The MiFID II regime will have significant ramifications for US investment managers and their use of client commissions to obtain research—especially as cross-border impacts have yet to be addressed by global regulators.

With the January 3, 2018 effective date of the Markets in Financial Instruments (MiFID) II regime looming over EU investment firms, many investment managers are struggling to deal with the changes affecting inducements and research. Some of the most challenging issues include determining the purchase price of research, assigning value to research internally, reconciling the cost of research to multiple clients, determining mechanisms for payment, and the clashing of EU and US regulatory regimes. Absent regulatory relief from either US or EU regulators, conflicts between regulatory regimes could force US broker-dealers to curtail providing research or execution services to covered investment managers.^[1] The issues and incompatibilities between the EU and US regimes are extensive and will affect US investment managers in many key ways.

As described in our April 3, 2017 article, effective January 3, 2018, EU investment managers will effectively no longer be able to use client dealing commissions (commonly referred to as “soft dollars”) to pay for research from broker-dealers. Rather, EU investment managers must either pay for research out of their own pockets (i.e., out of profit and loss (P&L)) or reach agreement with clients to have research costs paid by clients through so-called research payment accounts (RPAs) funded either by a specific research charge to the client or out of dealing commissions, provided that the research element of the commission is priced separately from the execution element (i.e., “unbundled”).

For US investment managers subject to the MiFID II regime (which is itself a matter subject to considerable uncertainty), this potentially means either (i) treating EU clients differently or (ii) coalescing around the MiFID II standards and relinquishing important safe harbors from liability under Section 28(e) of the Securities Exchange Act of 1934 (Section 28(e)). All of this is subject to forthcoming guidance from the European Securities and Markets Authority (ESMA) and regulatory authorities in EU member states (and possible “gold plating” ^[2] of the new rules by them), not to mention the likelihood of further complications with Brexit and third-country regulation in the EU.

Below, we identify and briefly discuss the key issues we are discussing with clients:

Uncertainties in the Reach of MiFID II to US Investment Managers in Cross-Border Dealings

MiFID II applies to EU investment firms, including investment managers, which means investment firms domiciled in the EU. (Typically, a US investment manager with an office or affiliate in an EU member state from which it provides portfolio management will be required to become licensed in accordance with the local regulation.) While it is clear that MiFID II will apply to US investment firms’ affiliates domiciled in the EU, it is less clear whether and when MiFID II restrictions effectively will apply to a non-EU-domiciled investment manager on a “pass through” basis managing client accounts under various types of sub-advisory arrangements (e.g., delegation, sub-advisory, and dual hatting or “participating affiliate” arrangements under SEC staff guidance). Potentially, covered arrangements might include any arrangement under which an EU investment manager has delegated investment discretion and trading authority to a US investment manager, which some EU regulators informally have suggested would require that MiFID II requirements be imposed contractually on the US investment manager. When considered with the potentially broad extraterritorial scope of MiFID II, which can apply to an EU investment manager generally without regard to where its clients are located, determining the reach of MiFID II is particularly tricky in a cross-border context. The numerous scenarios for cross-border dealings among affiliates and the analysis under MiFID II go beyond the scope of this commentary but deserve serious attention by US investment managers offering investment management services on a global basis. In particular, US asset managers should carefully consider any amendments to sub-advisory or other delegation arrangements with EU firms or EU-domiciled funds to understand fully the potential impact on their US regulatory obligations and organizational structure.

Effect of MiFID II Adherence on US Investment Managers Relying on Section 28(e)

A US investment manager that seeks to adhere to MiFID II should be able to continue to use client dealing commissions to pay for research outside the zone of MiFID II in reliance on Section 28(e). Section 28(e) insulates a fiduciary from claims that it has paid excessive commissions and, with disclosure, that the higher commissions for some clients are paid to finance research even though such research may be used in the management of accounts of other clients (so-called “cross-subsidization”). However, if a US investment manager seeks to pay for research in connection with its US business on an unbundled basis—i.e., using client commissions to follow an RPA-like approach of paying for research alongside commissions (e.g., by having each account charged a research fee alongside a trading commission, or “hybrid RPA”)—it is not clear that the research payment would be treated as a “commission” for purposes of Section 28(e).^[3] Correspondingly, issues might arise regarding the availability of the Section 28(e) safe harbor, including for accounts subject to the Investment Company Act of 1940 or the Employee Retirement Income Security Act of 1974 for which disclosure alone does not suffice to address conflicts, and transactions outside of the Section 28(e) safe harbor may be prohibited. In addition, taking this sort of hybrid RPA approach in the US could raise issues regarding the investment manager’s authority to impose research costs on clients outside bundled commissions and the treatment of such research expenses for various reporting purposes, including expense reporting for pooled investment vehicles such as investment companies and performance reporting on a “net” basis.^[4]

Effect on US Investment Manager Trading of US and EU Client Accounts

For US investment managers, including MiFID II covered accounts in aggregated trades for other accounts might complicate compliance with fiduciary obligations and regulatory requirements. Investment manager and broker-dealer mechanisms for the imposition of research costs through RPAs are still in development and could require that order flow for MiFID II covered accounts and other accounts be segregated. This could raise issues under traditional trade aggregation and trade order procedures, especially for orders that are potentially market moving or which might be only partially filled. Even where a US investment manager can aggregate orders for MiFID II covered accounts with orders for other accounts, current SEC staff guidance^[5] can be read to require that commission costs be allocated to all accounts participating in an aggregated order on a pro rata basis without regard to whether the accounts are similarly situated because of their research funding arrangements. This could mean that EU accounts included in an aggregated order would have to be charged an average commission with other participating accounts, even where the average commission includes the implicit cost of research. Accordingly, if the other accounts pay full service commissions to finance research on a soft dollar basis consistent with US law and practice, it could raise inducements concerns under MiFID II. (We would expect that the SEC staff will address this and confirm that the obligation to allocate commission costs pro rata only applies to similarly situated accounts.)

Potential Custody Issues for RPAs and the Authority to Fund Them

Depending on emerging EU guidance on the status of RPAs and investment managers’ authority to fund such accounts, US investment managers might be confronted with possible custody issues under Rule 206(4)-2 and, for investment company clients, Section 17(f) of the Investment Company Act of 1940. EU guidance thus far has indicated that, although clients need to agree to their managed accounts funding RPA accounts and that any unspent balances would revert to the client, RPA accounts need not be treated as client money (e.g., for purposes of UK client money rules). The research charges should belong to the investment manager once deducted from the client account (and until any unspent balances revert to the client) and should be used to purchase research to benefit that client. As long as these positions remain in place, it is possible that US investment managers will not have to treat RPA account balances as customer funds under Rule 206(4)-2 or Section 17(f) of the Investment Company Act of 1940, and that client authorization to use client monies to fund RPA accounts should be treated as akin to an investment manager’s authority to deduct fees from client accounts (i.e., such authority would not trigger the surprise examination requirements under the rule). However, SEC staff confirmation of these points will be important as we approach the compliance date in January 2018. Similarly, the requirement that unspent monies in RPA accounts be returned to the client is an aspect of the MiFID II requirements that will have to be evaluated for US law implications, including custody, required Form ADV Part 2A disclosure of fee arrangements, refundability of prepaid fees, and insolvency risk.

Complications with Research-Sharing Arrangements

Research-sharing arrangements between and among affiliates has been an open issue without clear regulatory guidance in the US on the proper analysis under Section 28(e), although various legal theories and policies can support the practice. This issue becomes more complicated in the context of MiFID II, which requires that research funded by a client’s RPA assessments be used in the management of that client’s account and, conversely, not be used in the management of other client accounts not contributing to the RPA arrangement (i.e., no cross-subsidization). The UK Financial Conduct Authority (FCA) stated the following in September 2016:

Firms must ensure the specific charge to a client and the corresponding budget that charge is contributing towards does actually pay for research which can assist its investment decisions for the client. Firms should document and be able to justify how they have grouped client portfolios for this purpose. . . . A group of portfolios for which a shared budget is set should not be so broad that portfolios with substantively different research needs are subject to the same budget.^[6]

Practical questions abound in this context with global investment managers that coordinate investment decision making and share research—and the related questions may well outnumber the answers. Further guidance from ESMA or regulators in EU member states on whether research may be shared, for example, where sharing is reciprocal (i.e., where the affiliated investment managers reciprocally and mutually share research for the benefit of all client accounts) or incidental (i.e., where the obtaining investment manager properly obtains and uses the research, and sharing it with an affiliate does not deplete the RPA balances available for the obtaining investment manager’s clients) will be critical for global investment managers.

Consequence of Conflicting Research Valuations

The need to ascribe a specific price or value to research under MiFID II could result in difficult-to-resolve pricing issues across multiple firms and strategies if pricing decisions differ. For example, since different research votes can value research differently, issues might arise if a global investment manager has established different prices for the same items of research for different strategies or categories of accounts (e.g., EU versus US accounts, or different values determined by different portfolio management or research teams). Moreover, if a global investment manager determines that an item of research has a lower value for MiFID II covered accounts and a higher value (and implicit cost) for US accounts for which the item can be obtained through soft dollars, will this raise questions under the reasonableness determination requirement under Section 28(e) or inducements concerns under MiFID II?

Clients That Say “No” to RPA Funding or Soft Dollars

In the past, global investment managers have had to navigate complexities of trading for a relative minority of clients that say “no” to soft dollars. Possible options have included having those clients’ accounts traded separately at an execution rate or aggregating those clients’ trades at the same commission rate as other clients’ trades but with the investment manager forgoing soft dollar credits on the accounts that said “no” to soft dollars. Of course, it has always been difficult to reconcile the potential cross-subsidization or “free-rider” issues that arise when certain clients prohibit the use of commissions to acquire research. The complexity of this issue may grow, however, if the universe of objecting clients increases in response to the imposition of explicit research charges, or if any of the current approaches is seen to exacerbate inconsistencies between the treatment of US and EU clients or raise other fiduciary concerns. At a minimum, investment managers may wish to consider the scalability of current approaches and revisit disclosures in this area.

Exposure of RPA Account Balances to the Claims of Creditors

While guidance from ESMA suggests that RPAs are not client assets and must be within the control of the investment manager, ESMA has not specified whether RPA accounts must be maintained in a manner sufficient to protect them from the claims of an investment manager’s general creditors. ESMA has made clear, however, that when administration of the RPA is outsourced, RPA account money should be “ring-fenced” and clearly separated from other funds of the RPA administrator “such that [the money] remain[s] legally owed to the investment firm” and the “third party provider should have no right of set-off over the money or be entitled to use it as collateral or otherwise for their own benefit.”^[7] The safekeeping of RPA accounts thus differs from maintenance of soft dollar balances by broker-dealers in the US, where at least one bankruptcy court has ruled that soft dollar balances maintained with a broker-dealer are not customer property under the Securities Investor Protection Act of 1970 but rather are general unsecured claims.^[8]

Strategies to “Ring Fence” MiFID II’s Research Requirements

Given the substantial change from current practice (i.e., using soft dollars), it seems obvious that both managers and broker-dealers will have incentives to “ring fence” the strict application of MiFID II’s requirements. However, the broad scope of the MiFID II restrictions may make this difficult and, currently, there are more questions here than answers:

• Will the MiFID II regime lead to a restructuring of inter-affiliate investment management agreements and arrangements to limit the scope and applicability of the regime?

• Will investment managers seek to restructure their operations to permit trades to be conducted under the US regime both to obtain research under Section 28(e) on a bundled basis and to avoid a possible cut-off from research by US broker-dealers, absent SEC relief making it clear that they may receive cash payments for research without causing them to be investment advisers under the Investment Advisers Act of 1940?

• Will global money managers with EU-domiciled affiliates seek to move investment management out of EU member states, thereby limiting the role of EU-domiciled investment teams to providing trading and/or research?

• Will global investment managers seek to bypass MiFID II or limit its scope by changing their trading strategies—such as by purchasing non-US securities in ADR form or synthetic exposure through derivatives in the US where available?

• Will the new MiFID II regime prompt research arbitrage—firms seeking to rationalize their usage of research to make the greatest use of available items (i.e., obtaining market data, corporate access, and conferences under Section 28(e) and using client RPAs to finance research on futures, foreign exchange, and principal trades in fixed income)?

Care with Disclosures

For US investment managers potentially subject to MiFID II’s research regime, the next round of Form ADV Part 2A disclosures will be particularly important to describe each firm’s approach to obtaining research—whether through the firm’s own money, soft dollars, or client-funded RPAs. This topic scarcely is covered in existing firm Form ADV Part 2As and will be an important area of focus—given that in-artful drafting can lead to sharp regulatory judgments with the benefit of hindsight.

And Many More

Other open questions under MiFID II include the following:

• Can EU investment managers use Section 28(e) vis-à-vis US clients?

• Does compliance with SEC staff guidelines requiring the use of gross performance require that gross performance be shown net of research costs? (Presumably, yes.)

• Who will be responsible for paying RPA administrators for their services (i.e., will investment managers have to pay the costs, or can they be passed on to clients through a debit from the RPA funds)?

• Since MiFID II requires client agreement to the use of RPAs to finance research, may a covered investment manager seek client agreement to use RPA funds to obtain items or materials that may otherwise be precluded under current law (e.g., in the UK, corporate access)?

_{[1] With no press coverage, the SEC’s Equity Market Structure Committee last week published recommendations of its buy-side members that steps should be taken to address MiFID II impacts in two ways: (1) “Ensure that the safe harbor established under Section 28(e) of the Securities Exchange Act of 1934 allows for firms to pay for research out of separate Research Payment Accounts as defined by MiFID II that are funded out of client’s custodian accounts”; and (2) “Exemptive Relief/rule-making from Investment Advisers Act Section 202(a)(11)(C) to allow broker-dealers to receive “hard dollars” without invoking the “special compensation” clause that would require them to become investment advisers.” According to the statement, “[b]uy-side participants are concerned that failure to provide such relief would limit U.S. broker dealer counterparties and prevent U.S. broker dealers from trading with them on a principal basis.” See Memorandum from Equity Market Structure Advisory Committee Customer Issues Subcommittee to Equity Market Structure Advisory Committee (EMSAC), Customer Issues Subcommittee Status Report (April 3, 2017).}

_{[2] The practice whereby national competent authorities in transposing an EU Directive into local law include additional requirements that go beyond what is required by the Directive.}

_{[3] The term “commissions” is not defined in the Exchange Act. The SEC itself has adapted the concept of “commissions” to embrace changes in US securities markets, including to overcome narrower SEC staff interpretations that construed the term to encompass only commissions on agency transactions. In 2001, the SEC stated that “we now interpret the term ‘commission’ in Section 28(e) of the Exchange Act to include a markup, markdown, commission equivalent or other fee paid by a managed account to a dealer for executing a transaction where the fee and transaction price are fully and separately disclosed on the confirmation and the transaction is reported under conditions that provide independent and objective verification of the transaction price subject to self-regulatory organization oversight.” SEC Interpretation: Commission Guidance on the Scope of Section 28(e) of the Exchange Act, Exchange Act Release No. 45194 (Dec. 27, 2001).}

_{[4] For example, see Form N-1A, Item 3, which sets forth requirements for disclosure of fund annual expenses in a prospectus. In general, a specific applied expense will be reflected in a fund’s expense ratio. In contrast, implicit soft dollar research costs generally will not be treated as an expense but will nonetheless affect total return.}

_{[5] SMC Capital, Inc., SEC Staff No-Action Letter (Sept. 5, 1995).}

_{[6] See FCA, CP16/20, Markets in Financial Instruments Directive II Implementation – Consultation Paper III, Section 3.22 (Sept. 2016).}

_{[7] ESMA, Questions and Answers on MiFID II and MiFIR investor protection topics (Apr. 4, 2017), Inducements, Answer 2 at 42.}

_{[8] In re Lehman Brothers, Inc., Debtor, 474 B.R. 139 (S.D.N.Y. July 10, 2012).}