On October 26, 2017, the staff of the SEC, following consultation with European authorities, issued three no-action letters to provide guidance to market participants seeking to comply with the requirements of the European Union’s (EU) Markets in Financial Instruments Directive II (MiFID II) that take effect on January 3, 2018.
MiFID II will, among other things, generally prohibit certain investment advisers from receiving or retaining “inducements” from a third party—such as commissions, fees or other monetary or non-monetary benefits, including, importantly, certain research from an executing broker-dealer—in connection with providing any investment or ancillary service to a client. Under MiFID II, an investment adviser can continue to receive research without violating the inducement prohibition if the investment adviser pays for that research (1) directly (i.e., out of the investment adviser’s own resources); (2) with client approval, from a separate research payment account (RPA) controlled by the adviser, funded with client assets and subject to a research budget that is regularly assessed and agreed upon with the client; or (3) through a combination of (1) and (2). The practical effect of the foregoing is the required separation of bundled commission payments for research and brokerage services made by investment advisers subject to MiFID, either directly or by contractual obligation.1
Subject to various terms and conditions, the three no-action letters essentially provide that: (1) broker-dealers, for 30 months from MiFID II’s implementation date, may receive separate payments for research—in hard dollars or through a MiFID II-governed RPA—without being considered, and possibly having to register as, an investment adviser under the Investment Advisers Act of 1940; (2) investment advisers may continue to aggregate client orders for purchases and sales of securities, with some clients paying different amounts for research because of MiFID II requirements, but with all clients continuing to pay the same average price and execution cost for a given security in an aggregated order; and (3) investment advisers may continue to rely on the soft dollar “safe harbor” under Section 28(e) of the Securities Exchange Act of 1934 when making payments to an executing broker-dealer out of client assets for research alongside execution payments through the use of a MiFID II-compliant RPA, provided that conditions of the Section 28(e) safe harbor are otherwise met.
We discuss each of the three no-action letters in greater detail below.
Division of Investment Management Staff Issues Temporary No-Action Relief Concerning Advisers Act Treatment of Broker-Dealers Providing Research Services to Investment Managers Subject to MiFID II
In a letter to the Securities Industry and Financial Markets Association (SIFMA), the staff of the SEC’s Division of Investment Management provided assurance, on a temporary basis, that it would not recommend that the SEC take enforcement action under the Advisers Act against a broker-dealer that provides research services that constitute investment advice under Section 202(a)(11) of the Advisers Act to an investment adviser that is required under MiFID II, either directly or by contractual obligation, to pay for the research services from its own resources or from an RPA funded with its clients’ money, or a combination of the two. The letter states that such assurance will expire on July 3, 2020, 30 months after MiFID II’s January 3, 2018 implementation date (the Temporary Period), and may or may not be renewed at that time.
SIFMA’s letter to the SEC staff requesting no-action assurance (the SIFMA Incoming Letter) stated that U.S. brokerdealers (and their EU broker-dealer affiliates) that provide research services to investment advisers subject to MiFID II can expect to receive separate payments for those research services. The SIFMA Incoming Letter expressed the concern that the receipt of such separate research payments might “inadvertently subject broker-dealers’ research services to the Advisers Act by creating questions about their ability to rely on the longstanding broker-dealer exclusion, and thereby disrupt existing business models that are already subject to a comprehensive regulatory framework overseen by the SEC and [FINRA] . . . .” This concern relates to the general exclusion of broker-dealers from the definition of “investment adviser” under the Advisers Act if the broker-dealer’s investment advisory services are “solely incidental to the conduct of his business as a broker or dealer” and the broker-dealer “receives no special compensation therefor” and the interpretation of “special compensation” vis-à-vis a separate, unbundled payment for research services. As articulated in a footnote to the SIFMA Incoming Letter,
SIFMA members are concerned that, because the contours of what constitutes “special compensation” is not necessarily clear in the context of research services, the SEC or its staff might view a broker-dealer as receiving “special compensation” for investment advice it if receives payments for research services directly or indirectly out of an investment manager’s own money, from an RPA funded with the investment manager’s clients’ money, or a combination of the two.
SIFMA warned that subjecting broker-dealers to additional regulation (i.e., as investment advisers) could ultimately prevent investment advisers subject to MiFID II from accessing U.S. research services and could place U.S. broker-dealers at a competitive disadvantage vis-à-vis their European competitors when doing business with EU investment advisers.
In providing the requested relief, the SEC staff stated that its no-action position is “intended to address concerns that have arisen in light of the adoption of MiFID II while preserving choice in maintaining the SEC’s long-standing approach to arrangements under section 28(e) of the [Exchange Act].” The staff also stated that the Temporary Period is intended to give the staff sufficient time “to better understand the evolution of business practices after the implementation of MiFID II,” noting that EU regulators recently issued guidance on key aspects of MiFID II and that the Temporary Period would afford the industry “time to review, comprehend, and implement the guidance, and evaluate impacts on their business models.” The staff stated that it would continue to monitor and assess the impact of MiFID II’s requirements to determine if additional action is necessary.
The Division of Investment Management’s staff No-Action Letter to SIFMA regarding treatment of broker-dealers under the Advisers Act is available at: https://www.sec.gov/divisions/investment/noaction/2017/sifma-102617-202a.htm.
Division of Investment Management Staff Issues No-Action Letter Permitting Aggregation of Client Orders for Securities Transactions Subject to MiFID II
In a letter to the Investment Company Institute (ICI), the staff of the SEC’s Division of Investment Management provided assurance that it would not recommend that the SEC take enforcement action under Section 17(d) of the Investment Company Act of 1940 and Rule 17d-1 thereunder, or Section 206 of the Advisers Act, against an investment adviser that aggregates client orders for the purchase or sale of securities in reliance on the staff’s position in the 1995 no-action letter to SMC Capital, Inc. (SMC), while accommodating differing arrangements regarding the payment for research that will be required by MiFID II.
In the SMC no-action letter, the SEC staff took the position that the mere aggregation of orders for advisory clients, including collective investment vehicles in which the adviser, its principals or employees have an interest, would not violate Section 17(d) of the 1940 Act, Rule 17d-1 thereunder or Section 206 of the Advisers Act if the adviser implements procedures designed to prevent any account from being systematically disadvantaged by the aggregation of orders.
The standard set forth in the 1995 SMC no-action letter required that (1) once an aggregated order was executed, the trade would be allocated among clients in accordance with a pre-trade written statement specifying the participating client accounts and the intended allocation among them (Allocation Statement), and, if the order was only partially filled, the trade would be allocated pro rata based on the Allocation Statement; (2) each client that participated in an aggregated order would participate at the average share price; and (3) transaction costs would be shared pro rata based on each client’s participation in the transaction.
In its request for no-action relief, the ICI stated that following the implementation of MiFID II, within a given aggregated order, (1) clients (including registered funds) may pay total transaction costs that include the cost of execution as well as research services; whereas (2) other clients may pay different amounts in connection with the same trade (including possibly execution costs only). As a result of the various potential research arrangements and combinations thereof, clients may not pay a pro rata share of all costs (i.e., research payments) associated with an aggregated order. The ICI asserted that absent no-action relief expanding the relief in the SMC no-action letter, investment advisers might be forced to place into the market competing orders in the same security, possibly resulting in worse execution for clients overall and the potential for one set of clients to receive a benefit at the expense of another.
The relief granted by the SEC staff permits investment advisers to continue to aggregate client orders (including orders executed on behalf of registered funds) for purchases and sales of securities, with some clients paying different amounts for research because of MiFID II requirements, but with all clients continuing to pay the same average price and execution cost for a given security in an aggregated order. The relief is conditioned on the requirement that an investment adviser has adopted policies and procedures reasonably designed to ensure that:
(1) each client in an aggregated order pays the average price for the security and the same cost of execution (measured by rate);
(2) the payment for research in connection with the aggregated order will be consistent with each applicable jurisdiction’s regulatory requirements and disclosures to the client; and
(3) the subsequent allocation of such trade will conform to the adviser’s Allocation Statement and/or the investment adviser’s allocation procedures.
Furthermore, the relief does not apply to an investment adviser that is not subject to the requirements of MiFID II (either directly or contractually).
In a public statement accompanying the letter, the SEC stated that this relief provides clarity and consistency to investment advisers by permitting the continued aggregation of orders while addressing the differing arrangements regarding the payment for research that will be required by MiFID II.
The Division of Investment Management staff’s no-action letter to the ICI concerning aggregation of client orders under MiFID II is available at: https://www.sec.gov/divisions/investment/noaction/2017/ici-102617-17d1.htm.
Division of Trading and Markets Staff Provides No-Action Assurance Concerning MiFID II-Compliant Research Payments and Section 28(e)’s Safe Harbor
In a letter to SIFMA’s Asset Management Group (SIFMA AMG), the staff of the SEC’s Division of Trading and Markets provided assurance that it would not recommend that the SEC take enforcement action if, in compliance with MiFID II, an investment adviser uses client assets to make payment through an RPA for research alongside payments for execution services in reliance on the safe harbor of Section 28(e) of the Exchange Act.
Under the Section 28(e) safe harbor, an investment adviser that satisfies the conditions of the section does not act unlawfully or breach its fiduciary duties solely on the basis that the investment adviser uses client commissions to pay a broker-dealer more than the lowest available commission rate for eligible research and brokerage services provided by the broker-dealer. To fall within the Section 28(e) safe harbor, advisers and other fiduciaries must make a good faith determination that the amount of commission paid is reasonable in relation to the value of the brokerage and research services being provided.
In its letter requesting no-action assurance, SIFMA AMG stated that investment advisers in the United States often rely on a client commission arrangement (CCA) structure to pay a single bundled commission to broker-dealers for order execution and Section 28(e)-eligible brokerage and research services. Under such a structure, the executing broker-dealer credits the portion of the commission for research to a CCA administered by the executing broker-dealer and retains the remainder of the commission payment. An alternative to the foregoing, as described in SIFMA AMG’s letter, is an arrangement in which the executing broker-dealer forwards the research portion of the commission to a CCA administered by an external “aggregator” or administrator. In such circumstances, the investment adviser instructs the executing broker-dealer to deduct the portion of the commission payment for brokerage, including execution, from payments going to the CCA administered by that third party. In either case, the investment adviser receives research from a research provider or the executing broker-dealer that is paid for through a CCA funded with client assets.
SIFMA AMG asserted that although the commission paid by the client is bundled to include research and brokerage (including execution), it effectively becomes unbundled when, pursuant to the adviser’s agreement with the executing broker-dealer, the executing broker-dealer retains its brokerage portion and credits (in the case in which the executing broker-dealer administers the CCA) or transmits (in the case in which an external “aggregator” administers the CCA) the research portion to the CCA.
SIFMA AMG’s letter to the SEC staff stated that a “typical RPA” is expected to operate in a manner similar to the CCA model with two relevant distinctions: (1) the amount paid for research is identified separately from the amount paid for execution before the investment adviser makes the payments to the executing broker; i.e., the unbundling occurs at a different point in time; and (2) the RPA is required to be under the control of the investment adviser and the investment adviser is held responsible for the RPA. According to SIFMA AMG, despite these differences, an RPA structure does not change the economic arrangements for research payments already falling under Section 28(e) safe harbor, continues to protect against illegal payments to brokers that do not actually provide or pay for research and is consistent with the public policy of cost transparency.
SIFMA AMG’s letter to the SEC staff stated that when an RPA is operated in connection with a CCA, the research payments continue to be paid to the executing broker-dealer and the payments into the CCA are then routed into an RPA. Although the investment adviser may in some circumstances engage the executing broker-dealer or a thirdparty administrator to administer the RPA, in all cases the executing broker-dealer is contractually required to collect research payments alongside payments for execution services made by the investment adviser out of client assets and pay such amounts into the RPA.
In providing no-action assurance regarding an investment adviser seeking to operate in reliance on Section 28(e) of the Exchange Act if its pays for research through the use of RPA that conforms to the requirements of MiFID II, the SEC staff noted that the relief will apply only in the following circumstances:
(1) the investment adviser makes payments to the executing broker-dealer out of client assets for research alongside payments to that executing broker-dealer for execution;
(2) the research payments are for research services that are eligible for the safe harbor under Section 28(e);
(3) the executing broker-dealer effects the securities transactions for purposes of Section 28(e); and
(4) the executing broker-dealer is legally obligated by contract with the investment adviser to pay for research through the use of an RPA in connection with a CCA.
The SEC staff cautioned that its position “is subject to modification or revocation at any time.”
The Division of Trading and Markets staff’s no-action letter to SIFMA AMG addressing Section 28(e)’s safe harbor and RPA arrangements is available at: https://www.sec.gov/divisions/marketreg/mr-noaction/2017/sifma-amg- 102617-28e.pdf.