FCA goes ahead with new investment research payment option

Following a consultation earlier this year on proposals to introduce a third option by which buy-side UK firms can purchase investment research – which we reported on here – the FCA has now published its final rules and guidance, which will come into effect on 1 August 2024.

Background

The new payment option represents the latest development in what has turned into a gradual reversal of the prohibition on payment bundling for investment research, as it has seemingly become apparent to both UK and EU regulators that there are significant drawbacks in not allowing firms to purchase investment research in this way.

Historically, bundled payments – that is, portfolio managers paying brokerages for trade execution and investment research by way of a single, bundled payment – had been permitted in the UK and, in general, throughout the EU.

Bundled payments were, however, progressively restricted in the UK over the course of approximately a decade up until 2018, such that latterly, investment research was the only benefit or 'inducement' for which payment could be bundled alongside trade execution payments.

In 2018, the revised EU Directive on Markets in Financial Instruments ("MiFID II") entered into force, including in the UK. This introduced a general prohibition under which portfolio managers may not receive monetary or non-monetary benefits in relation to the services they provide to clients (i.e. trade execution), with two key exceptions.

Under MiFID II, buy-side firms may receive, and pay for, investment research as a benefit in connection with executing transactions on behalf of their clients, provided that they do so according to one of two available payment models. They must either pay for investment research out of their own resources – the so-called 'profit and loss' or 'P&L' model, where the research is reflected as a cost on the buy-side firm's profit and loss statement – or via a separately identifiable payment explicitly pertaining to the purchased research. This latter model is known as the 'research payment account' or 'RPA' model, as it requires that buy-side firms operate a separate account, funded by separate charges levied on clients and out of which payments for research purchased are made.

"Minor non-monetary benefits" ("MNMBs") are also excepted from the MiFID II inducements prohibition, such that buy-side firms may receive these benefits in connection with trade execution, and unlike in the case of investment research generally, there are no particular 'models' that must be followed as to how these may be paid for. The scope of what will constitute an MNMB in the UK, as specified by FCA rules and guidance, has varied over time. Of particular note, in November 2021 the FCA revised the scope of MNMBs to include, among others, investment research relating to issuers with market capitalisation of £200 million or less.

The overall result is that prior to these latest changes, firms could still bundle payments for investment research together with trade execution payments in relation to such issuers, but for any issuer with market capitalisation over the threshold, firms had to follow either the P&L or RPA models. In practice, the FCA has noted that there was very low market uptake of the MNMB payment-bundling option for investment research relating to small issuers. The latest changes go further, and reintroduce a general payment-bundling optionality for buy-side firms purchasing investment research pertaining to issuers of any size or market capitalisation.

The EU is following a similar direction of travel, having previously introduced some targeted exemptions to its unbundling rules, and now contemplating the introduction of a third payment option under which payment bundling will be permitted subject to requirements that firms must meet.

The finalised new payment option

As of 1 August 2024, the rules will provide for a third payment option alongside the P&L and RPA models (both of which will be retained alongside the new option).

The new payment option will allow a firm to make 'joint payments' covering both third-party research and execution services, provided that the firm meets the requirements for doing so. These are that:

Firms must have a written policy in place dealing with their approach to joint payments;
Firms must stipulate and arrange for a methodology to calculate and separately identify research costs;
Firms must have in place a structure by which they will allocate payments between different research providers – including independent research providers ("IRPs");
Firms must specify an approach for allocating the cost of research purchased under joint payments across different clients – with this approach required to be fair such that the cost passed on to any one client is in proportion to the benefit that client received from that research;
Firms must conduct a periodic – at least annual – assessment of the value, quality and use of research purchased, and how and to what extent that research contributed to investment decision-making;
Firms must also review, at least annually, how they are ensuring that charges levied on clients in respect of research are reasonable against "relevant comparators";
Firms must disclose their approach to joint payments to clients, covering aspects such as costs incurred and the types of providers from which research services are purchased;
Firms must have in place procedures for the administration of accounts used for purchasing research; and
Firms must have in place a budget to determine the amounts needed to purchase third-party research, which must be reviewed at least annually.

There have been some additional changes to the rules alongside the 'headline item' of the new payment option. The FCA has opted to add "short term trading commentary" and "advice linked to trade execution" as acceptable MNMBs that firms may receive in connection with trade execution services they pay for. This has been brought in specifically to alleviate potential issues that UK firms might otherwise have faced in purchasing and receiving research from US firms jointly registered as broker-dealers and as investment advisors.

The inclusion in the list of acceptable MNMBs of investment research generally when relating to an issuer with market capitalisation of less than £200m, introduced in 2021, is now being removed as FCA research indicated there had been little take-up of the option in practice and the new payment option will permit bundled payments for research covering all issuers, irrespective of market capitalisation.

Finally, in response to concerns raised in the course of the FCA's initial industry engagement as to whether investment research would come within the scope of 'best execution' rules, under which asset managers are duty-bound to take all reasonable steps to obtain the best possible result for clients, the FCA has confirmed that research services will not be a factor in assessing best execution and that the rules on best execution in the FCA Conduct of Business Sourcebook will remain unchanged.

Changes following the consultation

Feedback to the consultation was, the FCA reports, generally positive, particularly in respect of the introduction of the new payment option. The proposals as set out in the consultation paper are, in the broad stroke picture, going ahead largely unchanged. There are a few areas in which the FCA has made amendments to its proposals in response to feedback, however.

The original consultation proposed examples for how budgeting for research spend might be done at an aggregated level, such as in respect of a particular group of clients or at investment strategy level. The FCA has clarified in the final rules that firms will have flexibility in respect of how, and the level at which, they choose to aggregate research budgets in this way.

The FCA has also clarified that where research budgets are exceeded, disclosure of this fact to clients should be 'as soon as reasonably practicable' – which may be as part of the firm's next periodic report covering costs and charges – not within the same research budget period as originally proposed, as this had led to some uncertainty on the part of some consultation respondents.

The original proposals would have required firms to disclose the 'most significant' individual research providers from whom research was purchased. The final rules provide instead that firms must disclose the types of research provider they have purchased research from – with accompanying guidance that it will be sufficient for these purposes that firms provide a breakdown of the proportion of research purchased from IRPs and from non-IRPs. The FCA has also amended the final rules to provide that disclosure may be at a level of aggregation that best suits the firm's particular clients, investment processes, and products and services – in a similar manner to the changes made in research spend budgeting.

Under the final rules, firms must ensure that research charges levied on clients are reasonable. The original consultation proposals would have required firms to conduct a price benchmarking exercise – under the final rules and guidance, this is merely noted as one way in which a firm can ensure compliance, whilst leaving open the possibility for firms to pursue other approaches which might be better suited to their particular circumstances.

The final rules are less prescriptive than the consultation proposals in respect of cost allocation and disclosure. Asset managers now have a choice of two distinct methodologies which they may use to estimate annual costs to clients. As with budgeting and research provider aggregation, firms have also been given greater flexibility to adopt a level of aggregation in respect of cost allocation that best suits their investment processes, clients and products.

Finally, the FCA has allowed for a greater degree of flexibility with respect to how research charges must be separately identified within joint payments. The original proposals would have required firms to have written agreements in place with research providers stipulating how research charges are to be separately identified – whereas, the final rules merely require that 'arrangements' must be in place to provide for this. This tweak is intended to sit better with the wide variety of market practices that exist for purchasing investment research.