Generally MiFID and namely the MiFID II unbundling rules aim at avoiding or mitigating conflict of interests between investment managers and their clients. Whilst in the recast MiFID directive there is no outright ban for all sorts of inducements – and some minor are permitted – there are more stringent rules, for instance, surrounding how managers purchase and pay for research from brokers. MiFID II unbundling rules have changed the scenario based on the so-called soft dollars arrangements – in American parlance – between brokers and investment managers, whereby research was acquired using a portion of the commission paid for brokerage services.
Be it simply a consequence of globalisation or just one more unintended consequence – indeed very frequent to be found these days across the entire spectrum of the European regulation on financial services – as a matter of fact MiFID II has a set of ultra-territorial effects, especially with the newly introduced MiFID II unbundling rules, and is applicable also to US managers and broker dealers.
Whilst the situation of each and any US global market participant is different and ensuing applicability of MiFID II unbundling rules dependent upon the types of interaction and ties with Europe and European based clients, as a rule of thumb we can say that a US adviser or broker dealer is generally caught by MiFID II rules in the following circumstances:
- When it uses EU sub-advisors;
- When it acts in the capacity of sub-advisor to a fund in the EU;
- When it trades EU securities on an EU market;
- When it is contractually bound to comply with MiFID II rules.
Of course, as we have seen now abundantly with other European regulation on financial services, it is expected that there will be instances where, despite technically no compliance with MiFID II is either envisaged or mandatory, US market participants will increasingly consider to abide to its provisions for commercial reasons in order to retain competitiveness with other global providers.
Investment research is now priced and paid under the newly introduced rules in a way that conflicts with a consolidated practice and some existing exemptions or safe harbours available to market participants in the US. In this article we will briefly touch upon what are the main changes on investment research under MiFID II and the response of the Securities and Exchange Commission with its non-action letters.
Pricing and paying for investment research
MiFID II unbundling rules requires that investment research is paid either directly by investment managers out of their own resources or by their clients via Research Payment Accounts (RPAs). An RPA is a separate account funded directly by the client either by payment of a separate research fee applied by the investment manager or a separate payment for research imposed by the broker and apportioned to the RPA. Whilst the separate payment for research can also be made alongside the payment for brokerage services it now needs to be unbundled. MiFID II unbundling rules require separating the relevant charges, even though research and execution payments can still be made at the same time one alongside the other. From a legal perspective, the one for research will become a separate charge, in addition to the investment management fee, unless investment managers opt to pay directly themselves for research out of their very own resources.
RPAs must abide to certain requirements and any related research budget for research has to be appropriately evaluated at specific periods of time and agreed by the client. From an operational perspective, the difference between RPAs and a Commission Sharing Agreements (CSAs) lies in that the charge for research in an RPA is taken by the investment manager before the transaction is made, whilst in the CSA the charge for research is taken after the transaction is made. Also, charges for research have to be calculated independently from the volume of transactions with brokers under the new rules introduced by MiFID II.
There has been debate in the industry, especially heated over the months preceding enactment of MiFID II, as to whether investment managers should have charged their clients or pay themselves for research. Whilst some global houses chose to bear directly the cost of research, some other firms have been recently creating internal research teams as an alternative workaround solution to solve this issue presented by MiFID II.
Temporary relief by the SEC
Industry participants from the US and with a global remit in their operations are now faced with one more regulatory mismatch, whereby soft dollar arrangements – still perfectly acceptable in the US – are perceived as hidden costs under the regulatory framework introduced by MiFID II in Europe. The unbundling of those charges under the new rules aims at obtaining more transparency for investors.
Whilst we can’t predict whether the US will ever catch up with the new European approach on transparency of fees, we witness a situation where US firms operating with EU clients will face substantial obstacles with compliance with the hard dollar payment model so introduced.
The receipt of a hard dollar payment for investment research represents an issue from different perspectives in the US market. By way of example, the Investment Adviser Act of 1940 provides for an exemption from the classification as investment adviser – and the relevant registration requirement – for broker dealers that provide investment advice only incidentally to their brokerage services and without receiving compensation that is specifically related to the advice provided. Accordingly, receiving hard dollar payment for research, as it is now the case under MiFID II rules, could be construed as special compensation for the investment advice and would trigger the requirement to register as investment adviser for broker dealers. Also, one more example lies in section 28 (e) of the Securities Exchange Act, which provides for a safe harbour from claims of excessive commission payments for those US managers that use client commission to pay for research and brokerage services. Accordingly, a payment in hard dollars for research, again, would not qualify as a commission as such and would expose those managers to those claims as well as impose additional disclosure obligations on them.
Whilst it is clear that at present compliance both with the US and the European rules might not be realistically possible, the response from the SEC has been released via a set of no-action letters allowing for non-compliance with the relevant US rules above for a specific period of time. Some similar sort of relief was also seen in a letter from the Financial Conduct Authority in the United Kingdom. This relief granted by the US authorities is coupled with a broader cooperation effort with their European counterparts to observe the developing market practice and find more definitive measures or wait for more creative solutions developed by the industry that would potentially close the existing regulatory gap.