Investment and corporate banking review: initial thoughts from the FCA

Practical Law UK Articles 0-627-0590 (Approx. 5 pages)

Investment and corporate banking review: initial thoughts from the FCA

by John Lane and Nicole Kar, Linklaters LLP

The FCA’s interim findings

The report finds that lending and corporate broking are typically supplied at a low rate of return or below cost in exchange for a flow of more lucrative transactional business. While this model works well for large corporates, that maintain a panel of lending banks or joint corporate brokers, the FCA notes that medium and small-sized corporates may feel the need to reward a lending bank or corporate broker with subsequent transactional mandates.

The FCA believes that this can be further exacerbated by the use of clauses in engagement letters restricting a corporate’s future choice of supplier. As a result, banks providing only transactional services may not be able to compete effectively.

Other practices where the FCA identifies potential concerns include:

The blackout period in the UK IPO process, which is typically a 14-day period between publication of the research and availability of the prospectus. The report states that, when coupled with a lack of access to the issuer’s management for non-syndicate bank analysts, this delays and reduces the diversity of information available to investors.
The IPO allocation process. The occasional paper analyses data from allocations for the period from January 2010 to May 2015. While the FCA found evidence of good practice, in the sample studied it also found evidence of a skew in allocations towards buy-side investors from whom banks derive revenue from other business lines.
Investment bank league tables. The report finds that these can be misleading, noting that banks may choose to enter into loss-making transactions to support their position in league tables.

The practice of reciprocity, that is, a bank issuing a mandate to another bank partly based on how much business it will receive in return, and syndication size and composition were also examined, but the FCA is not pursuing further action at this stage.

Potential remedies

The potential remedies proposed by the FCA at this stage in their review include the following.

Universal banking and cross-subsidies. The FCA does not think that highly interventionist measures are warranted at this stage and instead has focused on lowering barriers to entry and expansion for non-universal banks and other service providers by:

Aiming to remove the practice of banks using clauses that restrict choice in engagement letters. The FCA is, however, interested in understanding whether these clauses can lead to more favourable terms for clients.
Seeking views on whether there are proportionate ways to reduce barriers to competition for non-universal banks and other service providers without undermining the efficiency benefits of cross-selling.

IPO process. The discussion paper explores potential avenues for reforming the IPO process and is intended to be a stimulus for debate. If implemented, the proposals could have a significant impact on an IPO timetable.

The FCA’s stated aims are to: restore the prospectus as the central document in the IPO process by requiring or encouraging a re-ordering of the process to reduce the reliance placed on connected research to inform investor decisions; foster high standards of market conduct, in particular with respect to connected research; and encourage more unconnected research during the IPO process. To this end, and to frame discussion with market participants, the FCA has put forward three possible alternative models:

A blackout on connected research until seven days after an approved prospectus is published.
Analyst presentations to be open to unconnected research analysts and a blackout on connected research until seven days after publication of an approved prospectus.
Analyst presentations to be open to unconnected analysts and those meetings to be prohibited from taking place before publication of an approved prospectus.

It is worth noting that the third option is similar to the IPO process in France and would likely involve a significant extension to the public phase of an IPO.

The FCA is unclear as to the extent to which perceived legal and regulatory risks (issuer liability and potential loss of connected analyst independence) underpin the blackout period and has asked for further submissions. The proposed models do not seem to acknowledge the need for an investor education period, and likewise, potentially an extension of the blackout period following publication of research, resulting in an overall extension of the public phase of the IPO.

The FCA also looks at analysts’ involvement in the "private phase" of an IPO, referred to as the period before the formation of the syndicate, and specifically references meetings between analysts and the issuer’s management that occur before a mandate has been awarded. Market participants are asked to respond with views on whether they have any concerns with how conflicts are managed during the pitch process and, if so, how this could be improved, including whether clarification of the FCA’s expectations in this area would be helpful.

It is worth noting that the FCA is alert to the need to avoid unwarranted lengthening of the IPO timetable, or indeed any other unnecessary disruption to the established market practice that has developed around what is a comparatively modest regulatory framework. The FCA has not sought to prohibit pre-IPO research and recognises its benefits, including the potential disadvantages of not having written research but allowing analysts to engage in discussions with investors, as is the practice in the US.

Allocations. At this stage, the FCA states that it plans to investigate the evidence of the skew in allocations further with individual banks. The FCA intends to focus on ensuring compliance with its existing rules and guidance and assisting banks to prepare for the requirements that will be introduced under the MiFID II Directive (2014/65/EU) and the Markets in Financial Instruments Regulation (600/2014/EU).

League tables. The FCA is consulting on whether there are remedies that could help to increase the credibility of league tables by exploring ways in which they could be better presented so that they are more meaningful for clients and remove incentives for conducting trades carried out at a loss for the purpose of gaining credit. The FCA favours an industry-led solution and is seeking stakeholder views.

John Lane and Nicole Kar are partners at Linklaters LLP.

The interim report is at www.fca.org.uk/static/documents/market-studies/ms15-1-2-interim-report.pdf, and the occasional paper is at www.fca.org.uk/news/occasional-paper-no-15 and comments are requested by 25 May 2016. The discussion paper is at www.fca.org.uk/news/dp16-03-availability-of-information-in-the-uk-equity-ipo-process and comments are requested by 13 July 2016.

Background to the report

In July 2014, the FCA launched a review of competition in the wholesale sector and sought views on areas that might benefit from further investigation through an in-depth market study (www.practicallaw.com/4-578-8370). In February 2015, the FCA published a report stating that feedback received and the FCA’s own analysis indicated that competition may not be working effectively in the sector, particularly due to limited transparency of price and quality, and the bundling and cross-selling of investment and corporate banking services making it difficult for new entrants to compete.

On 22 May 2015, the FCA launched its market study into investment and corporate banking with the publication of its terms of reference, which identified three principal areas of investigation:

Whether the choice of supplier for corporate and investment banking services is more limited for particular types of clients.
Whether clients are hindered from making effective choices because of a lack of transparency in respect of the scope of services provided and fees.
Whether cross-selling, bundling, and cross-subsidisation of services limits the effectiveness of competition (see News brief "Investment and corporate banking: the FCA studies the market").

The market study focuses on the provision of regulated primary market and related services, such as corporate banking and ancillary services, insofar as they may affect competition for primary market services carried out in the UK by investment and corporate banking services providers. The primary market activities that are subject to the scope of the market study include:

Capital raising in equity capital markets and debt capital markets including: advising issuer clients on valuation, pricing and marketing the issue; syndication; arranging placement of an issue; and the provision of underwriting services.
Transaction services, such as identifying potential opportunities for mergers and acquisitions (M&A), and advising on restructuring and corporate recapitalisation.
Corporate advisory services to clients seeking to engage in M&A and capital-raising activity, such as advice on capital and legal restructuring, and acquisition advice, such as the provision of debt financing services to support planned acquisitions.

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