Published 31-Oct-2016 by
Ashley Kovas, Regulatory Intelligence, Thomson Reuters
The Markets in Financial Instruments Directive (MiFID) II’s regime for the funding of investment research by investment firms has proved controversial. It is however important to consider the full range of solutions, including a separate charge to the client to reimburse the manager’s expenditure on research. Regulatory consultant Oliver Lodge, director of OWL Regulatory Consulting, has pointed to a “third way”.
MiFID II Level 1
The MiFID II Level 1 directive requires that investment firms have in place: “effective organisational and administrative arrangements … to prevent conflicts of interest adversely affecting the interests of its clients”.
Article 23(1) requires investment firms to “take all appropriate steps to identify and to prevent or manage conflicts of interest” between the firm and its clients and between one client and another, “including those [conflicts] caused by the receipt of inducements from third parties or by the investment firm’s own remuneration and other incentive structures”.
Article 23(2) goes on to require clear disclosure to the client where the firm’s arrangements are insufficient to prevent the risk of damage to client interests. In that case, the firm must make prior disclosure to the client of the “general nature and/or sources of conflicts of interest and the steps taken to mitigate those risks”.
Article 24(9) says in its first paragraph that investment firms are not to be taken as fulfilling their obligations under Article 23 where they pay or receive any fee or commission or provide or are provided with any non-monetary benefit, except where the payment is made by or goes to the client. Any such payments must be clearly disclosed to the client in a manner that is “comprehensive, accurate and understandable”.
Article 23(9) concludes with: “The payment or benefit which enables or is necessary for the provision of investment services, such as custody costs, settlement and exchange fees, regulatory levies or legal fees, and which by its nature cannot give rise to conflicts with the investment firm’s duties to act honestly, fairly and professionally in accordance with the best interests of its clients, is not subject to the requirements set out in the first paragraph”.
The MiFID II delegated directive
Article 13 of the MiFID delegated directive, which though agreed has yet to appear in the Official Journal, further considers inducements in relation to research, saying that the provision of research is not to be regarded as an inducement where the research is paid for by:
• direct payments by the investment firm out of its own resources; or
• payments from a separate research payment account (RPA) where (a) the research payment account is funded by a specific research charge to the client; (b) investment firms set and regularly assess the necessary research budget; (c) the investment firm is responsible for the RPA; (d) the investment firm regularly assesses the utility of the research purchased.
Where an RPA is used, there is also a requirement to make prior disclosure to clients about the research budget, together with annual disclosure of the total costs incurred by each of them for third-party research.
Last month, the FCA published a consultation paper on MiFID II implementation (CP16/29), which included its intentions on implementing the requirements described above through changes to the inducements rules in a new rule 2.3B, “Inducements and research”.
The RPA solution is highly technical and would impose a significant administrative burden on investment firms.
“These accounts will not be cheap to run by the time you have determined your policy, worked out your budget, agreed your charges with every client, structured your management oversight, designed your disclosure documentation and appointed a third party or two to help,” Lodge said.
Payments by the manager
The alternative to the RPA is for the manager to pay for the research. On the face of it, this will impact on the manager’s pocket. “There is almost nothing said in the draft rules about the pay-for-it-yourself option. The FCA offers a one-liner: ‘direct payments by the firm out of its own resources,'” Lodge said. This wording is included in proposed rule COBS 2.2B.3R(1).
In addition, it is clear from proposed COBS 2.3A.3R(1)(a) that “a fee, commission or non-monetary benefit paid or provided by the client or a person on behalf of the client” is outside the prohibition on inducements. This implements Article 24(9) of the MiFID Level 1 Directive which similarly exempts payments to and from the client.
A third way?
These provisions point to another means of paying for investment research. As discussed above, it is generally understood that the manager can pay for the investment research itself.
Lodge said: “The FCA said nothing more than that the manager can pay for research “out of its own resources”. There is nothing to stop the manager creating a new charge to the client to recover that cost.”
He said the manager therefore has a choice between:
• paying for research and not recovering the cost;
• paying for research and recovering the cost with a charge to the client; and
• setting up a RPA.
The RPA route might appeal to firms already operating commission sharing arrangements (CSAs) since they are already bearing an administrative burden. For firms that do not, there is a choice between recovering or not recovering investment research costs from clients.
The informed client
Lodge said where the manager picks up the cost itself, it may have insufficient incentive to buy enough investment research which might impact adversely on fund performance. The RPA firm on the other hand may, according to Lodge: “impress the client with its diligence in the ample disclosure they provide, but the client may tire of the flood of data he has never asked for or wished to receive or pay for”. Importantly: “The RPA firm will experience significant cost in providing the data and other RPA baggage, either reducing profit or
necessitating some increase in fees, in addition to the research charge”. Where a separate research charge is levied, Lodge said the informed client will realise that while he will continue to pay for investment research, he will do so through a clear charge but he will not be paying for the administration inherent in an RPA.
Prior and annual disclosure
Lodge’s third option will require a change to terms and conditions and appropriate safeguards to ensure the amount charged to the client is reasonable in the light of the research cost applicable to the client.
Proposed COBS 2.2A will require prior disclosure of, among other things, “all costs and related charges”. Proposed COBS 6.1-A.2.8R will require an annual statement of costs and charges to be provided to the client during the life of the investment.
Lodge considers that in its turn, an enlightened firm will offer an appropriate degree of transparency: “a simple report to account for its research expenditure and justifying its additional fee”.