When they review how the mutual funds they oversee use soft dollars to pay for research, fund directors now must consider an additional wrinkle: cross-border rules that may require advisers to “unbundle” execution and research payments.
On Oct. 26, 2017, the staff of the Securities and Exchange Commission published three “no-action” letters that address some of the concerns of U.S. broker-dealers and investment advisers about how to comply with a directive from the European Union called the Markets in Financial Instruments Directive (MiFID II), rules that take effect on Jan. 3, 2018.
MiFID II requires investment managers who pay broker-dealers brokerage commissions in exchange for research to separate, or “unbundle,” payments for execution and research. MiFID II, however, conflicts with U.S. law, which allows U.S. advisers to pay more than the lowest amount of commissions if they receive bona fide research to benefit their clients. For investment advisers with U.S. and E.U. clients that share portfolio managers and research, this conflict creates a compliance conundrum. To carry out their fiduciary duties, fund directors must understand how advisers address this challenge.
In a nutshell, the three “no-action” letters provide the following:
- Until June 2, 2020, broker-dealers may receive MiFID II-compliant research from investment advisers that are required to comply with MiFID II but are not required to register as investment advisers under U.S. law;
- Investment advisers that pay for research and brokerage services through “research payment accounts” (RPAs) may rely on the soft dollar “safe harbor” provided by Section 28(e) of the Securities Exchange Act of 1934 (the 1934 Act); and
- Investment advisers that enter into research payment arrangements required by MiFID II may continue to aggregate (or bunch) buy and sell orders for their advisory clients, including mutual funds, as they have in the past, when relying on previous no-action letters.
Not surprisingly, the trio of no-action letters did not address any issues relating to fund directors that oversee these practices because MiFID II does not directly affect them. Nonetheless, directors should be aware of how MiFID II and the SEC’s response may affect their oversight of how investment advisers spend fund brokerage dollars.
What is MiFID II and how does it affect U.S. investment companies?
MiFID II, among other things, prohibits certain money managers from receiving “inducements” from third parties in connection with providing investment advice or related services to their clients. Research provided to a money manager from an executing broker-dealer would be an “inducement” under MiFID II. Money managers, however, can pay for research from their own resources or through an RPA funded by client assets, with the client’s approval.
DILEMMA FOR BROKER-DEALERS
MiFID II compliance would require broker-dealers to register as investment advisers.
The dilemma. First, MiFID II creates a legal challenge for broker-dealers that execute trades from advisers on behalf of their European clients. A person who provides securities research to clients would fall under the definition of an “investment adviser” under the U.S. Investment Advisers Act (the “Advisers Act”).
Unbundling of execution and research could require broker-dealers that are subject to MiFID II to register as investment advisers under the Advisers Act. Unbundling could result in significant legal, operational and compliance challenges for the broker-dealer providing the research. Moreover, when the research involves an investment company, the Investment Company Act of 1940 (the “1940 Act”) would require the broker-dealer to enter into an investment advisory contract, which fund shareholders must approve. The logistic implications are daunting.
The fix. In response to this question, the staff of the SEC’s Division of Investment Management said that it would not recommend enforcement action if a broker-dealer that provides research services to an investment manager that must comply with MiFID II, either directly from its own resources or through an RPA (or a combination of the two), does not register as an investment adviser. But the relief is only through July 2, 2020. The staff’s letter made it clear that the staff does not necessarily agree with the analysis and may not renew the no-action relief after it expires.
DILEMMA FOR INVESTMENT ADVISERS
MiFID II compliance would not allow advisers to rely on Section 28(e) safe harbor to “pay up” for research.
The dilemma. Section 28(e) of the 1934 Act creates a safe harbor for money managers that use client commissions to “pay up” for research. That is, the safe harbor provides that a money manager will not violate its fiduciary duties solely because it uses client commissions to pay a broker-dealer more than the lowest available commission rate for “pure execution” when the broker-dealer also provides certain research and brokerage services. MiFID II raises the issue of whether an investment adviser can continue to rely on the Section 28(e) safe harbor if it pays for research through an RPA, rather than as part of brokerage commissions.
The fix. In response to this challenge, the staff of the SEC’s Division of Trading and Markets said that it would not recommend enforcement action if an investment adviser seeking to rely on the Section 28(e) safe harbor pays a broker-dealer for research through an RPA, provided that the adviser complies with the other requirements of Section 28(e). The staff noted that the relief will apply only when:
- The investment adviser pays an executing broker-dealer out of client assets for research alongside payments to that broker-dealer for execution;
- The research payments are for research services that are eligible for the safe harbor under Section 28(e);
- The executing broker-dealer effects the securities transaction for purposes of Section 28(e); and
- The executing broker-dealer is contractually bound to the investment adviser to pay for research through an RPA with a client commission arrangement (soft dollar arrangement).
Although this no-action letter does not include a sunset provision, the staff noted that the relief is “subject to modification or revocation at any time.”
DILEMMA FOR INVESTMENT ADVISERS
MiFID II compliance would not allow advisers to aggregate trade orders for multiple clients, including funds.
The dilemma. Perhaps the most vexing and potentially most complicated fallout of MiFID II for U.S. investment advisers is whether they can aggregate, or bunch, orders for securities trades among their various accounts, including those that must comply with MiFID II.
Section 17(d) of the 1940 Act authorizes the SEC to adopt rules that limit or prevent registered investment companies from participating in joint transactions with affiliated persons on a basis that is different from, or less advantageous than, that of any other participants.
Among other things, Rule 17d-1 generally prohibits an “affiliated person” of a fund (which includes affiliated persons of affiliated persons, or second-tier affiliates), acting as principal, from participating in a “joint transaction” with a registered fund, unless the SEC has issued an order allowing the transaction. This rule is very broad in scope and covers many types of transactions, including arrangements when an adviser may “bunch” securities trades across several accounts. Section 206 of the Advisers Act, which is the anti-fraud provision, may also apply to an adviser that aggregates trades across multiple clients.
In a series of no-action letters published beginning in 1995, the staff of the SEC paved the way for investment advisers to aggregate orders among funds and other clients. The staff said that the mere aggregation of orders for advisory clients—including collective investment vehicles in which the adviser, its principals, or its employees have an interest—would not violate Section 17(d) of the 1940 Act, Rule 17d-1 under the 1940 Act, or Section 206 of the Advisers Act, if the adviser implements procedures designed to prevent any account from being systematically disadvantaged by the aggregation of orders. The staff based its position on, among other things, a representation that each client that participates in an aggregated order will participate at the average share price with all transaction costs shared on a pro rata basis.
MiFID II creates challenges for investment advisers that bunch trades of their U.S. clients with those subject to MiFID II. For example, depending on individual account arrangements, one client, say, a U.S. fund, will pay a brokerage commission that includes soft dollars for research, while a European account on the same trade may pay a different brokerage commission and a separate payment for research out of an RPA. With these differences in payment structures, the investment adviser may not be able to rely on the “aggregation of trades” no-action letters, because one of the conditions is that all clients that participate in the bunched trade must pay a pro rata share of all costs associated with the aggregated order (even though all clients would pay the same average security price and execution rates).
The fix. In response to this challenge, the Division of Investment Management said that it would not recommend enforcement action if an investment adviser aggregates orders for the sale or purchase of securities on behalf of its clients in reliance on past staff no-action letters when accommodating the differing arrangements regarding the payment for research required by MiFID II. The letter acknowledges that while all clients with bunched trades will pay an average price, the amount that each client pays for research may differ (that is, clients will not share transaction costs on a pro rata basis).
Implications for Fund Directors
MiFID II effectively tossed a hand grenade into the trading room of U.S. advisers. As the Investment Company Institute noted in its letter to the staff of the SEC, absent relief, MiFID II will prevent cross-border investment advisers from aggregating client trades. That is, advisers may be forced to place competing trade orders for the same securities for different clients, which could result in poor execution or the potential to benefit some clients at the expense of others. These changes may have implications for fund directors.
As part of their oversight responsibilities, fund directors evaluate trading practices to ensure that advisers seek best execution for the funds. While the adviser’s responsibilities to seek best execution have not changed, MiFID II requires cross-border advisers to seek best execution under slightly different conditions. Fund boards may consider asking fund advisers the following questions, among others:
- Are any of the adviser’s other clients required to comply with MiFID II?
- Will the adviser continue to aggregate trades with its other clients that must comply with MiFID II?
- Does compliance with MiFID II and SEC no-action letters create any new conflicts of interest of which fund directors should be aware?
- When an adviser aggregates fund trades with those of clients subject to MiFID II, what procedures will the adviser follow to ensure that the funds are not unfairly disadvantaged?
- How will the adviser continue to seek best execution?
- Should the adviser change or supplement its board reports concerning best execution to reflect aggregation of trades with clients subject to MiFID II?
While they do not apply to investment companies on their face, the SEC’s trio of no-action letters indirectly affects how fund directors oversee, evaluate, and monitor brokerage allocations, soft dollar payments, and potential conflicts of interest arising out of aggregation of trades. Fund directors should ask appropriate questions and seek appropriate information to ensure that they are fully informed, aware, and satisfied with how fund advisers address potential conflicts of interest arising out of MiFID II compliance.
Jay Baris is chair of Morrison & Foerster’s Investment Management Practice and represents investment companies, broker-dealers, investment advisers and other financial institutions in the full spectrum of financial services regulation. He helps clients develop new financial products that cross over banking, commodities, insurance and securities law, counsels independent directors on governance issues, and advises mutual funds and investment advisers on mergers and acquisitions, reorganizations, compliance, exemptive applications and innovative regulatory issues.
 Division of Investment Management No-Action Letter to Securities Industry and Financial Markets Association (October 26, 2017), available at https://www.sec.gov/divisions/investment/noaction/2017/sifma-102617-202a.htm.
 Division of Trading and Markets No-Action Letter to Securities Industry and Financial Markets Association (October 26, 2017), available at https://www.sec.gov/divisions/marketreg/mr-noaction/2017/sifma-amg-102617-28e.pdf.
 Division of Investment Management No-Action Letter to Investment Company Institute (October 26, 2017), available at https://www.sec.gov/divisions/investment/noaction/2017/ici-102617-17d1.htm.