The following is a guest article by Will Edick, partner at Pickard Djinis and Pisarri LLP which obtained U.S. no-action relief on paying brokers through client commission arrangements.
Summary
European securities market regulators are considering a regulatory regime which would require European investment managers to use hard dollars to pay for investment research. In the U.S., investment managers typically obtain investment research through client commission or “soft dollar” arrangements structured to comply with the safe harbor provided by Section 28(e) under the Securities Exchange Act of 1934. Adopting a hard dollar regime in the U.S. for the payment for research would raise issues under the Investment Advisers Act of 1940 for broker-dealers who accept cash payments for research. These issues are avoided by Section 28(e) arrangements involving the use of commissions to obtain research.
Possible developments in Europe
The European Securities and Markets Authority (“ESMA”) has provided proposed guidance on MiFID which, if adopted in the European Union (“EU”), would curtail or eliminate the ability for European investment managers to receive research services from broker-dealers other than for hard cash. Under the ESMA proposal, these hard cash payments would either come directly from the manager’s own resources, or via a “ring-fenced” account maintained by the manager that is funded by a specific charge to its client accounts. If such an arrangement were established in the United States, the broker-dealer receiving the hard dollar payment for its research would potentially be exposed to registration as an investment adviser.
History of payment for research through commissions
Traditionally broker-dealers who provide investment research to institutional asset managers in the U.S. are compensated for this activity through the receipt of brokerage commissions for executing securities transactions for the managers’ accounts. Asset managers typically seek to structure these client commission arrangements (”CCAs”) or “soft dollar” arrangements (known as commission sharing agreements (“CSAs”) outside the U.S.) to comply with the safe harbor established by Section 28(e) of the Exchange Act. The Section 28(e) safe harbor permits asset managers who meet the safe harbor’s requirements to use the commissions generated by their managed accounts to pay for research that has been or will be used in the investment-decision making process on behalf of these accounts.
A U.S. broker-dealer who provides investment research and is compensated through the receipt of brokerage commissions is typically exempt from registering as an investment adviser. The Investment Advisers Act of 1940 specifically 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.
Receipt of hard dollar payments for research
A U.S. broker-dealer who accepts a hard dollar payment for its research from an asset manager likely would not be able to rely on its status as a broker to avoid registering as an investment adviser because this hard dollar payment would be deemed “special compensation.” While other exemptions from investment adviser registration may be available to a broker-dealer who accepts hard dollar payments for its research, determining whether another exemption is available usually requires an analysis of the particular research arrangement and the investment advisor regulatory regimes in each state where the broker-dealer has an office or where any hard dollar paying client is located.
The consequences of a broker-dealer being required to register as an investment adviser are numerous; however, one in particular stands out for broker-dealers who also trade on a proprietary basis. Section 206(3) of the Advisers Act generally precludes an investment adviser from trading as principal with an advisory client without disclosing its capacity in writing and receiving client consent to the transaction. Some broker-dealers who refuse to accept hard dollar payments for their research services argue that this 206(3) prohibition may apply if they trade on a principal basis with research clients who pay with hard dollars. As noted below, this concern is not present in an appropriately structured CCA.
Payments received through CCA
The situation where a broker-dealer is compensated for providing its research to an asset manager through a CCA with another broker-dealer is distinguishable from the “hard dollar” scenario discussed above. In a CCA each broker-dealer typically performs some brokerage function for the asset manager and the research broker is compensated through the receipt of commissions from the executing broker. Thus a broker-dealer who provides investment research to an asset manager and is compensated through a CCA should be able to rely on the broker-dealer exception from investment adviser registration.
Furthermore, in a properly structured CCA, a broker-dealer would appear to avoid the potential application of Section 206(3) of the Advisers Act to its proprietary trading activities with the recipients of its research as the SEC Division of Investment Management Staff has granted no-action relief in this area. See SEC No-Action Letter issued to BNY ConvergEx Group, LLC (September 21, 2010)(available at http://www.sec.gov/divisions/investment/noaction/2010/bnyconvergex092110.pdf).