AUGUST 2005 Investment Management FSA 05/9: Financial Services Authority Issues Final Rules Regarding Bundled Brokerage and Soft Commission Arrangements By Michael S. Caccese and Vivian Z. Wexler* The U.K. Financial Services Authority (“FSA”) recently issued final rules in FSA 05/9 (“Final Rules”) to address conflict of interest concerns relating to the use of soft commission and bundled brokerage arrangements which create incentive misalignments between investment managers and their clients. The Final Rules take into consideration 52 responses received during the consultation period which ended on May 31, 2005. The Final Rules: ■ establish a high-level approach to disclosure that leaves much to the discretion of investment managers in connection with making determinations as to whether it is appropriate to pay for execution and research services with commissions; ■ limit investment managers’ use of dealing commission to the purchase of execution and research services; ■ require investment managers to disclose to their customers details of how these commission payments have been spent and what services have been acquired with them; ■ embed incentives to secure value for clients in the commercial relationship between investment managers and brokers, especially with regard to execution and research expenditures; and ■ promote a more level playing field in the production of research, whether within investment banks or by third parties. IMPLEMENTATION The Final Rules will be effective on January 1, 2006, with a transition period allowing firms to comply with the existing soft commission rules until the earlier of the expiration of any existing soft commission arrangements or June 30, 2006. DISCLOSURE CODE The Final Rules maintain the proposed rules’ requirement for an investment manager to disclose to its customers the details of how the customers’ commission payments are spent. FSA relies heavily on a self-regulated approach whereby the Investment Management Association (“IMA”) in conjunction with the London Investment Banking Association (“LIBA”) and the National Association of Pension Funds (“NAPF”) are empowered to develop proposals to secure improved management of conflicts concerning soft commissions. FSA suggests the IMA/NAPF Disclosure Code (“Disclosure Code”) should be amended to include a standard form of disclosure to clients that would provide information about the investment manager’s use of commissions for execution and research goods and services. The Disclosure Code is available for review at http://www.investmentuk.org. The Final Rules suggest that a new Disclosure Code should require firms to annually disclose descriptions of investment managers’ policies, processes and procedures in the management of costs paid on behalf of clients (“Level 1 Disclosure”) and to disclose on a six-month basis client-specific information on how commissions paid have been generated and how they * Michael Caccese is a partner in the Boston office of Kirkpatrick & Lockhart Nicholson Graham LLP. He works extensively with investment firms on compliance issues, including all of the CFA Institute standards. He previously was the General Counsel to AIMR and was responsible for overseeing the development of AIMR-PPS, GIPS and other standards governing the investment management profession and investment firms. He can be reached at 617.261.3133 and mcaccese@klng.com. Vivian Z. Wexler is an associate with K&LNG in the Boston office and can be reached at 617.951.9045 or vwexler@klng.com. have been used, including a split between commissions spent on execution and research (“Level 2 Disclosure”). While use of the Disclosure Code under the Final Rules is not mandatory so long as the investment manager is able to demonstrate that the level and content of disclosure to the client is sufficient and appropriate (based on the investment manager’s individual circumstances), FSA expects the Disclosure Code, as amended, to become the standard means for disclosure of commissions spent, particularly for U.K. Institutional Funds and retail funds. Some firms may choose to use it for non-U.K. clients as a matter of good policy to uphold the principles of transparency. The Final Rules take note that the substance and types of the disclosure made may be significantly different, depending on the unique qualities of the business of the investment manager. The FSA will monitor the potential difficulties that may arise with respect to less sophisticated customers, out of the flexibility allowed by the Final Rules. The FSA expects firms to inform their customers of the arrangements they have entered into that involve the use of dealing commission to purchase execution and research goods and services, either with or before the earlier of the first periodic disclosure made in 2006 or July 1, 2006. DETERMINATION OF EXECUTION AND RESEARCH GOODS AND SERVICES The Final Rules implement the guidelines set forth in the proposed rules for determining what constitutes “execution” and “research” goods and services and establish that permissible execution and research goods and services must: ■ be related to the execution of trades for customers or the provision of research; and ■ reasonably assist the investment manager in the provision of its services to customers and not impair its duty to act in the best interest of customers. Services provided by a broker (or other execution service) that are demonstrably linked to the arrangement and conclusion of a specific transaction or series of related transactions will be considered to fall within the definition of execution and research goods and services. In addition, services provided by a broker (or other execution service) that arise between 2 AUGUST 2005 the point at which the investment manager makes an investment decision and the point at which the transaction is concluded will also be considered to fall within the ambit of the definition of execution and research goods and services for the purposes of the rule. The Final Rules specifically establish certain non-permissible services for illustrative purposes as follows: ■ services relating to the valuation or performance measure of portfolios; ■ computer hardware; ■ dedicated telephone lines; ■ seminar fees; ■ subscriptions for publications; ■ travel, accommodation or entertainment costs; ■ office administrative computer software; ■ membership fees to professional associations; ■ purchase or rental of standard office equipment and/or ancillary facilities; ■ employees’ salaries; and ■ direct money payments. In addition, FSA determines that certain sales and trading advice may be considered an execution service if it can be attributed to a specific transaction after the investment manager makes an investment decision. The Final Rules further classify clearing and settlement services (i.e., the netting of positions to reduce costs, corresponding with sub-custodians on specific trades, and resolving and reporting failed trades) as included within the definition of execution services. The Final Rules specify that Post-Trade Analytics may not be considered to be execution services, if the products provide information about the quality of markets generally. However, FSA determined that products used to examine the quality of execution would be permissible as execution services. The Final Rules indicate that “research” goods and services should be capable of adding value by providing new insights that inform investment managers when making investment decisions about their clients’ portfolios. Research output should represent original thought, have intellectual rigor and KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP not merely state the readily apparent, and involve analysis or manipulation of data to reach meaningful conclusions. FSA does not, however, specify the form that research must take in order to be a permissible expenditure. The Final Rules further specify that the “repackaging” of existing research is excluded from the definition of “research services.” Research must be original. However, the FSA determined that existing material may be included in original research where the final conclusion provides new insights. In addition, research produced by a U.K. research provider’s sister company in another country and then passed on to a U.K. research provider’s customers would be regarded as research, if it was not generally available in the country already. provide best execution does not automatically qualify as an execution service. Investment managers must always be able to justify the classification as an execution service if they choose to classify something as such. Raw data feeds are not permitted to be considered research services under the Final Rules, unless the data has been manipulated into some form of output that is sufficiently original. The Final Rules specifically assert that a service or product that assists firms to 617.261.3133 3 AUGUST 2005 FSA expects, at a minimum, that investment managers determine whether the execution and research goods and services they propose to acquire with commissions are permitted services and, if so, that they disclose the costs involved and be able to justify the decision to purchase such goods and services. Michael C. Caccese mcaccese@klng.com Vivian Z. Wexler vwexler@klng.com 617.951.9045 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP If you have questions or would like more information about K&LNG’s Investment Management Practice, please contact one of our lawyers listed below: BOSTON Michael S. Caccese 617.261.3133 Mark P. Goshko 617.261.3163 Thomas A. Hickey III 617.261.3208 Nicholas S. Hodge 617.261.3210 George J. Zornada 617.261.3231 mcaccese@klng.com mgoshko@klng.com thickey@klng.com nhodge@klng.com gzornada@klng.com LONDON Philip J. Morgan 44.20.7360.8123 pmorgan@klng.com LOS ANGELES William P. Wade 310.552.5071 wwade@klng.com NEW YORK Robert J. Borzone, Jr. 212.536.4029 Jeffrey M. Cole 212.536.4823 Ricardo J. Hollingsworth 212.536.4859 Beth R. Kramer 212.536.4024 Richard D. Marshall 212.536.3941 Keith W. Miller 212.536.4045 Scott D. Newman 212.536.4054 rborzone@klng.com jcole@klng.com rhollingsworth@klng.com bkramer@klng.com rmarshall@klng.com kmiller@klng.com snewman@klng.com SAN FRANCISCO Jonathan D. 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