On October 26, 2017, the US Securities and Exchange Commission, European Commission and the UK Financial Conduct Authority released, in a coordinated manner, a series of significant orders and guidance to address some of the most problematic extraterritorial effects of the EU’s new financial regulation, MiFID II. The Staff of the SEC issued three no-action letters, designed to address concerns from US broker-dealers and investment advisers regarding their need to charge for research in the manner required by their European clients under MiFID II. On the same day, the European Commission published guidance (in the form of two “frequently asked questions”) regarding two key issues related to research payments and the FCA also provided guidance regarding acceptable cross-border compliance models. This note discusses the SEC, EC and FCA statements and the implications for research payment arrangements involving MiFID II regulated firms.
We have separately covered the impact of MiFID II on certain non-EU firms and the latest developments on payments for research in two recent client notes and webinars:
Client publication: MiFID II for Non-EU Fund Managers, June 21, 2017.
Client publication: MiFID II for Non-EU Investment Banks and Brokers, September 18, 2017.
Webinar: MiFID II for Non-EU Investment Banks, Brokers and Fund Managers, London and New York, October 10, 2017.
Webinar: MiFID II - SEC and EC Relief on Inducements and Research, London and New York, November 1, 2017.
MiFID II, Inducements and Research
The Markets in Financial Instruments Directive and its predecessor the Investment Services Directive have been the cornerstone of EU financial markets regulation since the 1990s. The latest update to this regime, MiFID II, comes into effect in January 2018. One of MiFID II’s aims is to give investors transparency into the cost of both research and trading commissions, by requiring payments for these elements to be unbundled. The research that investment managers typically receive from brokers will, under MiFID II, generally be classified as a prohibited “inducement” unless the investment manager pays for the research either: (a) directly from its own resources; (b) from a “Research Payment Account” funded with an advisory client’s money and with the client’s prior approval; or (c) a combination of the two methods.
Further information on MiFID II, and the inducement rules in particular, is available in the client notes and webinars linked above.
Industry Practice and the Unintended Regulatory Conflict Arising From MiFID II’s Research Payment Rules
It has long been industry practice to use client trading commissions to pay for both trade execution and fund research provided by executing broker-dealers. US investment managers (“money managers”) often make use of client commission arrangements to obtain brokerage and research services from a broker-dealer using a single bundled commission. Commissions can be used to pay for research from third-party research providers, when a commission sharing or “soft dollar” structure is established.
EU brokers will be required to price their research separately from execution costs when MiFID II comes into effect. The scope of MiFID II’s territorial reach means that it will only apply directly to EU-regulated investment firms. However, non-EU brokers may be affected by the legislation in several respects, due to new requirements on EU client entities or EU affiliates. As a result of MiFID II:
Executing non-EU brokers that are used to receiving a single, bundled commission may be asked by EU investment managers to receive separate payments for research and execution;
Non-EU delegates that provide sub-advisory or managed account services to EU asset or portfolio managers may be required by contract to comply with MiFID II or equivalent unbundling requirements;
Non-EU investment advisers may be required to purchase research in a MiFID II-compliant when they deal with EU brokers.
Broker-Dealers’ Receipt of “Hard Dollar” Payments From RPAs
A significant concern of US broker-dealers has been that receiving MiFID II-compliant direct payments for research from EU investment managers will amount to accepting “hard dollar” payments. US broker-dealers have historically benefited from an exemption from regulation under the Investment Advisers Act 1940, if any advice they provide is “incidental” to their business and they receive no “special compensation” for providing the advice. MiFID II-compliant hard dollar payments for research could be considered “special compensation” under Section 202(a)(11)(C) of the Investment Advisers Act, which would vitiate the exemption and would therefore require them to register and be regulated as investment advisers.
Under the Investment Advisers Act, an investment adviser is a “fiduciary” to its advisory clients. Fiduciary duties include a fundamental obligation on an investment adviser to act in the best interests of its clients and to provide investment advice in its clients’ best interests, along with a duty of loyalty and good faith. Although some US broker-dealers are already additionally regulated as investment advisers or have affiliated investment advisers, others prefer to avoid fiduciary obligations and uncertainties of the application of the investment adviser regulation regime to the publication and distribution of research.
In response to a letter from the Securities Industry and Financial Markets Association, the Investment Management Division of the SEC has issued a “no action” letter specifically to address this concern. The letter confirms that the SEC Staff will not recommend enforcement action if a broker-dealer provides research services that constitute “investment advice” under section 202(a)(11) of the Investment Advisers Act to an investment manager that is required to pay for the research services by using research payments under MiFID II.
This relief covers both (a) EU-based investment managers that are directly subject to the requirements of MiFID II and (b) non-EU domiciled delegates that are contractually (rather than as a regulatory matter) required to comply with MiFID II.
The relief is time-limited to 30 months from MiFID II’s implementation on January 3, 2018. During this time, the SEC will monitor and assess the impact of the MiFID II research payment provisions, with a view to determining whether more tailored or different action (such as making new rules) is necessary or appropriate. This has been criticised as “kicking the can down the road” by at least one dissenting SEC Commissioner, who wrote that full notice-and-comment rulemaking on the issue should be undertaken. The mood of the industry, on the other hand, is that the temporary period is a welcome — if partial and temporary — reprieve, and that it will take time for new industry norms to develop.
In the US, there are money managers that are considering requiring the payment of hard dollars for research, in some cases to harmonize the compliance of a fund, or a family of funds, with EU-compliant affiliates. The relief provided by the no-action letter is partial because it would appear not to address the receipt of hard dollars by US broker-dealers when the payer is electing or voluntarily choosing to pay for research in hard dollars, as opposed to using a traditionally bundled commission, but is not under any contractual obligation to do so.
Concern From US Investment Advisers That Aggregate Client Orders
Aggregation of trade orders among different clients can benefit clients by preventing competing orders and by increasing the probability of price improvement over smaller orders. The SEC Staff issued a no-action letter to SMC Capital in 1995, which has provided the industry with helpful guidance when aggregating orders. In relation to the SMC Capital case, SEC Staff stated 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 Investment Advisers Act if the adviser implements procedures designed to prevent any account from being systematically disadvantaged by the aggregation of orders.”
The effect of MiFID II is likely to be that, once the legislation is in force, clients will be paying different amounts in respect of research and execution costs for the same aggregated order. For example, some clients may be paying only for execution while others are paying for both execution and research.
There is some question whether the SMC Capital guidance would apply to both EU orders that separate research costs from trade execution costs and US orders that bundle sets of costs together, because the relief in SMC Capital is premised on clients paying a pro rata share of all costs. This point was brought to the attention of the SEC Staff by the Investment Company Institute. The response of the SEC’s Investment Management Division has been an additional no-action letter which provides an alternative approach to address MiFID II concerns, without superseding the position in SMC Capital. The relief provides that SEC staff would not recommend enforcement action to the Commission under Section 17(d) of the 1940 Act and Rule 17d-1 thereunder, or Section 206 of the Investment Advisers Act, against an investment adviser that aggregates orders for the sale or purchase of securities on behalf of its clients in reliance on the position taken in SMC Capital while accommodating the differing arrangements regarding the payment for research that will be required by MiFID II.
This relief allows investment advisers to continue to aggregate client orders while accommodating differing research payment arrangements, provided that the investment adviser implements procedures reasonably designed to prevent any account from being systematically advantaged or disadvantaged by the aggregation of orders. These procedures must ensure that each client in an aggregated order will continue to pay or receive the same average price for the purchase or sale of the relevant security and will pay the same amount for execution. Again, the relief is partial in that it includes a footnote suggesting limitations similar to those applied to the broker-dealer letter, discussed in the previous section. Nonetheless, firms appear likely to continue their trade aggregation and allocation practices largely without interruption.
Effect of MiFID II on the “Soft Dollar” Safe Harbor Under Section 28(e) Exchange Act
A safe harbor for “soft dollar” payments for research is provided by Section 28(e) of the Exchange Act 1934. A money manager that satisfies the conditions of Section 28(e) does not act unlawfully or breach its fiduciary duties solely on the basis that the 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.
These “soft dollar” payments for research are a long-standing market practice in the US. SIFMA wrote to the SEC with the concern that, absent SEC guidance, the MiFID II requirement that trade execution payments be separated from research payments could result in the research payments being deemed “hard dollars,” which fall outside the Section 28(e) safe harbor. Whilst investment advisers are permitted to receive hard dollars, the availability of the safe harbor is significant for ensuring certain transactions are not likely to be prohibited. The application of Section 28(e) has been the subject of extensive interpretation and guidance over the years.
Client Commission Arrangements are capable of falling within the Section 28(e) safe harbor. SIFMA urged the SEC to confirm that RPAs can also qualify, on the basis that the differences between RPAs and CCAs do not change the economic arrangement of the payment for research and should not result in different treatment for purposes of Section 28(e).
The response of the SEC’s Trading and Markets Division is that its Staff will not recommend enforcement action against a money manager seeking to operate in reliance on Section 28(e) of the Exchange Act if it pays for research through the use of an RPA and conforms to the requirements for RPAs in MiFID II, provided that all other applicable conditions of Section 28(e) are met. In particular, the relief will only be available if all of the following four conditions are complied with:
The money manager makes payments to the executing broker-dealer out of client assets for research alongside payments to that executing broker-dealer for execution;
The research payments are for research services that are eligible for the safe harbour under Section 28(e);
The executing broker-dealer effects the securities transaction for purposes of Section 28(e); and
The executing broker-dealer is legally obligated by contract with the money manager to pay for research through the use of an RPA in connection with a CCA.
Enforcement-Only Status of SEC Letters
All three of the SEC Staff’s no-action letters are enforcement-only letters. This means the letters are not “interpreting” law, only stating an intention not to recommend enforcement on a specific set of facts. Notably, an “interpretive” letter is more likely to be seen as binding other interested regulators or private litigants.
New Guidance From the European Commission on Operational Bundling
The SEC Staff’s no-action letters followed months of discussions with the European Commission and other EU regulators. The European Commission issued answers to frequently asked questions on the same day as the SEC no-action letters. The EC gave important confirmation that research and execution can continue to be combined into a single commission operationally. The traditional “uplifted” brokerage fee to incorporate a research charge can still be used, provided that the MIFID II-regulated recipient of the research can identify the amount of the fee that is attributable to research. Where an EU asset manager chooses to use the RPA option to pay for research, it must comply with all RPA requirements including maintaining a clear audit trail of all payments to research providers. It must be able at all times to identify — in relation to each client — the amount spent on research with a particular non-EU broker-dealer.
The EC has also clarified that non-EU broker-dealers are not required to separate out research charges or invoice them separately. The EU investment manager (or its non-EU sub-adviser) receiving the research is responsible for ensuring compliance with MiFID II research requirements and for separately accounting for research and commission where these are bundled at investment manager level. In practice, EU asset managers are likely to look to their research providers for information to assist them in identifying the amounts attributable to research.
FCA Guidance on Cross-Border Structures
The UK Financial Conduct Authority issued a statement welcoming the publication of the SEC and EC guidance as a constructive outcome that “represents a flexible solution that respects the integrity of both regulatory regimes.”
The FCA stated that it would view arrangements which comply with MiFID II and other jurisdictions’ rules, while enabling EU firms’ continued access to research produced by US and other non-EU jurisdictions as likely to be the best way of serving investors.
The FCA made two further pieces of important guidance in relation to cross-border structures in its statement, clarifying that:
It would be a compliant structure for a UK asset manager to pay the EU entity of a broker for global research content, such that research from US or other affiliates is charged via an EU broker.
It would also be compliant for research to be circulated within a buy-side group, e.g. purchased through a US fund manager to US broker relationship and then shared between the US fund manager and its EU affiliates.
In each case, there is a proviso that the structures must not influence the firm’s order routing decisions, execution costs and ability to act in its clients’ best interests.