Alert November 10, 2017

SEC Staff Issues No-Action Relief to Facilitate Implementation of MiFID II Research Provisions

Summary

On October 26, 2017, the staff (the Staff) of the U.S. Securities and Exchange Commission (SEC) issued three related no-action letters providing market participants with greater clarity as to how certain aspects of their business activities can comply with potentially competing systems of regulations. Specifically, the relief seeks to address potential conflicts between the requirements of the U.S. federal securities laws and the requirements of the European Union’s (EU) Markets in Financial Instruments Directive II (MiFID II), which have an implementation date of January 3, 2018.

On October 26, 2017, the Staff of the SEC issued three related no-action letters providing market participants with greater clarity as to how certain aspects of their business activities can comply with potentially competing systems of regulations. Specifically, the relief seeks to address potential conflicts between the requirements of the U.S. federal securities laws and the requirements of the EU’s MiFID II, which have an implementation date of January 3, 2018. In the words of the Staff, the relief “provides a path for market participants to comply with the research requirements of MiFID II in a manner that is consistent with the U.S. federal securities laws.”

This alert provides background information regarding MiFID II and summarizes each of the no-action letters issued by the Staff.

Background on MiFID II

Since 2007, the Markets in Financial Instruments Directive (MiFID) has been the framework for EU legislation regulating various investment intermediaries and the services and activities these intermediaries provide to clients. For purposes of the investment management sector, the services covered by MiFID include portfolio management, receipt and transmission of orders, and investment advice.

In 2014, the European Parliament and the European Council adopted a revised Markets in Financial Instruments Directive, MiFID II.  Under MiFID II, the European Parliament and the European Council made significant changes to the regulatory framework applicable to various investment services and activities. For a broader discussion of MiFID II, please see our August 7, 2017, client alert.

The no-action relief issued by the Staff seeks to address the impact of the provisions of MiFID II relating to “inducements.” In particular, except under limited conditions enumerated in MiFID II, investment managers subject to MiFID II will no longer be permitted to receive or retain inducements, including non-monetary benefits such as research, for conducting business. Only minor non-monetary benefits, such as limited hospitality and participation at conferences, are permitted. As a result, in order for a MiFID II investment manager to receive research, the investment manager must pay for the research from (1) its own money, (2) a client-approved research payment account (RPA), or (3) a combination of (1) and (2). This requirement will alter current practices where payments for research are typically “bundled” with payments for execution. This “unbundling” presents a number of issues for investment managers and other industry participants, including broker-dealers, under the U.S. federal securities laws. The following is a summary of the ways in which the no-action letters issued by the Staff seek to address these issues.

SEC No-Action Letters

Securities Industry and Financial Markets Association Letter (the SIFMA Letter)

In response to a request from the Securities Industry and Financial Markets Association (SIFMA), the Staff confirmed that it would not recommend an enforcement action against a broker-dealer that provides research services that constitute “investment advice” under Section 202(a)(11) of the Investment Advisers Act of 1940 (the Advisers Act) to an investment manager that is required under MiFID II, either directly or by contractual obligation, to pay for research services from its own money, from an RPA funded with its clients’ money, or from a combination of the two.

To avoid registration as an investment adviser and becoming subject to various requirements of the Advisers Act, broker-dealers typically rely on the “broker-dealer exclusion” from the definition of “investment adviser” in Section 202(a)(11) of the Advisers Act. Under the exclusion, brokers or dealers that perform investment advisory services that are “solely incidental” to the conduct of their business as a broker or dealer and receive no “special compensation” are excluded from the definition of “investment adviser.” As indicated above, under current practices, payments to a broker-dealer for research and execution are typically “bundled” in a single payment. However, as a result of the unbundling caused by MiFID II, broker-dealers can expect to receive from investment managers subject to MiFID II separate payments for research services. The relief granted in the SIFMA Letter sought to address concerns that the receipt of these separate payments for research services might be considered “special compensation,” subjecting a broker-dealer to the registration and other requirements of the Advisers Act. 

Notably, the assurances granted in the SIFMA Letter are intended to address concerns associated with the implementation of MiFID II. As such, the relief is limited to broker-dealers that provide research services to, and receive payments from, investment managers that are directly subject to MiFID II (by virtue of being domiciled in the EU) or are domiciled elsewhere, including U.S. investment managers, and contractually obligated to comply with MiFID II. The relief is not available to a broker-dealer that accepts payments for research from an investment manager that is not subject to MiFID II, directly or by contractual obligation.

This relief is available for a 30-month period following the January 3, 2018, MiFID II implementation date. The Staff noted that the temporary nature of the relief is intended to provide the Staff “with sufficient time to understand the evolution of business practices after the implementation of MiFID II.” The Staff indicated that this will allow for a determination of whether “more tailored or different action is necessary” upon the expiration of the relief.  

Investment Company Institute Letter (the ICI Letter)

In response to a request from the Investment Company Institute (the ICI), the Staff confirmed that it would not recommend an enforcement action under Section 17(d) of the Investment Company Act of 1940 (the 1940 Act), Rule 17d-1 thereunder or Section 206 of the Advisers Act against an investment manager that aggregates orders for the sale or purchase of securities on behalf of its clients in reliance on the position taken in a previous Staff no-action letter, SMC Capital, while accommodating the differing arrangements regarding the payment for research that will be required by MiFID II.

As a general matter, Rule 17d-1 provides that no affiliated person of a registered investment company, and no affiliated person of an affiliated person, may participate in any joint enterprise, arrangement, or profit-sharing plan without first obtaining an exemptive order from the SEC.  Section 206 of the Advisers Act makes it unlawful for an investment manager, directly or indirectly, “(1) to employ any device, scheme, or artifice to defraud any client or prospective client,” or “(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” In the SMC Capital letter, the Staff confirmed that it would not recommend an enforcement action against an investment manager that aggregates orders for advisory clients (including registered funds) and affiliated entities so long as the investment manager implemented procedures designed to ensure all clients participating in aggregated orders pay the same price and commission. As a result of the relief granted in the SMC Capital letter, investment managers can avoid placing into the market competing orders in the same security, which could result in worse execution for clients overall and the potential for one set of clients to benefit at the expense of other clients. In order to be able to aggregate orders consistent with the relief granted in the SMC Capital letter, each client who participates in an aggregated order pays the same average share price and all transaction costs are shared on a pro rata basis.

As noted above, under current practices, payments for research and execution costs are bundled. However, as a result of the unbundling caused by MiFID II, clients participating in an aggregated order may pay for research through different methods – i.e., from the investment manager’s own money, from an RPA funded with client money, or from a combination of the two. The relief granted in the ICI Letter seeks to address this issue by permitting investment managers to aggregate client orders in reliance on the SMC Capital letter while accommodating differing research payment arrangements, provided that the investment manager adopts policies and procedures reasonably designed to ensure that (1) each client in an aggregated order pays the average price for the security and 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 disclosures to clients, and (3) subsequent allocation of such trade will conform to the investment manager’s allocation statement and/or allocation procedures.

Asset Management Group Letter (the AMG Letter)

In response to a request from the Asset Management Group of SIFMA (the AMG), the Staff confirmed that it would not recommend an enforcement action against an investment manager seeking to operate in reliance on Section 28(e) of the Securities Exchange Act of 1934 if the investment manager uses client assets to make payments through an RPA for research alongside payments for execution services, provided certain conditions, noted below, are met.

Section 28(e) provides a safe harbor for investment managers that use commission dollars generated by account transactions of their advised accounts to pay for research and brokerage services without violating its fiduciary duties, provided that certain enumerated conditions are satisfied. Under current practices, investment managers often rely on client commission arrangement (CCA) structures in which a single “bundled” commission is paid to a broker-dealer for order execution as well as Section 28(e) eligible brokerage and research services. The broker-dealer may credit the portion of the commission for research to a CCA that it administers or forward the research portion of the commission to a CCA administered by an external “aggregator” or administrator. In effect, under current practices, an “unbundling” does result in the context of CCAs. However, although the RPA model contemplated under MiFID II is similar in many respect to the CCA model, there are two key distinctions that call into question the ability of an investment manager to rely on the Section 28(e) safe harbor: (1) the amount paid for research is identified separately from the amount paid of execution prior to the time when the investment manager makes the payments to the broker-dealer (as opposed to after-the-fact in the context of CCAs); and (2) the RPA is required to be under the control of the investment manager (as opposed to the broker-dealer or an external “aggregator” in the context of CCAs). 

The relief granted in the AMG Letter seeks to address concerns raised by the use of RPAs. The relief requires that all other applicable conditions of Section 28(e) are satisfied and will only apply only in the following circumstances:

  • The investment 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 harbor under Section 28(e).
  • The executing broker-dealer effects the securities transaction for the purposes of Section 28(e).
  • The executing broker-dealer is legally obligated by contract with the investment manager to pay for research through the use of an RPA in connection with a client commission arrangement.