The following guest article was written by Robert Nowicki, a commission management consultant with more than twenty years of experience managing the global commission management divisions of major Wall Street firms.
In the past few months, a number of US brokers have expressed concerns that a few US asset managers were pressuring them to accept hard dollar payments to pay for their research. Asset managers subject to MiFID II admit that paying for US broker research outside the country appears to circumvent US law, but they argue that ambiguous comments made by the SEC supports this option. Clearly, the financial markets are confused.
In the lead-up to the January 3, 2018 rollout of MiFID II’s requirement to unbundle research payments from equity commissions, over 100 asset managers in the US and Europe decided to pay for sell-side and independent research from their own resources (paying from their P&Ls) instead of using trading commissions. While this model worked as a means to pay broker-dealers domiciled outside the US, those in the US have been limited from accepting cash payments for their research due to regulatory constraints.
Consequently, on October 26, 2017, the SEC Staff issued a No-Action letter to SIFMA indicating that they would not take enforcement action against a broker-dealer who receives cash payments for the provision of their investment research from an asset manager who is subject to MiFID II. On November 4, 2019 this temporary No-Action letter was extended to July 3, 2023.
These No-Action letters allowed US broker-dealers to accept cash payments for the research they provide to EU domiciled asset managers, or US asset managers with operations in the EU, without the fear that they will be charged with a breach of the Investment Advisers Act of 1940. The SEC finally allowed these “no action” letters to expire on July 3, 2023.
One way US brokers can accept cash payments for their research is to move their research departments into entities that are registered investment advisors. Unfortunately, only six investment banks affiliated their research departments with investment advisors prior to the expiration of the “No Action” letter, including Bank of America Merrill Lynch, Deutsche Bank, Jefferies, Nomura Securities, Bernstein Research and BMO Capital Markets.
A handful of asset managers decided to take matters into their own hands by adopting an approach called the MFS model where equity commissions (either through an RPA or CSA) are used to pay for research. To become MiFID II compliant, these managers decided to reimburse any funds used to pay for research back to the clients. A few global asset managers, including MFS, Capital Group, T. Rowe Price, and TIAA have adopted this approach.
Confusion from Asset Managers
Unfortunately, the current marketplace regarding research payments is quite confusing for asset managers. Most US asset managers continue to use equity commissions to pay for sell-side and independent research, while a few global managers (listed above) and most European managers continue to pay for research from their own funds (P&L).
The big question is how long can the managers who are paying for research from their P&Ls continue to do so, particularly when many other asset managers are using commissions to pay for external research? Most asset managers admit it would be a tremendous headache to unwind existing processes that have been set up to pay for research from their own P&Ls. Despite this fact, a few of the asset managers who are paying research from their P&Ls say they are currently planning to shift back to using client commissions to pay for research.
A number of asset managers would love to move back to using commissions to pay for research, but they admit that poor fund returns would make it hard to justify to their clients. Some asset managers who are currently using hard dollars to pay for research have started informing clients that they will use commissions to pay for research with new funds and strategies. It is interesting to note that these announcements have garnered no pushback from their clients.
Of course, asset managers subject to MiFID II still need to figure out how to pay US brokers for their research now that these brokers don’t have the protection from the SEC “No Action” letter. Since most US broker-dealers have refused to roll their research departments into RIAs, these asset managers have been struggling to find a way to pay for this research.
Ambiguous comments from a couple of SEC officials have led many EU asset managers to pay for the largest US brokers’ research in their UK or EU offices. Unfortunately, this approach doesn’t work for mid-sized and smaller US brokers that don’t have UK or EU offices. These managers also admit that this solution seems to circumvent US law and seems unfair to smaller brokers, but they contend that they have no other options.
Broker-Dealers Also Suffer With Uncertainty
Most US brokers say that the expiration of the SEC’s “No Action” letter has altered their way of doing business. Now they will only accept hard dollar payments from MiFID managers for their research overseas – a model that works for the larger broker-dealers, but which disadvantages the boutique and mid-sized firms that don’t have branches in the UK and EU. This approach also raises the question of compensation for the US sell-side analysts who produced the research consumed and paid for overseas.
Some US broker-dealers have complained that in the past few months a handful of US asset managers have tried to pressure them into accepting hard dollar payments for their research. In addition, other US brokers discovered that their firms had accepted hard dollar payments in the past for their US research from US asset managers who were not subject to MiFID II, despite internal policies to the contrary.
Of course, most broker-dealers are uncertain about the tax consequences of accepting hard dollar payments in the UK or EU for US produced research.
Feedback from both the sell-side and buy-side indicates that confusion around research payments is widespread in the wake of the SEC “No Action” Letter’s expiration in early July 2023. Can asset managers subject to MiFID II use hard dollars to pay for research produced by US brokers, if they do so outside the US? How do boutique and mid-sized US brokers get paid for their research that is consumed by non-US asset managers? What are the tax consequences of receiving payment for US produced research outside the US?
Clearly, neither the SEC nor the UK and EU regulators have been able to clear up this confusion. In fact, comments by the regulators in recent months seem to have actually increased the confusion in the marketplace. Our biggest concern is that this confusion, if left unchecked, will increase the regulatory risk that broker-dealers and asset managers face when the regulators finally get around to addressing these issues in upcoming reviews.