The EU’s MIFID II, Broker Research, and the SEC’s No-Action Letters
June 15, 2023
The EU’s MIFID II, Broker Research, and the SEC’s No-Action
Letters
Broker-dealers are firms that buy and sell stocks or other
Securities and Exchange Act. The amendment gave legal
securities for their own accounts or on behalf of their
protection to investment advisers running asset
customers, such as pension funds, mutual funds, and other
management firms from claims that they violated their
asset management clients. Larger broker-dealers are also
fiduciary duties by using client commissions to pay higher
known as investment banks. A key role that broker-dealers
commissions to buy investment research than they might
play for their asset management clients is facilitating the
have paid for trade execution services. It also gave some
execution of their securities trades. Certain broker-dealers
impetus to the eventual U.S. and EU norm: the bundled
called sell-side firms have equity research units charged
soft-dollar arrangements, which combine trading and
with providing both them and their buy-side clients with
research into one price.
comprehensive financial analysis on corporate issuers
aimed at helping them and their clients decide whether to
Under the Securities and Exchange Act, domestic broker-
acquire, hold, or sell certain securities. While some asset
dealers described in this In Focus must register with the
managers depend on broker-dealers for the bulk of their
SEC and are also registered with and regulated by the
equity research, others reportedly also use research from
Financial Industry Regulatory Authority, a self-regulatory
independent entities or produce supplementary in-house
organization overseen by the SEC. They have historically
research. Academic literature has found that such broker-
been excluded from regulation under the Investment
dealer research on public companies can benefit the
Advisers Act (Advisers Act), which regulates investment
liquidity of their stocks and can help investors monitor their
advisers who have at least $100 million in assets under
management.
management or who advise investment companies (such as
mutual funds). The exclusion applies if any investment
Debate exists about how broker-dealers should charge asset
advice they provide is “solely incidental” to their business
management clients for their equity research. Some argue
as brokers-dealers and they receive no “special
that bundling these activities into one price can enable the
compensation” for providing the advice. Separate payments
broker-dealers to cross-subsidize their investment research
for research can be considered “special compensation”
on small- and medium-sized firms through payments they
under the Advisers Act, thus invalidating the exclusion. As
receive for research on larger firms. However, bundled
a consequence, the firms would be required to register as
pricing can be criticized for its lack of transparency and its
investment advisers, a different regulatory regime than that
potential for causing conflicts between asset managers and
for broker-dealers.
their clients to the latter’s detriment. In addition, questions
exist about whether broker-dealers who charge clients for
The EU’s MIFID II and the 2018 Amendment
equity research should comply with U.S. regulations for
The EU’s financial regulations are known as the Markets in
investment advisers.
Financial Instruments Directive II (MIFID II). Since
January 2018, the new MIFID-II-based protocol generally
This In Focus discusses U.S. and European Union (EU)
requires separate payments for securities research and trade
regulations around how broker-dealers charge for
execution to broker-dealers from MIFID-regulated asset
investment research and the potential impact that EU
managers, known as unbundled hard-dollar arrangements.
regulations may have on U.S. entities when a Securities and
It generally banned EU-based investment advisers who
Exchange Commission (SEC) no-action letter expires on
head asset management firms (such as pension and mutual
July 3, 2023. Broker-dealers that need to comply with EU
funds) from (1) compensating broker-dealers with a single
regulations may be subject to investment advisor
trading commission for both stock portfolio research and
regulations in the United States due to compliance with the
facilitating their securities trades or (2) depositing a certain
EU regulations. It discusses how the SEC regulates broker-
part of each securities trade commission (such as 2 cents a
dealers, the EU’s MIFID II 2018 amendments, the impact
share) into an account with either the trade executing
of these amendments in the United States, and the policy
broker-dealer or a third party such as an independent
debate about how the SEC should react to these impacts.
research firm, called commission sharing arrangements.
Both of these practices are known as bundled soft-dollar
U.S. SEC Regulation Background
arrangements.
In 1975, the SEC mandated that broker-dealers would
negotiate their trade execution commissions instead of
The Impact of MIFID II in the United States and
charging fixed commissions as they had done historically.
the SEC’s No-Action Letter
The same year, on the heels of that reform, Congress
In 2017, anticipating MIFID II, the SEC staff issued an
enacted a “safe harbor” under Section 28(e) of the
action letter recommending no enforcement (known as a
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The EU’s MIFID II, Broker Research, and the SEC’s No-Action Letters
no-action letter) on the regulatory implications of MIFID II
investment professionals—support the expiration.
for U.S. broker-dealers. The letter said that the SEC would
Meanwhile, some groups—such as the American Securities
temporarily not enforce the requirement that U.S. broker-
Association, a trade group of regional financial services
dealers in receipt of MIFID-II-compliant hard-dollar
firms—support the SEC making the thrust of the no-action
arrangements and RPA-based research payments from EU-
letter permanent. Both H.R. 2622, marked up by the House
and United Kingdom (UK)-based asset management firm
Financial Services Committee on May 24, 2023, and a
advisers must register as advisers under the Advisers Act.
provision in H.R. 2799, marked up by the same committee
Its aim was to give the SEC staff “sufficient time to better
on April 26, 2023, would codify the no-action letter.
understand the evolution of business practices after the
implementation of MIFID II.”
A criticism made by SIFMA and some others of the SEC
letting the no-action letter expire is that subjecting broker-
In 2019, the letter’s initial expiration date was extended to
dealers to Adviser Act registration is incompatible with
July 3, 2023, when it is set to expire. It has been reported
brokers’ client trade execution disclosure and consent
that most U.S.-based broker-dealers are not affected by the
requirements in the context of the “high speed and fluid”
no-action letter, because their asset management firm
trades that they often engage in. Another assertion is that
clients are not regulated by MIFID II. Thus, if the letter
the broker-dealers’ “arm’s length” relationships with their
expires, those brokers would not be required to comply with
clients in providing generalized client investment research
the Advisers Act. However, various domestic broker-
under the Securities and Exchange Act differs from the
dealers such as Goldman Sachs, Morgan Stanley, JP
Advisers Act’s fiduciary mandate requiring advisers to act
Morgan, and Citigroup are globally connected and serve
in the best interests of their clients. In addition, both the EU
UK- and EU-based asset managers regulated under MIFID
and the UK are reassessing MIFID II’s impact on smaller-
II. For such firms, the letter’s expiration would require that
sized firms, so some argue that the SEC should delay
they be subject to the Advisers Act. Some domestic broker-
removing the no-action letter until these EU regulations are
dealers, including Merrill Lynch, have formed new units
finalized.
registered under the Advisers Act that provide research
services for hard-dollar arrangements as required by MIFID
Supporters of letting the SEC’s letter expire argue that
II. Some are dual registrants separately registered as both
doing so may beneficially lead to more unbundled hard-
broker-dealers and SEC-registered investment advisers.
dollar arrangements, leading to more transparency and
growing asset manager interest in shopping separately for
In the event of the expiration of the no-action letter, non-
research and trade execution, stimulating a more
broker observers say that many U.S. broker-dealers
competitive market. In addition, some observers note that
currently impacted by MIFID II would likely (1) register as
while the costs of transitioning to advisory status would
investment advisers, (2) redeploy research units to affiliates
vary for each individual broker, overall, the cost may not be
already registered as investment advisers, or (3) withhold
large or “insurmountable.”
research produced by their U.S.-based operations from their
MIFID- and UK-regulated clients.
In 2023, Zhang and Jackson reviewed available research on
the impact of MIFID II’s commission unbundling. They
In early June 2023, SEC Chair Gary Gensler indicated that
noted that research generally showed that it had reduced the
plans for the letter’s expiration in July 2023 were still on
aggregate level of analyst coverage for large-sized public
course.
firms through reducing analyst redundancy but not with
respect to the coverage of small- and medium-sized firms.
Policy Debate
They found that MIFID II had expanded both the quality
Much of the public policy discussion surrounding the
and the impact of research analyst coverage, resulting in
possible impact of the letter’s expiration involves the
increased capital market efficiency. However, they also
prospect that SEC-registered broker-dealers will opt for
observed that the EU has responded to concerns that MIFID
Adviser Act registration and face transition costs.
II had hurt research coverage for small- and medium-sized
firms by permitting soft-dollar payments for research on
The prospect of the July 2023 expiration has garnered
firms with less than €1 billion ($1.072 billion) in market
mixed responses. Among others, the Securities Industry and
capitalization. Similarly, they noted that the EU is currently
Financial Market Association (SIFMA), the domestic
considering returning to allowing market capitalization
broker-dealer trade group whose earlier concerns prompted
below €10 billion ($10.720 billion), which reportedly
the no-action letter, and the SEC Small Business Capital
constitutes about 95% of EU-listed firms.
Formation Advisory Committee have advised that the SEC
extend the expiration deadline. Others—including the
Gary Shorter, Specialist in Financial Economics
Council of Institutional Investors, an institutional investor
trade group; the Healthy Markets Association, an investor
IF12427
advocate; and the CFA Institute, a global group of
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The EU’s MIFID II, Broker Research, and the SEC’s No-Action Letters
Disclaimer
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