ResearchWatch from Integrity Research Associates

Sunday, April 27, 2008

Using Commissions to Pay for Management Access?

New York, NY - In the past few years there has been considerable discussion about the appropriate use of the equity commissions generated from clients' accounts to pay for investment research (aka "soft dollars"). Consequently, both the FSA and the SEC have put out various rulings in recent years to clarify what money managers can purchase with client commissions. However, one very interesting issue that has been ignored by the market place is the inconsistent way the regulators have dealt with "management access" in these deliberations.

Appropriate Use of Client Commissions

Both the FSA and SEC agreed that client commissions should be limited to purchase execution and research services. The primary difference between the two regulators was the definition of what comprised research and execution.

The FSA provided three criteria to help ascertain whether a product or services could be paid with client commissions. This includes:

Original Thought – adds value by providing "new insight" to an investment manager in making an investment decision;
Intellectual Rigour – provides analysis or commentary that states more than what is "self evident;"
Analysis/Manipulation of Data – provides "meaningful conclusions" based on analyzed research.

The definition used by the SEC, on the other hand, was set forth in Section 28(e) of the Securities Exchange Act. According to the SEC, a person provides research services if he / she:

furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities; or

furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts;

The SEC noted that an important common element defining, "analyses," and "reports" is that each reflects substantive content – that is, the expression of reasoning or knowledge. Thus, in determining whether a product or service is eligible as "research" under Section 28(e), the money manager must conclude that it reflects the expression of reasoning or knowledge and relates to the subject matter identified in Section 28(e)(3)(A) or (B).

In this regard, the SEC felt that traditional company research reports analyzing a particular company or stock, certain financial newsletters and trade journals (if they relate to the subject matter of the statute), quantitative analytical software and software that provides analyses of securities portfolios, and certain seminars or conferences could also be defined as "research services" under the defintion outlined in Section 28(e).

Does Management Access Qualify As Research?

Based on these definitions, it seems quite surprising that neither the FSA nor SEC found it concerning that many money managers consistently say that the one service they value most that is provided by investment banks is access to company managements.

It is clear to us that setting up meetings with company executives does not reflect the expression of reasoning or knowledge, it does not include original thought, it does not reflect intellectual rigor, nor does it include the analysis and manipulation or data.

In fact, most sell-side management access programs are little more than professional concierge services where buy-side investors can sign up for one-on-one meetings with corporate executives. In some circumstances, the sell-side provides investors access to company executives they could never meet on their own. These programs merely save time for the largest investors who could easily set up many of these meetings for themselves.

This does not mean that investors are not receiving valuable insight, reasoning and knowledge from these meetings. They are getting considerable input from the company executives who participate in these meetings. Unfortunately, the executives are not the ones being paid for their expertise. Instead, the sell-side firms are the ones being paid (and quite handsomely I might add) for merely setting up these meetings.

Thus, we acknowledge that management access is valuable to the buy-side. However, it is also clear to us that based on the FSA and SEC definitions, management access does not qualify as research. As a result, it is unclear how investors can justify using their client's commissions to pay for this service.

Cannot Stand on its Own

In fact, we suspect that some regulators have seen the problem of using client commissions to pay for management access. A few years ago at a conference in the UK, a senior FSA official was asked about the appropriateness of defining management access as "research" due to the issues outlined above. This FSA official noted that management access could be paid for with commissions in the context of the entire suite of research services provided by the investment bank.

In other words, management access could not be defined as research in its own right, but rather it had to be bundled with other obvious research services (like research reports, conferences, and access to analysts) to meet the standards established by the regulators.

Unfortunately, any other answer would have been devastating for the buy-side as this would have forced them to pay for this valuable input to their investment process out of their own fees rather than using their client's commissions. In addition, the sell-side could also have been hurt by such a move as many buy-side firms would have paid them considerably less in commissions if they could not define management access as research.

Posted at 02:04 pm by mwmayhew

	Posted by Scott @ 05/12/2008 04:50 AM PDT
	Others here have already addressed the iissue, but I'll throw in my two cents, too. It seems to me that under Reg FD, the value of "management access" should be exactly $0 (well, actually less than that because there are other expenses incurred seeking and participating in that access -- transaction costs, if you will). If "management access" is on the up-and-up, then what have I missed? (As an aside, it still amazes me that no lawyers have snooped around in this area. The issues involved (conflicts of interest, inside information, kickbacks, etc.) and the dollars at stake here make the Global Analyst Settlement look like chump change).

	Posted by Bill George @ 04/29/2008 12:04 PM PDT
	My apologies the link to Chairman Donaldson's testimony that I pasted in the comment below is incorrect. The correct link is> http://www.sec.gov/news/testimony/ts050703whd.htm < scroll down to, Background Section II.).

	Posted by Bill George @ 04/29/2008 09:09 AM PDT
	I just re-read this article on brokerage commissions being used to gain access to management. I noticed something about the article which I hadn't noticed before. That is, you seem to stress that by providing "access" to management a broker does not perform the functions required under the definition of research in either the U.K. or the U.S. (see section of article titled, Does Management Access Qualify as Research?). And because access doesn't qualify under either regulator's guidance, the practice of providing access should be questioned. In the historic tradition of soft dollar brokerage and particularly the old interpretations of the "provided-by" clause, it seems to me providing "access" (and providing the mechanism for payment to research producers) has been an acceptable function. And it seems that, in typical access arrangements, company management might provide information, analysis, advice and maybe even reports which qualify as research. I believe the important question is not whether access qualifies as research. The important question is whether the information produced and exchanged is publicly available information and has been properly released under the requirements of Reg. FD. I believe there is also another interesting question that your article dredges from the tradition of soft dollar brokerage. In third party brokerage you can generally audit the trail of benefits exchanged. Commisssions paid in excess of the fully-negotiated costs of execution are exchanged for research produced by a third party research producer. By comparison the money trail in the full-service brokerage "access to management arrangement" seems to have an empty third leg. I don't believe most full-service brokerage "access to corporate management" arrangements include payment to the corporation or the manager for their cooperation in the "access" arrangement. From what I have read and seen, it seems most corporate managements participate in these arrangements to gain or maintain the favor of the full-service broker dealer. The question, why does management participate in such arrangements without demanding compensation? The answer to this question becomes more clear if you look at the breadth of possible relationships between corporate managements and full-service brokers, and study the possibilities for the exchange of favors between corporate managements and full-service brokerage firms. Looking at the breadth of these possible relationships should also make one wonder . . . does this array of potential exchanged favors create the possibility for conflicts of interest for the full-service brokerage firm? If anybody really wonders about the answer to this qustion they should read SEC Chairman Donaldson's Senate testimony on the Global Analyst Research Settlement at: http://www.sec.gov/news/speech/factsheet.htm (scroll down to Background Section II.)

	Posted by Bill George @ 04/28/2008 04:33 PM PDT
	Body Language? Full-service brokers tout the advantage they can provide by vetting access to company management (insiders) to invesment advisors. Presumably they do this in exchange for some portion of the undisclosed brokerage commissions paid in excess of the fully negotiated costs of execution (i.e. soft dollars). But, it seems to me, that taken together market efficiency and adherence to the requirements of Reg FD would substantially reduce any assumed benefit / value from access to management. This raises at least three questions in my mind: (1) Are managements and other insiders adhering to the requirements of Reg FD? (2) Does management and other insiders' assessment of internal and external conditions give investors any price advantage in an efficient market? and (3) If the excess commission paid to gain access was disclosed, and measured against portfolio performance, would the portfolio produce excess returns, or does the cost of access exceed the benefit. Without the unbundling and disclosure of commission costs and services provided it's extremely difficult (or impossible) to do cost benefit analysis.

	Posted by robT @ 04/28/2008 08:30 AM PDT
	Michael, Who cares that InvestmentBanks - Broker-Dealers with trading desks - get paid for dragging companies around NYC and San Francisco, or when they sponsor investor client invite only "conferences." What is much more troubling is that, under Reg FD, it goes on at all. Go to an investor conference and compare the attendance for the webcast formal presentations to the secret break-outs and super-secret one-on-ones - no notes, no recordings just management and investors huddled up and whispering. Can you imagine what happens in these one-on-one meetings? The occasional wink and nod on the current quarter? Or just the numbers out and out front-runned. Reg FD has turned out to be a huge joke. Institutional Investors still have proprietary access to selective disclosure and there is nothing the regulators are willing to do to stop it.

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