On April 7, 2016, the European Commission published a draft Delegated Directive (the Delegated Directive)1 which, among other things, sets out detailed rules on inducements and the use of dealing commission for investment research, in particular, the unbundling of research from execution fees.
These rules are being introduced as “Level 2” implementing measures pursuant to the revised EU Markets in Financial Instruments Directive (MiFID II).2 If adopted, the Delegated Directive would need to be transposed into the law of each EU Member State along with the rest of MiFID II by January 3, 2018 (expected).
This Update considers the position as set out in the Delegated Directive, in particular whether the Delegated Directive would allow for existing Commission Sharing Agreement models to be used to satisfy the new unbundling requirements.
Background to the Issue
MiFID II contains rules relating to inducements and conflicts of interest for EU investment firms (as to the territorial scope of application of the rules, please see Scope of Application below).
Under Articles 24(7)(b) and 24(8) of the MiFID II Directive,3 EU investment firms providing portfolio management, or investment advice on an independent basis, are not permitted to accept fees, commission or any monetary or non-monetary benefits from third parties in relation to the provision of services to clients. This is on the basis that such fees or benefits would be inducements and thus create conflicts of interest between a firm and its clients.
As an exception, investment firms may accept “minor non-monetary benefits” that are capable of enhancing the quality of service provided to a client and are of a scale and nature such that they could not be judged to impair compliance with the investment firm’s duty to act in the best interests of the client.
In its final advice to the Commission4 (the Final Advice), the European Securities and Markets Authority (ESMA) took the view that investment research that is tailored or bespoke in its content or rationed in how it is distributed or accessed cannot be a “minor non-monetary benefit.”
ESMA recommended that, in order for investment research not to constitute an inducement, the investment firm must pay for the research directly with its own funds, or pay for such research from a designated research payment account funded by specific charges to its clients. That is, investment firms could no longer pass on broker commissions to their clients where such commissions encapsulated execution fees as well as research costs.
In the Delegated Directive, the Commission has largely followed ESMA’s advice, although the Commission has introduced some language that leaves open the possibility of using Commission Sharing Agreements, as discussed in detail below.
The Position Under the Delegated Directive
Under the Delegated Directive, there is the fundamental requirement that execution fees are separated from research fees. There is, therefore, an unbundling of research fees from dealing commission, as recommended by ESMA.
Article 13(1) of the Delegated Directive provides that the provision of investment research by third parties (e.g., brokers) to investment firms providing portfolio management or other investment or ancillary services shall not constitute an inducement if the research is received in return for any of the following:
- direct payments by the investment firm out of its own resources; or
- payments from a separate research payment account (RPA) controlled by the investment firm.
An investment firm may, therefore, obtain research from third parties either where it pays for it directly from its own funds,5 or where the research is paid for from an RPA that complies with all of the necessary conditions.
Where an investment firm uses an RPA, the Delegated Directive requires that:
- the RPA must be funded by a specific research charge to the client (which must not be linked to the volume/value of transactions executed on behalf of clients);
- the investment firm must set and regularly assess a research budget which must be agreed with clients (see below as to how the budget is to be agreed);
- the investment firm must regularly assess the quality of research purchased and its ability to contribute to better investment decisions; and
- the investment firm must provide to its clients detailed information about the budgeted amount for research, the research costs actually incurred, the providers of research, the amount paid to such providers and the benefits and services received from such providers.
Neither the RPA nor research budget may be used by the investment firm to fund internal research.
The Delegated Directive requires that an investment firm must agree with its clients, in either the firm’s investment management agreement or general terms of business, the research charge as budgeted by the firm and the frequency with which the specific research charge will be deducted from the resources of the client over the year. Increases to the research budget may only take place after the provision of “clear information” to clients about such intended increases.
The position under the Delegated Directive is more flexible than that proposed in ESMA’s Final Advice, which appeared to require a specific written agreement between the investment firm and its client for the initial budget and for any increase.
If a surplus remains in the RPA at the end of a period, the investment firm is required to have a process to rebate that amount back to clients or offset it against future research costs.
The Delegated Directive also requires that investment firms must have a written policy in respect of investment research and provide it to clients. The policy must cover the following issues:
- the extent to which research purchased through the RPA may benefit clients’ portfolios including, where relevant, consideration of the investment strategies applicable to the various types of portfolios; and
- the “approach the firm will take to allocate such costs fairly to the various clients’ portfolios.”
In relation to the requirement to allocate costs fairly, one of the difficulties arising from unbundling is that research provided to the investment manager can benefit many clients of the investment firm, even if some of those clients do not agree to pay for the research or only agree to pay a small amount compared to others. Some clients could reap the benefits of the research but leave the burden of paying for it to other clients. It will be a challenge for investment managers to consider how best to allocate research costs fairly in such cases.
Impact on Commission Sharing Agreements (CSAs)6
As noted above, the Delegated Directive provides that the provision of investment research by third parties to investment firms shall not constitute an inducement if the research is received in return for any of the following:
- direct payments by the investment firm out of its own resources; or
- payments from a separate RPA controlled by the investment firm.
Interestingly, Article 13(3) of the Delegated Directive provides:
“Every operational arrangement for the collection of the client research charge, where it is not collected separately but alongside a transaction commission, shall indicate a separately identifiable research charge and fully comply with the conditions [relating to the operation of RPAs].” (Emphasis added)
This new provision was not contained in ESMA’s Final Advice to the Commission.
The question is whether this new provision means the current CSA model could satisfy the new rules on inducements in the context of investment research. In its Final Advice, ESMA noted that, although CSAs may have elements which address concerns around conflicts of interests, “the conditions under which such arrangements are currently operated often do not entirely address” those concerns. In particular, ESMA was of the view that the “current use of CSA’s by industry still enables amounts charged for research by the investment firm to be determined by the volume of transactions of the investment firm with the executing broker, although some investment firms apply budgets to control the total amounts accrued in CSAs. Also, CSAs do not guarantee a fair allocation of research costs to the client’s portfolio.”7
Article 13(3) of the Delegated Directive could be read to allow for more flexibility than ESMA had originally proposed, allowing, for example, the RPA to be funded by a single (bundled) commission charged to the client, which is then applied to research in accordance with the terms of the CSA.
However, it is important to note that Article 13(3) also requires that any such arrangement must in any event “fully comply” with the rules on funding an RPA, including research budget agreements/restrictions and so forth, as discussed above. The research charge must also not be linked to the volume and/or value of transactions executed on behalf of clients.
In this regard, it would appear that in order for a CSA to be compliant with the Delegated Directive, the investment manager would need to ensure that:
- the charging structure upon which the CSA is based is aligned with the overall research budget the manager sets and periodically reviews;
- the charging structure associated with the CSA is expressly agreed with each client;
- the funds collected from the research charge are held in a separate RPA. If operating under a CSA, this would presumably be maintained with each broker with whom the investment manager has entered into a CSA; however, the Delegated Directive appears to contemplate a single RPA for each client of the investment manager, so it is unclear how traditional multiple CSAs might work in this context;
- brokers and other third-party research providers price and charge for the research they provide as separate to any execution services; and
- each client receives a periodic account of the research spend allocated to it (i.e., maintaining full transparency as to the actions the manager took after collecting the research charge) and any funds charged but not spent are rebated (i.e., the research charge paid to the broker under a CSA would need to be fully revocable so that it can be refunded if not used).
Taking this into account, whilst arrangements that appear to operate like CSAs may be possible, the substantive requirements as to unbundling will nevertheless apply.
Specific obligations also apply to the sell-side under the Delegated Directive, particularly under Article 13(9), which requires in effect that:
- EU brokers identify separate charges for their execution services that only reflect the cost of executing the transaction;
- any other benefits or services provided by the broker to EU investment firms are subject to a separately identifiable charge; and
- the supply of those benefits and services and charges for them shall not be influenced or conditioned by the levels of payment for execution services.
Importantly, EU brokers will only need to price research separately when dealing with EU investment firms; EU brokers will not be required to provide such pricing information when providing research to non-EU investment managers. That said, given that clients of EU investment managers will soon be receiving information about research charges, it will be interesting to see if such clients start demanding the same of their non-EU investment managers.
Neither ESMA’s Final Advice nor the Delegated Directive addresses the issue of how the new rules would be applied in the fixed income markets, where the method of payment for, and delivery of, research differs from the equities markets. In fixed income, research costs are usually embedded within the bid/offer spread.
In this regard, the FCA has said: “We believe this would mean that, in the new regime, a manager would have the option either to pay directly for research, or use the research charge and payment account to do so, which can be applied to clients with fixed income portfolios in the same way as for equities. If research is currently a material part of a broker’s costs, we would expect a narrowing of spreads as a result of the decoupling of research from trading spreads.”8
Scope of Application
One final point worth discussing is the territorial scope of the rules. The inducements/investment research rules apply only to MiFID investment firms (i.e., investment firms authorised by EU Member State regulators under MiFID). Thus, the rules do not apply to non-EU investment managers with no presence in the EU. For example, U.S. managers can continue to pay for research - including from EU brokers - on a bundled basis, subject to U.S. regulatory requirements.
However, the effect of the rules would also be that EU investment managers would have to demand transparency on execution/research costs from non-EU brokers, since the EU investment manager may not accept research from any broker other than in the manner contemplated by the Delegated Directive.
As a separate matter, some non-EU managers have EU sub-manager affiliates. An interesting scenario arises where the EU sub-manager directs trades to brokers for execution and receives research not directly from those brokers but, rather, indirectly from the non-EU manager (its parent). The Delegated Directive is silent on such matters. One possibility is that the arrangement would nonetheless amount to an inducement since the EU sub-manager had received research (albeit indirectly) but not complied with the MiFID II requirement to pay for such research in the manner contemplated by the Delegated Directive.
Finally, it is clear that multinational investment managers will have to consider how best to address the new rules, given the higher standard imposed in the EU compared with most (if not all) other jurisdictions at present. Will such managers default to the most stringent (i.e., EU) standard at group level so as to ensure compliance with the EU rules?
Since the Delegated Directive is an EU “directive” (as opposed to a directly applicable EU “regulation”), it will need to be transposed into the laws of each EU Member State and take effect on the expected MiFID II implementation date of January 3, 2018. It is possible that there may be differences in implementation across Member States, with some Member States taking a more (or less) restrictive view than others.
Given the inducements rules apply only to MiFID investment firms, ESMA recommended in its Final Advice that the Commission “consider the possibility of aligning the relevant provisions that fall under UCITS and AIFMD with the MiFID II implementing provisions on this topic.” Thus far there has not yet been any proposal from the Commission in this regard.
On a broader international level, it will also be interesting to see whether the new EU approach on inducements and dealing commission will be adopted in other jurisdictions. The FCA said, in its Discussion Paper 14/3 (July 2014): “[W]e have continued to engage with international regulators through IOSCO... We believe global interest will increase if EU-wide reforms in this area appear more likely under MiFID II.”9
1 Available at http://ec.europa.eu/finance/securities/isd/mifid2/index_en.htm.
2 Directive 2014/65/EU of the European Parliament and of the Council of May 15, 2014 on markets in financial instruments, available at http://eur-lex.europa.eu/legal-content/EN/ALL/?uri=CELEX:32014L0065.
3 MiFID II comprises both an EU directive (the Markets in Financial Instruments Directive), as well as a separate EU regulation (the Markets in Financial Instruments Regulation).
4 Final Report – Technical Advice to the Commission on MiFID II and MiFIR, ESMA, December 19, 2014, available at https://www.esma.europa.eu/databases-library/esma-library?ref=2014/1569.
5 Woodford Investment Management, one of the UK’s most well-known retail fund managers, announced on April 3, 2016 that, as from April 1, 2016, investment research costs would be being paid by Woodford, rather than by the fund, with no increase to the existing annual management fee.
6 A convenient description of CSAs as used in the UK might be as follows: “In this model, the investment manager enters into an agreement (the Commission Sharing Arrangement) with each full-service broker that it chooses to execute with. This differs from the bundled model above as the CSA provides that the full-service broker retains all or part of the research payments in a separate book, for three or six months typically. The amount thus accrued over time can then be paid out periodically, as directed by the investment manager, to any research provider, whether that is to the broker holding the moneys, or ‘paid away’ to another broker or to an independent provider of research that offers no execution services.” (The Use of Dealing Commission for the Purchase of Investment Research, Investment Management Association, February 2014, p. 7).
7 In the UK, the FCA has expressed similar doubts about CSAs; it has said: “current CSA approaches would seem incompatible with the intention of ESMA’s proposals, and specifically the view that there should be no link between execution and research payments.” (see Feedback statement on DP14/3 – Discussion on the use of dealing commission regime, February 2015, Financial Conduct Authority (available at https://www.fca.org.uk/static/documents/feedback-statements/fs15-01.pdf).
8 Discussion on the use of dealing commission regime: Feedback on our thematic supervisory review and policy debate on the market for research, July 2014, Financial Conduct Authority, available at http://www.fca.org.uk/static/documents/discussion-papers/dp14-03.pdf.
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