Summary: Following the implementation of MiFID II, the vast majority of firms that receive investment research have chosen to pay for it out of their own funds. However, there are still a number of questions and ambiguities in the new inducements and investment research regime under MiFID II. In this blog Daniel Csefalvay and Joseph Ninan look at how providers and recipients of investment research are responding to the new regime.
In the run up to the implementation of MiFID II one of the biggest areas of concerns was the impact of the new rules governing how buy-side firms could receive investment research. The FCA’s longstanding antipathy towards the bundling of research and execution costs, paid for by dealing commission, found its way into the MiFID II inducement rules.
Under these rules MiFID investment management firms (and firms providing independent advice) must pay for investment research either out of their own funds or through a segregated research payment account (“RPA”). If a firm chooses to pay for research out of an RPA, they must comply with specific requirements concerning the administration of the RPA. However, as a result of the legal and operational complexities associated with the RPA option, the vast majority of firms have instead chosen to pay for research themselves, rather than passing on the cost to their clients via an RPA. We go into more detail on the substantive investment research rules (including those governing RPAs) in this article, first published in Butterworths Journal of International Banking and Financial Law.
Even though the RPA approach has been abandoned by the market almost entirely, there remain open questions about how the nature of the market for research will evolve. One of the key open issues relates to how the sell-side will go about pricing the research it produces and whether the particular pricing methodologies they adopt might still give rise to inducement problems for the buy-side. While MiFID II imposes an obligation on sell-side firms to price their execution services separately from other services or benefits they provide, there is minimal regulatory guidance on how they should go about pricing those other benefits, including research. The regime merely states that the provision of, and fees charged for, these non-execution services and benefits must not be influenced by the levels of payment for execution services.
Another interesting area of evolving market practice relates to the way in which many buy-side firms are reacting to the receipt of benefits from the sell-side. Given the restrictions on receiving research apply directly to these buy-side firms, many are taking a very cautious approach towards the receipt of anything provided to them by the sell-side. This can result in debates between the buy and the sell-sides about the legal characterisation of particular items that are being provided and discussions about operational issues involved in seeking to resolve these divergences on an ongoing basis.
In this regard, some specialist corporate finance houses have been (correctly) arguing that the research they produce is “issuer sponsored” and so falls within the “acceptable minor non-monetary benefit” exemption. Under this exemption, buy-side firms can receive this research free of charge, as it is published by the research providers on behalf of their corporate issuer clients. Such research is not considered an inducement under the MiFID II rules. Nevertheless, because of ambiguities in the way the rules are drafted, the buy-side is reluctant to receive such research without paying for it, as it prima facie looks like substantive research which should be subject to the general research restriction. Similar issues are arising over the provision of corporate access and the extent to which such access can be provided without it being considered an inducement. This issue is particularly acute for corporate finance firms which do not provide execution services and for which the conflict of interests usually present (and which the new inducement rules are designed to prevent) do not exist. The rationale behind the application of the rules towards firms which do not provide execution services, is not clear.
Given that the research rules were driven into MiFID II by the FCA, it is highly likely that this will be an area of thematic focus for the FCA in the months ahead. Accordingly, this is an area in relation to which firms must vigilantly continue to assess their own practices and to monitor market developments and any new regulatory guidance.