Top 400: The burden of harmony
Investment managers increasingly operate in an interconnected way across multiple jurisdictions. The direction of travel is to permit investment managers to work more effectively across borders; in Europe iterations of directives such as MIFID and UCITS allow for greater cross-border operation. MIFID II in particular will open the gateway for non-EU investment managers to operate more effectively across Europe. Such initiatives are clearly of benefit to the industry, allowing less constrained access to markets, and by increasing competition for investors.
But spare a thought for the compliance teams in these organisations. Operating internationally is complex.
While the concept of maximum harmonisation ought to mean regulation across Europe comprises the same broad principles, implemented the same way, member states continue to enact directives differently and enforce them to their own standards. So-called ‘gold-plating’ of directives – implementing national rules that go beyond the intention of the directive – does happen, even though it is arguably not in the spirit of European integration.
For example, the UK investment industry has been operating within the requirements of the retail distribution review (RDR) for nearly 18 months, and some European member states have similar rules in place, but certainly not all. MIFID II will, in theory, bring other member states into line with many of the provisions within RDR, but the devil is in the detail and activity that is prohibited in some member states will remain permissible in others.
So, while operating internationally affords investment managers enormous opportunity to tap new markets, is not always accompanied by increasing regulatory harmony across jurisdictions, and instead presents increasing complexity and mutual incompatibility. This places a great burden on the already over-stretched compliance functions.
Let us examine the FCA’s current position on dealing commissions as an example. Last year, the FCA clarified its interpretation of the types of services that investment managers can receive in return for payment using its investors’ money through commission charges on broker dealing. Rules dating back to 2006 have governed how investment managers may spend commissions generated in this way, and in particular those services which are eligible – broadly, the provision of research.
It is an important area of focus for the regulator, which estimates that some £3bn (€3.7bn) of dealing commissions are generated annually and, of that, half is used to pay for research. It found that some companies are using those commissions – which in large measure derive from investors’ pension assets – to pay either for services that were unlikely to provide value for money or, in some cases, for services that were not, in the FCA’s view, eligible at all.
So at last year’s FCA’s asset management conference, Martin Wheatley announced that the FCA would be clamping down. In May 2014, it issued a policy statement containing revised rules that come into force on 2 June. No doubt this initiative is a sensible one; investment managers are trusted to look after and invest wisely their clients’ wealth; unwisely spending it goes against the grain of that basic principle. Indeed, the vast majority of industry participants at the FCA’s conference agreed that the system in its current form doesn’t work.
The proposed solution, however, doesn’t come without its difficulties for those investment managers that operate internationally. Like RDR before it, the proposed rules create a situation where certain activities are permissible in one jurisdiction, but not in another – and this isn’t confined to Europe. Similar rules exist in the United States governing what may and may not be paid for using dealing commissions. Similar, yes, but not identical.
In the US, paying for services using dealing commissions is referred to as a ‘soft dollar’ arrangement. While investment managers are expected to seek to minimise commission rates when dealing on behalf of their clients, they are allowed to pay more where they receive research services in addition to brokerage services. Section 28(e) of the Securities Exchange Act of 1934 protects investment managers from liability for a breach of fiduciary duty when they do this by creating a ‘safe harbour’. If, among other things, the investment manager determines that the additional payment was reasonable in relation to the value of services received, then they can pay using soft dollars.
Apart from the language, this is not very different from the UK’s position, you might think. Again the devil is in the detail, and it is the detail that compliance teams need to ensure they understand.
Provided for in the US safe harbour, and therefore expressly permitted as an eligible research service, is the provision of corporate access. Corporate access services encompass the broker arranging for investment managers to meet with company executives to discuss the performance of the company in order to form a better view on whether the investment manager wants to invest, or continue to invest, in the company. Similarly, data services providing stock quotes, trading volumes and the like are eligible, as is the provision of wider generic data such as inflation rates, GDP figures and company financial data.
Not so in the UK. Expressly forbidden under the FCA’s rules is payment for these services through dealing commissions. The services are not forbidden of course, but the investment management company must pay for them itself and not use its investors’ funds. So they are paid for out of the annual management charge, rather than in addition to it.
This creates a dilemma in an international industry. Take, as an example, an internationally active investment manager. Its UK operation manages Luxembourg-based funds for UK retail clients, but delegates investment management of certain non-UK investments in those funds to the wider group. Its US operation manages Asian investments in this way, and US-based portfolio managers book their trades with the trading desk in Singapore. These trades generate dealing commission at the Singaporean branch of a Swiss broker. Meanwhile, back in the US, notes from a recent company meeting, arranged by a broker counterparty and paid for using soft dollars, are circulated worldwide to their investment professionals, including those back in London, in order that everyone in the global organisation has the opportunity to benefit from the insights provided.
Confused? Which jurisdictions rules govern this? US, Luxembourg, Singapore, UK or Switzerland? They are all different, and the above scenario is permitted in some, but prohibited in others.
Tackling issues like this requires compliance and legal teams that are familiar with the detailed differences in requirements across multiple jurisdictions. So we are seeing demand for larger, more highly skilled compliance departments, and this outstrips supply. Basic economics tell us that this comes at a cost, and that cost will inevitably be borne by the underlying investors’ pension assets.
So there is a bigger question that regulators need to consider when championing the cause of investors. Are the costs of unilateral rule implementation really justified by the benefits they seek to achieve?
Mike Ginnelly is senior manager, asset management regulatory practice, at PwC