On 4 November 2019, the U.S. Securities and Exchange Commission (“SEC”) issued a three-year extension (“the Extension Letter”) to its no-action letters of 26 October 2017, which was originally set to expire on 3 July 2020. The set of letters were originally provided to assist U.S. market participants in their engagement with the new EU rules relating to research under the then upcoming Markets in Financial Instruments Directive (“MiFID II”). In this note, we consider the longer-term implications of the Extension Letter, as well as summarising some interesting points raised by the SEC.
MiFID II reforms and the 2017 no-action letters
The EU’s new restrictions on inducements and paying for research were perhaps the most radical and, at the time, controversial of the MiFID II reforms. For as long as anyone could remember, investment managers had received “free” research from broker-dealer firms in return for directing execution order flow their way, albeit tempered by the widespread use of Commission Sharing Agreements (“CSA”). MiFID II sought to break that link by “unbundling” the provision of research from execution services. EU investment managers were now required to pay for research either from their own resources, or via a Research Payment Account (“RPA”).
In the run-up to these reforms going live in January 2018, the industry (particularly firms organised on a global basis) were alarmed by the contradictory requirements of the SEC and EU regimes. Under SEC rules, broker-dealers are prohibited from receiving hard dollars for research – effectively, the exact reverse of the MiFID II position. If a broker-dealer were to receive direct hard payments for research, they would be required to registered as an Investment Adviser.
The 2017 no-action letters neatly solved this conundrum, albeit for a temporary period of only 30 months. There were two main threads to this relief:
- U.S. Broker-dealers may accept research payments from investment managers who are subject to MiFID II requirements without triggering the requirement to be a registered Investment Adviser;
- U.S. Money Managers (i.e. investment managers) may pay broker-dealers for research services via an RPA and still rely on the Section 28(e) safe harbor (Securities Exchange Act 1934).
These no-action letters were also echoed in an FAQ from the European Commission to facilitate research payments to non-EU broker-dealers.
The No-Action Extension Letter and other clarifications
In coming to a decision on whether to continue or extend the temporary relief, the SEC have actively engaged with a cross-section of U.S market participants, as well as receiving direct observations from the EU. The three-year extension of relief signals there has been some positive industry feedback.
The Extension Letter also confirms the ability of broker-dealers to receive payments for research under Section 28(e) through client commission arrangements (“CCA”). “The use of CCA’s does not affect whether the exclusion for broker-dealers from the definition of “investment adviser” under the Advisers Act may be available.”The SEC also notes that this allows additional time for EU authorities to continue their evaluation of the effects of MiFID II and potentially modify their rules. It will also allow additional time for market-based solutions, together with greater transparency, to evolve further in both the EU and the U.S.
What insights does the Extension provide on the SEC’s thinking?
The SEC comments that “the Extended Period will allow for the staff to continue to monitor and assess the evolving impact of MiFID II and evaluate whether any additional guidance or recommendations to the Commission for regulatory actions are appropriate”.
Does this indicate a permanent harmonisation of SEC and EU rules on investment research?
Back in 2017, ACA commented “This (the 30-month interlude) implies some sympathy with the underlying intentions of the reforms, albeit tempered by a desire to watch and wait from the side lines.” This interpretation is reinforced by the new 3-year extension.
In this context, it is highly relevant that the UK’s FCA recently gave a positive assessment of the outcomes of the new regime, noting also that it has generally been well received by buyside firms. Taken together, in our opinion, the chances of a permanent equivalent regime in the U.S. and EU have just taken a significant step up.