On November 4, 2019, the Division of Investment Management (IM) of the Securities and Exchange Commission (SEC) issued a no-action letter (2019 Letter) to the Securities Industry and Financial Markets Association (SIFMA)1 extending by three years the term of a previous no-action letter that IM issued to SIFMA (2017 Letter).2 The 2017 Letter enabled broker-dealers to accept hard dollar payments for investment research from money managers that were either directly or contractually required to comply with MiFID II,3 as MiFID II effectively prohibited soft dollar payments for research. In addition to extending the relief provided in the 2017 Letter, the 2019 Letter addresses certain interpretive issues regarding the scope of the so-called “broker-dealer exclusion” from investment adviser registration set forth in Section 202(a)(11)(C) of the Investment Advisers Act of 1940, as amended (Advisers Act).
The 2019 Letter does not represent a definitive solution to inherent conflicts between MiFID II and the Advisers Act. Nevertheless, it does provide some benefits to market participants. In particular:
- It may provide market participants with some much-need predictability in structuring their research payment arrangements going forward; and
- The staff’s confirmation in the 2019 Letter that the broker-dealer exclusion may be available to common client commission agreement (CCA) research payment practices should provide some comfort to market participants that they are not operating outside of the broker-dealer exclusion.
It remains to be seen, however, whether the SEC will indeed act to provide a more permanent regulatory framework or whether the staff’s statements in the 2019 Letter about providing additional time for market-based solutions to evolve betrays a reluctance to tackle an admittedly complicated issue.
Background: The Conflict Between MiFID II and the Advisers Act
MiFID II sought to end the practice of investment advisers using client commissions to pay for investment research. MiFID II required investment advisers based in the European Union (EU) or managing EU client accounts to pay for investment research – including investment research obtained from U.S. broker-dealers – with their own money or through a client charge agreed to separately and funded in a manner that is not tied to the level of commissions generated.
By contrast, many U.S. broker-dealers took the view that a broker-dealer could not accept MiFID II-approved payments for investment research without registering as an investment adviser, which they viewed as imposing unacceptable costs.4 In particular, they noted that Section 202(a)(11) of the Advisers Act broadly defines an investment adviser to mean “any person who, for compensation, engages in the business of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or . . . issues or promulgates analyses or reports concerning securities.” Investment research regarding securities would literally be encompassed within this definition. By contrast, the broker-dealer exclusion encompasses a broker-dealer only when: (a) the investment advice it provides is solely incidental to its conduct as a broker-dealer; and (b) it receives no “special compensation” for its investment advice. Special compensation has been interpreted to mean compensation other than brokerage commissions or markups.5
The 2017 Letter allowed broker-dealers to accept hard dollar payments and MiFID II-approved client charges for investment research from a money manager that was either directly or contractually required to comply with MiFID II. The 2017 Letter stated that it would expire by its terms 30 months after the January 3, 2018 implementation date of MiFID II.6
The 2017 Letter was accompanied by an SEC press release (Press Release), which stated that the IM staff would “monitor and assess the impact of MiFID II’s requirements on the research marketplace and affected participants in order to ascertain whether more tailored or different action, including rule making, is necessary and appropriate in the public interest.”7 The Press Release also called upon members of the public to comment on this, and, in particular, to “provide data and other information relating to the impact of MiFID II’s research provisions on broker-dealers (including any changes to their business models), investors, and the quantity and quality of research” at least one year before the 2017 Letter was scheduled to expire.
The staff received 29 comment letters in response to the Press Release’s invitation to comment, many of which urged the SEC to adopt a rule permitting broker-dealers to accept hard dollar or other MiFID II-compliant payments for investment research without the need to register as investment advisers. However, the SEC and its staff appeared reluctant to do so. For example, in March 2019, the IM Division Director stated:
- [T]here are indications that market solutions are developing that may make extending the no-action relief unnecessary. For example, I understand that some fund managers are using reconciliation or reimbursement processes to deliver cost transparency while addressing compliance. At the same time, some broker-dealers have explored or taken steps to offer research through a registered advisory business.8
Many industry participants reacted with concern to the possibility that the staff would simply allow the 2017 Letter to lapse. For example, SIFMA argued that “there is increasing concern that the SEC or its staff will ultimately let the SIFMA No-Action Letter lapse without providing a sufficient alternative for affected firms or time for market participants to adjust . . . [which] would [lead to] significant uncertainty and likely substantial business disruption.”9
Ultimately, the IM staff determined to extend the 2017 Letter for three years, rather than allowing it to lapse or engaging in rule making at this time. The 2019 Letter states that:
- [T]he staff has observed that business practices concerning payments for research, including in response to the requirements of MiFID II, continue to evolve, but various challenges remain. In addition, the staff has observed that understanding of the effects of MiFID II on the supply of and demand for research continues to develop, that market participants continue to express concern regarding the effects of changes in the market for research on small- and mid-sized entities, and that authorities in the European Union (EU) are continuing to evaluate the effects of MiFID II.10
The 2019 Letter notes that the SEC or its staff may take further action or issue further guidance regarding MiFID II during the three-year extension. At the same time, the 2019 Letter notes that the three-year extension “will allow additional time for market-based solutions with respect to payments for research in the U.S. and Europe to evolve further, and for greater transparency regarding research payments and practices to develop.”
Finally, the 2019 Letter addresses the applicability of the broker-dealer exclusion to common research payment practices involving the use of CCAs. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor to protect money managers from liability for a breach of fiduciary duty solely on the basis that they paid more than the lowest commission rate in order to receive “brokerage and research services” provided by a broker-dealer. The SEC first interpreted Section 28(e) to encompass payments for research pursuant to CCAs in 2006.11
The staff noted that some broker-dealers questioned whether the broker-dealer exclusion is available if a broker-dealer receives a CCA payment when a money manager (a) does not have a trading relationship with a broker-dealer that receives commissions for research from the CCA or (b) to the extent it does have a trading relationship with such a broker-dealer, the trades do not relate to that broker-dealer’s research. The 2019 Letter states that the SEC was aware of these types of arrangements when it issued its interpretation and did not question the availability of the broker-dealer exclusion to these types of arrangements.12 The 2019 Letter indicates that the staff believes that the use of these types of CCAs does not cause the arrangement to fall outside the scope of the broker-dealer exclusion.13
1Securities Industry and Financial Markets Association, SEC Staff No-Action Letter (pub. avail. Nov. 4, 2019).
2Securities Industry and Financial Markets Association, SEC Staff No-Action Letter (pub. avail. Oct. 26, 2017).
3“MiFID II” means Directive 2014/65/EU of the European Parliament and of the Council of May 15, 2014 on markets in financial instruments and amending Directive 2011/61/EU, as implemented by the European Union member states.
4See 2019 Letter, supra note 1, at n. 4 (citations omitted).
5See, e.g., Financial Planning Association v. Securities and Exchange Commission, 482 F. 3d 481 (D.C. Cir. 2007).
62017 Letter, supra note 2, at n. 6.
7SEC Announces Measures to Facilitate Cross-Border Implementation of the European Union’s MiFID II’s Research Provisions, Press Release No. 2017-200 (Oct. 26, 2017) (https://www.sec.gov/news/press-release/2017-200-0) (visited Nov. 12, 2019).
8Keynote Address: ICI Mutual Funds and Investment Management Conference (March 18, 2019) (https://www.sec.gov/news/speech/speech-blass-031819) (visited Nov. 12, 2019).
9Letter from Aseel M. Rabie Managing Director, Associate General Counsel, et al., Securities Industry and Financial Markets Association (Aug. 2, 2019) (https://www.sec.gov/comments/mifidii/cll5-5915668-189007.pdf).
102019 Letter, supra note 1.
11Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, Securities Exchange Act Rel. No. 54165 (July 18, 2006), 71 Fed. Reg. 41,977 (July 24, 2006).
122019 Letter, supra note 1, at n. 8.