The SEC issued three no-action letters to enable market participants to comply with the research provisions of MiFID II while complying with the applicable requirements of U.S. securities laws. MiFID II is due to come into effect on January 3, 2018. The issues addressed by each letter arose because investment advisers subject to MiFID II (“MiFID Managers“) will be required to separate out payments for research from commissions they pay broker-dealers for execution services.
1. Relief for Broker-Dealers from Regulation as Investment Advisers. The Division of Investment Management issued a letter permitting broker-dealers to receive cash payments for research services from MiFID Managers without being subject to regulation as “investment advisers” under the Investment Advisers Act of 1940 (the “Advisers Act“). The relief is required, as such cash payments may constitute “special compensation” for advisory services that may cause a broker-dealer to fall outside the scope of the broker-dealer exclusion from the definition of “investment adviser” in Section 202(a)(11)(C) of the Advisers Act.
The relief applies both where a MiFID Manager pays for research from its own account, and from a separate MiFID-qualifying “research payment account” (an “RPA“), which is an account funded with client money for the purpose of paying for research. Further, the relief extends to payments by non-EU managers that are contractually required to comply with the research payment provisions of MiFID II (e.g., a non-EU sub-adviser appointed by a MiFID Manager). The Division granted the relief for 30 months from the implementation of MiFID II.
2. Aggregation of Orders by Investment Advisers. The Division of Investment Management issued a second letter permitting investment advisers to aggregate client orders if clients pay the same pro rata share of execution costs, even if they pay different amounts for research. Under prior guidance, the SEC permitted investment advisers to aggregate client orders where clients shared all transaction costs (which could include research costs) on a pro rata basis. As MiFID II will result in different clients paying different sums for research, the SEC relief limits the cost-sharing requirement to execution costs. The letter requires investment advisers to implement specified policies and procedures to ensure that they otherwise aggregate (and subsequently allocate) client orders fairly.
3. Reliance on Section 28(e) Safe Harbor by Advisers Making Cash Payments for Research with Client Funds. Section 28(e) of the Exchange Act establishes a safe harbor that permits investment advisers to use client funds to purchase “brokerage and research services” for their managed accounts without breaching their fiduciary duties to clients. The Division of Trading and Markets issued a letter to permit a MiFID Manager to use client funds to make payments for research through a client-funded RPA in reliance on Section 28(e). The relief was requested because Section 28(e) arrangements typically contemplate that an investment adviser will make a single “bundled” commission payment to a broker-dealer to cover both execution and research services. Under MiFID II, a MiFID Manager will be required to make separate payments for execution and research services, and retain control of any RPA account used to make payments for research services with client money. The letter acknowledges that, notwithstanding these different payment mechanics, a MiFID Manager should be permitted to rely on Section 28(e) provided the executing broker-dealer is contractually obligated to pay for research through use of an RPA, and the arrangement otherwise meets the requirements of Section 28(e).
While SEC Chair Jay Clayton said that the relief represents a “measured approach” that allows U.S. market participants to comply with MiFID II without significantly changing the U.S. regulatory approach, Commissioner Kara Stein argued that the relief merely “kicks the can down the road” without addressing key policy questions regarding the U.S. approach to the transparency of fees relating to research and trading.
Lofchie Comment: Notwithstanding Commissioner Stein’s comment as to kicking the can down the road, kudos to Chair Clayton for adopting a fairly long-term no-action letter that gives both regulators and market participants an opportunity to see what the effects of the MIFID rule changes might be, whether the U.S. rules should be changed, and, if so, what those rule changes should be. It is a waste of Commission and industry resources to adopt short-term no-action letters that must be continually renewed. While thirty months may seem a long time, the reality is that the SEC still has significant Dodd-Frank rulemaking on its plate, as well as numerous other issues that are also pressing, such as market structure and corporate disclosure.
Further, it should be pointed out that the SEC issued the no-action letters because the Europeans have adopted regulations that are inconsistent with the U.S. Securities Exchange Act. While Commissioner Stein is right in asserting that Section 28(e) of the Securities Exchange Act may not be good public policy, there are very good arguments to be made that it is; i.e., that the Section encourages the production of investment research. This is the determination that Congress made when it adopted the statutory provision. If the determination seems no longer correct, then, at least insofar as U.S. market participants are concerned, it is the U.S. Congress that should reverse the determination, not the Europeans.