SEC Staff Pulls Rug Out From Under ‘Hard Dollar’ Research Arrangements

The staff of the US Securities and Exchange Commission division of Investment Management announced that it would allow its October 26, 2017 no-action letter to SIFMA to expire on July 3, 2023—raising questions about the possible investment adviser status of broker-dealers that, after that date, accept cash or “hard dollar” payments for research from investment managers subject to the EU Markets in Financial Instruments Directive II.

In the 2017 no-action letter to SIFMA (SIFMA Letter),[1] the Securities and Exchange Commission (SEC) staff advised that it would not recommend enforcement action if a broker-dealer accepted cash payments for research from an investment manager that was required by the Markets in Financial Instruments Directive II (MiFID II)[2] to pay for research out of its own money rather than client commissions (or “soft dollars”). The announcement threatens to upend research arrangements between broker-dealers and investment managers (particularly global investment managers) that have been structured to comply with MiFID II.

In a July 26, 2022 speech, William Birdthistle (Director, Division of Investment Management) said that “the Division plans for the temporary position to expire on July 3, 2023, and does not expect to issue further assurances with respect to the adviser status of broker-dealers accepting compensation under MiFID II arrangements.”[3] He attributed this stance to “developments in the marketplace for research services,” noting that “firms have developed a variety of solutions to address the impact of MiFID II.” The only solutions to which he alluded were steps by broker-dealers to bring aspects of their research business under an investment advisory business, stating “[s]ome broker-dealers have dually registered as investment advisers and others utilize a registered adviser affiliate to provide certain research services.”

However, this practice has been limited in the marketplace, with many (if not most) broker-dealers still accepting cash or “hard dollar” payments for research under the SIFMA no-action letter. Indeed, the SEC’s February 18, 2022 report to Congress, Staff Report on the Issues Affecting the Provision of and Reliance Upon Investment Research Into Small Issuers, identified five broker-dealers that had “registered their research departments as investment advisers to enable any asset manager to use cash to pay for their investment research.”[4]

When the SEC staff extended the expiration date of the SIFMA letter on November 4, 2019,[5] the SEC staff stated that “business practices concerning payments for research, including in response to the requirements of MiFID II, continue to evolve, but various challenges remain.” It is by no means clear that these business practices have become any more settled than they were in 2019 or that the challenges have dissipated so as to obviate the need for the SIFMA Letter.

Importantly, the SEC staff made clear in the July 26 pronouncement that the sunsetting of the SIFMA Letter does not affect SEC staff “statements or positions that are independent of the temporary adviser status position, such as those regarding client commission arrangements.” This refers to comments on client commission arrangements (CCAs) made by the SEC staff in the 2019 extension, in footnote 8, stating that:

As a separate matter, we understand that, in connection with CCAs, … the money manager in some cases (a) may not have a trading relationship with a broker-dealer that receives commissions for research from the CCA or (b) to the extent it does have a trading relationship with such a broker-dealer, the trades may not relate to that broker-dealer’s research. We understand further that some broker-dealers have questioned whether accepting client commissions to pay for research in these circumstances would affect the availability of the exclusion for broker-dealers from the definition of “investment adviser” under the Advisers Act. In this regard, the staff believes that the Commission was cognizant of these types of CCAs when it issued its 2006 interpretation, and the Commission did not question the availability of the broker-dealer exclusion in the context of these types of CCAs. See Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, Exchange Act Release No. 54165 (July 18, 2006), 71 Fed. Reg. 41978 (July 24, 2006). Therefore, the staff believes that the use of these CCAs does not affect whether the broker-dealer exclusion may be available in connection with the receipt of payments for research under section 28(e).

This clarification is important if it provides broker-dealers with flexibility in the event the SIFMA Letter expires to restructure existing hard-dollar arrangements put in place in reliance on the SIFMA Letter.

More broadly though, the Division of Investment Management’s signal of the expiration next year of the SIFMA Letter flags the very concerns that prompted the SEC staff’s issuance of that letter in the first place—as summed up in the SEC’s February 18, 2022 report to Congress, “US broker-dealers expressed concern that if they received ‘hard dollars’ for their research, those fees could subject the broker-dealer to regulation under the Advisers Act. In turn, US money managers raised concerns that if a US broker-dealer is unwilling or unable to accept separate payments for research (i.e., payments that are not bundled with commission payments for order execution), money managers may not be able to obtain necessary research that would benefit their advised accounts.”[6]

In his speech announcing the SEC staff’s decision to permit the SIFMA Letter to expire next year, Birdthistle made it clear that the SEC staff was making its “intentions known well in advance of July 2023 to allow ample time to address any particular issue” and encouraged “the public to engage” with the SEC staff “on any particular issue relating to MiFID II, including any concerns related to the expiration of the temporary no-action position.”

The announcement by the SEC staff that it intends to allow the SIFMA Letter to expire next July does not appear to affect the other SEC staff no-action letters designed to address inconsistencies between US law and MiFID II, notably SEC staff no-action letters.[7]

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