by the manager

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.