The European Commission recently launched a consultation on a proposal that would allow investment firms to rebundle payments for research on small- and mid-cap issuers and fixed income instruments, to aid in the recovery from the COVID-19 pandemic and to mitigate the decline in research coverage of those sectors caused by unbundling as observed prior to the pandemic’s onset.
If adopted, the proposal would provide a limited exception from the requirement under the Markets in Financial Instruments II (MiFID II) regime that investment firms pay for research separately from execution.
Under the proposed legislative text, investment firms could rebundle (i.e., pay for covered research and execution jointly) if (1) the investment firm and research provider enter into an agreement on the amount of the bundled payment (i.e., full-service commission) to be paid for research and (2) the investment firm “informs” clients about the bundled payment.
Comments on the proposal are due by September 4, 2020.
ISSUES RAISED BY THE PROPOSAL
The proposal raises questions and portends operational challenges for buy- and sell-side firms that have already expended substantial resources and efforts in the unbundling transition as part of MiFID II, including the following:
- It is unclear how investment firms would be expected to calculate the trailing 12-month 1 billion euro (or other currency equivalent) market capitalization for small- and mid-cap issuers, whether the determination could be made annually or on a rolling basis, and how investment firms might address arrangements to receive research on mid-cap issuers that may surpass the 1 billion euro market capitalization during the time of the research agreement.
- The proposal does not explain what is encompassed by fixed income research, including whether that includes macro research or research on convertible debt.
- The proposal does not establish specific parameters about the required “agreement” between the investment firm and research provider or require agreement by the investment firm’s clients, although clients may have some “say” in the arrangements.
- Because the proposal is floated as a response to aid the recovery from COVID-19, it is unclear whether the changes are intended to be temporary or enduring in nature (a matter that the proposed text does not address).
- While the proposal allows rebundling of fixed income research, global investment firms seeking to rely on the US safe harbor for research (Section 28(e) under the Exchange Act of 1934) will still have to address interpretive limitations on relying on the safe harbor when obtaining such research from dealers in principal transactions.
- An open question is whether the proposal would, if enacted, meaningfully increase coverage of small- and mid-cap issuers and fixed income instruments in the European Union, the languishing of which in the EU has been a source of concern for EU policymakers. Such research has suffered lower relative demand and pricing in the marketplace for research, leading many research providers to focus on other issuers and issues in greater demand. Note that the covered research on small- and mid-cap issuers and fixed income instruments is not limited to EU issuers.
POTENTIAL ISSUES WITH EU/UK ENACTMENT
If enacted, EU member states will have to transpose the legislative text into their own laws. At this point, it is unclear whether the proposal will go forward, when the changes would take effect, whether the changes would be subject to any “gold plating” by EU member states, and how the United Kingdom would respond.
If the United Kingdom does not follow suit (but stays the course on unbundling), this would raise the question of whether it could effectively block this initiative given the number of global investment firms doing business in the country.
THE US PERSPECTIVE
Questions loom about the impact of the proposal on the US Securities and Exchange Commission (SEC) staff’s 2017 and 2019 no-action letters to the Securities Industry and Financial Markets Association (SIFMA) that—as extended until July 3, 2023—allow broker-dealers to receive unbundled payments for research from investment firms without being deemed an investment adviser only if the investment firms are “required” by MiFID II (or corresponding UK rules) to pay for research separately from execution either from their own resources or through a research payment account (RPA).
Namely, it is unclear whether investment firms would be viewed as “required” to unbundle for purposes of the SIFMA no-action letter where they have the option to make unbundled payments for research on covered small- and mid-cap issuers and fixed income instruments. This could complicate research arrangements for buy-side firms, sell-side firms, and other research providers.
In concept, if an investment firm does not satisfy the conditions specified in the proposal, it would be required to pay for research separately. As such, firms might explore whether the agreement requirement under the proposal can be applied to allow an investment firm and a research provider to have the “best of both worlds” by
- intentionally not satisfying the requirement where the investment firm desires to pay for research separately,
- satisfying the requirement where the investment firm desires to pay through bundled commissions, or
- in a hybrid fashion, allowing for the payment for research through bundled commissions up to an agreed-upon research budget, after which the agreement terminates.
However, the above might require refinements in the legislative text or accompanying interpretations. We understand that the SEC staff is aware of these developments and is monitoring the situation, in consultation with their European Commission counterparts.
 See Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU.
 For purposes of the proposal, small- and mid-cap issuers would include issuers that did not have a market capitalization greater than 1 billion euros during the 12 months preceding the provision of research. See Capital markets – research on companies seeking alternative financing (updated rules in light of COVID-19).
 See Commission Guidance on the Scope of Section 28(e) of the Exchange Act, Securities Exchange Act Release No. 45194 (Dec. 27, 2001), 67 Fed. Reg. 6, 7 (Jan. 2, 2002) (interpreting “the term ‘commission’ in Section 28(e) of the Exchange Act to include a markup, markdown, commission equivalent or other fee paid by a managed account to a dealer for executing a transaction where the fee and transaction price are fully and separately disclosed on the confirmation and the transaction is reported under conditions that provide independent and objective verification of the transaction price subject to self-regulatory organization oversight,” albeit with caveats limiting the interpretations applicability to fixed income research acquired in principal transactions).
 See Secs. Indus. & Fin. Mkts. Ass’n, SEC Staff No-Action Letter (Nov. 4, 2019) (Extension Letter); Secs. Indus. & Fin. Mkts. Ass’n, SEC Staff No-Action Letter (Oct. 26, 2017) (SIFMA Letter). The SIFMA Letter, which was set to expire on July 3, 2020, provided no-action relief for a broker-dealer that provides research services that constitute investment advice under the Advisers Act to a money manager in exchange for payment from the money manager’s own money, from a separate research payment account funded with its clients’ money, or a combination of the two, where the money manager is required, either directly or by contractual obligation, to pay for research services in those ways under MiFID II and substantially similar national rules of EU member states. The Extension Letter extends the SIFMA Letter to July 3, 2023 and confirms that the SIFMA Letter also applies an investment manager subject to compliance with provisions in UK law related to research that are substantially similar to MiFID II and its implementing rules and regulations.