Executive Summary
On July 3, 2023, regulatory no-action relief granted in October 2017 by the U.S. Securities and Exchange Commission (SEC) to address conflicts raised by the implementation of the Markets in Financial Instruments Directive II (MiFID II) in the EU and UK is set to expire. This summary is intended to provide related details and developments.
Please contact Adam Jacobs-Dean, Aniqah Rao or Suzan Rose with any questions regarding these events.
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Adam Jacobs-Dean
Managing Director, Global Head of Markets, Governance and Innovation
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Aniqah Rao
Associate Director, Markets, Governance and Innovation
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Suzan Rose
Senior Adviser, Government and Regulatory Affairs, AIMA
Background
Since MiFID II went into effect, broker-dealers are required to "unbundle" payments and charge EU and UK investment managers separately for research and execution services. Payments for research are not considered to be unlawful inducements under MiFID II if the investment manager pays for the research separately from execution costs and (i) directly out of its own resources, or (ii) with client approval, through a MiFID II-compliant research payment account (RPA) funded by client money based on a research budget or (iii) a combination of the two.
On October 26, 2017, the SEC issued a no-action letter (NAL) that provided exemptive relief to U.S. broker-dealers who accept "unbundled" payment for research services as required by MiFID II. Absent this exemptive relief, these payments would otherwise subject those broker-dealers to regulation as investment advisers under the Investment Advisers Act of 1940, which would have significant implications for their businesses and the research services they could provide.
The no-action relief was issued in response to an urgent appeal from SIFMA, on a temporary basis and as a stopgap measure due to MiFID II requirements for unbundling and certain hard-dollar payment arrangements for research that were to go live in January 2018 and were in conflict with U.S. rules. These regulatory conflicts did not have a straightforward U.S. solution, nor one that would not substantially harm the ability to offer, or to obtain, U.S. broker-dealer research services.
In November 2019, this temporary relief was further extended to 3 July 2023 to allow market participants more time as they engaged in efforts to find solutions for compliance with both the MiFID II provisions relating to research and SEC rules. As stated in the SEC’s 2019 letter, “the Extended Period will allow for the staff to continue to monitor and assess the evolving impact of MiFID II and evaluate whether any additional guidance or recommendations to the Commission for regulatory actions are appropriate. It will allow additional time for the EU authorities or regulators in individual member states to continue their evaluation of the effects of MiFID II and potentially modify their rules. Finally, it will allow additional time for market-based solutions with respect to payments for research in the U.S. and Europe to evolve further, and for greater transparency regarding research payments and practices to develop.”
At the time the 2019 extension was granted, the SEC stated that it may or may not choose to further extend the no-action relief beyond the stated expiry of July 3, 2023, three years post full implementation of MiFID II. In July 2022, SEC Director of the Division of Investment Management, William Birdthistle stated in a speech that the SEC would not extend the no-action relief beyond the 2023 expiry date. In explaining this position, Director Birdthistle noted “developments in the marketplace for research services”, and stated that firms had developed a variety of solutions to address the impact of MiFID II, presumably voiding the need to continue the temporary exemptive relief.
Unfortunately, these “solutions” to the MiFID II conflicts with U.S. law were limited to broker-dealers either bringing aspects of their research business under an investment advisory business or dually registering as an investment adviser which would then provide these research services – either of which would alter broker-dealer business models and come at a significant cost. The SEC also wrongfully assumed that certain types of SEC-condoned research payment accounts were compliant with MiFID II rules. However, none of the SEC-recognized solutions accounted for another significant conflict: The difference in the definition of “research services” under MiFID II versus SEC rules. In the U.S., sales and market commentary are not “Research”, whereas the MiFID II rules on research payment are agnostic to the differences between published research recommendations and sales and market commentary, defining all as “research” for the sake of payment.
Practical Implications
The no-action letter's (NAL's) expiry will impact investment managers’ ability to continue receiving the sales and trading content of broker-dealers. The role of sales and market commentary – short-term views separate from published research that often referred to as “market colour” – play an important part in forming independent investment opinions, where longer-duration, published research recommendations may be tested in the interim by market events or other broad factors. This market colour has proven value to investors and plays a critical role in some fund manager investment processes, yet it cannot be produced under an investment adviser arm of a broker-dealer, if one were to be formed in response to the SEC’s recommended solution. If it cannot be housed under an entity that can accept unbundled hard-dollar payments to comply with U.S. rules, then it cannot be paid for, or provided to, clients subject to MiFID II research payment rules. The emergency order in 2017, providing no-action relief for hard-dollar payment of research, had a headline benefit to payment arrangements for published research recommendations, but importantly, it also alleviated the blunt impact MiFID II rules would have had on fund managers’ access to sales and market commentary, which is vital market colour. If the no-action relief expires without solutions in place, access to market color may cease to exist for MiFID-subject fund managers.
In addition, since the announcement of the relief’s expiry in July 2022, only a small number of broker-dealers have developed “solutions” and AIMA members note that none of these are small or specialty research providers. Smaller U.S. broker-dealers are used by investment managers to obtain research in relation to a specific issuer or sector that might have a smaller market capitalisation and therefore may not be covered by many, or any, larger broker-dealers. The expiry of the NAL will lead to a situation in which investment managers may be forced to terminate their research relationships with providers that do not pursue dual registration or utilise a registered adviser affiliate. As a result, these investment managers will no longer be able to access necessary research and invest in certain issuers (some investment research is only available from one or certain U.S. research providers – research providers that tend to be mid-to-small sized), leading to poorer outcomes for end investors.
Timeline
AIMA has categorized this proposal as high impact for thosse effected/low priority since not all will be effected and it is therefore represented in mid-blue in the AIMA Regulatory Horizon Scan gantt chart.
Effective Date of Expiry of NAL/Compliance Date | July 3, 2023 |
AIMA Outreach
U.S.
- October 2022:
AIMA had a call with Director Birdthistle and other members of SEC staff to discuss in detail member concerns for and market impacts from the stated July 2023 expiry of the no-action relief.
- November 2022:
AIMA submitted a letter to Director Birdthistle detailing the critical importance of the no-action relief, providing significant further color to its October discussion with Director Birdthistle and other SEC staff members.
No formal response was received by AIMA to its letter.
- February 2023:
AIMA had a call with Director Birdthistle, Chairman Gensler, and SEC Investment Management staff. All steadfastly stated that the no-action relief will not be extended. The SEC stated that the industry had had ample time to come up with solutions, including broker-dealer registration as investment advisers. Among other facts, AIMA highlighted fund managers’ inability to “force” broker-dealers to register as a solution, which many are against due to the resultant harm to their business models. While the SEC have acknowledged inability for some broker-dealers to register as investment advisers without harm to their business models and the impact to market colour the expiry would have, they are as yet unwilling to compromise.
UK
- March 2023:
AIMA had a call with the Financial Conduct Authority (FCA) to explore the FCA’s willingness to amend the MiFID II definition of ‘research’ to exclude sales and trading commentary and permit bundled payments for research to U.S. broker-dealers where a Commission Sharing Agreement is used.
- March 2023:
AIMA submitted a letter to the FCA as a follow up to our earlier call, explaining AIMA’s concerns regarding the expiry and suggesting ways to mitigate the consequences of the expiry.
In May 2023, the FCA responded stating that:
- The operation of CSAs does not offer comparable levels of investor protection against research payment accounts
- Absent a change in the rules, there is no scope to introduce an interpretative variation to the definition of research, which would place trading floor generated market commentary outside of that definition
The FCA also requested the following data-driven evidence by 16 June 2023:
- Metrics demonstrating detriments to clients, business lines, assets and/or products;
- Evidence and metrics that place this loss of research in a broader context (e.g., relative to total research spend or providers); and
- Evidence and metrics that draw out specific areas of concern (e.g., non-substitutability of certain services, impact on specific aspects of the investment process).
- April 2023:
AIMA submitted a response to HM Treasury’s Call for Evidence on the UK Investment Research Review. The response set out AIMA’s views on how the UK could help to mitigate the consequences that will follow from the expiry of the SEC’s no-action relief on hard dollar research payments. We stated that, as a priority, targeted relief from the unbundling rules is required in the case there is a compliance conflict when procuring research from jurisdictions that apply different rules to the payment of research, such as the U.S.
- June 2023:
AIMA submitted a letter to HM Treasury highlighting AIMA’s concern about the impact of the NAL expiry on the coverage and availability of investment research and the UK’s investment management industry.
- June 2023:
Per the FCA’s request, AIMA submitted data to the FCA on the impact of the expiry of the NAL. Given that it is difficult to quantify and provide metrics demonstrating detriments to clients, business lines, assets and/ or products, AIMA gathered metrics that place firms’ loss of research in a broader context.
- June 2023:
Further to AIMA’s letter, AIMA had a call with HM Treasury to discuss AIMA’s concerns regarding the impact of the expiry and useful UK actions.
EU
- April 2023:
AIMA had an email exchange with the European Commission regarding the impact of the expiry and need for immediate legislative solutions.
The European Commission stated its interest in the impact of the expiry on U.S. broker dealers, in particular smaller/ speciality research providers, in quantitative terms and any empirical evidence of the potential concentration of the research market.
- May 2023:
AIMA emailed a briefing note on the expiry and possible EU legislative solutions to members of the Council of the EU.
- June 2023:
AIMA had a call with the Czech Ministry of Finance to discuss the expiry and EU proposals in the context of investment research and the EU Listing Act package.
Further calls with the Council of the EU are being scheduled.
Legislative Activity
U.S. Congressional Activity
Both the House of Representatives and the Senate have recently been active in proposing extensions to the NAL and its related relief, in order to provide more time to consider potential solutions. A further extension also would provide necessary time to UK and EU regulators who are considering timely legislative changes that would resolve these regulatory conflicts (see below “UK and EU Legislative Activity”).
On April 13, 2023, members of the U.S. House of Representatives introduced a bill to amend the Investment Advisers Act of 1940, in order to “codify certain Securities and Exchange Commission no-action letters that exclude brokers and dealers compensated for certain research services from the definition of investment adviser, and for other purposes.” This bill, known as H.R. 2622, would make permanent the relief that the NAL has provided since 2017.
On May 24, 2023, the House Financial Services Committee passed a bill as an amendment to H.R. 2622. This bill, which was voted and approved on a bipartisan basis (42-2), directs the SEC to extend the NAL and its related relief by six months and to study the impact of potential expiration, just as the SEC stated it would do at the time of the 2019 NAL extension.
On June 22, 2023, Senator Moran introduced bill S. 2141 to the Senate, requiring the SEC to extend the NAL and its related relief, similar to the House’s May 24 amendment. At present, the full text of the bill is not yet available but it was referred to the Senate Committee on Banking, Housing, and Urban Affairs. It is our understanding that the bill has now received bi-partisan sponsorship, and further action should occur as a result.
On June 26, 2023, Senators Moran and Menendez submitted a letter to SEC Chairman Gensler, urging him to extend the NAL by six months to study the impact of potential expiration and provide additional time for potential solutions being considered by the EU and UK.
It should be noted that independent action by the House of Representatives or the Senate does not have the force of law. The SEC itself has the authority to extend the NAL but has chosen not to. Although this legislative activity sends a very public message to the SEC on the importance of this issue, it would take joint action of Congress – both House and Senate – to compel the SEC to either extend the NAL or make a permanent change to the Investment Advisers Act of 1940 (as proposed under H.R. 2622).
UK and EU Legislative Activity
UK
In December 2022, HM Treasury announced that it would review the UK’s investment research rules, as part of the Edinburgh Reforms. As a first step, on 3 April 2023, HM Treasury published a Call for Evidence on the UK Investment Research Review. The Review seeks to gather information on improving the UK market for investment research. The Call for Evidence closed on 24 April 2023 and AIMA submitted a response focusing on the NAL’s expiry. We stated that, as a priority, targeted relief from the MiFID II unbundling rules is required in the case there is a compliance conflict when procuring research from jurisdictions that apply different rules to the payment of research, such as the U.S.
The Chair of the Review is due to provide a report to HM Treasury with recommendations on how to improve the research landscape in the UK by 3 July 2023.
EU
To help recovery from the COVID-19 crisis, the EU published a Capital Markets Recovery Package. The Recovery Package includes attempts to improve SME research coverage by including an exemption from the MiFID II unbundling rules for issuers with a market capitalisation below EUR 1bn for the period of 36 months preceding the provision of the research. That is, allowing in such cases joint payment for trade execution and research. The exemption has been applicable since 28 February 2022.
The EU Listing Act package, published in December 2022, includes a Regulation amending (i) the Prospectus Regulation (ii) the Market Abuse Regulation (MAR) and (iii) the Markets in Financial Instruments Regulation (MiFIR), and a Directive amending provisions in MiFID II – namely on the unbundling of investor-sponsored research. It includes proposals to increase the market capitalisation of SMEs below which the unbundling exemption applies from EUR 1bn to EUR 10bn to cover properly the SME (including mid-cap) segment and increase the availability and coverage of research.
On 19 June 2023 and 20 June 2023, the European Parliament’s Economic and Monetary Affairs (ECON) Committee published draft reports prepared by Rapporteur Alfred Sant in respect of the three proposals composing the Listing Act package. Overall, the Rapporteur is broadly supportive of the European Commission’s proposals. On MiFID II, the draft report proposes to involve the European Securities and Markets Authority (ESMA) in the preparation and supervision of regulatory technical standards (RTS) for the framing of the issuer-sponsored research. Members of the European Parliament are provided until 7 July 2023 to table amendments to the report. The Rapporteur aims to vote on the report in the ECON Committee in November 2023 and start negotiations with the Council of the EU on a final text before the end of 2023.
Through conversations with the European Commission and Council of the EU, AIMA understands that solutions to the NAL expiry and discussion of wider reforms of MiFID II unbundling rules is taking place in the Council in the context of the Listing Act Package.