The issue of how investment research should be paid for by investors is controversial, long-standing and seemingly perennially the subject of legislative iterations, failure and unintended consequence and more reform. Before the mid-2000s, it was allowed for investment advisers to pay more than the lowest possible commission for brokerage and research, without being deemed to have breached their fiduciary duty, provided that the amount paid for research was reasonable in relation to the value of the research, and the advisers made certain disclosures about their practices. This remains allowed in the U.S. In the U.K., then later in the EU, various measures have been introduced to unbundle execution fees from research costs. The most onerous – and perhaps a now-receding high water mark of such interventions – occurred with the second Markets in Financial Instruments package (MiFID II). That regime is now the subject of multiple proposals for reform.
In the lead up to the EU’s MiFID II taking effect in 2018, there was considerable industry concern about the impact of the then new restrictions on inducements and the research unbundling rules. U.S. broker-dealers faced challenges because receiving MiFID II-compliant direct payments for research from EU investment managers would have amounted to accepting “hard dollar” payments, vitiating an important exclusion from being regulated as investment advisers.
On October 26, 2017, staff of the U.S. Securities and Exchange Commission issued a “no action” letter specifically addressing this concern. The letter confirmed that the SEC Staff would not recommend enforcement action if a broker-dealer received hard dollar payments for providing research that constituted “investment advice” under the Investment Advisers Act of 1940 (the “Advisers Act”) to an investment manager that is required to pay for the research services by using research payments under MiFID II. The relief was temporary and would expire on July 3, 2020. In 2019 it was extended to July 3, 2023. The SEC confirmed that post-Brexit the relief extended to research provided to an investment manager subject to the U.K.’s MiFID II requirements. This relief has been crucial in preserving the market for investment research.
On July 26, 2022, the SEC Staff announced that it would not further extend the no-action relief. As a result, some U.S. broker-dealers that receive or continue to receive “hard dollars” for research may become seen to be investment advisers and will need to consider possible solutions. At the same time, the EU and U.K. are considering liberating reforms in this area, citing unintended consequences of the existing regime.
This client note sets out the MiFID II requirements, the actions of the SEC, potential changes to the U.K. and EU MiFID II rules and the implications for broker-dealers that receive “hard dollars” for research.
MiFID II, Inducements and Research
In this note, when we refer to MiFID II, it is to both the EU’s MiFID II and the U.K.’s MiFID II. When we are discussing the particulars of one of those regimes, we specify the jurisdiction.
One of MiFID II’s declared aims was 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 is, under MiFID II, generally 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” (RPA) funded, with the client’s prior approval, with an advisory client’s money; or (c) a combination of the two methods.
As a result of MiFID II, U.K. and EU brokers are required to price their research separately from execution costs. Execution costs are then separately regulated by ‘best execution’ rules. The scope of MiFID II’s territorial reach means that it will only apply directly to U.K. and EU-regulated investment firms. However, brokers outside of the U.K. and EU are affected by the legislation in several respects, due to the requirements on U.K. and EU client entities or U.K. and EU affiliates that are passed on when U.S. persons deal with such clients.
Broker-Dealers’ Receipt of “Hard Dollar” Payments
U.S. broker-dealers have historically benefited from an exclusion from regulation under the Advisers Act if any investment advice they provide is “solely incidental” to their brokerage 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 Advisers Act, which would invalidate the exclusion, causing them to be regulated as investment advisers.
Under the 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 U.S. 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.
The SEC Staff “no action” letter confirmed that the Staff will not recommend enforcement action if a broker-dealer provides research services that constitute “investment advice” under section 202(a)(11) of the 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) U.K. or EU-based investment managers that are directly subject to the requirements of MiFID II and (b) non-U.K. and non-EU domiciled delegates that are contractually (rather than as a regulatory matter) required to comply with MiFID II.
The relief is temporary, and is set to expire on July 3, 2023. On July 26, 2022, William Birdthistle, Director, Division of Investment Management, SEC, announced in a speech at PLI’s Investment Management conference that the SEC Staff did not intend to further extend the relief beyond July 3, 2023.
Broker-dealers have opted to take various actions since the MiFID II rules came in, including:
- Registering (or retaining their status quo) as an investment adviser to receive the “hard dollars” payment and preparing and distributing research in accordance with compliance procedures under the Advisers Act. However, many broker-dealers are prohibited from registering with the SEC as investment advisers because they do not meet the threshold of having $100 million assets under management. These brokers need to comply with several of the Advisers Act requirements nonetheless, for example, the fiduciary obligations to those clients that pay hard dollars for research.
- Moving research operations into an affiliate investment adviser who sells their research for hard dollars.
- Shutting down research operations.
On February 21, 2023, SIFMA called for the SEC to extend the current no-action relief to allow broker-dealers to receive cash payments for research without being deemed investment advisers. SIFMA refers to the potential for the MiFID II research rules to be rolled back since both the EU and U.K. are re-assessing the rules, and urges the SEC to extend the relief so that those processes can run their course. Any such extension would be most welcome and would mean that U.S. broker-dealers would not need to restructure their operations for rules that may be removed or significantly amended.
The EU Proposals
In December 2022, the European Commission published a legislative proposal to amend EU MiFID II. The Commission has noted that EU MiFID II rules on unbundled research have failed to achieve all of their objectives. While the unbundling rules have met some objectives, such as improving the transparency of costs linked to research provision and better conflicts of interest management, the rules have led to the production of independent research becoming unsustainable. Furthermore, the exemption for research on smaller issuers was intended to improve small and medium-sized enterprises (SMEs) research coverage, but this has not been achieved because investment firms and brokers have chosen not to introduce two systems for research invoicing, and have instead retained the unbundled scheme for all clients. It is proposed that the existing exemption from the rules for research on listed and unlisted issuers with a market capitalization below EUR 1 billion would be extended to capture issuers with a market capitalization below EUR 10 billion.
As with the existing exemption, research carried out pursuant to the proposed extended exemption would still be subject to other EU MiFID II rules on conflicts of interest. In particular, the EU firm would have had to: (i) notified its clients of the joint payments for research and execution services; and (ii) entered into an agreement with the research provider identifying the part of any combined charges or joint payments for execution services and research that is attributable to research. The revised exemption would be available to EU MiFID II firms providing portfolio management or other investment or ancillary services to clients. For research on larger issuers, the existing regime would continue to apply. At this stage in the legislative process, it is not possible to know if this proposal will be adopted, or if adopted, in what form.
What will the U.K. do?
Post-Brexit, the U.K. adopted the MiFID II regime in whole but has embarked on a program of targeted reform already (which we discuss in our notes, “UK Wholesale Markets Review” and “UK Financial Services and Markets Bill 2022”). The U.K. has an exemption for research on SME issuers, although there are differences to the EU’s exemption. The U.K. exemption applies to research on listed and unlisted issuers with a market capitalization below £200 million and is available to all firms subject to the U.K. MiFID II rules, provided that the research is provided on a re-bundled basis or for free.
There are no proposals to amend this exemption or to make other changes to the research unbundling rules. However, there is the potential for such changes to be included in the Investment Research Review, which was announced as part of the Edinburgh Reforms (which we discuss in our note: “UK Government Publishes Edinburgh Reforms for Financial Services.”) The Investment Research Review will analyze the interplay between levels of research and the attractiveness of the U.K. as a listing venue, taking into account the effect of the UK MiFID II research unbundling rules on the amount and quality of research. The Review will report within three months of commencement and may make recommendations for legislative and non-legislative changes, which will be for the government, the FCA and industry to implement.