Darien, CT - Conversations with money managers in recent weeks have reflected a wide range of views on the topic of unbundling and commission disclosure, with some large asset managers expressing a high level of confidence that the commission disclosure trends started in the UK will formerly take hold in the U.S. in the not too distant future. Other influential money managers, however, are convinced that regulators in the US will not force unbundling here.
While we agree that the SEC will probably not force actual unbundling, we do believe it will be extremely difficult for US regulators to argue that clients do not deserve transparency about how their commissions are being spent by their money managers -- particulalry when a large number of pension fund and plan sponsor customers need this information to effectively perform their fiduciary duties.
International Developments
The first reason we expect US regulators will formally back commission disclosure in the US is that regulators in many parts of the world have already adopted and implemented rules in this area.
For example, in July, 2005 the UK's Financial Services Authority mandated that money managers disclose how much of their client's commissions they were spending on execution and research services. This rule has now been in effect for fifteen months, with no obviously adverse effects to pension funds, the money managers that serve them, or the brokerage firms that provide execution and research to the buy-side.
In fact, the rather benign impact of the UK rules encouraged French regulators to follow suit by proposing a similar commission discosure rule. Other European regulators are playing a wait and see game to determine how best to move forward with unbundling.
Last summer, the Canadian Securities Administrators published proposed policies to regulate the use of soft dollar commissions by investment advisers and dealers governed by Canada's provincial and territorial securities regulators.
Not only did the proposed policy define "execution" and "research" services, but it also went a long way in mandating serious disclosure requirements. For example, the proposed Canadian policy would require that an adviser provide each of its clients with specific disclosure of all of its soft dollar arrangements, with the names of the dealers and third parties involved, and the relevant
goods and services provided.
This policy would also require the disclosure of the amount of commissions paid by the adviser on a client by client basis during the period. Estimates of the dollar amounts paid for research and execution services would also be included in these reports, and advisers would also be required to make certain other soft dollar related information available to their clients.
Impact of Globalization
Some expect that the market, left to itself, will naturally move to an unbundled environment as large pension fund and plan sponsor clients who currently employ UK asset managers, will start to demand the commission disclosure reports they are getting from their UK managers, from US managers.
We agree that this will eventually take place. However, this process could take an extremely long time -- a period in which U.S. pension funds and plan sponsors would not be able to effectively meet their fiduciary requirements to actively monitor the various expenses (including commission expenses) of their plans on behalf of their investors.
Thus, even though some regulators might think the market will fix itself, it is clear to us that this approach will leave unprotected the interests of millions of unsophisticated investors who have signifcant portion of their wealth in various pension funds, defined benefit, and defined contribution plans.
Revision of Form 5500
Last July, the Employee Benefits Security Administration (EBSA) -- the regulator of the $4 trillion pension industry -- surprised many in the financial markets when it took an extremely aggressive approach to the issue of commission disclosure.
EBSA proposed signficant changes to its annual Form 5500 disclosure filing. In the past, many in Congress, including the General Accountability Office, criticized Form 5500 as a useless disclosure document for helping to regulate pension plans.
EBSA's proposal includes disclosing how much client commissions are being spent for execution and research services on a plan-by-plan and broker-by-broker basis in the new Form 5500. EBSA's initial proposal is expected to be finalized into formal regulation in the next few months.
EBSA also plans to propose another rule this spring targeting organizations that service pension plans, such as money managers. The rule will require them to give customers information regarding the compensation and fees they receive.
As you might imagine, EBSA's proposed changes to Form 5500 have been denounced by many asset managers and brokers as unnecessary and overly expensive to implement. In fact, the sell-side trade organization, SIFMA, and the mutual fund trade goup, the ICI, have sent extensive complaints to the EBSA arguing the negative consequences of the proposed regulation.
In addition, both organizations contended that EBSA should not be involved in issues related to commission transparency, as it is normally the domain of the SEC. They added that EBSA's proposal was particularly unnnecessary as the the SEC was expected to address commission disclosure by the end of 2006.
Unfortunately, the SEC did not meet that unofficial deadline.
Lesser of Two Evils
However, some industry watchers believe that the SEC's Division of Investment Management is now under great pressure to come out with some form of proposed regulation to address commission disclosure -- particularly given the onerous proposal put forth by the Department of Labor's EBSA.
In fact, it is quite clear that an FSA-type of commission disclosure would be far less objectionable than either EBSA's proposal or the Canadian Securities Administrator's plan.
Consequently, some cynics might conclude that it would now be in the best interests of the ICI and SIFMA to encourage the Division to Investment Management to put out a proposal that would eliminate the need for the EBSA regulation as it would be the lesser of two evils.
The Upshot
Based on the various developments both at home and abroad over the past few years, we suspect that commission disclosure will become a reality in the US by the end of 2007 as securities regulators become convinced that plan fiduciaries have a right (in fact a need) to know how their investors' assets are being spent.
However, we need to be extremely clear that we do not expect that US regulators will go so far as to mandate the unbundling of equity commissions. Instead, we think that US regulators will require that money managers disclose to their clients how much of their commissions are being spent on execution and how much is being spent on third-party research, including research produced by sell-side investment banks and brokerage firms and boutique alternative research providers.
Of course, this type of disclosure will lead to a number of developments, including the move by many money managers to selecting their execution partners separately from the choice of their research providers. In turn, this will encourage many who are not already doing so to concentrate their brokerage list and adopt CSAs as a means to pay for their research.
Finally, we expect these developments will lead asset managers to develop more formal processes to evaluate the quality of the research they purchase (similar to a TCA for research); it will force them to establish more proactive research procurement procedures (similar to the procurement procedures seen in most industries); and it will lead money managers to push for more transparency about the price they are paying for the research they purchase.
Posted at 01:56 pm by mwmayhew
Permalink
