Last week, the Alternative Investment Management Association (“AIMA”) released the text of a letter it received from Stephen Hanks, Head of Market Policy at the FCA. The letter was dated 19 July 2017 but sent one week ago. The letter is a response to one sent by AIMA back in April, asking the FCA to clarify their position on how MiFID II requirements should be extended to non-EU delegates (e.g. those acting as sub-advisers), including its new rules on paying for research.
The FCA’s stated position is more extreme than most industry commentators (including ourselves) had been expecting. Clients, particularly those that serve as a delegate of a UK investment firm, should urgently review their arrangements in this area to ensure compliance with the new regime by 3 January 2018. There are also broader implications for non-EU delegates of EU firms in general, and a potential read-across to other investor protection rules.
Recap: MiFID II’s new rules on inducements and paying for research
MiFID II prohibits portfolio managers from accepting any form of monetary or non-monetary benefit (i.e. an inducement) paid or provided by a third party, unless it is a minor non-monetary benefit capable of enhancing the quality of service to the client. Research is only permitted (i.e. not treated as an inducement) if it is either:
- directly paid for by the manager; or
- paid for out of a Research Payment Account (“RPA”), funded either by a direct charge to the client, or out of a “research commission” collected alongside (but separately identified from) an execution commission.
In other words, “free” research (i.e. paid for out of a bundled commission rate) is no longer permitted, and indeed managers are expected to take “reasonable steps” to stop research providers from sending it (apart from a permitted 3 month trial period).
This radical change of rules is problematic for any manager organised on a global basis, for example where research is received in one location but shared and consumed elsewhere across potentially inconsistent, or conflicting, regulatory regimes. For US advisers in particular, either those with EU-affiliated entities authorised under MiFID, or acting as sub-advisors to EU funds, the new rules are incompatible with the SEC’s restriction on broker dealers from receiving separate “hard dollar” payments for research.
Firms with entities registered with both the SEC and under MiFID, operating under a shared research model, have for a while recognised that a delicate crafting of arrangements (e.g. a transfer pricing arrangement) would be required to ensure that they remain compliant on both sides of the Atlantic.
AIMA letter (April 2017)
In its opening letter, AIMA recognised the significance of Articles 31 and 32 of the MiFID II Delegated Regulation: firms outsourcing critical or important operational functions must remain fully responsible for discharging all of their obligations. Service providers located in third countries are required to be authorised or registered in its home country and is effectively supervised by the competent authority in that third country.
However, AIMA went on to assert that there is a substantive difference between requiring a manager to operate under local rules, and a full look-through to the MiFID rules themselves. It noted that this was the longstanding practice adopted by UK firms under the original MiFID, and argued for a similar approach to be taken under MiFID II.
FCA response (July 2017)
Instead, the FCA has taken what it refers to as a “purposive reading” of the MiFID II rules on paying for research: “We disagree with a narrow reading that the inducements provisions fall away where a service is outsourced by an investment firm, due to the fact that any third party benefits will be received by the service provider and not the MiFID firm”. In other words, it expects third country managers to operate within a framework that achieves the same investor protection outcomes for their underlying clients.
Although the FCA recognises that such firms may not be able to deliver operational arrangements that are exactly the same as a MiFID manager, it requires them to be at least consistent with these. It highlights three areas where consistency can be achieved by requiring the non-EU manager to:
- Set a budget with a maximum research spend, and implement a policy on how that budget will be used;
- Fully account for the research inputs received in relation to the delegated funds; make an assessment of the value of these inputs (using objective benchmarks or metrics); and control the payments made to such providers on the basis of this valuation;
- Maintain systems and controls to ensure that research does not compromise best execution and decisions on order-routing, or otherwise give rise to conflicts of interest.
Lastly, the FCA confirms that a MiFID firm could avoid such obligations by meeting the costs of third- party research itself rather than passing these onto the client (although it does not specify in practise how this could happen).
The FCA’s letter was also copied to other investment management industry associations, so it is clearly intended as definitive guidance on the subject. Further commentary from ESMA or other EU competent authorities is always possible, as is additional clarification on the broker payment issue from the SEC.
The FCA’s position will greatly disappoint firms and observers who expected a more pragmatic approach. It has for a long time taken a stand against the perceived risk of conflicts of interest in current market practices for dealing commissions and “bundled” services. Notwithstanding that, its latest stance is surprising in the light of a) its recent more conciliatory approach to the financial services industry in general; and b) a reluctance to take a pro-active role in EU regulation during the Brexit negotiations. At first sight, the practicalities of meeting the FCA’s expectations at an operational level look extremely demanding and present a challenging timeline with less than 5 months to the implementation date.
The wider implications of the FCA letter are also potentially troubling: firms outsourcing must remain responsible for discharging all of their obligations under MiFID II. If this look-through standard is applied to research, why not to other investor protection measures such as best execution and product governance? And will the FCA’s position become a template for other EU jurisdictions – notably in Ireland and Luxembourg where the advisory delegation model is so prevalent?
Implications for third country managers
Firms must urgently review their arrangements in this area to ensure that their investment activities are not disrupted from January 2018. Doubtless the industry will be coming up with innovative solutions about how to reconcile these requirements again in coming months.
As an initial guide, here are some specific steps that third country managers in this situation should be considering:
- Reach out to the MiFID firm who has delegated portfolio management to you to understand how they will be monitoring compliance and its arrangements to be adopted for research payments and valuation;
- Review your existing consumption of research and distinguish the essential from the “nice to have”;
- Contact your brokers to start assessing the value of research provided: this will be easier for EU brokers who have already started negotiating such arrangements with the buy-side; and
Consider how to formulate a research policy for the firm which addresses the requirements of both EU and non-EU rules.
For more information
ACA consultants will be engaging with affected firms in the near future to discuss how we may assist you in understanding and addressing this new position. In the meantime, please contact Martin Lovick, James Andrews or your regular ACA consultant with any questions on this paper, or to discuss how ACA can help.