SEC provides relief to US firms attempting to comply with EU MiFID II's research "unbundling" provisions

Financial Services Alert

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The US Securities and Exchange Commission provided welcome relief for US broker-dealers engaging in securities business with European investment managers when it issued three no-action letters designed to balance the requirements of US regulations applicable to such broker-dealers with new requirements being imposed by the European Union under its Markets in Financial Instruments Directive, which take effect on January 3, 2018.

The relief, issued October 26, 2017, will allow compliance with certain research payment "unbundling" requirements (the "research payment requirement"), which will require EU investment managers to pay separately for investment research ("research") received from broker-dealers that execute securities transactions for such investment managers.

Background

Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments, and amending Directive 2002/92/EC and Directive 2011/61/EU, as implemented by the EU member states (MiFID II), prohibits EU investment managers from accepting any form of inducement from those with which they conduct business. Such inducements can include fees, commissions, and other monetary or non-monetary benefits, including the receipt of research. Pursuant to MiFID II, investment managers can receive research without violating the inducement prohibition only if they pay for that research directly (ie, out of their own funds) or, with client approval, they pay for it from a research payment account (RPA) funded with client money (or they can use a combination of both payment methods). The RPA must be funded via a separate research charge assessed to each client pursuant to an agreed-upon budget for research, 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 the execution of securities transactions; however, such payments may not be linked to the volume or value of transactions executed on behalf of such client.

The problem for US broker-dealers arises because Section 202(a)(11) of the Investment Advisers Act of 1940 (Advisers Act) 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." However, Section 202(a)(11)(C) of the Advisers Act exempts from the definition of investment adviser "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 has traditionally taken the position that providing research may constitute the provision of investment advice; however, since broker-dealers that provide research generally include the cost of that research in the commissions they charge for execution of securities transactions, Section 202(a)(11)(C) exempts them from treatment as investment advisers.

If those broker-dealers begin receiving separate payments for the research by investment managers complying with the MiFID II research payment requirement, those payments would likely qualify as "special compensation" and the broker-dealers would lose their Advisers Act exemption. And while such broker-dealers might be able to avoid the need to register with the SEC as investment advisers if they can demonstrate that they have less than $25 million in assets under management (see Advisers Act Section 203A(a)(1)(A)), they could still be subject to other Advisers Act requirements including treatment as a fiduciary, restrictions on certain types of trading with those customers deemed advisory clients (including acting as principal in transactions with such clients), and other requirements that could significantly change the relationship between such broker-dealers and their clients, and result in additional burdens and costs on both the broker-dealer and the customer side. Such broker-dealers also could be subject to registration and other requirements under various US states' securities laws.

Relief for US broker-dealers

In requesting the no-action relief, the Security Industry and Financial Markets Association (SIFMA) explained that requiring broker-dealers to register as investment advisers would upset long-established business models that are already subject to a comprehensive framework of regulation under the oversight of both the SEC and the Financial Industry Regulatory Authority (FINRA), including SEC Regulation AC and FINRA Rules 2240, 2241 and 5380, which impose significant requirements and restrictions on broker-dealers that provide research to their clients. If the result is that US broker-dealers providing research to EU investment managers are deemed to be investment advisers under the Advisers Act, such broker-dealers could either choose to cease providing research to EU investment managers, or they could continue to provide research and be treated as investment advisers. Neither approach is desirable. The former would result in EU investment managers losing a significant source of information as they conduct their advisory businesses, while the latter approach could limit the manner in which the broker-dealers effect transactions with or for those EU investment managers, including the restrictions on principal trading found in Advisers Act Section 206(3).

In response to SIFMA's request, the SEC Division of Investment Management agreed that it will not recommend enforcement action if a broker-dealer provides research to an investment manager that is required to pay for the research services pursuant to the research payment requirement. The relief, however, is temporary – granted for a temporary period of 30 months from MiFID II's implementation date (January 3, 2018). During that period, the Division of Investment Management will not consider such broker-dealers to be investment advisers. The temporary period is intended to permit US firms to comply with the research payment requirement without substantially altering treatment of those activities by the SEC, while providing the SEC with an adequate period during which it can the analyze, evaluate and better understand the impact of the research payment requirement on the firms' business practices. The SEC will also be considering whether any different or more tailored relief is needed, which could include new rules.

To facilitate its analysis, the SEC is asking the public to provide comments, data and information relating to the impact of the research payment requirement on broker-dealers, investors, and the quantity and quality of the research itself. The SEC would like to receive such input at least a year before the temporary relief expires. The letter also states that the relief may or may not be renewed "as appropriate."

Relief for investment advisers and investment companies

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 (Investment Company Act), that will permit investment advisers to continue the long-standing procedure of aggregating client orders for purchases and sales of securities where certain of those clients may end up paying different amounts for research because of the research payment requirement, while all clients pay the same average price for purchased securities (or receive the same proceeds for sales) and the same execution costs.

Specifically, the Division of Investment Management stated that it will not recommend enforcement action under Section 17(d) of the Investment Company Act and Rule 17d-1 thereunder, or Section 206 of the Advisers Act, against an investment adviser that aggregates orders for the purchase or sale of securities on behalf of its clients, which may include registered investment companies, following implementation of the research payment requirement. ICI argued that the aggregation of orders benefits clients generally and explained that 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 specific harm that the SEC's earlier relief allowing aggregation was intended to address.

As a condition to the relief, investment advisers will be required to adopt policies and procedures reasonably designed to ensure that: (1) each client whose order is represented in an aggregated order pays the average price for the security, as well as 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 the disclosures made to the client; and (3) allocation of each such trade will conform to the adviser's allocation procedure and/or the pre-trade written "allocation statement" specifying the participating client accounts and the intended allocation among them.

Division of Trading and Markets no-action relief

Finally, the SEC's Division of Trading and Markets also provided MiFID II-related no-action relief, this requested by the SIFMA Asset Management Group to address issues raised by the research payment requirement under the soft-dollar "safe harbor" provisions in Section 28(e) of the Securities Exchange Act of 1934, as amended.

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 order execution and safe-harbor-eligible brokerage and research services. This satisfies the conditions of the safe harbor because the executing broker is deemed to "effect" the transaction and to "provide" the research, two requirements of the safe harbor. The executing broker credits the portion of the commission for research to a client commission arrangement it administers and retains the remainder as payment for the execution. In an alternative form of arrangement, the executing broker forwards the research portion of the commission to a client commission arrangement administered by an external administrator. The investment manager then receives research from a third-party research provider or the executing broker, paid for by the CCA assets and thus satisfying the conditions of the safe harbor. Where an external aggregator or administrator is used, the investment manager instructs the executing broker to deduct the portion of the commission payment for brokerage, including execution, from payments going to the client commission arrangement administered by that third party.

The Division of Trading and Markets provided relief 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 research payment requirement, provided the executing broker-dealer is legally obligated to pay for the research and all other applicable conditions of the safe harbor are met. The relief will apply only where:

  • the manager makes payments to the executing broker-dealer out of client assets for research alongside payments to that broker-dealer for execution;
  • the research payments are for safe-harbor-eligible research services;
  • the executing broker-dealer effects the transaction for purposes of the safe harbor; and
  • the executing broker-dealer is legally obligated by contract to pay for research through an RPA in connection with a CCA.

We would be happy to discuss with you the SEC's no-action letters and their impact on your business and/or investment activities. Also, as noted above, the no-action relief for broker-dealers providing research to investment managers is temporary, and the SEC is requesting comments, data and other information relating to the impact of MiFID II's research provisions on broker-dealers, investors, and the quantity and quality of research, ideally at least one year before the expiration of the 30-month temporary period. We would be happy to help you with the preparation and submission of any such comments, data or other information.

Please contact one of the authors or your regular DLA Piper contact.