AIMA's Use of Dealing Commission Working Group (a small group, comprised of manager, broker and lawyer members of AIMA) has prepared a series of questions and answers, which are intended to assist members with the interpretation and scope of the new regime. A number of issues are still unclear and we will be seeking further clarification from the FSA on these and will advise members when we have further details.

1. My firm does not use soft commission agreements, so am I right in thinking that I don't need to worry about the new rules, set out in PS05/9?

   No. Any firms which use client commissions/charges to pay for goods or services in addition to the execution of orders are affected by the rules, ie not just those who soft.

   It also seems likely that the 'arrangements' referred to in COB 7.18.12 do not just encompass commission-sharing arrangements or soft commission agreements, but also any broking agreement that includes research.

   For instance, COB 7.18.3R (and, therefore, COB 7.18.4E -11G) would apply whenever there are commissions/charges for anything other than pure execution. It would, therefore, cover any commissions charged by brokers under bundled commission charges, even if they are not softed.
   

2. Will I have to approach each of the brokers I deal with and agree a separate percentage split with them in respect of "execution" and "research" received from them, or can I rely on each broker publishing their standard split (by currency etc) and issuing me with a statement at each month/year end?

   As a manager, you will have to ensure that prior and periodic disclosures meet the requirements of COB 7.18.12. This specifically refers to separately identifying goods or services attributable to the provision of research.

   The broad manner in which the rules are drafted apparently captures any counterparty/broking agreement that makes specific reference to any other services. The LIBA/IMA disclosure codes (or similar "waterfall" methodologies) are, therefore, likely to be critical in ensuring that adequate reporting takes place to managers, allowing them simply to pass on details to their customers (ie, the fund(s)).

   Paragraph 2.21 of the PS indicates that a prior agreement between brokers and investment managers about rates is expected, although the FSA highlights the fact that the disclosure rules apply to investment managers and not to brokers.

   London Investment Banking Association (LIBA) has issued a Statement of Good Practice that encourages its members to cooperate with fund managers in respect of regular reviews of commission payments and discussions to agree indicative forward-looking splits between research and execution. The Statement of Good Practice can be accessed at http://www.liba.org.uk/publications/Final%20Good%20Practice%20Statement_20050324.pdf.

   AIMA will seek to provide further guidance to members in respect of the rates that brokers are quoting for research and execution.

3. When do the new rules apply to me?
   
   The rules come into force on 1 January 2006. There is a transitional period so that, where a firm has an existing soft commission agreement in place, the old rules may be applied for a maximum of an additional 6 months (ie, to midnight on 30 June 2006).

   However, firms should note that no new agreements can be entered into and followed under the old rules during this time, as the transition is only available for 'existing' agreements.

   Where the IMA/NAPF Disclosure Code is to be followed, reporting to UK Pension fund clients will commence in the first quarter 2006 for the six-month period commencing 1 July 2005.

4. The new rules say that, where I have entered into arrangements to purchase execution services or research with dealing commission that are acceptable under the rules, I must make "adequate" disclosure of these arrangements to my customers. What does "adequate" mean in this context? How do I assess what is the minimum information I need to disclose, how often I need to disclose it and the appropriate format in which to send it to my customers?

   Rules COB 7.18.12 (2) and 7.18.14 (1) give further information about what the FSA would consider adequate. There are 2 types of disclosure: 'prior' and 'periodic'.

   Prior disclosure is all about a firm's policies on the use of commissions for execution and research costs and this must be made before investment is conducted, ie, before a customer is taken on, and can be provided in the terms of business or contract. There is a requirement to provide this information to all existing clients by 1 July 2006 under rule 7.18.13 (3).

   Please note that an investment manager may provide terms of business to an intermediate customer after having commenced conducting business for him (though within a reasonable period of doing so). However, if the required prior disclosure is to be made as part of the terms of business, these must be provided to the customer before conducting business for him, although there is no requirement that the customer sign these before the start of the relationship.

   It is also worth noting that prior disclosure cannot just state that goods or services may be received but must, under COB 7.18.14 (1), explain why the firm might find it necessary or desirable to purchase the goods or services.

   Periodic disclosure appears to be in terms of a narrative description and a retrospective breakdown of amounts paid for execution and research services and this disclosure has to be made at least once a year to meet the requirements of rule 7.18.13 (4).

   There have been questions about the identity of the party to whom disclosure must be made and the rules are not clear other than the requirement under 7.18.12 (1) to make disclosure to 'customers'. This is likely to mean that the legal entity with whom the manager contracts, for example a fund, is the party to whom disclosure should be made. There is a pointer within the text below paragraph 2.8 of the PS that the FSA does not require 'look-through' to underlying clients.

5. I need to disclose to my customer information on the split between execution and research services, but an overseas broker with whom I deal will not provide me with this information. What should I do?

   The FSA have specifically stated that they cannot require overseas brokers to provide details on the components of commission but that they can expect managers to request this information from the broker.

   As a result, for transparency and in keeping with the FSA's statement, it would be advisable for firms to illustrate what endeavours they have made to obtain the information (and retain this in their records) and, where relevant, to include clear reference in their disclosures to customers as to why the information is not available.

   Where information has not been made available by brokers, it might be appropriate for an investment manager to consider the following points:

   (a) setting out (in the main text or as a footnote) the fact that some information is not available and providing a description of his 'best endeavours';
   (b) disclosing to customers what information is available (with a relevant analysis of that information and a narrative description as to the services received if these go beyond pure execution); and/or
   (c) not attempting to "estimate" the missing figures.
   
   

6. My UK-based firm is part of a group which includes a US firm. The US firm receives goods and services which it may legitimately (under current US rules) purchase with dealing commission. Our firms have traditionally pooled these resources, with one part of the group able to benefit from the softed goods/services received by another part. Can we continue to do so under the new FSA rules and, if not, how should I deal with such goods/services?

   The existing/old rules clearly make reference to disclosure requirements where a group company has a soft commission agreement in place. However, no such guidance or references are included in the new rules.

   As a result, firms must focus on the precise requirements laid out in COB 7.18.3R. As this rule is specific to the UK firm and its order flow/commission to brokers, any services or resources made available by a group company should not fall within the scope of the new regime.

   However, this only applies where the group company's broker relationships are operated separately from the relationships of the UK firm. If the UK firm's executions are in any way linked to the services made available on a group basis, then this would seem to fall within the scope of the new rules and would have to be assessed against the definitions of 'research' and 'execution'.

   The rules apply to a UK authorised manager providing services in the UK, even if some of its business functions are located overseas. So, if the manager uses its group's US desk to instruct US brokers, those trades must comply with the UK softing rules, including disclosure of research costs and restrictions on acceptable goods and services.

   Where sub-managers are used, it appears that the onus will fall on the main investment manager to collate the information received from the sub-managers and prepare the information to be reported to the client.
   
   

7. Can we use commission sharing for market data feeds sent through value added service providers, such as Bloomberg or Reuters?

   The FSA has not made definitive rules on this topic, other than to say that raw data feeds cannot be classed as research under rule COB 7.18.7 and paragraph 2.15 of PS05/9. It appears that fund managers will have to review at a detailed level all of the services they receive from Bloomberg and Reuters to assess exactly what can be classified as research and execution. To be classified as research, there would have to be evidence of original thinking and analysis of data as set out in rule COB 7.18.5 (1). To be classified as an execution cost, the services would need to meet the criteria set out in rule COB 7.18.4.4 and managers would be expected to be able to justify their assessment under this rule as set out in paragraph 2.15 of PS05/9.

   AIMA will provide further guidance to members on this point once we have obtained clarification from the FSA.
   
   

8. We want to enter into an agreement with a broker which, we feel, has a track record of producing good quality research. Under the new rules, when looking to see whether services fall within the definition of "research" (does it add value, represent original thought, have intellectual rigour etc), can we take the broker's output as a whole or do we have to look at each piece of research as it comes out?

   In this case, it would appear reasonable to consider the overall aim of the research, as presented by the provider. It would seem impractical to assess each individual piece of research as this would be too time consuming.
   

9. How will the provision of commission for 'execution services' work? For example, firms at present have soft commission agreements in place whereby, in accordance with a pre-determined agreement, a broker will pay invoices for a service in return for a specified amount of commission.

   Under the new agreement would just one broker contribute to a specified execution service and, in return for a set level of commission, pay the invoices for this service? (If so isn't this effectively the same as the current 'soft commission' agreements but with a different name?)

   It could work as suggested above and yes, this would be softing by another name but with extra restrictions on the types of costs that could be met this way. We could anticipate seeing wider usage of commission sharing agreements, under which the broker will pay the invoices of third party research providers, which will result in outcomes very similar to the softing practices which the FSA is seeking to bring to an end.

   Commission sharing agreements are agreements between the manager and a broker, or series of brokers, under which the broker agrees to share some of the commissions they receive with other providers (typically in return for the other provider providing research to the customer concerned). Such agreements are becoming more common and can be an effective way in which to pay for third party research. The manager instructs the broker as to how much should be paid away and to whom. The payments are usually, but not always, funded out of the research element of the commission payments rather than the execution element. In terms of disclosure requirements, under the minimum standards of the FSA rules it may only be necessary to disclose the total research amount paid to the main broker. However, under the IMA/NAPF Pension Fund Disclosure Code it will be necessary to separately disclose the amounts retained by the executing broker and the amounts paid by the broker to third parties.
   

10. If a broker arranges company visits/lunch presentations and one-on-ones, do these come under the definition of 'research'? If not, how are they funded?

    If these formed part of a formal service provided by the broker, it would be necessary to review them against the FSA's general requirements and it would appear that they are not permitted. However, ad hoc arrangements which are neither formally provided nor received with a direct link to executed customer orders appear to fall outside the rules.

    This is a fine distinction and it would, therefore, be advisable to make a specific record of the broker arrangements that could potentially give rise to arrangements which could fall within the scope of COB 7.18.3.

    In a similar fashion to considering the intended aim of research provided by brokers, looking at the substance of events arranged by brokers in aggregate rather than in isolation may be appropriate. The firm should ensure that clear records are maintained where such events are only made available in return for directing business where the charges are then passed to the firm's customers. It may also be that certain events are linked to other meetings/research reports and as a result when considered together (as intended by the broker) meet the criteria for being acceptable 'research'.
    

    
    

AIMA working group members
Ernst & Young LLP - Karen Jordan
Dechert LLP - Richard Frase
UBS Investment Bank (UK) - Ashley Jarvis
EN Asset Management Ltd - Jon Easton
Olympus Capital Management Ltd - Debbie Tanner

AIMA
Mary Richardson and Matthew Jones, seconded by Simmons & Simmons

Disclaimer: This document is provided to and for AIMA members only. It is intended as indicative guidance only and is not to be taken or treated as a substitute for specific advice, whether legal advice or otherwise. It does not seek to provide advice on wider issues relating to the FSA's regime for the use of dealing commission. All copyright in this document belongs to AIMA and reproduction of part or all of the contents is strictly prohibited unless prior permission is given in writing by AIMA.