MiFID II: Commissions Cannot Fund RPAs in USA

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As we wrote last week, global asset managers have been slowly learning that a number of MiFID II research unbundling rules conflict with US regulatory practice, including the ability to use research payment accounts or RPAs to make research payments globally.  The following is an edited excerpt from Integrity’s recently released 150 page study called MiFID II Research Solution Providers that addresses this and a wide range of related topics.

One Global Approach to MiFID II Unlikely

US-based asset managers wishing to conform to MiFID II face considerable difficulties in adopting one consistent compliance framework around research payments in both US and Europe because Research Payment Accounts (RPAs) as envisioned by European regulators fundamentally differ from the existing US research payment infrastructure, including Commission Sharing Agreements (or Client Commission Arrangements) which seek to unbundle execution costs from research payments.  Moreover, there is uncertainty about whether US regulation will permit monies to be transferred from commission accounts to separate RPA accounts.

Under MiFID II, Research Payment Accounts are intended to be ring-fenced accounts controlled by the asset manager.  They can be funded by separately identified research fees charged by the asset managers to their clients (the accounting method), in which case there are no problems with setting up RPAs under US regulation.  However, if US asset managers try to use such RPAs, they will run into the same problem that European asset managers experience in paying cash for US brokerage research.

MiFID II also allows RPAs to be funded ‘alongside’ transactions made on behalf of clients, which is the preferred method for most asset managers, in part because the current research payment infrastructure is built around commissions.  A majority of US asset managers have some form of commission sharing agreements (CSAs) [1] in place and the hope has been that the basic CSA structure could be used to implement MiFID II research payments.

RPAs ≠ CSAs

In a Q&A released December 2016, the European Securities and Markets Authority (ESMA), the EU financial regulatory authority responsible for drafting the MiFID II rules, provided additional guidance on RPAs, requiring that RPAs be under the legal control of the asset manager:

“When  administration  of  the  RPA  is  outsourced,  the  investment  firm  should  maintain  legal control over RPA funds until such time as it decides to make a payment to a research provider… The investment firm must be satisfied that through the outsourced agreement it continues to retain full discretion and control over the use of the account.  The  money  should  be  ring-fenced  and  clearly  separated  from  other  funds  of  the  RPA Administrator, such that they remain legally owed to the investment firm.”[2]

This requirement differentiates RPAs from CSAs as they are currently structured because CSAs are typically accounts controlled by brokers on behalf of asset managers, but not under the legal control of asset managers.

UK regulators have expressed a similar view of RPAs as fundamentally distinct from CSAs.  In the Financial Conduct Authority’s consultation paper outlining its approach to implementing MiFID II’s research payment provisions, the FCA makes it clear that RPAs differ from the commission sharing accounts maintained by brokers for their asset manager clients:

“Except when the research charge temporarily passes through an executing broker, an investment firm’s RPA monies are to be ring-fenced and separately identifiable from the assets of any third party entity they use to hold and administer the RPA (which can include a broker), prior to the investment firm instructing payment to a research provider.” [3]

Under the new MiFID II rules, simply using CSAs as a proxy for RPAs does not seem to be an option.

RPAs Alien to US Regulation

The RPA challenge is heightened by US regulation which views commissions generated to pay for research as the property of a broker.  The safe harbor provided by Section 28(e) under the Securities Exchange Act of 1934 stipulates research payments with commissions, which are deemed broker money not client money, as the Lehman bankruptcy made clear to all its CSA clients.

For this reason, some commentators argue that RPAs funded through commissions would be problematic in the US: “In Europe, the research charge or dollars are the legal property of the manager. So in Europe, all managers will have to migrate to RPAs,” ITG’s Head of Global Commission Management Jack Pollina said in a Traders Magazine interview.[4] “In the U.S. many asset managers don’t have the option to run an RPA as the SEC views commissions as the property of a broker and not the asset manager.” In Pollina’s view, the SEC would have to change its view on commissions and allow the dollars to be placed in the asset manager’s name.

 

[1] Regulators have generally endorsed commission sharing agreements (CSAs) because they parse equity commissions into a research component and an execution component, providing more transparency on research costs.  In the US, CSAs are known as “client commission arrangements” (CCAs).

[2] ESMA Q&A on MiFID II December 16, 2016, page 39  https://www.esma.europa.eu/sites/default/files/library/2016-1444_mifid_ii_qa_investor_protection.pdf

[3] Section 3.24, page 29 of CP 16/29; https://www.fca.org.uk/sites/default/files/cp16-29.pdf.

[4] http://www.tradersmagazine.com/news/buyside/north-american-buy-side-increasingly-concerned-about-mifid-ii-115814-1.html

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About Author

Mike Mayhew is one of the leading experts on the investment research industry. In addition to founding Integrity Research, Mike is on the board of directors of Investorside Research Association, the non-profit trade association for the independent research industry, and a frequent speaker on research industry trends and developments. Mike has over thirty years of research industry experience. Email: Michael.Mayhew@integrity-research.com

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