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SEC Staff Solves Section 28(e)-MiFID II Compliance Conundrum—For Now

Posted in Broker-Dealer Regulation, Investment Adviser Regulation

In a series of three “no-action” letters, the staff of the Securities and Exchange Commission (SEC) published guidance to address concerns by U.S. broker-dealers and investment advisers about how to comply with Markets in Financial Instruments Directive (MiFID II) rules that limit the use of soft dollars.  Among other things, the Division of Investment Management said that broker-dealers, on a temporary basis, may receive research payments from money managers in hard dollars or through MiFID II governed research accounts from clients subject to MiFID II, without being considered to be an investment adviser.

After consulting with European regulators, the SEC staff published the guidance in response to concerns that U.S. broker-dealers that must comply with MiFID II soft dollar limitations would be forced to register as investment advisers if they provided research for hard dollars.  The long-awaited guidance provides some clarity for financial institutions faced with the dilemma of how to comply with conflicting U.S. and EU regulatory requirements.

The temporary action provides the SEC a breather to “monitor and assess” the impact of MiFID II’s requirements on the research marketplace and whether any new rules are needed.

The European Union’s (EU) recast MiFID II, which kicks in on January 3, 2018, effectively eliminates the ability of EU clients to pay broker-dealers for research services through “soft dollars.”  Section 28(e) of the Securities Exchange Act of 1934 (the “Exchange Act”) provides safe harbor for a money manager to use client commissions to purchase “brokerage and research services” without breaching its fiduciary duty.  In the U.S., money managers often use client commission arrangements to obtain brokerage and research services from a broker-dealer, using a single, “bundled” commission that is separated after execution to pay for order execution and research.  Broker-dealers can provide this research to advisers without having to register as investment advisers if the research is incidental to their brokerage business.

The Division of Investment Management also provided relief under the Investment Company Act of 1940 and the Advisers Act to permit investment advisers to continue to aggregate client orders for purchases and sales of securities, when 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.  This relief allows advisers to continue to aggregate orders while addressing the differing arrangements regarding the payment for research that will be required by MiFID II.

MiFID II permits money managers to pay an executing broker-dealer for research out of a client-funded research payment account (RPA) alongside payments for order execution.

The Division of Trading and Markets said that U.S. money managers may operate within the safe harbor if they pay for research to an executing broker-dealer out of client assets alongside payments for execution through the use of an RPA that conforms to the requirements for RPAs in MiFID II, and the executing broker-dealer is legally obligated to pay for the research, provided that they meet the conditions of the Section 28(e) safe harbor.

The SEC has invited market participants to visit its website and comment on the issues.

Our Take

The long-awaited guidance from the SEC takes a practical approach that acknowledges the conundrum faced by U.S. advisers and broker-dealers that must comply with conflicting U.S. and EU requirements.  The actions solve the immediate issue while leaving open the door for future regulation once the SEC wraps its regulatory arms around how the U.S. and EU laws will work in practice and how they affect the capital markets.  Also, this approach signals that the SEC and its staff are mindful of the need for regulation while recognizing that regulations must be practical and flexible.