What the FCA’s proposed investment research rules mean for UK companies

May 8, 2024

4 minutes read

As part of the Edinburgh reforms, which were intended to drive growth and international competitiveness in financial services, the UK government called for an independent review of the country’s investment research market.

This 2023 review issued a series of recommendations to help boost the UK investment research market.

Investment research has a crucial role in providing information to potential and existing investors. It helps investors understand the company and risks of investing in such a business and hence allows informed investment decision-making.

The quality of investment research is significant in attracting and retaining issuers and investors to UK capital markets.

The Financial Conduct Authority’s Consultation Paper CP24/7, Payment Optionality for Investment Research (CP24/7), focuses on just one of the recommendations made from the 2023 review and may potentially give UK buyside companies — asset managers and others — greater flexibility on how they can purchase investment research.

The current rules allow companies to either fund research out of their own resources such that research payments are a cost in a company’s overall profits, or agree a separate research charge with each of their clients with the payment for research made from a so-called “research payment account”.

New third option

The FCA is consulting on a “new” third option of “bundling” payments for third-party research and execution. It says the greater choice should suit companies of varying business models and sizes, helping to promote competition.

The regulator’s rules are said to favour larger asset managers, to have reduced the number of research providers and hence competition in the market, and to have restricted UK companies’ ability to buy investment research produced outside the country.

There has also been a suggestion that while providers continued to provide good research on larger issuers, the amount of and quality of research in relation to smaller issuers has fallen and is being produced by more junior staff.

The current rules stem from Mifid II, which introduced requirements to separate charges for trade execution from charges for research

The current rules stem from Mifid II, which introduced requirements to separate charges for trade execution from charges for research, thereby “unbundling” these two services and left companies with the two options mentioned earlier.

The concern was that this bundled practice led to a less-disciplined spending on duplicative or low-quality research, inappropriate influence of research procurement considerations on trade allocation decisions, and opaque charging structures.

The Mifid II policy objective at that time sought to remove any conflicts of interest and create costs and pricing transparency to clients.

For this third option, companies would need to establish appropriate “guardrails” to protect investors including:

a formal policy on use of the approach. This approach would need to fall within the company’s governance framework and hence its decision-making, periodic monitoring and controls;
a budget for the research to be purchased will need to be set and reviewed on an annual basis;
ongoing assessments of research value and price. This will need to be benchmarked annually;
an approach to the allocation of costs across their clients;
a structure for the allocation of payments across research providers;
operational procedures for the administration of accounts to purchase research;
disclosures to clients on the company’s approach to bundled payments, their most significant research providers, and costs incurred. Full transparency would need to be given on the firm’s approach to bundled payments.

CP24/7 also highlights that companies to which the consumer duty applies would need to consider whether their policies and arrangements for bundled research meet the requirements of the duty. Companies will need to consider price and value aspects, as well as customer communications about research.

The FCA will seek to implement this new option by adding to the list of minor non-monetary benefits commentary and advice linked to trade execution.

In addition, the regulator is proposing certain changes to small and medium-sized enterprise research, while retaining some of the changes that PS21/20 introduced, including treating corporate access in relation to companies with a market capitalisation below £200mn as a minor non-monetary benefit.

While the FCA defends its previous stance on unbundling in CP24/7, there does appear to be some softening of this previous policy decision. It also recognises the limited take-up of the research payment account option, so it is yet to be seen if companies would take on something just as, if not more so, operationally complex.

The changes being proposed are not yet relevant to Ucits management companies, full-scope UK alternative investment fund managers, small-authorised UK AIFMs and residual collective investment scheme operators.

But the regulator’s policy intention is to extend its proposals to all buyside companies, and they are expected to familiarise themselves with the proposals. It plans to achieve alignment in a future consultation later this year.

More prescriptive standards

Also, just to flag the warning the FCA gives in CP24/7 that further guidance and more prescriptive standards could be introduced if the new option reintroduces opaque charging structures or conflicts of interest that were prevalent before Mifid II. Given the potentially limited take-up by companies of the new option, the likelihood of this happening may be minimal but the warning to firms is already there.

While the FCA defends its previous stance on unbundling in CP24/7, there does appear to be some softening of this previous policy decision

The regulator claims this proposal will allow compatibility with rules governing research payments in other major jurisdictions, including the US, and hence it should make it easier for UK companies to access research from cross-border providers. It will also allow UK investment research providers to compete effectively on a global basis.

Of course, how this proposal will fit with the EU’s legislative reforms to the Mifid II unbundling rules is yet to be seen. But the the FCA has already flagged in its consultation that while the EU’s proposals share some similarities there are differences as regards the guardrails, including the UK regulator requiring budgets for research spending, an approach to the allocation of costs across clients, and a structure for the allocation of payments across research providers.

The FCA is asking for comments by June 5. This is an eight-week consultation period and, dependent on the responses, a quick turnaround is expected, with the regulator aiming to publish any new rules or guidance in a policy statement in the first half of 2024.

Jonathan Herbst is global head of financial services and Uzmah Yunis is counsel at Norton Rose Fulbright

Source link

May 8, 2024

4 minutes read