Equal Treatment for U.S. Investors

Howell E. Jackson is the James S. Reid, Jr., Professor of Law at Harvard Law School, and Tyler Gellasch is the President and CEO of the Healthy Markets Association. This post draws on two forthcoming papers by Professor Jackson and Jeffrey Zhang, available here and here, and on Mr. Gellasch’s SEC comment letters.

The expiration of an SEC no-action letter is typically not a topic of interest to the general public or members of Congress. But a firestorm is about to descend on Washington over the SEC’s plans to let a temporary measure adopted nearly six years ago expire this summer. Wall Street lobbyists are gearing up to push for an extension. If the SEC succumbs to their pressure, public pension plans, endowments, and millions of Americans invested in mutual funds will lose out.

The Problem of Bundled Commissions

Securities firms like Morgan Stanley and Goldman Sachs typically offer investors potentially valuable research as well as trading services. These firms have long preferred that investors pay for both trade execution and research services with a single bundled commission. So an investment fund, like a public pension plan or a mutual fund, will often be forced to accept a bundled commission that can be thought of as having two components, a component attributable to the trading (nowadays often less than 1 cent per share), and a component attributable to research services (which can often be as high as 5 or even 10 cents per share).

In 1975, Congress created a statutory safe harbor allowing brokers to add research charges onto trading commissions in what was envisioned to be a short-term accommodation to facilitate a smooth transition from the industry’s traditional price-fixing practices, which were then the subject of scandal and extensive litigation. That short term accommodation is now approaching the half century mark.

In the five decades since 1975, the markets have changed dramatically: trading has become much more automated and the cost of executing trades has fallen sharply. At the same time, investor advocates and academic experts have increasingly raised alarms about how bundling commissions harms investors. With bundled commissions, investors seeking to obtain critical research from sell-side firms may be forced to accept substandard execution services, leading to higher overall trading costs. Bundled commissions also allow mutual fund sponsors and other asset managers to shift operating costs to retail customers without clearly disclosing what’s going on. Moreover, asset managers may also use commissions from trading by one fund to pay for research benefitting other funds of the manager, effectively forcing some of its customers to subsidize others. Some retail mutual fund customers end up paying for research that may not even benefit them. While Wall Street may profit from bundled commissions, investors lose out.

Over the years, the SEC has attempted to constrain the use of bundled commissions, especially the research components of bundled commission, which are often called “soft dollars.” The Commission has repeatedly had to restrain financial firms from expanding the scope of soft dollar payments to cover clearly inappropriate expenses like office renovations and trips to the Caribbean. Less successfully, the SEC has also tried to improve soft dollar disclosures for retail investors and even at one point proposed that bundled commissions be prohibited altogether. At every step, the big banks have resisted reforms, with a shifting set of arguments, but with the single goal of retaining an opaque and inefficient business practice that generates millions of dollars in inflated commissions at the expense of investors.

A European Revolution

Beginning a decade ago, the ground began to shift, when regulators in the United Kingdom undertook a careful review of research payment practices, and identified a myriad of investor harms and market distortions. At the urging of British authorities, the European Commission concluded that bundled commissions were abusive and often meant that investors did not know how much they were paying their investment advisers. Worse, many were paying for research that did not even benefit them, or they were accepting wildly excessive prices. After years of studies and consultations, European regulators adopted rules (as part of a directive known as MiFID II) to ensure that investors (1) could separately shop for research and trading services, and (2) would let their own customers know exactly what they were paying for research.

MiFID II also created a somewhat cumbersome process that would allow investment firms to charge retail customers a separate fee to cover the cost of sell-side research, but the amounts would need to be clearly disclosed and tied directly to research that benefited the customer charged. When the Directive went into effect, very few European firms chose to establish these arrangements. Rather, most European asset managers recognized that the only acceptable way forward was to pay for investment research out of their own funds, using cash payments. Thus, in European markets, commissions were unbundled and research costs largely internalized by asset managers.

When MiFID II unbundling provisions were first implemented in January of 2018, its requirements were controversial, especially among the financial service industry. Some argued that the volume and quality of investment research would dramatically deteriorate. That didn’t happen. Some argued that the number of research firms would plummet, or that research coverage would collapse. That didn’t happen either. To the contrary, while research expenses paid by investors fell dramatically, there was no measurable deterioration in access to or the quality of research. Research pricing became transparent. At the same time, asset managers have also been better able to separately shop for research and trading services, leading to greater investor choice and broker competition. Oversight of best execution practices also improved.

To be sure, the rollout of MiFID II was not without bumps. Back in 2018, industry analysts were surprised at how quickly research budgets were adjusted and there were definitely some dislocations of personnel as well as industry challenges in adapting to compliance requirements. Since 2020, European authorities also have made adjustments in the bundling requirements for research related to smaller companies, but these reforms still require that research costs be broken out from execution costs and that the price of research services be clearly disclosed to investors, requirements substantially more investor friendly than those the SEC has been able to impose on soft dollar payments here.

Also telling, the unbundling of commissions in Europe went well beyond the formal requirements of the Directive. Many European investments funds not formally subject to MiFID II restrictions have chosen to unbundle commissions as well, and European banks were powerless to object because MiFID II has required all of these firms to develop procedures for unbundling commissions for clients that are subject to MiFID II. While in London there has recently been some grumbling in industry circles that British authorities should consider a relaxing of MiFID II rules now that Brexit is complete, knowledgeable City sources recognize that European investors are unlikely to be willing to go back in time to being forced to pay for research through trading, and for paying unknown amounts for research that may not benefit them. Investors like unbundled commissions, and do not want to return to a conflicted, costly, and discredited regime.

The SEC 2017 No-Action Relief and its Aftermath

Back in 2017, in the months before the implementation of MiFID II, many U.S. securities firms, like Morgan Stanley and Goldman Sachs, faced a legitimate problem. Many of those firms did business with European clients subject to MiFID II’s unbundling requirements. Under MiFID II, these clients needed to be able to start making separate cash payments investment research. As a result of a peculiarity of U.S. law, shifting to direct cash payments for research could require the legal entity receiving those payments to register under the Investment Advisers Act of 1940, a time consuming process difficult to implement on short notice. Recognizing the challenges that this extra-territorial application of E.U. law posed, the SEC in the Fall of 2017 granted temporary no-action relief, allowing brokers who provide research to accept cash payments as a result of MiFID II without having to register under the Investment Advisers Act. Originally, that relief was set to expire in 2020, but in 2019, the SEC staff tweaked and extended the temporary relief until July 2023. In July of 2022, SEC Division of Investment Management Director William Birdthistle publicly confirmed that the SEC intended to let the no-action relief expire as scheduled.

Now, nearly nine months after Director Birdthistle’s announcement, in breathless press releases, industry representatives are complaining of an emergency that requires “immediate action to preserve critical research.” But there is no emergency: MiFID II has been in place for more than five years and the industry has been well aware of its implications for U.S. firms for longer than that. More importantly, the U.S. financial services industry has already made many adjustments in the aftermath of MiFID II and has several ways of complying with legal requirements, including the Investment Advisers Act, with more special deals from the SEC.

To begin with, since 2017, many U.S. institutional investors and even some larger mutual fund complex have begun to insist on unbundled commissions too, inspired no doubt by developments in Europe. In response, some U.S. securities firms, like Bank of America/Merrill Lynch, have solved their Investment Advisers Act problem by establishing new units that have registered under the Advisers Act and can now provide research services for cash. Others have converted their trading desks into “dual registrants,” registered as both broker-dealers and investment advisers. A few other firms, notably the MFS mutual fund complex have adapted existing contractual arrangements – known as Commission Sharing Agreements (CSAs) – to allow U.S. clients to cover the cost of soft dollar payments by reimbursing their investment funds for the component of bundled commissions used to cover research costs. Wall Street firms could use any of these approach to accept cash payments from MiFID II clients, and there are other potential mechanisms of compliance that the industry has been actively considering since last summer.

Why Does the Industry Care?

If the industry now has many ways to accept cash payments from MiFID II clients for research, why are they so intent on getting their temporary no-action relief extended yet again? The answer is that they want to continue forcing U.S. investors to pay bundled commissions as long as possible. The industry is fighting a rearguard action so that they can continue to exploit U.S. investors as long as possible.

Since 2017, the SEC’s no-action letter has discriminated against U.S. investors. By its terms, the letter applied only to clients subject to MiFID II by law or contract. The relief did not allow securities firms to accept cash payments for research from the vast majority of U.S. investors. As a result, millions of U.S. investors are still paying the cost of bundled research despite not being informed (1) how much they are paying, or (2) whether even whether the research is benefiting them. Worse, in many cases, many asset managers are being compelled to trade with a few brokers to obtain their research, even if they don’t want to trade with those brokers.

While some large institutions—like the MFS mutual fund complex—had the market power and resources to negotiate workarounds, many U.S. investors were stuck with bundled commissions and securities firms could hide behind the Investment Advisers Act as a reason for refusing to accept cash payments for research service provided U.S. clients, while doing so for European clients (until the cover of the SEC’s limited no-action relief).

Beyond being patently unfair to U.S. investors, the SEC no-action relief causes three distinct problems. First, it distorts best execution practices because it allows securities firms to force investors to accept inferior execution quality in order to obtain critical research. Second, it encourages asset managers to opt for bundled commissions and thereby to push operating costs onto less sophisticated investors (often, mutual fund investors) without any meaningful disclosures. Third, it runs a serious risk that U.S. investors will end up subsidizing European clients working with global asset managers, who may use U.S. bundled commissions to pay for research costs that then support investments made on behalf of European clients who do not bear a similar charge.

What the big banks understand is that the expiration of no-action relief will make all of these pernicious practices more difficult to sustain. If MiFID II clients have to be treated the same way as U.S. clients, then securities firms will have to work out cash payment practices for research services that would be available for all of their clients, foreign and domestic. Possibly with separate registered affiliates along the lines that bank of America/Merrill Lynch has adopted or possibly with the MFS reimbursed CSA model. Or possibly some other mechanisms. But the key point is that all clients would be on the same footing and all U.S. investors could start enjoying the benefits that research cost transparency and broker selection freedom that the Europeans have enjoyed over half a decade.

While there are several other steps that the Commission could and should take to improve the transparency of soft dollar payments in the United States, a first and essential step is to let its 2017 no-action relief expire this summer as planned. Equal treatment of all investors, foreign and domestic, should be a platform on which we can all agree.

Both comments and trackbacks are currently closed.