The UK Investment Research Review: calling time on unbundling?

Background

As discussed in an earlier blog post, on 10 July 2023, the Chancellor delivered his first Mansion House speech in which he outlined new “Mansion House reforms” to help unlock additional investment from defined contribution and local government pensions, increase investment in British businesses, and enable Britain’s financial and professional services sector to drive the long-term sustainable growth of the economy.

One of the changes included in the reforms that is aimed at strengthening the UK capital markets is an overhaul of the investment research regime. Previously, at the end of 2022, the Chancellor had announced that he would be launching an independent review of financial services investment research and its contribution to UK capital markets competitiveness. The results of the UK Investment Research Review (the “Review”) were published by HM Treasury on 10 July 2023, and in his speech the Chancellor announced that the government was accepting all of the recommendations in the Review, including a commitment to remove the MiFID II requirement to unbundle research costs.

UK Investment Research Review

The Investment Research Review was launched in December 2022 alongside a Call for Evidence as part of the government’s broader efforts to make the UK a more attractive place for both large and small companies to raise capital following Brexit. Some concerns had been raised about the quality and quantity of investment research produced in the UK compared to other jurisdictions, in particular the United States. This was especially the case for high growth sectors such as technology and life sciences, and the government was worried that the paucity of good quality research could make it harder for investors to value companies and for companies to access the capital markets.

One of the key targets of the Review was the requirement introduced by MiFID II in 2018 for the unbundling of payments for research and trading, which was intended to increase transparency for investors. Under MiFID II, research received by an investment manager from brokers was classified as a prohibited inducement, unless the investment manager paid for the research out of its own resources and/or from a Research Payment Account (RPA) funded by an advisory client with the client’s consent.

As noted in the Review, the unbundling requirements have had an adverse effect on the availability of research, without necessarily increasing the transparency of pricing. RPAs are rarely used due to their complexity, and asset managers have reduced the amount they spend on external research. However, the Review also notes that the decline in research coverage in the UK actually predates the introduction of the MiFID II unbundling requirements, due to institutional investors adopting a risk averse strategy and moving away from UK equities as well as a decline in secondary trading and falling commission rates.    

The situation is further complicated by the fact that in the United States, broker-dealers could become subject to regulation under the Investment Advisers Act of 1940 if they receive “hard dollar” payments for research in accordance with MiFID II. The U.S. Securities and Exchange Commission had issued no-action relief indicating that they would not recommend enforcement action if brokers charged European asset managers separately for research, but this relief expired on 3 July 2023.

Against this backdrop, the Review has come up with seven recommendations for improvements.

Recommendation 1: Introduce a Research Platform to help generate research

The Review recommends the introduction of a new platform that would provide a central facility for the promotion, sourcing and dissemination of freely available research of publicly traded companies, with a focus on smaller cap companies. Third party operators would procure a roster of research providers with the relevant expertise who would commit to certain minimum standards but with the possibility to have different levels of coverage and price points.

Options for financing could include funding (a) through a levy on issuers, on participants in the market in connection with the purchase of shares, or on financial services firms, (b) by the exchanges, or (c) by contributions from government. The Research Platform could only be a temporary measure if it is deemed to be no longer needed after reviving research coverage in the UK.

Recommendation 2: Allow additional optionality for paying for investment research

The Review also recommends giving buy-side firms the option to pay for research either (a) out of their own resources, (b) by making a charge to their clients, or (c) by combining the cost of research with execution charges. The costs of research would need to be allocated fairly among clients and research providers, and firms would need to make appropriate disclosures to clients.

In addition, the Review recommends that the UK should seek to remain aligned with key jurisdictions in relation to investment research, with a particular focus on removing any barriers that prevent UK buy-side firms from paying for investment research in other jurisdictions (such as the United States) where payment on a bundled basis is standard practice in that jurisdiction.

Recommendation 3: Allow greater access to investment research for retail investors

The Review suggests that retail investors should have greater access to investment research, much of which is not currently made public. It invites the FCA to consider amending its rules or offer guidance to help retail investors get access to investment research more easily.

Recommendation 4: Involve academic institutions and bursaries in the provision of investment research

The Review recommends that Research Platform operators explore ways to strengthen the collaboration between academic institutions and the capital markets. Academic assistance (and thus the inclusion of the know-how available there) might prove helpful in different ways, be it the provision or support of research, providing training for analysts, or assisting innovative enterprises that seek to develop out of academic study.

Research Platforms could also fund bursaries to help academic institutions train new analysts, which might be a way to address a (potential) shortfall in the number of analysts available.

Recommendation 5: Support issuer-sponsored research by implementing a code of conduct

The Review recognises the importance of issuer-sponsored research and suggests that it should be available in addition to what is available on the Research Platform. To help structure the market for issuer-sponsored research and enhance its integrity, the Review recommends that the industry should collaborate to create and adopt a voluntary code of conduct that would apply to all issuer-sponsored research, in addition to any other legal or regulatory requirements that the signatories are subject to. The code could be industry-led, although the Review suggests that it could also be recognised by the FCA.

Recommendation 6: Clarify aspects of the UK regulatory regime for investment research and consider introducing a bespoke regime

The Review recommends that steps should be taken to simplify or clarify the regulatory regime relating to investment research as it is now seen to be unclear, unnecessarily complex, or difficult to justify in certain areas. This could include creating a bespoke regime for the provision of investment research.

Recommendation 7: Review the rules relating to investment research in the context of IPOs

Respondents to the government’s Call of Evidence noted that changes introduced to the FCA’s Conduct of Business Rules in 2018 had not had the desired effect of encouraging unconnected analysts to produce research in connection with IPOs. Furthermore, these changes had resulted in an extension to the IPO timetable to accommodate the publication of unconnected research, which risked putting the UK at a competitive disadvantage. The Review therefore recommends a review and possible changes to simplify the IPO timetable, while also ensuring that adequate and timely access to the information is maintained.

Changes could also include making connected analyst research available on a similar basis to the prospectus, so that all investors can access the same information. The Review also suggests a reconsideration of the FCA rules that limit the ability of connected analysts to meet with potential IPO candidates prior to an investment bank being mandated on an IPO transaction.

Outlook and next steps

Some of the recommendations set out in the Review will require rulemaking by the FCA (following consultation), while the creation of a Research Platform and any changes to the regulatory perimeter would need to be led by HM Treasury. The FCA has issued a statement in which it welcomed the Chancellor’s Mansion House speech. The FCA says it will carefully consider the Review and its recommendations and is aiming to make relevant rules in H1 2024, subject to feedback from market participants on the substance and timing of any rule changes.

Meanwhile, in the EU, the European Commission has raised similar concerns regarding the unbundling provisions of MiFID II, noting that the restrictions on investment research had made it more difficult for SMEs to access capital. New rules were introduced in February 2022 that provide an exemption from the unbundling requirements for issuers whose market capitalisation did not exceed EUR 1 billion for a period of three years preceding the research. In December 2022, the Commission proposed to increase this threshold to EUR 10 billion and to provide a new framework for issuer-sponsored research. The proposal, which forms part of the Commission’s “Listing Act” package, is now being considered by the European Parliament and Council.