On 07 April 2016, the European Commission published its long-awaited Delegated Act, dealing with investment research under MiFID2. This note provides a detailed summary of the requirements of the new rule and how it will impact investment managers.
The receipt of investment research by investment managers has been a controversial and (until now) unresolved MiFID2 “hot topic”, which has caused concern ahead of the January 2018 implementation of MiFID2. The European Commission published on 07 April 2016 its long-awaited Delegated Act dealing with investment research under MiFID2. We set out in this note a detailed summary of the requirements of the new rule and how it will impact investment managers.
The Delegated Act adopts the European Securities and Markets Authorities (ESMA’s) proposal that the receipt of investment research should, on the face of it, be treated as an inducement. It also adopts the proposal that investment research can be received by a firm only if it is paid for either from the manager’s own resources or from a research payment account (RPA). As had been feared by some in the asset management community, this effectively outlaws the receipt of “free” research.
The asset management industry had been concerned that MiFID2 would require a full unbundling of payments for research from dealing commission. However, in a development which may be seen as good news by the asset management community, the Delegated Act preserves (with conditions) the ability of investment managers to pay for research out of dealing commission generated by the execution of orders for clients. This is a significant step back from the more onerous unbundling proposals which had been previously proposed by ESMA (although there are detailed conditions around the operation of RPAs, disclosure of RPAs, and obtaining client agreement). All investment managers will need to review carefully and adapt their existing procedures.
MiFID2 states that, when providing portfolio management services, MiFID firms must not accept and retain fees, commissions or any monetary or non-monetary benefits paid or provided by, or on behalf of, a third party. This is part of MiFID2’s inducement rules.
In its December 2014 proposals on the detailed rules to flesh out this headline requirement, ESMA had proposed that the receipt of all research by an investment manager would be treated as an inducement and that such research could only be paid for either by the manager from its own resources or from a new research payment account. In addition, ESMA had (controversially) proposed that such RPAs would not be permitted to be funded by commissions generated from executing trades. The concern in the asset management industry for the last year and a half has been that this appeared to outlaw the use of dealing commission and commission sharing agreements (CSA) to pay for investment research.
The European Commission has now published its long-delayed and much anticipated Delegated Act, which sets out the final rules on investment research. Article 13 of the Delegated Act sets out the detailed new rules around investment research. The key change from the ESMA proposals is that (subject to meeting various conditions), RPAs can be funded from commission generated from specific trades.
In a development that will be significant for EU-based banks and brokers, the Commission also makes a rule that firms providing execution services must expressly and separately identify the charges for (a) the execution of an order, and (b) any other services provided by the broker (including research).
Status of the draft Delegated Act
The European Commission has published the Delegated Act in the form of a draft Directive. The European Council and Parliament now have three months in which to scrutinise the Act - which can be extended to six months on application of either of these institutions. If no objections are made, prior to or at the end of the scrutiny period, the Delegated Act will be published in the Official Journal and formally enter into force twenty days later. The Delegated Act will apply from the date of the introduction of MiFID2, currently expected to be 03 January 2018.
In addition, as an EU directive, the Delegated Act will not be directly applicable to EU investment firms. Instead (as with all EU directives) it will need to be implemented into the national law and regulatory regime of each EU member state by the local regulator. The following commentary assumes that member states implement the Delegated Act as stated in the current draft text.
Payments for research - own account payments by managers and RPAs
The Delegated Act adopts ESMA’s proposal that the receipt of investment research should, on the face of it, be treated as an inducement. The Delegated Act also adopts the proposal that investment research can be received by a firm only if it is paid for either:
- directly by the investment manager out of its own resources, or
- from a separate RPA controlled by the investment manager, provided that various requirements are met relating to the operation and documentation of the account.
The Commission has therefore decided to retain the proposed ESMA approach that the receipt of research is, in itself, an inducement for MiFID purposes, which can only be paid for using the manager’s own funds or via RPAs. This approach means (as feared) that those EU managers which currently receive research on a “free” basis will need to move to a model of paying for that research either from own funds or via the establishment of RPAs. This may present a particular operational challenge for managers operating in the fixed income space, where the use of dealing commission to pay for research is less common.
The good news (and the divergence from the ESMA proposals) is that the Delegated Act acknowledges that a RPA can be funded using transaction commission / dealing commission. In other words, it will be possible to retain a model similar to the CSA model for payments for research, which is currently widely used within the equities space.
Requirements for the use of RPAs
Article 13 sets out detailed requirements which apply if a firm wishes to make use of RPAs, instead of paying for research from its own account. These requirements fall within three principal areas:
- specific conditions around the operation and use of the RPA, in particular:
- the RPA must be funded by a specific research charge to the client
- the manager must set and regularly assess a research budget as an internal measure
- the manager will be held responsible for the RPA
- the manager must regularly assess the quality of the research purchased, based on robust quality criteria and its ability to contribute to better investment decision
- prior, ongoing and ad-hoc disclosure of the use of the RPA, and
- obtaining and documenting the client’s agreement to use of the RPA.
Each of these three sets of requirements is summarised in more detail below.
(1) RPA conditions
As noted above, there are four specific conditions which must be satisfied if an investment manager wants to make use of RPAs.
- Condition (i) - funded by a specific research charge: In order to meet this condition, the specific research charge must be based on a research budget set by the investment manager for the purpose of establishing the need for third party research. In addition, the charge must not be linked to the volume or value of transactions executed on behalf of clients. The total amount of research charges received cannot exceed the research budget.
- Condition (ii) - setting and agreeing a research budget: In order to meet this condition, the research budget must be managed solely by the investment manager, and must be based on a reasonable assessment of the need for third party research. The allocation of the research budget to purchase third party research must be subject to appropriate controls and senior management oversight,to ensure that it is managed and used in the best interests of the firm’s clients. Those controls must include a clear audit trail of payments made to research providers and how the amounts paid were determined with reference to the quality criteria referred to in condition (iv) below. In addition, investment managers must not use the research budget and RPA to fund internal research.
- Condition (iii) - holding the investment manager responsible: The Delegated Act clarifies that, although the investment manager remains responsible, a degree of delegation is possible. In particular, the investment manager may delegate the administration of the RPA to a third party, provided that the arrangement facilitates the purchase of third party research and payments to research providers in the name of the investment manager.
- Condition (iv) - assessing the quality of research: In order to comply with this condition, the investment manager must establish a written policy which documents all elements of how it assess research quality, and provide it to their clients. That written policy must also address the extent to which research purchased through the RPA benefits clients’ portfolios.
(2) Disclosure requirement if using RPAs
The investment manager must also comply with an initial disclosure requirement, a separate ongoing disclosure requirement, and an ad-hoc disclosure requirement (on request from clients and regulators).
- Prior disclosure: Before the provision of a service to clients, the investment manager must provide to its clients information about the budgeted amount for research and the amount of the estimated research charge for each of them.
- Annual disclosure: On an ongoing annual basis, the investment manager must provide to each of its clients information on the total costs that each of them has incurred for third party research.
- Ad-hoc disclosure: Finally, if requested by clients or by competent authorities, an investment manager must provide a summary of the providers paid from the RPA, the total amount they were paid over a defined period, the benefits and services received by the investment manager, and how the total amount spent from the RPA compares to the budget set by the firm for that period.
(3) Express agreement with the client
It will also be necessary for the investment manager to seek the client’s express agreement to the use of RPAs. In particular, the investment manager must agree with clients (for example in 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 in the research budget may only take place after the provision of clear information to clients about such intended increases. If there is a surplus in the RPA at the end of a period, the firm must have a process to rebate those funds to the client or to offset it against the research budget and charge calculated for the following period.
Impact on sell-side firms
As a final requirement, the Delegated Act also imposes new express restrictions on the sell-side, around the pricing of execution and research services. An EU bank or broker providing execution services must identify separate charges for these services that only reflect the cost of executing the transaction. The provision of any other benefit or service (which would include investment research) by that bank / broker to EU based investment firms must be subject to a separately identifiable charge. It is interesting to note that the Delegated Act expressly limits this rule to the situation where an EU bank / broker is dealing with another MiFID investment firm established in the EU (and so this pricing rule would not apply if dealing with non-EU investment managers, such as US firms).
In addition, the Delegated Act states that the supply of and charges for those benefits or services must not be influenced or conditioned by levels of payment for execution services.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.