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Karen Jordan reviews the impact on fund managers and brokers of Consultation Paper (CP) 176 – Bundled Brokerage and Soft Commission Arrangements.

Rarely has an FSA CP galvanised the fund management and broking sectors of the financial services industry to such an extent as CP176. It has been dubbed “Big Bang Two” because of the far-reaching impacts of its proposals, particularly in respect of the cost implications for fund management firms and the effects on demand for research from brokers.

On the one hand, the Treasury and consumer groups support the principles behind the FSA’s proposals for making fund managers more accountable to their customers in respect of some of the costs that are currently passed on direct to customers’ funds.

On the other hand, the proposals have provoked an extreme reaction within the fund management and broking sectors of the industry, mainly because the proposals could add millions of pounds to firms’ costs unless they are able to pass these costs on to their customers.

There have also been claims that the proposals do not appear proportionate since the independent research published alongside CP176 does not substantiate claims that the potential for abuse is significant.

The FSA is proposing that fund managers should no longer be able to use soft commission to purchase services such as dealing screens and market pricing services and so would need to pay for these services themselves. Costs for research which are currently “bundled” within commissions paid to brokers should be reimbursed to customers. This effectively means that the only costs that could be charged direct to customers’ funds would be pure execution costs unless there was a specific agreement with customers to allow other costs to be charged.

The proposals should lead to cheaper dealing costs for customers because the fund managers would be bearing more costs themselves. However, it is likely in the current economic climate that fund managers would have to increase management fees or levy other charges in order to remain profitable.

Background
In February 2001 the FSA published a policy statement on the Conduct of Business Sourcebook in which it said that its future rolling review of the Sourcebook would include a review of inducements, including soft commission. This review was initiated in light of the comments made by Paul Myners in his report Institutional Investment in the UK: A Review, central to which was his proposition that the costs relating to broking commissions, “which are substantial”, are “subject to insufficient scrutiny” and that “clearer and more rigorous disciplines could be applied”.

The Investment Management Association (IMA) and National Association of Pension Funds introduced the Pension Fund Disclosure Code subsequent to the publication of the Myners report to ensure a common level of disclosure by investment managers to their clients, and also to help trustees understand the charges and costs incurred on their behalf. This has gone some way to addressing issues of accountability.

Current concerns
The regulator has highlighted four main areas of concern with regard to the current regime.

• There is a lack of transparency in the current system since there is little accountability to clients about the costs that are being passed on to them and whether these represent good value for money.
• There are strong incentives for fund managers to direct trade towards particular brokers in order to take advantage of soft commission deals.
• Fund managers argue that they are judged on investment performance and so are already incentivised to control the costs they pass on to customers’ funds. The FSA does not believe this is an adequate control and neither do they believe increased disclosure will help.
• Bundling and softing are treated differently under the current regulatory system despite the perceived similarity in incentive terms and the FSA feels this creates distortions.

The main proposals
The FSA’s proposals intend to address the issues of better disclosure and clearer incentives by:

• narrowing the range of permitted softed goods and services specifically to exclude market pricing and information services and
• requiring fund managers to evaluate the costs of any services other than execution costs and to rebate this amount to customers’ funds.

The FSA is also considering whether services such as computer hardware and custody fees should be prohibited.

Managers would be allowed to increase management fees to cover these costs or to levy additional charges. Since management fees are transparent and subject to more scrutiny and negotiation between the customer and the fund manager, the FSA believes that this will improve the accountability of fund managers.

Since fund managers currently pass most of the costs of research on to their customers, the FSA believes there is potential for overbuying as there is no need for the fund managers to consider whether or not they need all of the research.

There are concerns in the broking sector that the proposals may lead to a reduction in the amount of research that fund managers are willing to buy and indeed to a reduction in the overall levels of research to support markets.

Next steps
The original response period deadline of 29 August was extended to 10 October. The regulator will review responses in conjunction with the findings of the Treasury’s recently announced examination of industry progress on implementing the recommendations of the Myners report. A further FSA CP, based on the responses to CP176 and originally scheduled to be issued towards the end of 2003, is now expected early in 2004.

In order to make an impact on the FSA’s thinking on this subject, firms should have put forward well-reasoned arguments and possibly proposed alternative solutions that would ensure customer protection and increased transparency. The IMA has commissioned its own research and held a series of meetings with its member firms to consider the potential impacts and to formulate its response.

Now is the time for investment management firms to assess the implications of the proposals on their business and to start considering their strategy for passing costs on to customers should the proposals go ahead as currently drafted. For brokers, serious consideration should be given to changing strategies for the provision of research covering all sectors if these proposals go ahead in whole or in part.

Softing
Softing is the practice where one party, in exchange for business provided by another, provides services or products but not money. For example, in exchange for sending a specific volume of business to a broker, the broker will pay certain bills of the fund management company, usually market pricing screens, investment research and software.

Bundling
Bundling is the practice where the fund manager’s payment to the broker is inclusive of trade execution costs and other services from the broker, including research and access to analysts.

Karen Jordan - Senior Manager, PricewaterhouseCoopers

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