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One Year Left to Run on Critical No-Action Letters for Investment Managers

The Securities and Exchange Commission issued three no-action letters on the issue of research payments, in light of developments on that issue in Europe in 2017.

Specifically, they dealt with the cross-border of Europe’s rules (MiFID II), which were scheduled to take effect, and which did take effect, on Jan. 3, 2018. MiFID II required the separation, also known as the “unbundling,” of execution and research payments made by investment managers to broker-dealers. The underlying idea is that an investment manager should not receive inducements from a third party in connection with the provision of the services an investment manager provides to its clients. If it does receive such inducement, then an agency/principal question arises. Is its commitment to its clients’ interest compromised by its relationship with the institution whence comes its research?

Not all Services are Inducements

But MiFID allows for managers to receive some research from broker-dealers, deeming the services not to be inducements, if the payments for them come from the investment manager’s own resources, or if they come from a separate research payment account (RPA) controlled by the investment manager and funded by a client out of a research budget that is set, regularly assessed, and agreed upon between manager and client.

This system raised several questions for US-based managers. Suppose for example that a US-based broker-dealer receives payments from a European investment manager for research, in accordance with MiFID. Can it still rely on the broker-dealer exemption from the regulatory requirements of the Advisers' Act? And can the investment manager who makes such a payment and receives the research still rely on section 28(e), which offers a (conditional) safe harbor from fiduciary duty claims? At the Tabb equities conference in June, participants in both the buy and the sell side discussed the pros and cons of MiFID II’s rules, and their desire for further guidance from the SEC.

Those no-action letters will expire in July 2020. For that reason, and more generally, many US asset managers are said to be concerned with whether they can and how they should be paying for research on behalf of their clients.

SEC Monitoring the Consequences

The letters said that the following points will hold, at least into July 2020, for the US industry: first, broker-dealers may receive research payments without becoming subject to the Advisers Act; second, the SEC will continue to treat investment managers as falling with the scope of 28(e) even though they pay broker-dealers for research and brokerage; and third, investment managers may continue to aggregate orders for advisory clients.

During the period of the effectiveness of these letters, the SEC said, it will closely monitor and assess the impact of MiFID on the market for research and on the participants in that market to decide whether some other or more tailored action is necessary, and along with this to decide whether it is appropriate to proceed to rule making on this point. The agency has asked for public comment on the issue of the impact of MiFID.

Investment managers in the US often rely on the client commission arrangement model to pay for research using client transaction commissions. In a typical CCA, the manager puts in a client order through an executing broker-dealer and pays that broker-dealer a single commission. The executing broker-dealer will then credit the “research” portion of the commission to a CCA. There are some respects in which the European model, the RPA, differs from the CCA. For example, in the RPA model the amount that represents research is identified separately from the amount that represents execution before the investment manager makes the payment. But in the CCA model, the two portions of the payment are not separated until after a single bundled payment has been made to the broker-dealer.

Related to this, the RPA is expected to be under the control of the investment manager.

In one of the no-action letters, the SEC said that it will treat an investment manager as falling within the existing safe harbor if it pays for research services through the use of an RPA that conforms to MiFID II requirements, provided that all other applicable conditions of 28(e) are met.

The participants in the Tabb FORUM were aware of the goals of the European rules—greater transparency, fairness, more efficiency—but they thought in general that the jury is still out as to whether these goals are being served.