Soft dollars have been a significant contributor to the bottom lines of many investment managers. With the most recent delegated directive under MiFID II, however, European regulators have mandated major changes to the use of soft dollars. While this has been the No. 1 topic of conversation among IMs in Europe, it also has a significant impact on IMs in the US (or anywhere else that allows soft dollars).
When the European Parliament passed the Delegated Directive C(2016) 2031 (the “DD”) under MiFID II in early April, it contained a Chapter V on inducements. Article 13 of that chapter pertains to inducements in relation to research, which makes major changes to the use of soft dollars by investment managers (IMs). What complicates matters somewhat is that, as in many other areas of regulatory reform, the EU and the US have taken different lines on soft dollars.
Soft dollars in the US
In the US, the use of soft dollars is regulated by Section 28(e) of the Securities Exchange Act of 1934. This section was passed in 1975, as a result of the end of the fixed commission era and provides a safe harbor for IMs using trade commissions to pay for services other than brokerage. The SEC has issued several interpretations and guidances on Section 28(e), the last of which was issued in July 2006.
The gist of all the guidance is that IMs can use commissions, which are paid by their clients, above the base rate paid for execution services, if and only if the excess is reasonable payment for research used to benefit the clients. The many updates the SEC issued served to narrow the services for which soft dollars could be used, eliminating any hardware, connectivity, services, or software that don’t directly benefit the client or enhance the management of the client’s assets.
However, even with all those restrictions, soft dollars have been a significant contributor to the bottom line of many IMs, and an integral and important part of their business.
Soft dollars in the EU
The DD turns that practice completely on its head. In Article 12 it says, “Investment firms providing investment advice on an independent basis or portfolio management shall not accept non-monetary benefits,” which it calls inducements. Then Article 13 says that soft dollar research will be regarded as an inducement unless it is received in return for any of the following:
(a) direct payments by the investment firm out of its own resources;
(b) payments from a separate research payment account controlled by the investment firm, provided the following conditions relating to the operation of the account are met:
(i) the research payment account is funded by a specific research charge to the client;
(ii) part of establishing a research payment account and agreeing to the research charge with their clients, investment firms set and regularly assess a research budget as an internal administrative measure;
(iii) the investment firm is held responsible for the research payment account;
(iv) the investment firm regularly assesses the quality of the research purchased based on robust quality criteria and its ability to contribute to better investment decisions.
The research payment account (RPA) has become the No. 1 topic of conversation among IMs in Europe, but it has a significant impact on IMs in the US (or anywhere else that allows soft dollars).
[Related: “To Bundle or Unbundle? A Look at CSAs, RPAs and MiFID II”]
Understanding the impact on IMs
Initially, most market participants saw this requirement as falling mostly, if not completely, on IMs domiciled in the EU; but that is very much not the case. Various parts of MiFID II are triggered by either the instrument traded or the client served, and this Directive is triggered by the client. Thus, it says that any IM serving EU-domiciled clients will have to stop using soft dollars for those clients, but not necessarily for other clients, when the directive goes into force, probably in early 2018.
For traditional IMs, which often do block trades and then allocate them to individual clients, Article 13 creates significant complications. Assuming the IM is using soft dollars for a particular block trade, any allocations to EU clients will require the IM to split its commissions between an execution component and a research component, and the research component must be charged to the RPA. If the IM has used up that client’s RPA for the year, it will have to rebate the research component to the client or deduct it from the commission charged, resulting in two different commissions to two clients on the same trade.
What to do?
For a non-EU IM, this brings up several questions, and a few possible answers.
First, does the IM have any EU clients? For this purpose, the domicile of a collective, such as a mutual fund, is determined by where it is headquartered, not by whether it has any EU-domiciled shareholders. If no EU clients, then none of this applies.
Second, because this DD is part of MiFID II, there is the question of whether an IM that has no presence in the EU, but has EU clients, is even subject to it. MiFID II has a category called “third country firms,” which comprises non-EU firms serving EU clients or transacting in EU instruments. Membership in that category can involve dealing with retail clients, in which case all of the EU rules, including the DD, apply.
Alternatively, if the IM has only institutional clients (called professional and eligible in MiFID-speak), then, if the IM’s home regulator achieves regulatory equivalence with ESMA, the IM follows its home regulations and not the DD. However, since the SEC rules are so different from the EU’s, I am dubious whether the SEC would receive regulatory equivalence on this matter.
Finally, on this point, the IM could determine unilaterally that, since it is completely outside the EU, it can ignore any EU rules. One can safely assume that ESMA, and any other EU regulator, would take a dim view of this, but the IM could take the risk of whether the EU would be able to enforce any of its rules on a purely external entity.
Third, if the IM determines that it is subject to the DD, it then needs to determine whether it will apply the EU soft dollar rules to all its customers, or only to its EU customers. If it plans to apply separate rules to the different classes of customers, it will need the technology to split the commissions for EU customers into the two components, and then ensure that 1) the total commissions are the same for both classes of customers, and 2) the RPA for every customer is sufficient to cover each year’s research component.
The status of being a global investment manager, able to serve a global client set in global investments, has had a certain cachet in the past. IMs are now rethinking the value of that status in light of increased costs and risks. The EU approach to soft dollars has added another layer of complication to that decision matrix.
