The following is a guest article by Lee Pickard, Will Edick, and Kristen Hutchens, lawyers at Pickard Djinis and Pisarri LLP which has previously obtained U.S. no-action relief relating to Section 28(e) of the Securities Exchange Act of 1934.
A hot topic on Wall Street and beyond this summer is the looming effective date for the European Union’s new directive on markets in financial instruments (“MiFID II”). Among other things, MiFID II restricts investment firms from obtaining research from broker-dealers through proprietary and third-party client commission arrangements unless such arrangements unbundle research fees from transaction commissions. As you will read below, we recommend that US firms seek legal counsel before changing their current practices under Section 28(e) of the Securities Exchange Act of 1934 for buying research and disclosing those changes to investors and regulators. Absent special circumstances, MiFID II does not require US firms with no presence in the EU to change their current practices under Section 28(e) of the Exchange Act for purchasing research. Moreover, MiFID II’s provisions regarding research payments can be read to conflict with certain U.S. securities laws and rules, a point which SEC Chair Jay Clayton and US lawmakers have now acknowledged.
MiFID II, the EU’s new directive governing research payments
MiFID II takes effect on January 3, 2018. EU directives such as MiFID II, however, are not self-executing legal instruments. While directives “direct” EU members to achieve certain policy goals, EU member states must then pass relevant domestic legislation to achieve those goals. As of July 3, 2017 (the deadline for transposing MiFID II into national law), only one member – Cyprus – had communicated full transposition measures to the EU.
Due in part to the iterative process for implementing MiFID II, the full extent of MiFID II’s reach remains unclear. MiFID II applies to investment firms domiciled or permissioned (registered) in the EU, including the EU offices of any US investment managers. Less clear, by way of example, is whether and when MiFID II reaches US asset managers with no presence in the EU who execute sub-advisory arrangements with an EU-domiciled investment manager.
Among other things, MiFID II prohibits investment managers from accepting “fees, commissions or any monetary or non-monetary benefits paid or provided by any third party,” unless otherwise stated. MiFID II makes an exception for research under certain conditions. Investment firms may accept substantive research services if, and only if, paid for directly by the investment firm (1) out of its own resources or (2) from a separate research payment account (“RPA”) controlled by the investment firm. RPAs can be funded either through a specific research charge directly billed by the investment manager to its account(s) or through a charge collected by a broker-dealer alongside dealing commissions, but if the latter, the research portion of the charge must be priced separately from the execution portion and remitted to the RPA controlled by the investment manager.
MiFID II does not affect the US’s longstanding legal and regulatory regime for research payments
The provision of investment research by broker-dealers has long been an acceptable business practice in the United States, with research being a natural component of the securities execution process. In 1975, on the heels of a ban by the SEC on fixed commission rates, Congress made client commission arrangements possible by creating a statutory safe harbor for fiduciaries who pay for qualifying research with “soft dollars,” i.e., commission dollars generated by brokerage transactions for the fiduciary’s client accounts. This safe harbor resides in Section 28(e) of the Exchange Act.
Today, money managers continue to rely on the Section 28(e) safe harbor to pay broker-dealers for research. And neither the President, nor Congress, nor the SEC has given the investment community cause to believe it hopes or intends to remove or restrict this statutory safe harbor in response to the EU’s new directive. To the contrary, when responding to questions by Senators Jerry Moran (R-KS) and John Boozman (R-AR) during a recent budget hearing, SEC Chair Jay Clayton explained that the SEC and its staff are looking into the amount of relief it, using the powers it has, can provide US firms from this regulatory clash. Chair Clayton cautioned that he is “not certain that the power [the SEC has] will be able to facilitate all relief that people might want”.
Conflicts between MiFID II and US law
As explained, most US investment firms do not need to make any changes to how they purchase research because they are outside MiFID II’s reach. Those firms thinking about moving to a MiFID II RPA (either for compliance or business reasons) should seek legal counsel before making and disclosing those changes. Counsel can advise on the extent to which MiFID II requirements are incompatible with, or insufficient under, US securities law and rules, and the legality of different business solutions to deal with those conflicts. In this regard, it has been reported that at least one Wall Street bank is considering withholding US research from asset managers in the EU due to the regulatory clash between the EU and US rules.
By way of example, the Section 28(e) safe harbor may be incompatible with RPAs. The Section 28(e) safe harbor applies to protect money managers who pay commissions to broker-dealers from whom the managers receive research. MiFID II, on the other hand, specifically indicates that while research fees may be charged on a transaction basis alongside a commission, they are not themselves commissions. Rather, under MiFID II, research fees charged to an investment manager’s customers must be specifically identified as such and be deposited into an RPA controlled by the investment manager to be used by the investment manager to purchase research. Because the balances in an RPA are not commissions, it is unclear whether the Section 28(e) safe harbor would cover an investment manager’s use of these funds to purchase research. While some investment managers (e.g., managers of hedge funds) are permitted to engage in arrangements outside the Section 28(e) safe harbor upon notice to, and consent of, their managed accounts, advisers to other types of accounts, including managers to ERISA plans and registered investment companies, may only participate in arrangements that fall under the safe harbor and thus likely would not be able to use MiFID II RPAs to pay for research.
In addition, depending on the relief the SEC or its staff ultimately provides, if any, the Custody Rule (Rule 206(4)-2) under the Investment Advisers Act of 1940 may make RPAs impractical for US investment advisers. Under MiFID II, the investment firm controls the RPA and is supposed to have a process for rebating surplus research fees back to clients or offsetting them against the clients’ next research charge. The Custody Rule, however, prohibits investment advisers from holding custody of client funds and securities (as arguably would be the case for an RPA), absent compliance by the adviser with the rule. If the SEC were to treat the refundable research fee as a client asset, then US investment advisers using RPAs would need to comply with the Custody Rule, which imposes heightened regulatory obligations on the adviser and may prove too costly or burdensome for some advisers to justify. At minimum, tracking the amounts held in an RPA back to the investment manager’s clients who contributed to the RPA will raise significant recordkeeping issues for the investment manager.
Finally, Section 202(a)(11)(C) of the Advisers Act may be incompatible with a payment arrangement such as an RPA in which a broker-dealer (1) accepts hard dollar payments, i.e., cash fees or payments, yet (2) is not registered as an investment adviser. Because the Advisers Act exempts from the definition of “investment adviser” a broker-dealer whose provision of investment advice is “solely incidental” to its brokerage services and who receives no “special compensation” for providing such advice, broker-dealers – who provide research based on commission received in arrangements that comply with Section 28(e) – need not register with the SEC as an investment adviser. On the other hand, a broker-dealer who accepts a hard dollar payment for its research, including a payment from an RPA, likely cannot rely on its status as a broker to avoid registering as an investment adviser because this hard dollar payment would be deemed “special compensation” under the Advisers Act.
Absent special circumstances, US investment advisory firms with no presence in the EU are not required to adhere to the new research provisions under MiFID II. To the extent firms are contemplating moving to a MiFID II-style RPA, they should consult legal counsel before changing their current practices for obtaining research and disclosing those changes to investors and regulators.
About the Authors
Lee A. Pickard, William D. Edick, and Kristen A. Hutchens practice law at Pickard Djinis and Pisarri LLP, a boutique securities law firm located in Washington, DC. Mr. Pickard served as Director of the SEC’s Division of Trading and Markets (1973-1977) and has worked on issues relating to the Section 28(e) safe harbor since then. This article is based on a piece prepared by Pickard Djinis and Pisarri for The Interstate Group, which has provided independent research to the institutional investment community since 1975. This article is for general information purposes only, and it does not necessarily reflect the views of all of the firm’s clients.
Editor’s Note: Further discussion of the issues surrounding using RPAs in the U.S. see our earlier article ‘MiFID II: Commissions Cannot Fund RPAs in USA‘. For a detailed discussion of the issue surrounding cash payments to U.S. brokers see Will Edick’s earlier article: ‘The Challenges of Paying Cash For Research in the U.S.‘ One additional conflict between U.S. regulations and MiFID II is the issue of research cross-subsidization.
 Timing and other information regarding MiFID II can be found on the website of the European Securities and Markets Authority at: https://www.esma.europa.eu/policy-rules/mifid-ii-and-mifir. A copy of Directive 2014/65/EU is available at http://eur-lex.europa.eu/legal-content/EN/ALL/?uri=CELEX:32014L0065.
 See, e.g., Article 93 (“Transposition”) of MiFID II.
 The transposition status for each EU member can be found at: https://ec.europa.eu/info/publications/mifid-ii-directive-transposition-status_sl.
 The scope of MiFID II is set forth in Article 1 of Directive 2014/65/EU as follows: “This Directive shall apply to investment firms, market operators, data reporting services providers, and third-country firms providing investment services or performing investment activities through the establishment of a branch in the Union.”
 See Article 24 in Directive 2014/65/EU.
 See Article 13(3) in the delegated directive dated July 4, 2016 supplementing Directive 2014/65/EU, available at http://ec.europa.eu/finance/docs/level-2-measures/mifid-delegated-regulation-2016-2031.pdf. See also ESMA, Questions and Answers on MiFID II and MiFIR investor protection topics (Apr. 4, 2017), available at https://www.esma.europa.eu/press-news/esma-news/esma-updates-mifid-iimifir-investor-protection-qas.
 A video of Chair Clayton’s testimony on June 27, 2017 can be found at c-span.org. See also Crabb, John, SEC: Mifid II is a conflict we didn’t create, Int’l Fin. Law Review (Apr. 7, 2017), available at http://www.iflr.com/Article/3707585/SEC-Mifid-II-is-a-conflict-we-didnt-create.html.
 See generally Julie Edde, Wall Street Stuck in Legal Stalemate Over Research Payments, Bloomberg (May 23, 2017), available at https://www.bloomberg.com/news/articles/2017-05-23/wall-street-stuck-in-legal-stalemate-over-paying-for-research.