Investment Funds Update

Implications of Final UK FCA Rules on Payment for Investment Research

July 31, 2024

On 26 July 2024, the UK Financial Conduct Authority (FCA) published a policy statement (PS24/9) on payment optionality for investment research (the Policy Statement).

The Policy Statement sets out the FCA’s final rules (the Final Rules) for its proposed new option to pay for investment research, following publication of its consultation paper (CP 24/7) on this topic on 10 April 2024 (the Consultation Paper). For a brief discussion of the Consultation Paper, see our May 2024 Update.

This Sidley Update discusses the Final Rules and the likely implications of these for UK asset managers.

Background

Under current rules, UK asset managers are prohibited from purchasing research with bundled payments (whereby payments for execution and research are combined) unless the payment is made from a research payment account (RPA), whereby the firm agrees a separate research charge with each of its clients. Due to the operational complexity of the RPA model, to date, most asset managers have not adopted the RPA model but, instead, pay for research out of their own resources.

In the Consultation Paper, the FCA proposed a third option – enabling firms to purchase investment research using joint payments for third-party research and execution services, provided that the firm complies with certain guardrails (details of which, as set out in the Final Rules, are set out in the table below).

This third option will exist alongside those already available: payment for research from a firm’s own resources and payment from an RPA.

Policy Statement – Overview

In the Policy Statement, the FCA notes the broadly positive feedback received its proposed joint payment option and confirms that it will proceed with introducing it, having made some modifications to the accompanying guardrails to address concerns raised in the consultation. These modifications are discussed in the table below.

Importantly, the new payment option is not a return to “full bundling” of research and execution payments, as one of the associated guardrails requires separately identifiable research charges (in contrast, full bundling would mean there is no need to calculate what portion of total commission is a charge for research).

The FCA notes in the Policy Statement that it has intentionally not reintroduced full bundling to retain the benefits achieved by research unbundling (including as to price transparency and comparability) since its introduction in 2018 pursuant to the implementation of the revised EU Markets in Financial Instruments Directive (MiFID) II. The FCA views its joint payment option as facilitating the use of structures more akin to the existing practice in certain jurisdictions of commission-sharing arrangements.

The FCA also acknowledges the point raised in feedback to the consultation that the joint payment option is, in certain respects, more onerous than the bundled payment option as currently proposed in the European Union, in its corresponding reforms to the MiFID research payment rules (which, for example, are less explicit on client disclosure requirements).

New payment optionality should in principle be a welcome change for UK asset managers. However, in practice, the uptake of the new option may be limited, given that the operational complexity of implementing the guardrails will likely deter many firms. When weighing this against any potential benefits a joint payment model may represent, many firms may decide it is simpler to retain their current payment models.

Timing and next steps — UK investment firms

The rules come into effect on 1 August 2024. UK investment firms may therefore avail themselves of the new joint payment option from this date.

Firms will need to consider what contractual obligations they have towards clients — such as disclosure or consent requirements — before starting to use the new payment option.

Timing and next steps —UK AIFMs and UCITS management companies

The new payment option applies only to firms authorised as investment firms under the UK rules that implemented MiFID.

This means that other types of firms subject to the MiFID rules on payment for research – notably, UK alternative investment fund managers (AIFMs) and undertakings for the collective investment in transferable securities (UCITS) management companies – will not at this stage have the option to use the new joint payment option.

The FCA intends to consult on updating the corresponding MiFID research payment rules applicable to UK AIFMs and UCITS management companies in fall 2024.

In the Policy Statement, the FCA notes its intention to make the same option available in substance, with technical aspects of how best to achieve this in practice to be considered over the coming period.

Guardrails in relation to the new joint payment option

The table below summarises the guardrails with which firms that choose to use the new joint payment option must comply.

Guardrail	Summary	Changes since the Consultation Paper
Written Policy	The firm must have a formal policy describing the firm’s approach to bundled payments, including with respect to governance, decision-making, controls, and how these are maintained separately from those that are for trade execution.	None.
Methodology for cost calculation	The firm must establish arrangements that stipulate the methodology for how the research costs will be calculated and identified separately within total charges for such joint payments.	The guardrail as proposed in the Consultation Paper had provided that the firm must enter into written agreements with research and execution providers establishing such a methodology. The Final Rules refer more broadly to arrangements, with the intention of accommodating the variety of forms a firm’s arrangements with its research providers may take.
Payment allocation structure	The firm must have a structure for the allocation of payments between different research providers, including providers of research and execution services (i.e., full-service brokers), and research providers not engaged in execution services at either firm or group level (i.e., independent research providers or IRPs).	None.
Operational procedures	The firm is fully responsible for the administration of accounts for purchasing research. Where administration of accounts or payment allocation structures is delegated, the firm is responsible for ensuring that reconciliation and reporting is undertaken with an appropriate frequency and timeliness, that timely payments are made to research providers, and that risks arising from unspent surplus amounts and research provider concentrations are monitored and managed. However, in contrast with the existing RPA model, there is no requirement that monies be periodically swept to a bank account controlled by the asset manager.	None.
Budgeting	The firm must set a budget to establish the amount needed for third-party research, reviewed and renewed at least annually, and based on expected amounts needed to purchase such research as opposed to volumes or values of transactions. The budget must be set at least annually, at a level of aggregation that is appropriate to the firm’s investment process, products, services, and clients, and that does not compromise its ability to meet the requirements in respect of fair cost allocation and client disclosures. If the research charged to clients exceeds this budget, or the budget is increased, the firm’s policy must set out the relevant actions to be taken and information to be disclosed to clients.	The guardrail as proposed in the Consultation Paper provided examples of how budgeting could be aggregated at the level of an investment strategy or group of clients. In response to feedback, the rule has been revised to provide greater flexibility as to how firms may choose to aggregate their research budgets. The Final Rules also clarify that disclosures on budgets being exceeded can be made as part of a firm’s next periodic costs-and-charges report (rather than requiring a separate communication to clients).
Research cost allocation	The firm must fairly allocate the costs of research purchased using joint payments between clients. For these purposes, the firm should determine a level of cost allocation appropriate to its business model. This may be allocated among clients for which the firm has different research payment arrangements, clients managed according to similar strategies, clients / groups of clients that benefit from the same research, or some other level of allocation.	The Final Rules include additional flexibility as to the level of aggregation at which a firm may determine its approach to cost allocation, mirroring equivalent changes to the budgeting, research provider and cost disclosure guardrails.
Periodic assessment	The firm must periodically, but at least annually, assess the value, quality, use, and contribution to the investment decision-making process for the research purchased and ensure that the amount of research charges to clients are reasonable when compared with those for comparable services. The FCA notes in guidance that price benchmarking is one means of demonstrating compliance with this requirement.	While the guardrail as proposed in the Consultation Paper had specifically required firms to undertake price benchmarking, the Final Rules reference benchmarking only as an indication of one means of compliance, with a view to providing flexibility for firms to comply by other means.
Client disclosures	The firm must disclose the following information to clients prior to providing an investment or ancillary service, and thereafter upon request (but at least annually): the firm’s use of joint payments; the key features of the firm’s policy on the use of joint payments; the expected annual costs to the client, as part of the firm’s ex ante costs and charges disclosures, and based on the most appropriate of either the firm’s budget-setting and cost-allocation procedures or actual costs incurred for prior annual periods; the most significant research of the following items, at a level of aggregation appropriate to the firm’s investment processes, products, services, and clients: benefits and services received from research providers (by total paid); and types of research providers used (which can be in the form of a breakdown between IRPs and non-IRPs); total costs incurred by the client for research purchased using joint payments, disclosed on an annual basis, as part of (and identified separately within) the firm’s ex post costs and charges reporting.	As proposed in the Consultation Paper, the FCA had proposed requiring disclosure of the firm’s most significant research providers. This has been replaced in the Final Rules with a requirement to disclose the types of providers. Accompanying guidance indicates that a breakdown of IRPs vs. non-IRPs is one way of complying with this requirement. The level of aggregation at which research provider disclosures may be made has been modified to mirror the corresponding changes to the budgeting and cost allocation guardrails.

Other changes

Short-term trading commentary

As proposed in the Consultation Paper, the Final Rules will add commentary and advice linked to trade execution to the list of acceptable minor non-monetary benefits (MNMBs) for all payment options.

As a result, short-term trading commentary will be excluded from the scope of the inducements rules and hence able to be received by firms on a bundled basis, whether or not they adopt the new joint payment option.

This change was proposed with the provision of short-term trading commentary by U.S. broker-dealers in mind. As the FCA noted in the Consultation Paper, U.S. broker-dealers are permitted to provide short-term trading commentary without being required to register as investment advisers under the U.S. Investment Advisers Act of 1940, if the investment advice provided by each broker-dealer is purely incidental to the brokerage business and it receives no “special compensation” for providing the advice.

Adding short-term trading commentary to the list of MNMBs therefore means UK firms can receive such commentary from U.S. broker-dealers on a bundled basis.

Small-and medium-sized enterprise research

In the course of 2021 to 2022, the FCA consulted on and introduced changes to the rules relating to research. This included extending the list of MNMBs to include research on small and medium-size enterprises (SMEs) with a market capitalisation below £200 million.

As a result, such research was carved out of the inducement rules and could therefore be bought on a bundled basis. The FCA noted in the Consultation Paper that following this change, very few firms had availed themselves of the ability to purchase SME research on a bundled basis.

In the Policy Statement, the FCA confirms it is proceeding with its proposed deletion of SME research from the list of MNMBs, on the basis of the limited uptake of the option to pay for it on a bundled basis, the fact that the new bundled payment option will apply to research on companies of any size, and to avoid additional complexity in the rules.

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