The SEC staff issued three related no-action letters Oct. 26 to mitigate the impact of a European Union financial markets rule on firms that provide investment research services. Market participants subject to European Union oversight will have to comply with the EU’s Markets in Financial Instruments Directive (MiFID II) early next year. The relevant portion of MiFID II is a ban on a long-standing practice of brokerage firms including the cost of investment research in a lump sum fee charged to their customers. Under the amended EU directive, brokerage firms subject to the law will be required to separately identify research costs billed to customers rather than including them along with other expenses such as trading fees in one line item. The trap for the unwary under U.S. law, however, is that a separate charge for research could subject firms to classification as an investment adviser under the Advisers Act, with its increased compliance costs and disclosure obligations. The separate charge could also cause financial firms to run afoul of other securities law provisions.
The MiFID directive is a far-reaching measure that regulates the organization and activities of investment firms and the trading of financial instruments. European regulators added the research fee disclosure provision to their regulatory directive with a view toward increasing competition, price transparency, and improving the quality of investment research. The new European approach is creating a world-wide headache for certain global financial firms subject to both EU and U.S. jurisdiction.
The relief granted by the SEC staff, in letters to the Investment Company Institute (ICI), the Securities Industry and Financial Markets Association (SIFMA), and SIFMA’s Asset Management Group, is temporary, and expires in July 2020. According to the letters, the 30-month period will provide the staff with sufficient time to understand the evolution of business practices under MiFID II, and will allow the industry time to review, comprehend and implement EU guidance on the rules and evaluate the impacts on their business models. The SEC staff stated that it will monitor and assess the impact of MiFID II’s requirements on the research marketplace and market participants in order to determine whether more tailored or different action is necessary.
The Investment Management Division staff issued two of the three letters. One issued to SIFMA provided relief from definition of an investment adviser under §202(a)(11) of the Advisers Act. The relief allows firms to receive payments in hard dollars or through MiFID-governed research payment accounts from MiFID-affected clients without being considered an investment adviser. The Investment Management staff also allowed advisers, in a letter issued to ICI, to continue to aggregate client orders for purchases and sales of securities, where some clients may pay different amounts for research because of MiFID II requirements, but all clients will continue to receive the same average price for the security and execution costs. According to the SEC, this relief provides clarity and consistency to investment advisers by permitting the continued aggregation of orders while addressing the differing arrangements regarding the payment for research that will be required by MiFID II.
The third letter, issued to SIFMA’s Asset Management Group, came from the Division of Trading and Markets, and deals with money managers and the safe harbor for investment research under Exchange Act §28(e). MiFID II allows money managers to pay an executing broker-dealer for research alongside payments for order execution out of client assets. The directive requires the executing broker-dealer to transmit the research payments into segregated research payment accounts (RPAs).
The Division of Trading and Markets letter allows money managers to operate within the §28(e) safe harbor if they pay an executing broker-dealer for research with client assets alongside payments for execution through the use of an RPA that complies with the MiFID II RPA requirements. The executing broker-dealer must be legally obligated by contract with the money manager to pay for the research, and the money manager and the executing broker-dealer must comply with all other applicable conditions of the securities laws.
Chairman Jay Clayton stated that the staff relief “was designed with input from a range of market participants to reduce confusion and operational difficulties that might arise in the transition to MiFID II's research provisions.” According to the chairman, the no-action letters “take a measured approach in an area where the EU has mandated a change in the scope of accepted practice, and accommodate that change without substantially altering the U.S. regulatory approach.”
Commissioner Kara Stein was not pleased with the process, however. She applauded the EU action, stating that MiFID II “will give investors transparency into the cost of both research and trading commissions by requiring that payments be unbundled.” She recognized that that the bundling of payments is a common practice in the U.S., and that Europe’s new approach creates a conflict for many global firms. Her concern is that the staff’s no-action relief “does not adequately address these issues and merely kicks the can down the road.” That road is too long and there is far too much kicking, she suggested. Some delay in giving the staff time to review the landscape and allowing the process to shake out may make sense, but “taking over 900 days is simply unreasonable.”
She is also concerned that the informal no-action letter process is not the proper approach to take to address this issue. She observed that questions about transparency and investor protection are central to this conflict, and that transparency in government process is equally important. Rather than to submit the matter to informal staff deliberations and case-by-case resolution, she called for formal notice and comment rulemaking so that “investors and other market participants have an opportunity to voice their concerns and ideas ... in order to reach the best policy outcome in this area.”
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