Can a Firm Use Soft Dollars to Pay for Research from US Based Brokers under the MiFID II Regime?

Concept

The core of your question is about the operational friction between two powerful regulatory systems ▴ the European Union’s Markets in Financial Instruments Directive II (MiFID II) and the United States’ established securities laws. At a fundamental level, MiFID II mandates a clean separation, or “unbundling,” of payments for trade execution and investment research. This directive treats research as a distinct service that a firm must pay for directly, using its own capital (“hard dollars”), rather than bundling the cost within client trading commissions (“soft dollars”). The foundational principle of this unbundling is to enhance transparency and ensure that investment managers act in the best interests of their clients, without their decisions being influenced by the provision of research.

This creates a direct conflict with the long-standing structure of the U.S. securities market. For decades, the U.S. system has permitted the use of soft dollars, a practice codified in Section 28(e) of the Securities Exchange Act of 1934. The issue arises because under the U.S. Investment Advisers Act of 1940, a broker-dealer that receives separate, direct payments for research ▴ the “hard dollar” payments required by MiFID II ▴ could be deemed an investment adviser. This reclassification carries with it a host of regulatory obligations that are often incompatible with the business models of broker-dealers.

The central challenge is a clash of regulatory philosophies ▴ MiFID II’s unbundling of research payments directly conflicts with the U.S. framework that has historically allowed for bundled soft-dollar arrangements.

To navigate this impasse, the U.S. Securities and Exchange Commission (SEC) issued a temporary no-action letter in 2017. This letter provided a safe harbor, allowing U.S. broker-dealers to accept hard dollar payments for research from firms subject to MiFID II without triggering the requirement to register as investment advisers. This was a temporary solution designed to give the market time to adapt.

However, this relief expired on July 3, 2023, and the SEC has indicated it will not be extended. The expiration of this no-action letter removes the bridge that once connected these two divergent regulatory systems, forcing firms to confront the underlying conflict directly and re-architect their operational and compliance frameworks.

What Is the Core Conflict between MiFID II and US Law?

The fundamental conflict is one of definition and regulation. MiFID II defines research as a distinct service that must be paid for with hard dollars, while the U.S. Advisers Act views the receipt of such payments as a trigger for investment adviser registration. This creates a situation where a U.S. broker-dealer, in complying with the payment structure of a European client, would inadvertently fall under a different and more stringent U.S. regulatory regime. This is not a simple matter of paperwork; the fiduciary duties and operational constraints imposed on registered investment advisers are substantially different from those governing broker-dealers, creating significant business model challenges.

• MiFID II Mandate The unbundling of research and execution fees is a core tenet of MiFID II, designed to eliminate potential conflicts of interest and improve transparency for investors.
• U.S. Regulatory Framework The U.S. has a well-established system that allows for soft dollar payments, and the receipt of separate compensation for research can trigger investment adviser status.
• The No-Action Letter This was a temporary measure to reconcile the two systems, and its expiration has brought the underlying conflict back into sharp focus.

Strategy

With the expiration of the SEC’s no-action letter, firms must now devise a clear strategy to address the structural divergence between MiFID II and U.S. securities law. There is no single, universally applicable solution; the optimal path depends on a firm’s specific business model, client base, and operational capabilities. The primary strategic decision point is whether to adapt to the MiFID II hard-dollar regime, which may necessitate significant structural changes, or to find ways to operate within the existing U.S. soft-dollar framework where possible.

One of the most direct strategies is for a U.S. broker-dealer to register with the SEC as an investment adviser. This approach fully embraces the hard-dollar payment model and allows the firm to accept direct payments for research from MiFID II-regulated clients without restriction. However, this is a significant undertaking.

The firm must be prepared to comply with the fiduciary standards, disclosure requirements, and other obligations of the Advisers Act, which can be a substantial departure from the traditional broker-dealer model. This path is most suitable for firms that have a substantial European client base and for whom the revenue from research is a critical part of their business.

Firms must now choose between adapting their structure to the hard-dollar world of MiFID II or re-architecting their service delivery to remain within the U.S. soft-dollar framework.

An alternative strategy involves corporate restructuring. A firm can establish a separate, affiliated entity that is registered as an investment adviser. This allows the core broker-dealer to continue its traditional operations while the affiliate handles the provision of research services and receives hard-dollar payments. This can be an effective way to segregate the different regulatory requirements and avoid the complexities of dual registration for the entire firm.

Another approach is to move the research services for MiFID II clients to a non-U.S. affiliate, thereby taking the activity outside the direct jurisdiction of the Advisers Act. This can be a viable option for firms with a global footprint.

How Can Firms Operationally Manage Divergent Payment Structures?

Operationally, firms must be able to segregate their client relationships and payment flows. This means having systems in place to identify clients subject to MiFID II and to process their payments for research separately from execution commissions. For firms that choose to maintain both hard- and soft-dollar capabilities, this requires robust internal controls to prevent cross-subsidization and to ensure that each client is being serviced in accordance with the applicable regulatory regime. This can be a complex undertaking, requiring significant investment in compliance and accounting systems.

The table below outlines the primary strategic options available to firms and the key considerations for each:

Execution

The execution of a chosen strategy for navigating the MiFID II and U.S. regulatory landscape requires a detailed and rigorous approach. For firms that have decided to register as an investment adviser or to use a registered affiliate, the process is multifaceted and involves legal, compliance, and operational considerations. The first step is a thorough gap analysis to identify all the areas where the firm’s current practices fall short of the requirements of the Advisers Act. This includes a review of disclosure documents, marketing materials, and internal compliance procedures.

A critical aspect of the execution phase is the implementation of a robust compliance framework. This framework must be designed to address the specific requirements of the Advisers Act, including the fiduciary duty to act in the best interests of clients, the prevention of principal trading conflicts, and the management of conflicts of interest. This often requires the development of new policies and procedures, as well as the training of staff to ensure they understand their new obligations. The firm’s technology infrastructure may also need to be upgraded to support the new compliance requirements, such as the tracking of communications and the monitoring of trading activity.

Successful execution hinges on a meticulous gap analysis of current practices against the Advisers Act, followed by the implementation of a robust and technology-enabled compliance framework.

For firms that opt to use a non-U.S. affiliate to provide research to MiFID II clients, the execution phase is focused on corporate structuring and cross-border regulatory compliance. This involves establishing the legal entity in the chosen jurisdiction, ensuring it is properly licensed and capitalized, and putting in place the necessary inter-company agreements to govern the provision of services. Careful attention must be paid to transfer pricing rules to ensure that the affiliate is being compensated on an arm’s-length basis. The firm must also have systems in place to track and report on the activities of the affiliate in accordance with the requirements of both the U.S. and the foreign jurisdiction.

What Are the Practical Steps for Implementation?

The practical implementation of any of these strategies can be broken down into a series of distinct steps. The following is a high-level overview of the key phases of implementation:

1. Strategic Decision The first step is for senior management to make a clear decision on the firm’s overall strategy for addressing the MiFID II challenge. This decision should be based on a thorough analysis of the firm’s business model, client base, and risk appetite.
2. Gap Analysis and Planning Once a strategy has been chosen, the firm must conduct a detailed gap analysis to identify all the changes that will be required to its legal, compliance, and operational infrastructure. This analysis should form the basis of a comprehensive implementation plan.
3. Legal and Corporate Structuring This phase involves making any necessary changes to the firm’s legal and corporate structure, such as registering as an investment adviser or establishing a new affiliate.
4. Compliance Framework Development The firm must develop and implement a new compliance framework that is designed to meet the requirements of the chosen strategy. This includes drafting new policies and procedures, providing training to staff, and implementing new technology solutions.
5. Client Communication and Transition The firm must communicate its new approach to clients and manage the transition to the new service delivery model. This may involve renegotiating client agreements and providing education on the new payment arrangements.

The table below provides a more detailed breakdown of the execution process for a firm that has chosen to register as an investment adviser:

Reflection

The challenges posed by the interaction of MiFID II and U.S. securities law are a powerful reminder that in today’s interconnected financial markets, regulatory compliance is not a static, check-the-box exercise. It is a dynamic and ongoing process that requires a deep understanding of the underlying principles of different regulatory regimes and a willingness to adapt and evolve. The expiration of the SEC’s no-action letter has closed a chapter, but it has also opened a new one, in which firms must take a more proactive and strategic approach to managing their cross-border regulatory risks.

As you consider the information presented here, I encourage you to reflect on your own firm’s operational framework. Is it agile enough to respond to these kinds of regulatory shifts? Do you have the systems and processes in place to manage the complexities of a multi-jurisdictional client base?

The answers to these questions will be critical in determining your firm’s ability to thrive in the years to come. The knowledge you have gained from this analysis is a valuable component of a larger system of intelligence, and it is the application of that intelligence that will ultimately provide you with a decisive operational edge.