JUNE 2005
Investment Management
FSA 05/5: Financial Services Authority Issues Proposed Rules
Regarding Bundled Brokerage and Soft Commission
Arrangements
Financial Services Authority (“FSA”) recently issued
proposed rules in FSA 05/5 to address conflict of
interest concerns relating to the use of soft
commission and bundled brokerage arrangements.
Such arrangements, according to the FSA, create
incentive misalignments between investment
managers and their clients. The proposed rules seek to
address the lack of transparency and associated
accountability issues with respect to these
arrangements and to reduce conflicts of interest within
the investment management industry. The proposed
rules:
■
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.
DISCLOSURE CODE
The proposed rules require an investment manager to
disclose to their customers the details of how their
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. 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
proposed rules suggest that a new Disclosure Code
should require firms to annually disclose descriptions
of investment manager’s 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
have been used, including a split between commissions
spent on execution and research (“Level 2 Disclosure”).
While use of the Disclosure Code under the proposed
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 UK
Institutional Funds and retail funds. Some firms may
choose to use it for non-UK clients as a matter of good
policy to uphold the principles of transparency.
DETERMINATION OF EXECUTION
AND RESEARCH GOODS AND SERVICES
The proposed rules also establish guidelines for
determining what constitutes “execution” and
“research” goods and services. Under the proposed
rules, 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
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
proposed rule. FSA specifically establishes 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 proposed 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
2 JUNE 2005
services. Post-trade analytical software may be
classified as a non-permitted service depending on
how it is used.
The proposed 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
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.
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.
APPLICABILITY AND TIMING
The FSA 05/5 proposed rules further revise the
proposals put to the financial services industry in
April 2003 in CP 176 and its follow up papers, PSO 4/
13 and PSO 4/23. The proposed rules have been
drafted at the level of principle to provide investment
managers sufficient flexibility to determine the most
appropriate means of compliance while giving due
prominence to the Disclosure Code. Firms must retain
records of disclosures made pursuant to the proposed
rules for five (5) years.
The proposed rules are applicable to investment
management activity in the United Kingdom.
Comments on the proposed rules established by FSA
05/5 are requested by May 31, 2005 and final rules are
anticipated to be forthcoming as early as the third
quarter of 2005. The effective date of the final rules is
hypothesized to be January 1, 2006 with a six (6)
month transitional period from the date the final rules
come into full force and effect.
Michael S. Caccese
617.261.3133
mcaccese@klng.com
Vivian Z. Wexler
617.951.9045
vwexler@klng.com
KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
Kirkpatrick & Lockhart Nicholson Graham LLP maintains one of the leading investment management practices in
the United States, with more than 70 lawyers devoting all or a substantial portion of their practice to this area and
its related specialties.
We represent mutual funds, closed-end funds, hedge funds, offshore funds, insurance companies, broker-dealers,
investment advisers, retirement plans, banks and trust companies and other financial institutions. We also regularly
represent mutual fund distributors, independent directors of investment companies and service providers to the
investment management industry. In addition, we frequently serve as outside counsel to industry associations on a
variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities,
including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance
products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the
investment company business.
We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also
visit our website at www.klng.com for more information, or send general inquiries via E-mail to
investmentmanagement@klng.com.
BOSTON
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
Thomas A. Hickey III
Nicholas S. Hodge
George J. Zornada
WASHINGTON
617.261.3133
617.261.3156
617.261.3163
617.261.3208
617.261.3210
617.261.3231
mcaccese@klng.com
pfina@klng.com
mgoshko@klng.com
thickey@klng.com
nhodge@klng.com
gzornada@klng.com
Clifford J. Alexander
202.778.9068
Diane E. Ambler
202.778.9886
Mark C. Amorosi
202.778.9351
Catherine S. Bardsley 202.778.9289
Arthur J. Brown
202.778.9046
Arthur C. Delibert
202.778.9042
Jennifer R. Gonzalez 202.778.9286
LOS ANGELES
Robert C. Hacker
202.778.9016
William P. Wade
310.552.5071 wwade@klng.com
Kathy Kresch Ingber
202.778.9015
Michael J. King
202.778.9214
NEW YORK
Rebecca H. Laird
202.778.9038
Jeffrey M. Cole
212.536.4823 jcole@klng.com
202.778.9107
Ricardo J. Hollingsworth 212.536.4859 rhollingsworth@klng.com Cary J. Meer
Dean E. Miller
202.778.9371
Beth R. Kramer
212.536.4024 bkramer@klng.com
R. Charles Miller
202.778.9372
Richard D. Marshall
212.536.3941 rmarshall@klng.com
Charles R. Mills
202.778.9096
Robert M. McLaughlin 212.536.3924 rmclaughlin@klng.com
Jean E. Minarick
202.778.9029
Keith W. Miller
212.536.4045 kmiller@klng.com
R. Darrell Mounts
202.778.9298
Scott D. Newman
212.536.4054 snewman@klng.com
C. Dirk Peterson
202.778.9324
Steven A. Yadegari
212.536.4889 syadegari@klng.com
David E. Pickle
202.778.9887
SAN FRANCISCO
Alan C. Porter
202.778.9186
Eilleen M. Clavere
415.249.1047 eclavere@klng.com
Theodore L. Press
202.778.9025
Francine J. Rosenberger 202.778.9187
Jonathan D. Joseph
415.249.1012 jjoseph@klng.com
Robert H. Rosenblum 202.778.9464
David Mishel
415.249.1015 dmishel@klng.com
William A. Schmidt
202.778.9373
Timothy B. Parker
415.249.1042 tparker@klng.com
Lori L. Schneider
202.778.9305
Mark D. Perlow
415.249.1070 mperlow@klng.com
Lynn A. Schweinfurth 202.778.9876
Richard M. Phillips
415.249.1010 rphillips@klng.com
Donald W. Smith
202.778.9079
Martin D. Teckler
202.778.9890
Robert A. Wittie
202.778.9066
Robert J. Zutz
202.778.9059
calexander@klng.com
dambler@klng.com
mamorosi@klng.com
cbardsley@klng.com
abrown@klng.com
adelibert@klng.com
jgonzalez@klng.com
rhacker@klng.com
kingber@klng.com
mking@klng.com
rlaird@klng.com
cmeer@klng.com
dmiller@klng.com
cmiller@klng.com
cmills@klng.com
jminarick@klng.com
dmounts@klng.com
dpeterson@klng.com
dpickle@klng.com
aporter@klng.com
tpress@klng.com
francine.rosenberger@klng.com
rrosenblum@klng.com
william.schmidt@klng.com
lschneider@klng.com
lschweinfurth@klng.com
dsmith@klng.com
mteckler@klng.com
rwittie@klng.com
rzutz@klng.com
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