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 www w.. k l n g . c o m BOSTON DALLAS HARRISBURG LONDON LOS ANGELES MIAMI NEWARK NEW YORK PALO ALTO PITTSBURGH SAN FRANCISCO WASHINGTON ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ Kirkpatrick & Lockhart Nicholson Graham LLP (K&LNG) has approximately 950 lawyers and represents entrepreneurs, growth and middle market, capital markets participants, companies and leading FORTUNE 100 and FTSE 100 global corporations nationally and internationally. 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