SEC Grants No-Action Relief for MiFID II Research Payment Accounts Under Section 28(e)
The U.S. Securities and Exchange Commission ("SEC") has granted no-action relief for the use of MiFID II research payment accounts ("RPAs") to pay brokers for research under Section 28(e) of the Securities and Exchange Act of 1934 (the "Exchange Act"), in response to a request from the Securities Industry and Financial Markets Association ("SIFMA").1 As a result, U.S. broker-dealers and investment advisers with cross-border advisory practices will want to revisit their brokerage arrangements to ensure compliance with the SEC's guidance. The SEC's relief resolves a significant uncertainty on the application of the ban on inducements included in European Union ("EU") Directive 2014/65/EU ("MiFID II") and comes on the same day that the European Commission ("EC") published guidance clarifying that the RPA model proposed by SIFMA would be consistent with MiFID II. 2 In addition to the no-action relief under the Exchange Act, the SEC provided MiFID II-related no-action relief in response to separate requests from SIFMA and the Investment Company Institute to: (i) broker-dealers from regulation under the Investment Advisers Act of 1940 (the "Advisers Act") for the provision of research services that constitute investment advice under Section 202(a)(11) of the Advisers Act, for a period of two and a half years after the implementation of MiFID II, and (ii) to advisers of registered investment companies under the Investment Company Act of 1940 (the "Company Act") that aggregate orders for clients with varying research payment arrangements, from liability for violation of Section 17(d) of the Company Act. This piece focuses on the Exchange Act relief and its effects on the brokerage model.
In accordance with their fiduciary duty to clients, investment advisers in the United States are generally required to execute trades at the best price available and may not directly benefit from brokerage services paid for by their clients. As brokerage arrangements evolved to include the provision of research services, Congress passed Section 28(e) of the Exchange Act3, which provides a safe harbor that permits investment advisers to consider research services in addition to execution services in their best execution analysis without breaching their fiduciary duty. The inclusion of research charges with brokerage commissions has come to be accepted as a standard "soft dollar" arrangement. Under existing soft dollar arrangements, an investment adviser places a trade on behalf of its clients with an executing broker, which transaction is subject to a brokerage commission that covers the value of both the execution and research services provided by the broker. Upon receipt of the commission, a broker will generally deduct its execution costs from the commission, and then pass on the remainder in a client commission arrangement ("CCA"), which is used to finance research provided by the broker to the investment adviser. The CCA is administered by the broker or a third party administrator.
MiFID II and Section 28(e)
The existing model for bundling research and execution costs in a brokerage commission has been jeopardized by the passage of MiFID II, which includes several provisions on conflicts of interest and best execution which prohibit the payment or provision of an inducement to an investment adviser in exchange for services to its clients.4 Under MiFID II, the provision of research to an investment adviser, as funded by a CCA, would constitute an "inducement" and therefore be prohibited. As a result, the existing brokerage model, which operates under the Section 28(e) safe harbor, results in a violation of MiFID II.
Pursuant to MiFID II Delegated Directive (EU) 2017/593 of 7 April 2016 ("MiFID II Delegated Directive"), the EC clarified that investment advisers which paid for research from client accounts would not be considered inducements in violation of MiFID II, if such payments were made through an RPA which meets certain conditions. Those conditions include a requirement that (i) the RPA be funded by a specific research charge to the client, (ii) the investment adviser regularly assess the annual research budget and provide such information to the client, (iii) the investment adviser be responsible for the RPA, and (iv) the investment adviser regularly assesses the quality of the research purchased based on robust criteria.5 These requirements differ from the existing CCA model in two important respects: (1) a specific research charge is not identified in Section 28(e) soft dollar transactions, and (2) while Section 28(e) transactions involve a separate accounting arrangement (the CCAs), such CCAs are not controlled by the investment adviser, as required in the case of an RPA.
As a result, in order to comply with the EU requirements, SIFMA proposed an adjustment to the existing CCA model that would result in: (1) a separate research charge being made alongside the execution charge to a broker (rather than built into the execution charge and then separated out later into a CCA after the broker deducts its execution cost), and (2) payment for research being conducted out of an RPA controlled by the investment adviser, rather than a CCA controlled by the broker.
In its letter to the SEC, SIFMA requested that the SEC confirm this adjusted model would still be eligible for the safe harbor under Section 28(e). In particular, SIFMA's letter requested no-action relief that the payment of a separate research charge alongside an execution charge would still fall within the definition of "commission" for purposes of the Section 28(e) safe harbor, and that research services funded via an RPA would be "provided by" the broker as required under Section 28(e). In its response, the SEC Division of Trading and Markets granted SIFMA's no-action request, subject to a number of conditions, as set forth below:
(i) "alongside": the research payments are made alongside the payments for execution to the executing broker;
(ii) "research services": the payments made are for research services that are eligible for the Section 28(e) safe harbor;
(iii) "effects": the relevant executing broker-dealer effects the securities transaction in connection with which the payments are made; and
(iv) "contract": the executing broker is obligated by contract to pay for any research through the RPA.
Pursuant to the no-action relief granted by the SEC, investment advisers will therefore be able to pay for research from client accounts. While the administrative burden of doing so may be increased, investment advisers are permitted to delegate the administration of RPAs to third parties, though any amounts left over in the RPA will need to be rebated back to the client.
The SEC's relief comes on the same day that the EC released FAQs on the use of RPAs by third country (e.g., the United States) broker-dealers. In its release, the EC clarifies that brokers may receive a combined payment for research and execution as a single commission "as long as the payment attributable to research can be identified," the investment adviser maintains a clear audit trail of payments made to research providers, and the investment adviser can identify the amount of research payment attributable to its client. The EC's clarification effectively paves the way for the use of RPAs under which investment advisers make payment for research "alongside" execution payment, as such research payments will be clearly identifiable and auditable.6
In order to meet the requirements of the SEC no-action relief, investment advisers and broker-dealers will need to review their existing contractual arrangements to ensure compliance with the SEC's conditions and those advised by the EC. In particular, investment advisers and brokers should ensure that brokerage commissions include clearly identifiable charges for research and that any third party administration of the RPA is conducted pursuant to the instruction of the investment adviser. In addition, investment advisers will need to review their best execution policies and procedures to ensure oversight of the RPA model and compliance with the MiFID II conditions.
Should you have any questions regarding the SEC no-action relief, MiFID II's ban on inducements or the implications of these on brokerage models, please contact Richard Shamos at 212.573.8027 or email@example.com or Dan Viola at 212.573.8038 or firstname.lastname@example.org.
1. See SEC No-Action: https://www.sec.gov/divisions/marketreg/mr-noaction/2017/sifma-amg-102617-28e.pdf 2. MiFID II: FAQs on obtaining brokerage and research services from non-EU brokers, European Commission, 26 October, 2017. 3. Section 28(e) provides: "No person using the mails, or any means or instrumentality of interstate commerce, in the exercise of investment discretion with respect to an account shall be deemed to have acted unlawfully or to have breached a fiduciary duty under State or Federal law...solely by reason of his having caused the account to pay a member of an exchange, broker, or dealer an amount of commission for effecting a securities transaction in excess of the amount of commission another member of an exchange, broker, or dealer would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by such member, broker, or dealer, viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion." 4. See MiFID II, Articles 16(3), 23, 24 and 27. 5. MiFID II Delegated Directive Article 13(1)(b). 6. See EC MiFID II FAQs: https://ec.europa.eu/info/system/files/non-eu-brokers-dealers.pdf