The SEC recently provided welcome relief for US broker-dealers engaged in business with European investment managers, issuing no-action letters designed to balance the requirements of US regulations applicable to those broker-dealers with new requirements imposed under the European Union’s Markets in Financial Instruments Directive (MiFID II), which take effect on January 3, 2018. The relief will allow compliance with certain research payment "unbundling" requirements that require EU investment managers to pay separately for investment research received from broker-dealers that execute securities transactions for such investment managers.
The MiFID II requirements prohibit EU investment managers from accepting any inducement, including investment research, from those with whom they conduct business. They can receive research only if they pay for it directly (ie, out of their own funds) or, with client approval, they pay for it from a client-funded research payment account (RPA) (or a combination of both methods). The RPA must be funded via a separate charge assessed to each client pursuant to an agreed-upon research budget, and paid for with separate cash contributions from the client or levied and debited on a trade-by-trade basis alongside but separate from payments for trade execution. The payments may not be linked to the volume or value of transactions.
The problem for US broker-dealers is that the Investment Advisers Act of 1940 defines an "investment adviser" as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities." The Act exempts "any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor" (emphasis added). The SEC traditionally has taken the position that providing research may constitute providing investment advice; however, since broker-dealers generally include the cost of research in the commissions they charge, they are exempt from treatment as investment advisers. If they begin receiving separate payments for research, that likely would be "special compensation" and the broker-dealers would lose their Advisers Act exemption.
In requesting relief, The Security Industry and Financial Markets Association (SIFMA) explained that treating broker-dealers as investment advisers would upset long-established business models already subject to comprehensive regulation under SEC and FINRA oversight. SIFMA also explained that if US broker-dealers are deemed to be investment advisers, they may cease providing research to EU managers, or they could continue to provide research and be treated as investment advisers. Neither would be desirable. In response, the SEC Division of Investment Management agreed not to recommend enforcement if a broker-dealer provides research to a manager that is required to pay separately for the research pursuant to MiFID II.
The relief is temporary – granted for 30 months from MiFID II's implementation date. This will permit US firms to comply with MiFID II while providing the SEC with adequate time to analyze, evaluate and better understand the impact on firms' business practices. The SEC also will consider whether any different relief is needed, including new rules. The SEC requests comments, data and information relating to the impact of the MiFID II requirement on broker-dealers, investors, and the research itself, preferably a year before the temporary relief expires. The SEC also stated that the relief may or may not be renewed "as appropriate."
The Division of Investment Management also provided MiFID II-related no-action relief requested by the Investment Company Institute (ICI) under the Advisers Act, and the Investment Company Act of 1940, permitting advisers to continue the procedure of aggregating client orders for securities transactions, where certain clients may end up paying different amounts for research because of the MiFID II requirement while all clients pay the same average price for purchases (or receive the same proceeds for sales) and pay the same execution costs. Subject to certain conditions, the Division will not recommend enforcement against advisers that aggregate orders for clients (including registered investment companies) following implementation of MiFID II. ICI argued that aggregation benefits clients generally and that without relief advisers might be forced to place competing orders for the same security into the marketplace, resulting in inferior executions for clients generally and potentially benefiting one group of clients at the expense of another – the harm that the SEC's earlier relief allowing aggregation was intended to address.
Finally, the SEC's Division of Trading and Markets provided MiFID II-related no-action relief requested by the SIFMA Asset Management Group to address issues raised by the MiFID II requirement under the soft-dollar "safe harbor" provisions in Section 28(e) of the Securities Exchange Act of 1934. US investment managers often use client commission arrangements (CCAs) to obtain brokerage and research services from a broker-dealer, using a single "bundled" commission for execution and safe-harbor-eligible brokerage and research. The executing broker credits part of the commission for research to a CCA it administers and retains the rest for the execution, or forwards the research portion to a CCA administered by an external administrator. The investment manager then receives research from a third-party provider or the executing broker, paid for by CCA assets and thus satisfying the conditions of the safe harbor. The Division of Trading and Markets provided relief, subject to conditions, to allow investment managers to remain within the safe harbor if the investment manager pays an executing broker-dealer for research out of client assets, alongside payments for execution, using an RPA that conforms to the MiFID II requirement, provided that the executing broker-dealer is legally obligated to pay for the research and all other applicable conditions of the safe harbor are met.
The foregoing is a summary. For a more in-depth discussion of the SEC’s no action letters, please see our Client Alert.