Should Broker-Dealers That Accept Hard Dollars for Research from EU Money Managers Register as Investment Advisers?
The European Union (EU) issued Markets in Financial Instruments Directive – II (“MiFID II”), which, as of 2017, compelled asset managers and brokerage firms to separate the cost of trading from research, more commonly known as “unbundling.” MiFID II’s unbundling requirements raised an issue under U.S. law, since a U.S. broker-dealer who received separate “Hard Dollar” payments for research could be deemed an investment adviser and be required to register under the Investment Advisers Act of 1940 (the “Advisers Act”). To deal with this issue, the SEC issued a temporary No-Action Letter to SIFMA, which allowed U.S. broker-dealers to accept cash payments for research rather than using client commissions (“Soft Dollars") as payment without having to register as an investment adviser. The relief provided by this no-action letter expires on July 3, 2023.
In a July 26, 2022 speech, William Birdthistle, Director, SEC Division of Investment Management, said the “Division does not intend to extend the temporary position beyond its current expiration date in July 2023.“ He mentioned that some broker-dealers had dealt with the issue by becoming dually registered or by using a registered adviser affiliate to provide research services.
U.S. broker-dealers that accept Hard Dollar payments from EU/UK asset managers for research should consider their options, including:
- Registering with the SEC as investment advisers, assuming such broker-dealers continue to accept payments for research apart from any commissions generated from duly authorized EU/UK Money Managers transactions (“Hard Dollar payments”);
- Shifting their Hard Dollar payments to an affiliated, but separately organized business entity in the UK/EU for non-U.S. clients, to comply regulations enacted under MiFID II, while also segmenting Soft Dollar payment operations in the U.S. affiliate for the benefit of U.S. clients;1
- Relying on the exclusion from registration under Section 202(a)(11) of the Advisers Act for broker-dealers that provide advisory services when such services are (i) “solely incidental” to the conduct of the broker-dealer’s business and (ii) provided for no special compensation;
- Relying on another registration exemption (at the Federal or State-level, as appropriate), including seeking no-action relief from the respective regulators based on the broker-dealer’s business model; and
- For research-only firms registered as broker-dealers that do not have any Client Commission Arrangements (“CCA”) relationships with an executing broker-dealer,2 withdrawing from broker-dealer registration and registering as an investment adviser (since any compensation received for research could be considered special compensation without associated transactions).
For broker-dealers relying on option two, the SEC typically has not viewed the use Soft Dollars to pay for research as special compensation, assuming the investment adviser complies with the conditions of Section 28(e) of the Securities Exchange Act of 1934 (the “Exchange Act”). There is risk involved with this approach, however, for brokerage firms providing research for EU clients and receiving Hard Dollars. Providing research services for a fee could result in the SEC or a state securities authority determining that broker-dealers are serving as investment advisers and therefore should be registered as such. This risk may be mitigated if the broker-dealers’ only EU clients are EU-based institutional investors, such as qualified institutional buyers (“QIBs”) or qualified purchasers (“QPs”) that buy services for their own enterprise or account and/or operate under Institutional Suitability treatment, because, from a US broker-dealer or investment advisory perspective, putting aside their US jurisdictional ties, there is neither a retail investor nor a U.S. investor to protect.
European and U.S. regulators differ in their views of how asset managers should pay for research. In Europe, MiFID II requires investment managers to pay for the research they obtain, either by paying for it themselves, by passing on the charge to clients, or a combination of both. While both the U.S. and EU impose best execution obligations, MiFID II bans the use of commissions to pay for research (aka Soft Dollars) as a prohibited inducement. A key principle of the MiFID II unbundling reforms is to ensure that portfolio managers act in the best interests of their clients and that their investment decisions are not unduly influenced by third parties. Thus, the European authorities sought to separate or “decouple” research from brokerage. The following are some conventions that developed to address either the EU and or U.S. perspective on such research:
- First, EU money managers could pay for the research themselves;
- Second, the EU money manager could create a Research Payment Account (“RPA”), upon informed written client consent, with the understanding that such client funds would pay for research; and
- Third, U.S. registered broker-dealers continue to use CCAs.
Under the SEC’s Guidance Regarding Client Commission Practices under Section 28(e) of the Securities Exchange Act of 1934, the SEC permitted investment advisers to generate commission credits in an account at a broker-dealer and direct the broker-dealer to make payments from those credits to others to pay for eligible research and brokerage services consistent with the Section 28(e) safe harbor under the Securities Exchange Act of 1934, as amended (the “Soft Dollar Safe Harbor”). These CCA arrangements must meet certain criteria. Specifically, the broker accumulating the commissions must be involved in effecting the trades that generated the commissions. Insofar as transactions are linked to and commissions emanate from a CCA, then the revenue model for this holistic service approach is, in our assessment, unlikely to be considered “special compensation” under the Advisers Act.
Conversely, RPAs may be more likely to represent the receipt of special compensation under the Advisers Act, since research provided by U.S. registered broker-dealers is paid for with Hard Dollars and decoupled from any brokerage transactions. RPAs and Hard Dollar payments for research by the EU money manager are essentially the accepted conventions for EU money managers under MiFID II, solving the “European side” of these cross-border business models.
Considering the U.S. side of this cross-border business model, Section 202(a)(11) of the Advisers Act provides exclusions from the definition of investment adviser, including for “any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.” Moreover, as noted by the SEC is its Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion from the Definition of Investment Adviser, advice need not be trivial, inconsequential, or infrequent to be "solely incidental"; the point is that advice must be inextricably related to the core function of the broker-dealer, which is to effectuate transactions in exchange for commissions.
While U.S. broker-dealers have traditionally relied upon Soft Dollar Safe Harbor in the provision of research, MiFID II introduced challenges for US broker-dealers. Because the Hard Dollar compensation compelled by MiFID II, from a US perspective, ostensibly represents “special compensation” under the Advisers Act, it more could require broker-dealers to register under the Advisers Act, absent some other registration exemption or a SEC no-action letter. Therefore, the SEC issued the SIFMA No Action Letter that solved for one aspect of those challenges; namely, the SEC would not recommend enforcement action against broker-dealers that provide research services that constitute investment advice under the Advisers Act to EU asset managers that are required to pay for such services with Hard Dollars. (See our blog post for more information) While the SEC issued the SIFMA No Action Letter as a short-term solution, the imminent expiration of the letter on July 3, 2023 means that firms must confront the choices outlined above.
For research-only broker-dealers, the expiration of the SIFMA No-Action Letter raises a few additional questions. One issue is whether the research would be considered incidental to the brokerage function if there are no purchases, sales, exchanges, trading, market making, underwriting/investment banking, merger and acquisition (“M&A”) transaction-based engagements or even M&A advisory engagements for buy/sell-side transactions or other transactional business. Where a broker-dealer distributes and gets paid Hard Dollars for its research without the possibility of an associated brokerage transaction, then it is hard to argue that such services fall under the Advisers Act Section 202(a)(11) broker-dealer exemption. One plausible path forward would be for subscription-based, research-only firms to register as investment advisers, despite the fact that they, for whatever reason, historically registered as broker-dealers.3 Understandably, there may be other enterprise-level considerations, but this is nevertheless an approach firms may wish to consider.
This regulatory landscape is presently vague and, essentially, the SEC has signaled that it will evaluate firms on a case-by-case basis. Whether or not you make any changes to your business model, it would be prudent to document your business model, including the parameters and limitations, including how your business has determined that it complies with applicable regulations. In addition, it is very important to seek legal guidance to support whatever actions you decide. As your trusted partner, ACA can help you further evaluate your approach.
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1. Notably, if such Hard Dollar/Soft Dollar segmentation occurred within the same US entity, then there are still jurisdictional ties to the US and its regulatory scheme.
2. For clarity, this point is intended to refer to broker-dealers that neither engage in a transaction-based/commission-based business, nor have a relationship with another broker-dealer whereby the research itself could be essentially linked research with execution.
3. Research-only firms should also consider whether they are required to register with a state securities authority or with the SEC, or whether any exemptions from registration as an investment adviser apply.