On Oct. 26, 2017, the U.S. Securities and Exchange Commission (SEC) staff issued three no-action letters intended to provide guidance to broker-dealers and investment advisers affected by the European Union’s Markets in Financial Instruments Directive (MiFID) II requirements, which become effective on Jan 3, 2018. MiFID II, among other requirements, compels EU investment managers to pay separately for trade execution and for investment research — services that historically have been bundled in the U.S. Specifically, the SEC staff advised:
- Investment adviser registration for broker-dealers. In a letter to the Securities Industry and Financial Markets Association (SIFMA), the SEC Division of Investment Management staff stated that for the first 30 months after the implementation of MiFID II (i.e., until July 2020), a U.S. broker-dealer may accept payments from an investment manager required by MiFID II to pay for investment research, without being registered as an investment adviser.
- Section 28(e) of the Exchange Act. In a letter to the SIFMA Asset Management Group, the SEC Division of Trading and Markets stated that payments made to an executing broker-dealer out of client assets for research, if made alongside payments to that executing broker-dealer for execution, would qualify under the safe harbor in Section 28(e) of the Securities Exchange Act of 1934 so long as all of the other conditions for reliance on Section 28(e) were also satisfied.
- Aggregation. In a letter to the Investment Company Institute (ICI), the SEC Division of Investment Management staff stated that an investment adviser may aggregate orders for execution without violating Section 17(d) of the Investment Company Act or Rule 17d-1 if the orders participate in the same average price for the underlying security and pay the same pro rata share of execution costs, even if some of the orders pay for research costs and others of the orders (because of MiFID II) do not.
On the same day, in what appears to be a coordinated move, the European Commission published FAQs on EU MiFID firms obtaining brokerage and research services from non-EU brokers.
Investment adviser registration for broker-dealers
The relief permits broker-dealers to accept hard dollars from investment managers that are “required under [MiFID II] … either directly or by contractual obligation” to pay for research with their own money or through a separate research payment account funded by client money (or a combination of the two) without requiring those broker-dealers to register as investment advisers. This means the broker dealer would be permitted to accept hard dollars for research paid for by either an EU MiFID firm or, say, a U.S. subadviser that is a delegate of an EU MiFID firm where the U.S. subadviser is contractually required to satisfy the MiFID II research unbundling requirements.1
Broker-dealers had been concerned that accepting “hard dollar” payments for research might be considered “special compensation” under Section 202(a)(11)(C) of the Investment Advisers Act of 1940 and thus would require them to register as investment advisers. Moving the research function to investment advisers would not have been in the SEC’s interest – both SEC Regulation AC and the Financial Industry Regulatory Authority (FINRA) research rules, adopted in the wake of the 2002 research analyst scandal, are premised on research being produced by broker-dealers and do not apply to investment advisers. But the SEC staff, after having its interpretation of “special compensation” rejected in Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Cir. 2007), felt it had limited interpretive flexibility. As a result, the SEC staff issued a time-limited no-action letter so it can “better understand the evolution of business practices after the implementation of MIFID II.” SEC Commissioner Kara Stein issued a statement criticizing this letter as “merely kick[ing] the can down the road” and encouraged full notice-and-comment rulemaking on the issue.
Section 28(e) of the Exchange Act
Section 28(e) of the Exchange Act, adopted as part of the end of fixed commissions in 1975, provides a safe harbor that allows an investment adviser to pay a commission higher than the lowest commission available in the market if the investment adviser receives research along with trade execution services. This practice has become known as “soft dollar” payments for research. Absent SEC guidance, the MiFID II requirement that trade execution payments be separated from research payments would have resulted in the research payments being deemed “hard dollars” — something that always has been permitted under U.S. law but that is simply outside the Section 28(e) safe harbor. However, many U.S. investment managers had disclosed that they obtain their research in compliance with the Section 28(e) safe harbor, and an important Employee Retirement Income Security Act (ERISA)-prohibited transaction exemption relies on compliance with the Section 28(e) safe harbor. The new SEC no-action letter allows investment managers to take the position that if they comply with the “transaction method,” also referred to as the “CSA method” (i.e., using commission sharing arrangements) of payment for research under MiFID II, they are within the Section 28(e) safe harbor. This SEC no-action letter does not appear to apply to firms that use the “accounting method” of payment for research under MiFID II or that simply pay for research out of the adviser’s profits. This ambiguity exists even though the EU views all three methods as economically indistinguishable.
As the SEC staff acknowledged, aggregation of trade orders among related mutual funds and separate accounts often benefits clients by preventing different clients’ orders from competing with each other. A 1995 no-action letter to SMC Capital gave the industry helpful guidance when aggregating orders. But the SMC Capital guidance could not have applied to EU orders (with research costs separated from trade execution costs) and U.S. orders (with both sets of costs bundled). The ICI letter provides guidance for what will be a common scenario.
The three SEC no-action letters answer some questions but leave others unanswered.
As discussed above, the no-action relief for broker-dealers from investment advisers applies to investment managers who are subject to MIFID II “either directly or contractually.” The “contractual” language appears tailored to cover U.S. subadvisers to EU investment managers. Whether it could be interpreted more broadly is an open question, although on the face of the letter, that does not appear clearly to be the policy intention.
Similarly, the Section 28(e) release leaves open questions: What does it imply about the fiduciary evaluation of hard dollar arrangements, and how should those arrangements be evaluated for ERISA purposes? The fact that the relief appears limited to the “transaction” or “CSA” methods of paying for research also means that the relief may not be not applicable to most fixed income transactions, which are executed as principal transactions with no “commission” paid as such; rather, the broker-dealer is paid through the spread built into the transaction amount. The SEC has given Section 28(e) relief for “Eligible Riskless Principal Transactions” in certain equity securities; when some fixed-income riskless principal markups and markdowns are disclosed (starting in 2018), might the SEC grant similar Section 28(e) relief for fixed-income riskless principal trades?
And the no-action relief for broker-dealers from investment advisers is time-limited. Will the SEC start a rulemaking proceeding to address research issues? Will research migrate out of the highly regulated broker-dealer environment to the more principles-based investment adviser regime? There also remains open the question of whether the separation of research from trade executions in the EU will, as a business matter, force a separation of the two services in the U.S. If so, what are the implications for the availability of research on small issuers at a time when SEC Chair Jay Clayton says he wants to encourage more initial public offerings, but small companies already find it difficult to attract research coverage?