Payment for Research
Soft commissions, bundled fee payments, and brokerage arrangements all stem from investment managers’ use of client assets. As such, they are the property of the client. Investment managers should make clear and complete disclosures to clients as to the nature of such arrangements, detailing how client transactions are handled and how the commission benefits are used. Such disclosures help mitigate conflicts of interest and enable fund investors to evaluate the appropriateness of any commission or brokerage arrangements. In particular, disclosures help investors determine whether they are receiving value in return for these services. Research purchased with soft commissions should follow CFA Institute’s Soft Dollar Standards.
Traditionally, broker-dealers who provide investment research to institutional asset managers in the U.S. are compensated for this activity through the receipt of brokerage commissions for executing securities transactions for the managers’ accounts. Asset managers typically seek to structure these client commission arrangements (CCAs) or “soft dollar” arrangements (known as commission sharing agreements (CSAs) outside the U.S.) to comply with the safe harbor established by Section 28(e) of the Securities Exchange Act of 1934. The Section 28(e) safe harbor permits asset managers who meet the safe harbor’s requirements to use the commissions generated by their managed accounts to pay for research that has been or will be used in the investment-decision making process on behalf of these accounts.
A U.S. broker-dealer who provides investment research and is compensated through the receipt of brokerage commissions is typically exempt from registering as an investment adviser. The Investment Advisers Act of 1940 specifically exempts from the definition of investment adviser a broker-dealer whose provision of investment advice is “solely incidental” to its brokerage services and who receives no “special compensation” for providing such advice.
But a U.S. broker-dealer who accepts a hard dollar payment for its research from an asset manager likely would not be able to rely on its status as a broker to avoid registering as an investment adviser because this hard dollar payment would be deemed “special compensation.” While other exemptions from investment adviser registration may be available to a broker-dealer who accepts hard dollar payments for its research, determining whether another exemption is available usually requires an analysis of the particular research arrangement and the investment advisor regulatory regimes in each state where the broker-dealer has an office or where any hard dollar paying client is located.
The consequences of a broker-dealer being required to register as an investment adviser are numerous; however, one in particular stands out for broker-dealers who also trade on a proprietary basis. Section 206(3) of the Advisers Act generally precludes an investment adviser from trading as principal with an advisory client without disclosing its capacity in writing and receiving client consent to the transaction. Some broker-dealers who refuse to accept hard dollar payments for their research services argue that this prohibition may apply if they trade on a principal basis with research clients who pay with hard dollars.
In Europe, MiFID II (see MiFID Conduct-of-Business Rules) will allow EU lawmakers to distinguish between permissible and impermissible third-party benefits to discretionary portfolio managers. There has been significant debate since the European Securities and Markets Authority (ESMA) proposed characterizing the investment research that brokers provide to discretionary portfolio managers as an impermissible nonmonetary benefit. It is not clear whether ESMA’s proposals, which are not yet final draft laws, will be adopted given that the United Kingdom, France and Germany have jointly challenged ESMA’s view.
If ESMA’s original proposals are adopted, discretionary portfolio managers may no longer be able to receive investment research from brokers unless they pay for that research themselves, raise management charges to absorb the extra costs or, with client agreement, use research payment accounts that are funded in advance. It is widely believed that adoption of ESMA’s original proposals would put pressure on smaller managers who may not be able to afford the research themselves, would result in discretionary portfolio managers being more selective in the investment research for which they pay, and would call into question the business models of some investment banking research desks. However it is expected that ESMA’s original proposals will be watered down to a position slightly more palatable to the investment management industry.