Paying for Buy-Side Investment Research: Will the FCA’s Third Way Ease the US-UK Divide?

On 10 April 2024, the Financial Conduct Authority (FCA) published a Consultation Paper on payment optionality for investment research (CP24/7). CP24/7 followed the UK Investment Research Review, in which recommendations were made to help boost the UK investment research market. A key recommendation was for the FCA to amend its rules on research unbundling to allow FCA-authorised investment managers more flexibility in how they pay for research. This included a recommendation that the “rebundling” of research and execution charges be permitted.

The proposals do not return the regime to a pre-unbundling approach but will create an exception for investment managers that are willing to use a Commission Sharing Arrangement (CSA) with brokers who are prepared to offer a CSA. This will give limited relief to managers that are subject to the rules on research; the rules no longer apply to fixed-income research, which is good for credit fund managers. Private equity managers tend not to use investment research.

The proposals should, however, have a positive impact on US brokers, making it possible for them to receive payments from UK managers. 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. 

The FCA has not proposed equivalent changes to its rules for FCA-authorised alternative investment fund managers (AIFMs), but it intends to consult further in 2024 to ensure consistency between the regimes of FCA-authorised investment managers and AIFMs. The FCA has also indicated that it has further work to do as a result of the Investment Research Review, including a review of the rules on investment research in the context of IPOs.

The consultation closes on 5 June 2024, with rules to be published shortly thereafter.

The Current UK Position

Since 2018, when the UK implemented the revised Markets in Financial Instruments investment (MiFID 2), FCA-authorised managers have had to pay brokers for investment research in one of two ways:

• Using their own money
• Using their client’s money and making payments via a “research payment account” (RPA) mechanism, which requires the managers to agree on a budget with the client and fund payments for research only from that budget.

The FCA rules are clear that any payment from the RPA must not link to the volume or value of transactions executed on behalf of clients and must not be used to cover anything other than research, such as charges for execution.

A failure to use either of these two ways of paying for investment research will place a manager in breach of the FCA’s rules, which prohibit the receipt of or payment of any non-monetary benefit.

In 2021, the FCA broadened the list of so-called acceptable “minor non-monetary benefits” to include research on small and medium-sized enterprises with a market cap of less than £200 million and fixed income, commodities, and credit (FICC) research. As a result, FICC research is not subject to the inducement rules and an investment manager does not have to pay for them using its own money or an RPA.

The Proposed Rules and Guidance

The FCA is looking to meet its objective for bundling payments for research and execution services by including a specific carve-out from the inducement rules, rather than by adding to the list of acceptable minor non-monetary benefits.

An FCA-authorised manager will still be able to pay for research using its own money or using an RPA, but a proposed rule will offer a third way: joint payments for third-party research and execution services, provided the manager meets certain requirements relating to the operation of these payments.

These requirements, described in CP24/7 as “guardrails” (each with a specific name), will require the manager to:

• 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 (the “no free-rider guardrail”)
• Ensure that a client pays only for research directly materially relevant to the investment strategy in which it is invested (the strategy-specific guardrail)
• Apply minimum standards when choosing research providers and agreeing on prices for goods and services whenever client dealing commissions are used (the procurement guardrail)
• 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 (the research budget guardrail)
• Provide periodic disclosures to clients describing the nature of research purchased, describing the impact research, strategy, level, and investment art comes during such period (the disclosure guard rail)
• 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 (the all in the basis points disclosure guard rail)
• 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 (the counterparty guardrail)

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

When MiFID 2 introduced the restrictions on payments by managers for research, the position of payments by EU (of which the UK was then a part) buy-side managers to US sell-side broker-dealers was complicated by the fact that 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 has made it clear the changes in CP24/7 are designed, in part, to address this divergence, noting that it is important for UK investment managers “to be able to obtain research from global sources without impediments to remain globally competitive.”

The FCA is also proposing to add commentary and advice linked to trade execution as a new acceptable minor non-monetary benefit to ensure the UK regime is compatible with practices in the United States.

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 a similar outcome.