New York—Over the past week we've had the opportunity to hear regulatory staff from the U.S. Securities and Exchange Commission and the UK Financial Services Authority speak on their respective regulations of commissions used to pay for research. Distinctions between the two raise questions about the different regulatory approaches—and which are ultimately more effective.
Last Wednesday, Mike Mayhew and I were speaking at the AQ Research conference in London, which also featured a panel with Christopher Preston from the FSA's Institutional Business Policy group. The FSA was originally spurred to action on commissions by the Myners Report in 2001 which among other things highlighted the lack of transparency of commission payments. After a consultation period, the FSA drafted regulation in 2004 which was implemented in 2006. The new regulation: 1) narrowed what was permissible to be paid for by commissions; 2) implemented increased disclosure of commissions used for execution and research and 3) kick started pricing mechanisms for research, requiring ex-ante splits of commissions into execution components and research components. The FSA also created an environment conducive to the spread of Commission Sharing Arrangements.
The FSA is now reviewing the results. Beginning last year, it has met with 15 or 16 money managers to assess what has changed and what else needs to be done. It has retained consultants to assess the impact of the regulation. Preston indicated that the FSA was 'broadly encouraged' and the response from the market has been 'reasonably positive.' The ex-ante pricing discussions have been constructive, broker voting is widely adopted, brokers report that feedback received has been useful in prioritizing resources, and there has been a downward drift in commission rates. One area of disappointment for the FSA has been that trustees have not provided much feedback on fees, despite the increased disclosure. "Not entirely unexpected, but there is a need to address," Preston said. The FSA is considering whether pension consultants might be a point of leverage in putting pressure on trustees.
Then we heard from Patrick Joyce, Special Counsel from the SEC's Division of Market Regulation at Monday's Investorside conference. Actually, before we heard from Joyce the panel's first priority was regulation not associated with the SEC—the Department of Labor's revisions to Form 5500 [click here to see previous commentary], the annual filing made by pension funds, which is now requiring disclosure of research received through indirect compensation (commissions). Then discussion turned to the SEC's proposed revisions to Form ADV, which is filed by investment advisors. Actually, there wasn't much discussion since the changes to Form ADV, as they pertain to commission disclosure, are minor. There was mention that the SEC is working on guidance for fund directors regarding commission disclosure, but Joyce could not comment on when—or if—this regulation would be completed since it is being drafted by a different division, the Division of Investment Management.
The two regulators are at very different places regarding commission regulation. The FSA is busy working on second generation modifications to its disclosure regime, while the SEC is struggling to produce first generation regulation on commission disclosure, despite repeatedly announced promises from its chairman and division directors. Why the stark contrast? One answer lies in the way the regulators are organized. The FSA was created in 1998 through a merger of 4 or 5 separate regulators giving it a consolidated, unified mandate. No such consolidation has occurred in the U.S., as highlighted by the Treasury's recent proposal to consolidate financial regulators.
However, in the case of commission regulation, the SEC has the requisite authority, but has been unable to exercise it. One problem is that the different divisions operate in a highly independent fashion. The division most familiar with Rule 28(e) is the Division of Market Regulation which regulates investment banks whereas the disclosure regulation has been the responsibility for commission disclosure lies in the Division of Investment Management, which regulates investment advisors. It is apparent there is little collaboration between the two areas.
The other problem appears to be one of management. Despite high drama from the current SEC Chairman, Christopher Cox, who at one point called for the abolition of commission payments for research, there is no effective management structure. Political appointees at the commissioner level and director level have modest sway over staffers, who can act—or not act—with impunity.
The SEC glosses over its inaction by claiming to seek a market led solution. In fairness, it has clarified some of the issues surrounding the use of Commission Sharing Agreements (called Client Commission Arrangements in the US), although open issues remain. Nevertheless, CSAs alone will not improve commission disclosure. Lacking a regulatory framework for commission disclosure, CSA adoption in the U.S. is around 20-30% versus 60-70% in the UK. Further, CSAs would not have gained popularity if the FSA hadn't taken the initiative. On commission disclosure, the SEC appears content to ride the coat-tails of other regulators.
equity research, commissions, commission sharing agreements, client commission arrangements, Securities and Exchange Commission, SEC, FSA
Posted at 07:06 am by Sanford (Sandy) Bragg
 | Posted by Bill George @ 04/11/2008 08:09 AM PDT | |
Please note the date on letter I have copied and pasted below.
William T. George
P.O. Box
Encino, CA
April 4, 2006
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
100 F. Street N. E.
Washington, D.C. 20549-9303
Subject: S7-09-05
Dear Mr. Katz:
Recent comment letters responding to The Commission’s Proposed Interpretive Guidance on Client Commissions Under Section 28(e) of The Securities Exchange Act of 1934 have suggested significant changes to the interpretation and design of commission sharing arrangements (CSAs).
I am hopeful The Commission will consider these proposals in the context of the history of the brokerage industry.
Full service brokers and their investment banking divisions control the manufacture and the distribution of the brokerage product (securities). Since the year 2000 the numerous prosecutions by the New York State Attorney General, the SEC, and the numerous Senate and Congressional hearings on conflicts-of-interest and similar issues have focused the public’s attention on how powerful a few monolithic full service brokerage firms are.
Bundled commissions and opaque accounting provide these monolithic brokerage firms with significant market advantage. To asset managers they offer mutual fund distribution, a late trading window, wrap account introduction, first calls, IPO allocation - and “flipping” (with a short holding period). To investment banking clients they offer massive distribution capabilities with lock-ups (lock-ups seem to be only for retail clients) and allocation of IPOs to decision makers. All for a six cent per share bundled commission. There is no commission transparency, and disclosure is inadequate.
Over the years these powerful advantages have put full service investment banking brokerage firms at the nexus of order flow. By definition they are the “Execution Service Providers”. They also are the undisclosed quid-pro-quo providers.
These full service brokerage firms have no interest in the economic vitality of independent unbiased research, quite the contrary. And their bundled brokerage commissions provide little or no information to further the cause of fiduciary oversight or Section 28(e) enforcement. To suggest that these same firms become the overseer and distributor of soft dollar commission premiums seems to ignore these facts. Any structure or mechanism that serves to separate the free negotiation of research valuation (and pricing) between fiduciaries and independent research providers should be studied with great suspicion.
Now is the time for full service brokerage firms to provide clear, transparent, detailed accounting of brokerage commissions. It’s not the time to introduce another opportunity for conflicts of interest.
Thank you,
William T. George
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| Posted by Bill George @ 04/09/2008 12:56 PM PDT | |
Related to the comments in this article, I recently filed a Comment Letter with the SEC on the Proposed Amendments to Form ADV. My Comment Letter explains why an amended Form ADV will not provide fair and informative disclosures if the SEC does not first reiterate definitional clarity on what soft dollars are, and also issue Interpretive Guidance on mandatory minimum soft dollar disclosure requirements. In my Comment Letter I also stress that once the definition of soft dollars is republished and guidance on required disclosures is issued, it is very important that regulators enforce the requirements equally across all kinds of institutional brokerage commission arrangements. My comment letter was published on the SEC website this morning. It can be accessed at:
http://www.sec.gov/rules/proposed/s71000.shtml
I’ve noticed that the hyperlinked URL’s in the footnotes on the copy of my comment letter published on the SEC website have been rendered “inactive”. If you would like to access and / or download a copy of my Comment L Letter that has active hyperlinks, a copy of the comment letter is also available at:
http://www.scribd.com/groups/view/3108-investing-in-mutual-funds-and-other-investment-vehicles-managed-by-fiduciaries
Once the Scribd page opens scroll down to Recent Documents: Comment on Proposed Form ADV Amendments.
Fact checking my footnoted comments will be easier when the hyperlinks are active and when the document is resident on your computer.
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