The staff of the U.S. Securities and Exchange Commission (“SEC”) has issued two no-action letters intended to facilitate compliance by investment advisers with requirements of the European Union’s (“EU”) revised Markets in Financial Instruments Directive (“MiFID II”), which is scheduled to take effect on January 3, 2018. Under MiFID II, investment advisers will have to separate payments for research from commissions they pay brokers for execution services.1
Subject to specified terms and conditions, including the use of new client disclosures and agreements, the two no-action letters would permit: (1) investment advisers to continue to rely on an existing “soft dollar” safe harbor when paying broker-dealers for research and brokerage2 and (2) investment advisers to continue to aggregate orders for mutual funds and other clients when those clients pay different amounts for research.3
This memorandum summarizes the letters, which provide regulatory relief to investment advisers.
Section 28(e) Safe Harbor for Brokerage and Research Services
Section 28(e) of the Securities Exchange Act of 1934 (“Section 28(e)”) establishes a safe harbor for discretionary investment advisers who use client commissions (soft dollars) to purchase brokerage and research services for advised accounts. Many US investment advisers rely on a client commission arrangement structure to pay a single “bundled” commission rate to broker-dealers for order execution as well as Section 28(e) eligible brokerage and research services. An investment adviser subject to MiFID II, however, will be required to select one of two options to pay for investment research: (1) pay for research out of the adviser’s own funds or (2) establish a client research payment account (“RPA”) through which a client can pay for research.4
The SEC staff provided relief under Section 28(e) to permit an investment adviser to operate within the Section 28(e) safe harbor if the adviser makes payments 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 under MiFID II, provided that all other applicable conditions of Section 28(e) are met.
The SEC staff limited its relief to the following circumstances only:
- the adviser makes payments to the executing broker-dealer out of client assets for research alongside payments to that executing broker-dealer for execution;
- the research payments are for research services that are eligible for the safe harbor under Section 28(e);
- the executing broker-dealer effects the securities transaction for purposes of Section 28(e); and
- the executing broker-dealer is legally obligated by contract with the adviser to pay for research through the use of an RPA in conjunction with a client commission arrangement (“CCA”).5
Aggregation of Client Orders
The SEC staff provided relief under Section 17(d) of the Investment Company Act of 1940 (the “1940 Act”) and Rule 17d-1 thereunder and Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) to permit an investment adviser subject to MiFID II directly or by contract to continue to aggregate orders for purchases and sales of securities on behalf of its clients (which may include registered investment companies (“RICs”)), 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.6 This relief is an expansion of the SEC staff’s position taken in SMC Capital,7 a prior no-action letter which provided that the mere aggregation of orders for advisory clients would not violate Section 17(d) or Rule 17d-1 of the 1940 Act or Section 206 of the Advisers Act if the adviser implements procedures designed to prevent any account from being systematically disadvantaged by the aggregation of orders.8 That position was based on, among other things, a representation that each client who participates in an aggregated order will participate at the average share price with all transaction costs shared on a pro rata basis.9
The SEC staff conditioned its recent relief on an investment adviser adopting and implementing policies and procedures reasonably designed to ensure that (1) each client in an aggregated order pays the average price for the security and the same cost of execution (measured by rate); (2) the payment for research in connection with the aggregated order would be consistent with each applicable jurisdiction’s regulatory requirements and disclosures to the client; and (3) subsequent allocation of such trade will conform to the adviser’s allocation statement (i.e., a pre-trade written statement specifying the participating client accounts and the intended allocation among them) and/or the adviser’s allocation procedures.
The SEC staff noted that the relief “does not apply to an investment adviser that is not subject to MiFID II (either directly or contractually).”
1 MiFID II generally applies to investment firms that have a physical presence in Europe. Non-EU investment advisers may become subject to certain MiFID II requirements under various circumstances, such as having an EU-regulated office; providing sub-advisory services to a MiFID firm; or, as required by individual EU member states, providing advisory services to clients domiciled in that state.
2 See Securities Industry and Financial Markets Association, Asset Management Group, SEC No-Action Letter (October 26, 2017).
3 See Investment Company Institute, SEC No-Action Letter (October 26, 2017).
The SEC staff also issued a no-action letter that provides temporary relief for thirty (30) months from MiFID II’s implementation date under the Investment Advisers Act of 1940 to permit a broker-dealer to receive payments in hard dollars or through MiFID-governed research payment accounts from MiFID-affected clients without being considered an investment adviser. In connection with this temporary relief, the SEC staff will continue to 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 rulemaking, is necessary and appropriate in the public interest. See Securities Industry and Financial Markets Association, SEC No-Action Letter (October 26, 2017).
4 To fund an RPA, an adviser has two options: (i) bill each client directly for an RPA contribution fee; or (ii) collect client research charges alongside transaction commissions. The SEC staff has limited its relief to the latter option – i.e., specified circumstances under which the adviser uses client assets to make payments through an RPA for research alongside payments for execution services.
5 Consequently, research acquired outside the use of a CCA/RPA arrangement is not covered by this relief.
6 After MiFID II takes effect, within a given aggregated order, some clients (including RICs) may pay total transaction costs that include the cost of execution as well as research services, while other clients may pay different amounts in connection with the same order because of varying research arrangements and/or if the adviser has elected to pay for research for such clients in whole or in part using its own resources.
7 See SMC Capital Inc., SEC No-Action Letter (Sept. 5, 1995).
8 The SEC staff stated that “[i]f a portfolio manager allocates trades in such a way as to disadvantage a registered investment company, a joint enterprise or arrangement raising the concerns section 17(d) was designed to address may result.”
9 The SEC staff noted that there may be other allocation methods that advisers can use without violating Section 17(d) or Section 206.
If you have any questions regarding the matters covered in this memo, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel’s Investment Management Group.