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Regulatory Update: UK Financial Services Authority publishes draft rules on soft dollar and bundled brokerage

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The FSA has published a further consultation paper on its proposals for the new soft dollar and bundled brokerage regime for UK authorised fund managers.

The draft

The FSA has published a further consultation paper on its proposals for the new soft dollar and bundled brokerage regime for UK authorised fund managers.

The draft rules outlined in CP05/5, as anticipated, significantly narrow the services that may be purchased with dealing commission to “execution” and “research” (all other non-permitted goods and services having to be paid for out of the manager’s own funds).

Also, managers will be required to disclose to clients details on how commission has been used to purchase execution or research services

The FSA has decided against allowing hedge fund managers either a full or a partial exemption from the general disclosure obligation, although there is some flexibility within the rules as to how a manager may comply with his disclosure requirement.

 The rules also seek to lay the foundation for a regime under which managers and brokers agree clear payment and pricing mechanisms, so that individual services may be purchased separately.

A more detailed summary by AIMA’s Mary Richardson of the contents of CP05/5 is set out below:

The FSA’s further consultation paper on “Softing & Bundling” (CP05/5) was issued 1st April.

It contains proposed new rules in the COB Sourcebook (at Annex 6, pages 55-70) and a Cost Benefit Analysis (CBA, as Annex 4, from page 37)). It also contains a statement as to compatibility with the FSA’s objectives and principles.

The paper is accessible on the FSA website - – and comments are invited by 31 May (the paper asks two questions – see below). Final rules will be made in July, with implementation by 1 January 2006.

A transitional period is provided – firms may continue complying with the existing soft commission rules until the earlier of the expiry of any existing soft commission arrangements or the end of this transitional period (see para 3.41 of CP05/5 on page 23).

Managers’ use of commissions for goods and services are limited to those providing “execution” and “research”.

The IMA and NAPF’s enhanced Disclosure Code – with the FSA’s new high-level rules – should address issues of transparency and accountability to all fund clients by limiting managers’ use of commission-bought resources/facilites. Compliance with the Code will NOT be required – it is an acceptable, but NOT necessarily the only, form of disclosure.

All managers’ clients should get information on how dealing commissions are used on their behalf but (the FSA say) the rules provide sufficient flexibility for managers to decide the most appropriate means of compliance. (NB the ref (at 2.30) to our suggestion that HFMs should not have to provide increased disclosure, as their clients are sophisticated investors, are based overseas and receive adequate disclosure already).

Where commission paid to third parties is a very small element of transaction-related charges, or for particular clients, the code may not be appropriate. In such a case, the manager may agree with his clients other forms of disclosure BUT he must be able to show why he believes that that is sufficient and appropriate (3.12).

The two questions set in CP05/05 (3.38 and 3.41 on page 23 and listed as Annex 2 on page 31) ask whether the FSA is right to:

1 provide parameters but leave it to managers to make judgements on particular services; and

2  require all managers to provide information to clients on services received but allow flexibility in compliance, whether through the Disclosure Code or other  appropriate means.

Effect (3.35 and following)
The new rules – effective on 1 January 2006 (with a 6 months’ transition period) – will apply to investment management activity carried out in the UK, regardless of the location of the client (2.37 and 3.22). Execution and research resources/facilities bought with commission must:
• relate to execution or research;

• reasonably assist the manager in providing services to customers; and

• not impair the manager’s duty to act in the customers’ best interests.

Details of goods and services bought must be disclosed to clients (consistent with requirements under MiFID for a firm to act fairly, honestly and professionally towards clients and to avoid conflicts of interest). Disclosure must be provided once a year and can be combined with other information (e.g. periodic statements). Records must be retained for five years.

As overseas brokers cannot be compelled to provide information on commission components, managers must manage conflicts of interest for their UK clients and ask for information from overseas brokers on the execution/research services split (as they would from UK brokers).

The test for permitted execution resources is in the new COB 7.18.4E (substantially the same as in the FSA’s Policy Statement PS04/23 of November, 2004 and see 2.11 of this new paper). For research resources, see new COB 7.18.5E (and PS04/23 and 2.22).

It is for a manager to decide – and to be able to justify to his clients – whether market pricing information (MPI) services are research or execution services, depending on how he has used them (see the CBA, Annex 4, from page 37).

Non-permitted goods and services are in COB 7.18.8G (e.g., computer hardware, seminar fees, travel and entertainment expenses).

The FSA says (Annex 5, from page 49) that it has complied with its regulatory objectives and principles (in restricting what can be bought with commission) because:

• the burden of disclosure will be outweighed by the benefits;
• innovation will be encouraged, by increased competition;
• other countries are likely to make similar regulatory revision;
• managers will not have to disclose to non-UK managed funds;
• benefits will accrue to the UK as there will be more control over brokers and third party providers, better transparency and accountability to funds;
• quality and economical execution services will flourish;
• managers who rely disproportionately on brokers’ additional services may, properly, be forced out of the market;
• brokers will all compete and must become more transparent; and
• market competition will increase, so that managers will be able to buy more stand-alone and appropriate products.

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