Soft Dollar Disclosure Proposal Abandoned by SEC

January 20, 1997

In a Federal Register notice of November 29, 1996, the Securities and Exchange Commission announced that it has withdrawn its February, 1995 proposal to require investment advisers to expand the disclosure they provide regarding their "soft dollar" practices. Proposed Rule 204-4 and proposed Form ADV-B would have required registered investment advisers to report to their clients annually on their brokerage practices, including soft dollar arrangements.

The term "soft dollars" refers to the difference between the commissions that an advisory client actually pays on brokerage transactions initiated by the client's investment adviser and the minimum commission that the broker would be willing to charge if it provided no services beyond the mere execution of those brokerage transactions. Section 28(e) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), provides a safe harbor that permits investment advisers to utilize soft dollars generated by their clients' brokerage transactions to pay for research services,¹ provided that the nature of the research services and the use of soft dollars to pay for them has been fully disclosed to the clients. Other uses of soft dollars are not prohibited, per se, but they are not entitled to the protection of the safe harbor. Accordingly, the uses of soft dollars for services or products falling outside the safe harbor will be subject to review as to conformity with an investment adviser's fiduciary responsibilities to its clients. In all cases, the investment adviser must determine in good faith that the amount of commissions that is in excess of "execution only" commissions is reasonable in relation to the value of all of the property, products and services provided by the broker.

Under the proposed rule, an investment adviser would have had to disclose to its clients in a tabular format:

1. the three (3) brokers to whom the adviser directed the largest amounts of commissions exclusively for execution services ("execution-only brokers");
2. the twenty (20) brokers (other than "execution-only brokers") to whom the adviser directed the greatest amounts of commissions (and, where Rule 10b-10 is applicable,² mark-ups and mark downs) and information concerning the soft dollar products or services obtained from such brokers;
3. (c) the aggregate amount of commissions directed by the adviser to each named broker, the percentage of the adviser's total discretionary brokerage such amounts represent and the percentage represented by client-directed brokerage; and
4. (d) the average commission rate (in cents per share) paid to each named broker.

A prospective client would have to have received the report before or at the time he entered into an advisory agreement with the investment adviser. The description of services obtained from each broker would have had to include, among other things, an identification of products or services obtained, including computer hardware, software, databases and on-line services, publications available by subscription, and services falling outside the §28(e) safe harbor. Proposed Form ADV-B would have required these items to be "identified separately and specifically."

In announcing withdrawal of proposed Rule 204-4, the SEC stated that it was doing so "because the Commission does not expect to consider the item within the next 12 months." It added, though, that it "may consider the item further at some point."

However, the SEC's Office of Compliance Inspections currently has underway a "sweep exam"³ aimed at uncovering possible abuses in brokerage firms' soft dollar payments to investment advisers who send them business (28 SRLR 1464). In addition, investment advisers remain subject to existing requirements concerning soft dollar disclosure in client brochures⁴ and, where applicable, in hedge fund and other offering materials. The SEC's existing position is that if the value of products, research and services paid for with commission dollars is a factor in the broker-dealer selection process or in determining the reasonableness of commissions charged, the SEC requires,⁵ at a minimum, that the following be described:

1. the types or categories of products, research, and services (if non-safe harbor products or services are obtained additional disclosures may be warranted);
2. whether clients may pay commissions higher than those obtainable from other brokers in return for those products and services;
3. whether research is used to service all of the adviser's accounts or just those paying for the research; and
4. any procedures used during the last fiscal year to direct client transactions to a particular broker in return for products and services received.

Also, to the extent an investment adviser enters into soft dollar arrangements with brokers, the arrangements may need to be disclosed even if they fall entirely within the safe harbor.

Investment advisers have the additional burden of periodically evaluating the execution performance of their broker-dealers and determining that the value of research and brokerage services is reasonable in relation to the amount of commissions paid. This can be a very difficult process, especially in light of the SEC's position that where a product or service obtained with soft dollars has a mixed research and non-research use or provides both research and non-research assistance to an investment adviser (e.g., a computer system that is used to monitor the stock market and to prepare statements to clients), the adviser is required, for client accounting purposes, to make a reasonable allocation of the costs that may be paid for with commission dollars. To the extent that a product or service falls outside the soft dollar safe harbor, the fact that the allocation requirement exists presents a conflict of interest which may also have to be disclosed.

Our Analysis

The abandonment of proposed Rule 204-4 and proposed Form ADV-B notwithstanding, the SEC continues to express concerns regarding soft dollar practices prevailing in the industry. Investment advisers need to remain aware of, and in compliance with, existing requirements regarding soft dollar and other brokerage practices. Investment advisers should also recognize that concerns regarding soft dollar disclosures stem from the fact that commissions paid to brokers in excess of "execution-only" commissions are client funds that do not belong to the investment adviser. Accordingly, any use of such funds to pay for a service that benefits the investment adviser must be consistent with the investment adviser's fiduciary duties to the client.

Prior disclosure of prospective use of a client's soft dollars is absolutely required, of course. Although full disclosure is the sine qua non without which the use of soft dollars is prohibited, disclosure alone will not satisfy an investment adviser's fiduciary duties to the client. At a minimum, actions taken in a fiduciary context must be reasonable. Thus, an investment adviser is required to determine in good faith that the amount of commissions a client pays in excess of "execution only" commissions is reasonable in relation to the value of all of the property, products and services provided by the broker. It is, of course, impermissible to use soft dollars to pay for a product or service that benefits primarily the investment adviser rather than the client.

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¹Research services are those which provide lawful and appropriate assistance to the adviser in the performance of his investment decision-making responsibilities. Research services may include, for example, research ideas, publications, investment strategies and analyses.

²Mark-ups and mark-downs paid in connection with principal transactions are deemed to be commissions for this purpose if they are required to be set forth in confirmations of the transactions pursuant to Rule 10b-10 under the Securities Exchange Act of 1934 (e.g., riskless principal transactions in equity securities if the dealer is not a market maker; and transactions in listed equity securities and certain NASDAQ securities).

³Sweep exams are undertaken to help the SEC understand industry practices.

⁴See Part II of Form ADV.

⁵ SEC Release No. 34-23170.

For more information, please contact Howard Neuman in the firm's New York office at (212)818-9200.