MIFID II Unbundling Impacts SMEs Access to Capital in Europe

US investment advisers of European funds wrestled for a few years now with the consequences of the so-called MiFID II unbundling. An apparently innocuous move from European authorities aimed at enhancing investor protection, which resulted in a clamorous conflict with different sets of US rules, governing soft dollar arrangement between investment advisers and broker dealers in the US. The consequences of the MiFID II unbundling rules for US broker dealers were contained by grandfathering measures issued by the SEC and in force until last July 2023.  

Europe seems to have recently acknowledged though that the success of the MiFID II unbundling rules is somewhat debatable. The aim of investor protection pursued by these rules had also other unintended and less favourable consequences. More namely, for what concerns the ability of small medium enterprises to access the capital markets for their funding needs. 

A new legislative proposal, aimed at making European capital markets more attractive and vibrant, intends to rebundle investment research and brokerage fees under certain specific circumstances. This legislative proposal, once applicable, will also relieve US broker dealers from the issues they continue to face, pending the expiration of the SEC grandfathering measures and the conflict with European rules.  

The Whys for the MiFID II Unbundling Rules 

 There were different set of drivers for the introduction of the MIFID II unbundling rules. We can categorise them in regulatory and commercial drivers.  

Investor protection and conflict of interest avoidance are the main drivers under the regulatory bracket. Overproduction of investment research can be counted instead under the commercial drivers, in one with the potential for creating an independent market for investment research.  

The so-called unbundling refers to a popular practice where investment research was sold together with brokerage and execution services. The charge for investment research was bundled with the price of brokerage and execution services. This practice would conflict with different aspects of investor protection as envisaged under MiFID II. On the one hand, the obligation for investment firms under MiFID II article 27 to offer the so-called best execution. In other words, orders have to be executed at the most favourable terms for investors. The ability to comply with this obligation and execute orders at the best price available or possible could well be impaired if asset managers were also receiving another service from the investment firm chosen for brokerage and execution services, without paying separately for it.  

The bundling of investment research and execution services is also relevant relative to another aspect of investor protection – inducements. Under MiFID article 24, when providing portfolio management services, investment firms shall not accept or retain fees, commissions or any monetary or non-monetary benefits, paid or provided by any third party and related to the provision of the service to clients. For what concerned investment research, an exemption for related inducements was introduced via a delegated act. The receipt of third-party research by investment firms carrying out portfolio management services would not be considered an inducement, if directly paid by the investment firm out of its own resources or a distinct research payment account, controlled by the investment firm itself and funded by a specific charge to clients.  

From a commercial perspective, the MIFID II unbundling rules wanted to tackle two separate issues. Concerns were mounting on the quality of the output investment research. And that was because investment research was bundled with other brokerage and execution services for the express purpose of selling more of these services. At the same time, being able to independently price investment research would have helped, in the eyes of European authorities, to create a separate market for investment research. Which ultimately ended up not being the case, in one with other less favourable consequences for certain specific issuers.  

We wouldn’t disagree that the MIFID II unbundling rules are in line with the aims of investor protection of the overall framework under MiFID II. The side effects of these rules on the commercial side of the equation though are indeed far from desirable. That is especially when looking at the aims of the second iteration of the Capital Markets Union.   

The effect of MiFID II unbundling rules on US broker dealers 

It makes sense at this point to refresh also the implications of the MiFID II unbundling rules on US broker dealers. These are by and large relative to the ability of broker dealers to enforce an exemption under the US Investment Adviser Act. In case the investment advice is provided exclusively in an incidental manner and without receiving a distinct compensation for it, broker dealers are exempted from being registered as investment advisors. Conversely, for the MiFID II unbundling rules creating a separate special payment for investment research, that would per se prevent broker dealers to enforce the exemption. Whilst not all broker dealers use the exemption, with some being registered as investment advisers, the breadth of obligations imposed due to the fiduciary nature of the relationship between investment advisers and their clients is amongst the reasons for a fair share of broker dealers to prefer to continue to enforce the exemption where possible.  

From 2018 and until July 2023 by means of a no action letter, the SEC provided a transitory relief to broker dealers. It did recommend that no action was taken vis-à-vis those broker dealers who provided investment advice under the Investment Adviser Act to investment managers caught by compliance with the rules on unbundling of investment research under MiFID II. This has no longer been the case since July this year. Broker dealers are facing the option of either registering as investment adviser or else discontinue the research part of their service offering.   

The MiFID Quick Fix 

The first attempt to partially rebundle investment research and execution brokerage charges comes with the so-called MiFID Quick Fix Directive. This directive was born under the Capital Markets Recovery Package, introduced in 2020 during the COVID 19 pandemic. To facilitate recovery of European economy and capital markets, the MiFID Quick Fix Directive aims at removing unnecessary red tape and make temporary exceptions to mitigate the economic turmoil ensuing the COVID 19 pandemic. The intent of the directive is to ensure temporary relief for the economy and capital markets. More complex legislative issues are left though for the forthcoming planned review of the MiFID II directive. 

Just on time before being approved, a last amendment was introduced to cover for the partial rebundling of investment research and execution brokerage charges, until then left out of the legislative proposal. Article 24 MiFID II is proposed to be amended with the introduction of a new paragraph detailing the instances and the conditions for the rebundling. It is noteworthy to mention that the variable introduced as part of the rebundling exemption is relative to the market capitalisation, over a certain period, of the issuers covered by the investment research. The rebundling exemption applies only for investment research relative to issuers that did not exceed a market capitalisation of one billion Euros over the period of 36 months prior to the provision of the research. In addition to this condition, an agreement is required to be in place between the investment firm and the research provider to identify the portion of the payment attributable to investment research. Clients of the investment firm must also be informed about the joint payments.  

The MiFID II Quick Fix is important because it gives us the methodology of the exemption and the approach whereby the charge for investment research, even though rebundled with the one relative to the execution services, has to be identified separately.  

Sexing Up European Capital Markets 

Another go at some further rebundling of investment research and execution services fees comes with a later proposal for broader amendments to the MiFID II directive. The specific proposal is part of the Listing Act package and contains measures to facilitate, amongst other things, access to capital for small and medium-sized enterprises. The Listing Act Package is born as well under the second iteration of the Capital Markets Union and shares the same objective of the other legislative measures that come with it. Ensure easier access to capital markets for small and innovative enterprises. In this context, the proposal tackles the debatable success of the MiFID II unbundling rules. The Listing Act Package proposal comes into play to support the needs for small medium enterprises to make themselves known to the broadest investor audience possible.

The low level of investment research on small medium enterprises, one of the side effects of the MiFID II unbundling rules, has further limited the liquidity of small medium enterprises already listed. It is acknowledged that whilst the unbundling rules have indeed met some of their objectives, including mitigating risks of conflicts of interest, they have not been able by themselves to contribute to the growth of a market of independent investment research providers. To the very contrary, further to the introduction of these rules, independent research has become unsustainable. That is mostly because larger research providers can charge much lower prices for research. In addition to that, the European brokers that had in the past provided research on small medium enterprises, bundled with execution services, decided to scale back the provision of research on small medium enterprises not to pass related costs to their clients. In the years after the unbundling was introduced, the coverage on SMEs was reduced significantly too. Unbundling rules did fail ultimately to facilitate the creation of a market for independent investment research. They could not prevent the decline in research coverage for small and medium enterprises.  

The measures proposed as part of the proposal do not envisage a tout-court elimination of the unbundling. Rather, the methodology employed remains the one of the market capitalisation thresholds for issuers, this time increased from one to ten billion Euros. This threshold increase intends to ensure coverage for the small and medium sized enterprises left out completely from the research coverage during the tenure of the unbundling rules.  

The proposal goes further with the creation of a framework to support the development of a different type of research. The so-called issuer sponsored research. A type of research that started to appear already following the advent of the unbundling rules, for the very purpose of compensating the lack of research coverage on small and medium enterprises. Given the inherent conflicts of interest to this type of research, it makes sense to regulate it. Most importantly, ensure that its production can guarantee levels of fairness and accuracy of the related information for investors. Here it is also envisaged that member states shall make available facilities or collection entities where the issuer sponsored research can be submitted.  

Conclusions 

It is not the first time that European authorities express concerns about the success of certain regulatory initiatives. We have seen something similar already for what concerns both SFDR and the retail disclosures under PRIIPs regime. Yet it is the first time that defeat is admitted so overtly like in the case of the MiFID II unbundling rules. Most importantly, we have confirmation that whilst investor protection is one of the critical pieces of the puzzle, it is not always the most important one. There have been unknown unknowns over time, including the COVID 19 pandemic. Yet, the preparatory works to the broader MiFID II reform have demonstrated that funding needs of small medium enterprises play a much more important role vis-à-vis best execution.