The recommendations of the Investment Research Review and the implications for investment managers

Introduction

Jeremy Hunt confirmed, in his Mansion House speech on 10^th July 2023, the UK government’s acceptance of the recommendations of Rachel Kent’s Investment Research Review (“the Review”). This brings to a swift conclusion this aspect of one of the most important strands of the Chancellor’s Edinburgh Reforms announced last December. The Review’s recommendations and, in particular, the key proposal on greater “optionality” for paying for research, represent a significant retreat from the unbundling regime so long championed by the FCA.

The seven recommendations of the Review are as follows:

• Introduce a Research Platform to help generate research.
• Allow additional optionality for paying for investment research.
• Allow greater access to investment research for retail investors.
• Involve academic institutions in supporting investment research initiatives.
• Support issuer-sponsored research by implementing a code of conduct.
• Clarify aspects of the UK regulatory regime for investment research and consider introducing a bespoke regime.
• Review the rules relating to investment research in the context of IPOs.

If you would like more context to how we arrived at the current position please click here to read a background summary. But right now let’s examine what these recommendations boil down to and discuss their implications.

1. The key proposal on greater “optionality” of research

For the avoidance of doubt, greater optionality means paying for research services through a third option - combining the cost of research with execution charges - (the first two options being out of “own resources” and through an RPA).

However, some important conditions will apply to optionality…

It is important to note that the Review recommends certain conditions apply to investment managers to mitigate some of the original conflicts of interest concerns. They must:

• allocate the costs of research fairly between their clients, having regard to the obligation on firms to treat their customers fairly;
• have a structure for the allocation of payments between the different research providers - such as Commission Sharing Agreements (“CSA”);
• establish and implement a formal policy setting out their approach to investment research and how it is paid for;
• periodically undertake benchmarking or price discovery in relation to the research that the firm uses; and
• make appropriate disclosures to the client (depending on which option to pay for research is adopted).

Another condition proposed by the Review is that sell-side firms should not be required to facilitate payments on a bundled basis or be able to limit buy-side firms from receiving bundled charges.

Furthermore, it recommends that investment managers are not compelled to require specific consent from clients to their investment research arrangements, rather that these would be subject only to any pre-existing contractual arrangements.

Cosegic comment: At a stroke, this proposal concedes the principle of bundling payment for research services with execution charges – a somewhat humiliating outcome for the FCA after investing so much political capital in this aspect of MiFID II.

At this point, it may be reasonable to ask whether the first two options will survive in practice at all – a question that will probably be settled by the attitude of large institutional investors. The quantity (and maybe quality) of research may improve but is still likely to be focused on larger companies.

2. Introduce a research platform to help generate research

The Review proposes a research platform which provides a central facility to promote, source and disseminate research on publicly traded companies, with an emphasis on smaller cap companies. The platform would be operated by a third party with research providers subject to minimum standards and coverage commitments. Various funding models are discussed, including levies on issuers or regulated firms, or short-term government subsidies.

Cosegic comment: it is difficult to see how a research platform would make any substantive difference to the current reluctance of research providers to support smaller companies.

3. Greater access to research for retail investors

The FCA is asked to consider whether the regulatory regime could be amended, or guidance offered to allow retail investors to access investment research more easily.

Cosegic comment: a laudable aim but not supported by any substantive proposals to improve retail access (other than via the research platform discussed above).

4. Involvement of academic institutions and bursaries in supporting research

Also related to the proposed research platform, the Review suggests three ways for closer collaboration between academia and the “capital market ecosystem”: i) greater involvement in the provision or support of research, ii) training of analysts supported by bursaries, and iii) encouraging academic institutions to assist innovative enterprises.

Cosegic comment: these are essentially supply-led solutions which don’t address the current lack of demand for research in certain sectors (or at least research that someone is willing to pay for).

5. Support issuer-sponsored research through a code of conduct

The Review recognises the importance of issuer-sponsored research and recommends the introduction of a voluntary code of conduct to add structure and enhanced integrity, sponsored by the industry and potentially recognised by the FCA.

Cosegic comment: this is a sensible proposal to boost the credibility of this form of research.

6. Clarify aspects of the regulatory regime for investment research and consider implementing a bespoke regime

With investment advice and financial promotions currently falling within the regulatory perimeter, and the provision of investment research (arguably a combination of the two) outside, the Review recommends a review of the current set-up followed, potentially, by the introduction of a bespoke regime.

Cosegic comment: the Review correctly identifies the present anomaly, but it is difficult to see how a bespoke regime would remove current inhibitions.

7. Review the rules relating to research in the context of IPOs

The Review recommends that “connected” analyst research (i.e. that produced by the investment bank sponsoring an IPO) is made available on a similar basis to the company's prospectus, so that potential investors can access the same information. The adjacent limitation on connected analysts being allowed to meet with potential IPO candidates prior to their investment bank being mandated on an IPO transaction should also be reconsidered.

Cosegic comment: These are sensible proposals that reign back on current concerns about biased IPO-sponsored research and play to the international competitiveness theme. However, they are also closely related to the FCA’s existing work on the recommendations of the Listing Review and the Secondary Capital Raising Review already in play.

How will the Review’s recommendations transition into revised FCA rules?

The FCA made a statement following the Mansion House speech confirming that it will work closely with the Treasury to “support” these proposals. To this end, it promises an accelerated timetable to introduce more options on how to pay for investment research, insisting that these will achieve an outcome of improving the market for investor research while providing value for money to institutional and retail investors.

Reading between the lines of the FCA statement (and can one also discern some gritted teeth?), we anticipate its acceptance of the key proposal to effectively re-bundle research and execution payments. However, we expect the FCA will also flesh out the Review’s recommendations to offset some of the perceived adverse consequences.

We expect the FCA will launch a Consultation Paper on the proposed rule changes in the last quarter of 2023, with the final rules confirmed during the first half of 2024.

Background Summary

i. MiFID II reforms: the new rules introduced at the beginning of 2018 were the culmination of a long campaign by the UK’s FCA to address the inherent conflicts of interest posed by investment managers paying for research through execution commissions. Faced with a choice of setting up Research Payment Accounts (“RPA”) or paying for research out of their own resources, buy-side firms slashed the amount of research services consumed instantaneously. Although this eliminated much unnecessary duplication of research into the largest/most liquid companies/securities, doubts have grown about the availability of research in the SME space, notwithstanding the introduction of an exemption for issuers with a market cap of below £200 million in 2022. The conditions for operating an RPA are seen as onerous and unfairly disadvantage smaller managers. Additionally, a race to the bottom in terms of pricing has led many to question whether research provision has truly ceased to be an inducement to execution activity.

ii. The International context: it is noteworthy that international competitiveness is cited as a key concern both in the Treasury’s Call for Evidence, published in April, and in the Review paper. Indeed, the end of the SEC’s no action relief for US broker-dealers receiving hard dollars from UK and EU managers at the beginning of July can be seen as a key driver for abandoning the current unbundling regime. Also of relevance is the EU’s exemption for research on issuers with a market cap of less than €1 billion announced last year which the UK now appears to be leap-frogging.