(Article from Registered Funds Alert, September 2017)
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The Council of the European Union, through its Markets in Financial Instruments Directive (“MiFID II”), is changing how investment advisers can use client commissions to pay for securities research. These changes are far reaching and are poised to have a ripple effect in the United States and throughout the world.
Significantly, MiFID will ban the very common practice of an investment adviser using bundled client trading commissions to pay for securities research. That ban is scheduled to become effective in the European Economic Area (“EEA”) on January 3, 2018. Under MiFID II, an investment adviser located in the EEA must pay the costs for research directly or pay for that research with “unbundled” client commissions deposited into a new kind of account, called a research payment account (“RPA”).
RPAs are similar to the currently-used client commission arrangement (“CCA”), but there are a few differences. The RPA would be funded with payments for research that are charged separately from payments for execution. In addition, the investment adviser – not a broker-dealer – would control the RPA. MiFID II also requires the investment adviser to negotiate a research budget with the client and regularly assess that budget and annually disclose to the client the total cost of research. While research payments can be made in connection with a transaction, the total amount must be based on the set budget and cannot be linked to trading volume or the value of transactions. Investment advisers must also have a process in place to rebate any surplus budget in the following period and provide a written policy to clients describing all necessary information, including how the investment adviser intends to allocate costs fairly across various clients’ RPAs.
MiFID II applies to investment personnel exercising investment discretion from offices located in the EEA regardless of whether they are managing accounts located in the United States, including for U.S. registered investment companies. Under these circumstances, an investment adviser or subadviser located in, or with personnel located in, the EEA exercising investment discretion over an account located in the United States would be subject to compliance with rules governing payments for securities research under both the EEA and U.S. regulatory regimes.
Unfortunately, the unbundled approach permitted by MiFID II does not align with the current U.S. regulatory regime and the safe harbor investment advisers rely on under Section 28(e) of the Exchange Act. This article discusses this issue, but MiFID II also raises other questions outside the scope of this article. For example, a broker-dealer’s offering of unbundled commissions raises the question of whether the broker-dealer must register as an investment adviser under the Advisers Act. For registered investment companies, variations in the total transaction cost of aggregated trades may raise joint transaction concerns under Section 17(d) of the 1940 Act because they could be construed to be participating on a basis different from, or less advantageous, than other clients.
Turning to the impact of MiFID II on soft dollar practices in the United States under the Section 28(e) safe harbor, an investment adviser that satisfies the conditions of the statute is permitted to use client commissions to pay a broker-dealer more than the lowest available commission rate for a bundle of products and services provided by the broker-dealer (i.e., more than “pure execution”). Historical SEC guidance in this area has been premised on the protections of Section 28(e) being available only when an investment adviser pays a bundled “commission” for both brokerage and research services.
The implementation of MiFID II creates a severe problem for investment advisers in the United States with operations in the EEA. The question is how such an investment adviser can comply with MiFID II’s requirement for unbundled research payments when, in the United States, the law and guidance has to date presumed a bundled commission.
An investment adviser has a fiduciary duty to invest client assets prudently and seek best execution when executing trades, which includes engaging in a balancing act weighing the costs of executing a transaction with the amount being charged for research. Providing a mechanism to support the unbundling of research and execution costs likely will require additional disclosure to investors, giving investors the benefit of increased transparency. The heightened transparency provided by the unbundling of research from execution costs may ultimately lead to increased fairness to investors and stronger investor protection – two of the cornerstones upon which the SEC was founded. Moreover, those who deal with the European trading environment may begin to question why they cannot obtain the same level of transparency regarding the cost of research when conducting transactions in the United States. The SEC needs to act to address these concerns, or explain why it does not support transparency in the execution of brokerage transactions in U.S. financial markets.
Guidance to facilitate MiFID II-compliant research payments within the Section 28(e) safe harbor also is fully consistent with the enacting spirit of Section 28(e), which strove to protect the market for research services. One of the concerns that led to the enactment of Section 28(e)’s safe harbor was that research services could have dried up or the cost of such services could have been unfairly passed on to investment advisers. To the extent relief is not provided, there may be a decline in the amount of research used by investment advisers who must comply with MiFID II, with a potential collateral negative impact on investment performance. This result clearly would be contrary to Congressional intent.
The U.S. and MiFID II approaches are both predicated on ensuring that clients of investment advisers have transparency into the costs of receiving valuable services and best execution standards are met. Broadening the scope of the Section 28(e) safe harbor is imperative to provide the financial markets with cost-efficient options for complying with multiple and conflicting extraterritorial compliance regimes. Fortunately, the SEC and its staff have a long history of responding to market participants’ concerns with the impact of new developments on the availability of Section 28(e) for investment advisers. We have every confidence that the SEC staff is taking this matter very seriously and is seeking to take steps that will better facilitate implementation of MiFID II and also retain the ability of investment advisers to rely on the Section 28(e) safe harbor.