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Benefits and Pensions MonitorCommission Issues In The UK MarketBrokers’ Response The brokersʼ response to unbundling has been to create Commission Sharing Arrangements (CSAs). Cashfrom a managerʼs trading builds up in the CSA and can then be used at the manager ʼs direction to pay for research, either proprietary or third-party or both. In light of the number of Commission Sharing Arrangements (CSAs) that have now been signed, brokers are simply resigning from commission recapture programs as it is economically more attractive to manage a ʻsoft commission programʼ as opposed to a commission recapture program. The tangible benefits (the commission) are kept within the manager / broker relationship. Brokerage firms have had their business scrutinized as a result of the Consultation Paper 176 (Bundled Brokerage & Soft Commission Arrangements, FSA) debate and are now showing some resistance to any attempts to substantially reduce commissions. Where managers are negotiating substantially lower commission rates, there may not be room for commission recapture, but examples of this are few. Commission recapture addresses inefficiencies in the way commissions are decided upon and spent. If those blended rates fall or if provision is made for the fact that, rightly, some trading should be done at an execution only rate, then commission recapture no longer applies and the inefficiencies it set out to counter-balance have been addressed. Evidence Of Targets Falling In our discussions with the investment management community, there is at least one consensus of opinion – commission recapture targets are becoming increasingly harder to meet. In some cases, this is because managers have lowered their full service commission rates. Others, however, have made no change or, more commonly, their brokers have indicated that service levels would fall if rates were reduced. However, the primary concern facing managers who want to meet recapture targets for their client is that they are unable to facilitate the business with their preferred brokers as they have resigned from commission recapture networks or, in the majority of cases, have produced an ʻexclusionʼ list which prohibits some, but not all, managers from directing orders. This has led to the brokers ʻcherry-pickingʼ the business they want, to the disadvantage of those managers with less order flow and, ultimately, their clients. Impact Of CSAs We think that in common with old style soft commission agreements, there remains a fundamental ʻincentive misalignmentʼ present in the case of CSAs. The CSA segregates execution from research, but it does nothing to address whether the manager is ʻpurchasingʼ the appropriate amount of research, receiving optimum value, or, of course, whether that research is adding any value to the investment process. The FSA considers the distinction between an old style soft commission agreement and a CSA to be that the manager is not forced to put a particular level of commission flow through any particular broker. The fundamental issue is that there is no incentive for the manager not to over-consume research or to consider adequately how much value the research adds. In any event, even though there is no legal requirement, there appears to be an unwritten rule that reward is given in increased order flow. The basic problem is the classic ʻprincipal/agentʼ one that the agent (in this case, the manager) has insufficient incentive to minimize inappropriate consumption of research as the underlying client is paying for it. The indirect effect on fund performance is too blunt to provide a sufficient incentive not to over-consume research. The Accrual Of Commission An additional problem with CSAs is that if too much commission is allowed to accrue, circumstances whereby cash remains on balance unused could result. We question how this residual cash balance will be accounted for. From meetings with the investment management community, our findings show mixed opinions. Some investment managers say it will be left with the broker as additional reward – that it has already been paid and is the brokers ʼ responsibility. Some managers seem to think that the FSAʼs client money rules state that commissions are owned by the broker, unless they are ordered to pay it to a third-party. Others suggest it might be rolled over to the following financial period. We believe that if there is a balance of cash generated through trading that is not used for the purposes of execution or the purchase of research, it should be returned to the fund. An Alternative Solution In light of the limits, to the extent to which CSAs solve the problems identified with regard to soft commission arrangements, proactively managed Commission Recapture programs have a valid and important role to play as a definable benefit to pension funds. We would like to see recaptured commissions reported fully as part of the Disclosure Code. This would account for the possibility that there may be overspending on research and would address any uncertainties surrounding the interpretation of permitted services payable with commissions. It would also return any monies remaining on balance, unused, back to the fund whose assets they are. The fundamental point about Commission Recapture is that it does not create a conflict of interest between the pension fund and its investment manager as the fund benefits directly from the commission rebate. Overall, a proactively managed commission recapture program, working alongside a well-administered CSA, is the best way to ensure excess commissions do not accumulate on account with the broker and that managers do not overspend on unnecessary research. In doing so, this gives pension funds real control in managing their commission budgets and expectations that they otherwise have no knowledge of at the outset and little control of throughout the management process. ■
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Todd Burns is president of Lynch, Jones & Ryan, a subsidiary of BNY Brokerage Inc.