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Division of Trading and Markets Staff Provides No-Action Assurance Concerning MiFID II-Compliant Research Payments and Section 28(e)’s Safe Harbor

In a letter to SIFMA’s Asset Management Group (SIFMA AMG), the staff of the SEC’s Division of Trading and Markets provided assurance that it would not recommend that the SEC take enforcement action if, in compliance with MiFID II, an investment adviser uses client assets to make payment through an RPA for research alongside payments for execution services in reliance on the safe harbor of Section 28(e) of the Exchange Act.

Background

Under the Section 28(e) safe harbor, an investment adviser that satisfies the conditions of the section does not act unlawfully or breach its fiduciary duties solely on the basis that the investment adviser uses client commissions to pay a broker-dealer more than the lowest available commission rate for eligible research and brokerage services provided by the broker-dealer. To fall within the Section 28(e) safe harbor, advisers and other fiduciaries must make a good faith determination that the amount of commission paid is reasonable in relation to the value of the brokerage and research services being provided.

In its letter requesting no-action assurance, SIFMA AMG stated that investment advisers in the United States often rely on a client commission arrangement (CCA) structure to pay a single bundled commission to broker-dealers for order execution and Section 28(e)-eligible brokerage and research services. Under such a structure, the executing broker-dealer credits the portion of the commission for research to a CCA administered by the executing broker-dealer and retains the remainder of the commission payment. An alternative to the foregoing, as described in SIFMA AMG’s letter, is an arrangement in which the executing broker-dealer forwards the research portion of the commission to a CCA administered by an external “aggregator” or administrator. In such circumstances, the investment adviser instructs the executing broker-dealer to deduct the portion of the commission payment for brokerage, including execution, from payments going to the CCA administered by that third party. In either case, the investment adviser receives research from a  research provider or the executing broker-dealer that is paid for through a CCA funded with client assets.

SIFMA AMG asserted that although the commission paid by the client is bundled to include research and brokerage (including execution), it effectively becomes unbundled when, pursuant to the adviser’s agreement with the executing broker-dealer, the executing broker-dealer retains its brokerage portion and credits (in the case in which the executing broker-dealer administers the CCA) or transmits (in the case in which an external “aggregator” administers the CCA) the research portion to the CCA.

SIFMA AMG’s letter to the SEC staff stated that a “typical RPA” is expected to operate in a manner similar to the CCA model with two relevant distinctions: (1) the amount paid for research is identified separately from the amount paid for execution before the investment adviser makes the payments to the executing broker; i.e., the unbundling occurs at a different point in time; and (2) the RPA is required to be under the control of the investment adviser and the investment adviser is held responsible for the RPA. According to SIFMA AMG, despite these differences, an RPA structure does not change the economic arrangements for research payments already falling under Section 28(e) safe harbor, continues to protect against illegal payments to brokers that do not actually provide or pay for research and is consistent with the public policy of cost transparency.

SIFMA AMG’s letter to the SEC staff stated that when an RPA is operated in connection with a CCA, the research payments continue to be paid to the executing broker-dealer and the payments into the CCA are then routed into an RPA. Although the investment adviser may in some circumstances engage the executing broker-dealer or a thirdparty administrator to administer the RPA, in all cases the executing broker-dealer is contractually required to collect research payments alongside payments for execution services made by the investment adviser out of client assets and pay such amounts into the RPA.

No-Action Relief

In providing no-action assurance regarding an investment adviser seeking to operate in reliance on Section 28(e) of the Exchange Act if its pays for research through the use of RPA that conforms to the requirements of MiFID II, the SEC staff noted that the relief will apply only in the following circumstances:

(1) the investment adviser makes payments to the executing broker-dealer out of client  assets for research alongside payments to that executing broker-dealer for execution;

(2) the research payments are for research services that are eligible for the safe harbor under  Section 28(e);

(3) the executing broker-dealer effects the securities transactions for purposes of Section 28(e); and

(4) the executing broker-dealer is legally obligated by contract with the investment adviser to pay for research through the use of an RPA in connection with a CCA.

The SEC staff cautioned that its position “is subject to modification or revocation at any time.”

© 2017 Vedder Price

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Vedder Price P.C. attorneys provide a full range of services to a diverse financial services clientele. Attorneys practicing in the firm’s Investment Services Group are experienced in all aspects of investment company and investment adviser securities regulations, broker-dealer regulatory and compliance matters, derivatives and financial product matters, and ERISA and tax matters. Clients include mutual fund complexes, hedge and other private funds, money managers, broker-dealers, independent directors, and many other types of institutions such as banks, savings and loans,...

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