The EU’s Markets in Financial Instruments Directive II (“MiFID II”), which came into effect on January 3, 2018, raised concerns that US brokers would receive “hard dollars” for research from firms that subject to MiFID II can be classified. as investment advisers under the US Investment Advisers Act of 1940 (the “Advisers Act”). US registered broker-dealers have historically relied on an exception to the definition of “investment adviser” under the Advisers Act (relating to the distribution of research), which requires (i) that the investment advice be incidental to the firm’s broker-dealer business, and (ii) the broker-dealer who does not receive “special compensation” therefor.1 The conventional view is that “hard dollar” payments in exchange for securities research are “special compensation” for investment advice (viz, investment research). A 2017 SEC Staff no-action letter provided temporary relief from this concern regarding payments to dealer brokers by firms subject to MiFID II, and was later extended in 2019 until July 3, 2023.2
On July 26, 2022, William Birdthistle, Director of the SEC’s Division of Investment Management, stated in a public address3 that after 3 July 2023, US brokers accepting MiFID II compensation arrangements can no longer rely on the 2017 opt-out letter to escape classification as investment advisers.
II. BACKGROUND: MIFID II, HARD DOLLARS AND THE TIPS ACT
Before MiFID II, investment managers regularly paid US brokers for research through “soft dollars” – commission payments bundled with the cost of other services, such as research. For businesses subject to EU jurisdiction, MiFID II addressed this, stating that unless an exemption is met, the research that investment managers normally receive from brokers is a prohibited “inducement”. To be exempt, the investment manager must pay for research (i) directly from its own resources, (ii) from a “Research Payment Account” (RPA) funded with an advisory client’s money and with prior approval of the client, or (iii) through a combination of the two methods. Many EU investment managers prefer the first option – paying directly from their own resources – which has reduced the use of the soft dollar by EU resident managers.
This reduction in soft dollar payments was a cause for concern for US registered agents because the alternative – receiving hard dollar payments for research – potentially triggers investment adviser status under the Advisers Act. On the one hand, receiving soft dollar payments is within the exception to investment adviser status discussed above and found in Advisers Act Section 202(a)(11)(C) (soft dollars, being commissions, are not viewed as “special compensation” for investment advice) (“Section 202(a)(11)(C) broker-dealer exception”).4 On the other hand, receiving hard dollar payments for research calls into question the status of a broker-dealer seeking to rely on the section 202(a)(11)(C) broker-dealer exemption.
In response to the potential disruption of the broker-dealer research model, the SEC Staff issued a no-action letter in October 2017 providing temporary relief from enforcement actions under the Advisers Act. The relief applies to broker-dealers who provide research services that constitute investment advice to an investment manager that is subject, directly or by contractual obligation, to the MiFID II requirement or pays for research services out of its own money, by an RPA, or by a combination of both. The no-action letter relief was set to expire on July 3, 2020, but on November 4, 2019 it was extended until July 3, 2023 (the letter granting such extension, the “2019 Extension Letter”).5
III. SUMMARY OF JULY 26, 2022 SPEECH
In the July 26, 2022 speech, Director Birdthistle gave a clearer conclusion to the no-action letter. After July 3, 2023, a broker-dealer will not be able to accept hard dollar payments, including from firms subject to MiFID II requirements, in exchange for research in support of Section 202(a)(11) )(C) broker-dealer exception.
The 2019 Supplemental Letter also contained, in note 8, confirmation that dealer agents would be entitled to rely on the section 202(a)(11)(C) exemption for receiving commissions in connection with Customer Commission Agreements (“CCA”) , notwithstanding that the money manager in some cases (i) may not have a commercial relationship with a broker-dealer that receives research commissions from CCA or (ii) to the extent that it has a commercial relationship with a broker-dealer -such trader, trades may not be related to that broker-dealer’s search. In the July 26, 2022 speech, Director Birdthistle noted that this position will not be affected by the sunset of MiFID II-related relief.
IV. the impact
Broker-dealers are given just under a year (until 3 July 2023) to consider their stance on providing research to MiFID firms that are required to pay hard dollars. Without the protection of the no-action letter, they face the potentially difficult decision of (i) jeopardizing investment adviser status by continuing to receive hard research dollars, failing to identify a different means of avoiding investment adviser status , or (ii) cease to provide research to such firms in exchange for hard dollars.
1Counselors Act Section 202(a)(11)(C).
2Securities Industry & Financial Markets Ass’n, SEC No Action Letter (Oct. 26, 2017), https://www.sec.gov/divisions/investment/noaction/2017/sifma-102617-202a.htm.
3William Birdthistle, Remarks at PLI: Investment Management 2022, https://www.sec.gov/news/speech/birdthistle-remarks-pli-investment-management-2022-072622.
4See Russell D. Sacks and Steven Blau, “Researchers and Research Analysts”, PLI: Broker-Dealer Regulation (July 2022), at p. 17-11, available at https://plus.pli.edu/Details/Details?rows=10&fq=~2B~title_id~3A282B22~32789~2229~&fq=~2B~id~3A282B22~32789-CH17~229 &facet=true&origin=title.
5See Russell D. Sacks and Steven Blau, “Researchers and Research Analysts”, PLI: Broker-Dealer Regulation (July 2022), at p. 17-15, available at https://plus.pli.edu/Details/Details?rows=10&fq=~2B~title_id~3A282B22~32789~2229~&fq=~2B~id~3A282B22~32789-CH17~229 &facet=true&origin=title. The 2019 Extension Letter is available at https://www.sec.gov/investment/sifma-110419.