Summary

The EU Markets in Financial Instruments Directive II (“MiFID II”), which came into effect on January 3, 2018, raised concerns that U.S. broker-dealers that would receive “hard dollars” for research from firms subject to MiFID II could be classified as investment advisers under the U.S. Investment Advisers Act of 1940 (the “Advisers Act” or the “Investment Advisers Act”) or analogous state law. MIFID II required the “unbundling” of securities trading and securities research compensation, so that under that law, subject to limited exemptions, it is no longer possible for a person to prepare and distribute securities research without charge, seeking securities trading commissions in exchange for the research. This form of compensation for securities research has been a cornerstone of the U.S. securities research industry for decades.

At the same time, under the Investment Advisers Act, an “investment adviser” is a person who, for compensation, advises “as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities”. [i] U.S.-registered broker-dealers have historically relied on an exception from the definition of “investment adviser” under the Investment Advisers Act (in respect of research distribution) that is conditioned on (i) investment advice being “incidental” to the firm’s broker-dealer business, and (ii) the broker-dealer not receiving “special compensation” for providing advice.^[ii] The conventional view is that receipt of “hard dollar” payments in exchange for securities research is “special compensation” for investment advice (i.e., the investment research). A 2017 SEC Staff no-action letter, however, provided temporary relief from this concern in respect of payments to broker-dealers from firms subject to MiFID II, and was later extended in 2019 until July 3, 2023.^[iii]

On July 26, 2022, William Birdthistle, Director of the SEC Division of Investment Management, indicated in a public speech^[iv] that after July 3, 2023, U.S. broker-dealers accepting MiFID II compensation arrangements can no longer rely on the 2017 no-action letter to escape classification as an investment adviser. Since that time, Director Birdthistle has repeated this announcement to various industry participants, including the Securities Industry and Financial Markets Association, or SIFMA.

Background: MiFID II, Hard Dollars, and the Investment Advisers Act

Prior to MiFID II, investment managers regularly paid U.S. broker-dealers for research through “soft dollars” — bundled commission payments embedding the cost of other services, such as research. For businesses subject to EU jurisdiction, as noted above, MiFID II states that, unless an exemption is met, research that investment managers typically receive from brokers is a prohibited “inducement.” To be exempt, the investment manager must pay for the research (i) directly from its own resources, (ii) from a “Research Payment Account” (RPA) funded with an advisory client’s money and with the client’s prior approval, 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 soft dollar use by EU-resident managers.

This reduction of soft dollar payments was a cause for concern for U.S.-registered broker-dealers, because the alternative — receipt of hard dollar payments for research — potentially triggers investment adviser status under the Advisers Act. On the one hand, receipt of soft dollar payments is within the exception from investment adviser status discussed above and found at Advisers Act Section 202(a)(11)(C) (soft dollars, being commissions, are not viewed as “special compensation” for investment advice) (the “Section 202(a)(11)(C) broker-dealer exclusion”).^[v] On the other hand, receipt of 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 exclusion.

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 that provide research services that constitute investment advice to an investment manager that is subject, either directly or by contractual obligation, to MiFID II’s requirement to either pay for research services from its own money, from an RPA, or from a combination of the two. The no-action letter’s relief was set to expire on July 3, 2020, but on November 4, 2019 it was extended to July 3, 2023 (the letter granting such extension, the “2019 Extension Letter”).^[vi]

Summary of July 26, 2022 Speech

In the July 26, 2022 Speech, Director Birdthistle provided a more definite 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 reliance on the Section 202(a)(11)(C) broker-dealer exclusion.

The 2019 Extension Letter also contained, in footnote 8, confirmation that broker-dealers would be eligible to rely on the Section 202(a)(11)(C) exclusion for receipt of commissions in connection with Client Commission Arrangements (“CCAs”), notwithstanding that the money manager in some cases (i) may not have a trading relationship with a broker-dealer that receives commissions for research from the CCA or (ii) to the extent it does have a trading relationship with such a broker-dealer, the trades may not relate to that broker-dealer’s research. In the July 26, 2022 speech, Director Birdthistle noted that this position will not be affected by the sunsetting of the MiFID II-related relief.

Impact, Next Steps, and Current Options

Broker-dealers were provided just under a year (to July 3, 2023) to consider their posture regarding provision of research to MiFID firms that are required to pay hard dollars. Without the protection of the no-action letter they are faced with potentially difficult decisions.

Among the steps that are available to broker-dealers that are faced with the withdrawal of the SEC "no action" letter are: (a) investment adviser registration, and accepting the ongoing costs of investment adviser registration with respect to that portion of the research business that is paid in hard dollars; and (b) ceasing to provide research to firms that, either by choice or because of MIFID II, are only willing to pay “hard dollars” for research. For firms that have existing registered investment adviser affiliates, expanding the scope of business of those affiliates is sometimes an available option. For firms that have substantial non-U.S. activities, research may be able to be provided to non-U.S. persons who are subject to MIFID II by a non-U.S. affiliate of the research preparer entity. Each of these options has costs and benefits that broker-dealers dealing with this issue are evaluating.

At the same time, managers and other research recipients who are subject to MIFID II continue to find access to securities research to be a shifting landscape, and many are reaching out to their research providers to discuss what strategies are being undertaken by the research provider.

[i] Advisers Act Section 202(a)(11).

[ii] Advisers Act Section 202(a)(11)(C).

[iii] Securities Industry & Financial Markets Ass’n, SEC No-Action Letter (Oct. 26, 2017), https://www.sec.gov/divisions/investment/noaction/2017/sifma-102617-202a.htm.

[iv] William Birdthistle, Remarks at PLI: Investment Management 2022, https://www.sec.gov/news/speech/birdthistle-remarks-pli-investment-management-2022-072622.

[v] See Russell D. Sacks and Steven Blau, “Research 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-CH17~2229~&facet=true&origin=title.

[vi] See Russell D. Sacks and Steven Blau, “Research 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-CH17~2229~&facet=true&origin=title. The 2019 Extension Letter is available at https://www.sec.gov/investment/sifma-110419.