MiFID II and the U.S. Investment Adviser Regime

In Europe, various legislative and regulatory controls on the usage of brokerage commissions and payment for research were imposed, first in the U.K. in the mid-2000s, and then in the EU. The second Markets in Financial Instruments Directive (MiFID II), which came into force in 2018, brought about radical and highly prescriptive reforms in this area. One of its declared aims was to give investors transparency into the cost of research and trading commissions, by forcing an unbundling of payments for these services. The MiFID II process, under which research is invoiced and paid for separately, removes the exclusion from being regulated as a U.S. broker-dealer.

The U.K. and EU rules have extraterritorial implications, including for U.S. broker-dealers, because U.K. and EU investment firms which obtain execution or research services from broker-dealers outside of the jurisdiction must still comply with the MiFID II rules. Receiving MiFID II-compliant direct payments for research from U.K. or EU investment managers would amount to accepting “hard-dollar” payments for U.S. purposes, rendering unavailable an exclusion from being regulated as an investment adviser. In the immediate aftermath of MiFID II, the Staff of the U.S. Securities Exchange Commission (SEC) issued a no-action letter, providing temporary relief and allowing brokers to provide execution and research services on a MiFID II-compliant basis without being regulated as an investment adviser. However, this is due to expire on July 3, 2023.

While there is no sign of the relief extending beyond the July 3 deadline, some changes are being made to the unbundling rules in the U.K. and EU. However, the changes proposed so far are of minimal use to U.S. broker-dealers and in any event will not take effect before the SEC relief expires. U.S. broker-dealers have now been forced to consider whether or not to continue selling research for hard dollars (and become subject to the requirements of the Investment Advisers Act of 1940 (the “Advisers Act”)) or how to comply with the MiFID II regime in the context of the no-action letter falling away.

We discussed these issues in our March client note, “MIFID II: An Update on the Rules for Unbundling of Research.” This client note provides an up-to-date analysis of the situation as it stands on the cusp of the SEC’s no-action letter expiring.

MiFID II, Inducements and Research

We set out here a reminder of the MiFID II requirements, how they have affected U.S. broker-dealers, and the actions of the SEC. The latest potential changes to the U.K. and EU MiFID II rules are discussed below. When we refer to MiFID II, it is to both the EU’s MiFID II and the U.K.’s implementation of MiFID II. When we are discussing the particulars of one of those regimes, we specify the jurisdiction.

One of MiFID II’s declared aims was to give investors transparency into the cost of both research and trading commissions, by requiring payments for these elements to be unbundled. The research that investment managers typically receive from brokers is, under MiFID II, generally classified as a prohibited “inducement,” unless the investment manager pays for the research either: (a) directly from its own resources; (b) from a “Research Payment Account” (RPA) funded, with the client’s prior approval, with an advisory client’s money; or (c) a combination of the two methods.

As a result of MiFID II, U.K. and EU brokers are required to price their research separately from execution costs. Execution costs are then separately regulated by “best execution” rules. The scope of MiFID II’s territorial reach means that it will only apply directly to U.K. and EU-regulated investment firms. However, brokers outside of the U.K. and EU are affected by the legislation in several respects, due to the requirements on U.K. and EU client entities or U.K. and EU affiliates that are passed on when U.S. persons deal with such clients.

Broker-Dealers’ Receipt of “Hard-Dollar” Payments

U.S. broker-dealers have historically benefited from an exclusion from regulation under the Advisers Act if any investment advice they provide is “solely incidental” to their brokerage business and they receive no “special compensation” for providing the advice. MiFID II-compliant hard-dollar payments for research could be considered “special compensation” under Section 202(a)(11)(C) of the Advisers Act, which would invalidate the exclusion, causing them to be regulated as investment advisers.

Under the Advisers Act, an investment adviser is a “fiduciary” to its advisory clients. Fiduciary duties include a fundamental obligation on an investment adviser to act in the best interests of its clients and to provide investment advice in its clients’ best interests, along with a duty of loyalty and good faith. Although some U.S. broker-dealers are already additionally regulated as investment advisers or have affiliated investment advisers, others prefer to avoid fiduciary obligations and uncertainties of the application of the investment adviser regulation regime to the publication and distribution of research.

The SEC Staff “no-action” letter confirmed that the Staff will not recommend enforcement action if a broker-dealer provides research services that constitute “investment advice” under section 202(a)(11) of the Advisers Act to an investment manager that is required to pay for the research services by using research payments under MiFID II. This relief covers both (a) U.K. or EU-based investment managers that are directly subject to the requirements of MiFID II and (b) non-U.K. and non-EU-domiciled delegates that are contractually (rather than as a regulatory matter) required to comply with MiFID II.

The relief is temporary and is set to expire on July 3, 2023. On July 26, 2022, William Birdthistle, Director, Division of Investment Management, SEC, announced in a speech at PLI’s Investment Management conference that the SEC Staff did not intend to further extend the relief beyond July 3, 2023.

On February 21, 2023, SIFMA called for the SEC to extend the current no-action relief to allow broker-dealers to receive cash payments for research without being deemed investment advisers. SIFMA refers to the potential for the MiFID II research rules to be rolled back. They argued that, since both the U.K. and EU are re-assessing the rules, the SEC should extend the relief so that those processes can run their course. Any such extension would mean that U.S. broker-dealers would not need to restructure their operations for rules that may be removed or significantly amended. To date, there is no indication that the SEC has any interest in such an extension.

Implications of SEC Relief Being Removed

Possible Solutions for U.S. broker-dealers

Some broker-dealers have opted to take various actions since the MiFID II rules came in, including:

• registering (or retaining their status quo) as an investment adviser to receive the “hard-dollar” payment and preparing and distributing research in accordance with compliance procedures under the Advisers Act;
• complying with the Advisers Act. Many broker-dealers are prohibited from registering with the SEC as investment advisers because they do not meet the threshold of having $100 million assets under management. These brokers need to comply with several of the Advisers Act requirements nonetheless; for example, the fiduciary obligations to those clients that pay hard dollars for research, resulting in a need for new compliance procedures;
• moving research operations into an affiliate investment adviser (e.g., a U.K. or EU affiliate) who sells their research for hard dollars; and
• shutting down research operations.

The EU Proposals

According to the European Commission, the EU MiFID II rules on unbundled research have failed to achieve all of their objectives. While the unbundling rules have improved the transparency of costs linked to research provision and led to better conflicts of interest management, they have also resulted in the production of independent research becoming unsustainable and a considerable reduction in size of the research industry and the number of issuers covered by research analysts.

The European Commission has tabled two sets of proposals in this area, the first of which was published at the end of 2022 and the second in May this year. The proposals seek to maintain a balance between granting industry flexibility on how they deal with payments for research and ensuring consumer protection.

Expanding the Exemption for Research on SME Issuers: the 2022 EU Proposals

There are exemptions from the inducements rule, for example, for minor, non-monetary benefits and for trial periods. During the Covid pandemic, the EU introduced an exemption from the inducements rule for research on smaller issuers, which was intended to improve small and medium-sized enterprises (SMEs) research coverage. The exemption applies to research on listed and unlisted companies with a market capitalization below EUR 1 billion and is available provided that a firm has: (i) notified its clients of the joint payments for research and execution services; and (ii) entered into an agreement with the research provider identifying the part of any combined charges or joint payments for execution services and research that is attributable to research.

However, the introduction of this exemption has not been successful because investment firms and brokers have chosen not to introduce two systems for research invoicing and have instead retained the unbundled scheme for all clients. Therefore, in December 2022, the European Commission published a legislative proposal to amend EU MiFID II, which included a proposal to expand the existing SME research exemption to capture issuers with a market capitalization below EUR 10 billion, replacing the existing threshold of EUR 1 billion. As with the existing exemption, research carried out pursuant to the proposed extended exemption would still be subject to other EU MiFID II rules on conflicts of interest. The revised exemption would be available to EU MiFID II firms providing portfolio management or other investment or ancillary services to clients. For research on larger issuers, the existing regime would continue to apply.

Ban on Inducements for Execution-Only Services to Retail Clients: the 2023 EU Proposals

The European Commission’s latest proposals, published in May 2023, include some liberalization. However, there will be a new express prohibition on inducements for execution-only services involving the reception and transmission of orders or the execution of orders to or on behalf of retail clients. The Commission is of the view that only a full ban would eliminate conflicts of interests in this context.

Where a firm provides investment advice as the main service, the new ban would not apply to the execution or reception and transmission of order service for that client’s transactions covered by the advice. The new ban would not apply either to fees or remuneration received or paid from an issuer for placement and underwriting services. This exemption would not be available for instruments that qualify as packaged retail investment products.

The existing ban on inducements when a firm provides portfolio and other services will remain, provided that disclosure is made to the client. The existing exemptions to the inducements rule will apply to the new ban for execution-only services. The exemption for minor non-monetary benefits is being clarified to apply to benefits that are either below EUR 100 per annum (a new explicit limit) or that could not be considered to impair compliance with the investment firm’s duty to act in the best interest of the client due to their scale and nature, provided that disclosure is made to the retail client.

The existing ‘quality enhancement’ test for inducements is replaced with new criteria for firms to act in the best interest of their clients. Firms providing investment advice to retail clients will need to: (i) base their advice on an assessment of an appropriate range of financial products; (ii) recommend the most cost-efficient financial product from the range of suitable financial products; and (iii) offer at least one financial product without additional features which are not necessary to the achievement of the client’s investment objectives and that give rise to additional costs, so that retail investors are presented also with alternative, and possibly cheaper, options to consider.

There are also enhanced disclosure obligations to ensure retail client protection, including a requirement for firms to have appropriate risk warning in all information materials.

These proposals are part of the European Commission’s proposed Retail Investment Strategy. We discuss other elements of that Strategy in our blog, Financial Regulatory Developments Focus.

Status of the EU Proposals

The end of 2022 revealed divergent opinions within the EU bodies on the future appropriate approach on inducements and unbundling of research, in particular whether to impose a full ban on inducements. Such divergence is still apparent and the debate continues as these latest proposals are considered by the European Parliament and Council. Although the Commission is now only proposing a partial ban, there will be intense lobbying about whether that is the correct course. A future comprehensive ban on inducements has not been fully ruled out, including by the Commission which will report on the effects of the revised inducements regime three years after these latest proposals are adopted, possibly proposing a full ban then. Interestingly, the Council recently adopted its negotiating mandate on the 2022 proposals in which it indicates how far the EU might go to create more flexibility for firms and alleviate some of the burden imposed by the research unbundling rules.

At this stage, it is not possible to know if these proposals will be adopted, or if adopted, in what form. Both sets of proposals would apply 18 months after entry into force, with the earlier proposals likely to take effect first, unless the EU legislature moves the proposals into one procedure. The Council’s proposed approach would be the most useful to U.S. broker-dealers. However, even if that is agreed to by the European Parliament, any changes to the EU rules will not take effect before the expiry of the SEC’s relief on July 3, 2023.

U.K. Update

Post-Brexit, the U.K. adopted the MiFID II regime in whole but has embarked on a program of targeted reform already (which we discuss in our notes, “UK Wholesale Markets Review” and “UK Financial Services and Markets Bill 2022”). The U.K. also has an exemption for research on SME issuers, although there are differences to the EU’s exemption: the threshold is £200 million, and the exemption is available to all firms subject to the U.K. MiFID II rules, provided that the research is provided on a re-bundled basis or for free. The U.K. also has the following exemptions:

• FICC-related research: third-party research received by a U.K. MiFID II firm providing investment services or ancillary services to clients, where it is received in connection with an investment strategy primarily relating to FICC instruments. FICC research would be allowed to be rebundled;
• Independent Research Exemption: research provided to a U.K. MiFID II firm by independent research providers, where the independent research provider is not engaged in execution services and is not part of a financial services group that includes an investment firm that offers execution or brokerage services; and
• “openly available” material: written material that is made openly available from a third party to any U.K. MiFID II firm wishing to receive it or to the general public. “Openly available” means without conditions or barriers to accessing the written material other than those necessary to comply with relevant regulatory obligations.

There are currently no proposals to amend these exemptions or to make other changes to the research unbundling rules. However, there is the potential for such changes to be included in the Investment Research Review, announced as part of the Edinburgh Reforms (which we discuss in our note: “UK Government Publishes Edinburgh Reforms for Financial Services”). The Investment Research Review is concerned with the interplay between levels of research and the attractiveness of the U.K. as a listing venue, taking into account the effect of the U.K. MiFID II research unbundling rules on the amount and quality of research. The Review may make recommendations for legislative and non-legislative changes, which will be for the government, the FCA and industry to implement. Any legislative changes would need to be made under the powers to restate or amend retained EU law to be conferred on HM Treasury by the Financial Services and Markets Bill, which will soon be finalized. Such legislative change may lead to the FCA revising its rules, which would come into effect in tandem with the legislative amendments.