Update on Soft Dollar Arrangements

August 16, 2006

On July 18, 2006, the Securities and Exchange Commission (the “Commission”) issued an interpretive release [1] (the “Interpretive Release”) regarding “soft dollar” arrangements; arrangements in which a discretionary money manager effects transactions on behalf of its clients where a portion of the brokerage commissions are used to purchase goods or services to be used by the adviser.  While such transactions would ordinarily give rise to claims of breach of fiduciary duty, Congress provided a fiduciary duty safe harbor in Section 28(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) [2] if such transactions fulfill certain criteria.  Specifically, the “soft dollar safe harbor” provides that a manager will not have breached his fiduciary duty to his clients solely because he effects a transaction on a client’s behalf which includes a commission that is more expensive than the lowest market alternative, if the manager determines in good faith that the amount of the commission paid is reasonable in relation to the value of the brokerage and research services provided by the broker-dealer effecting the transaction.  The Commission had previously published for comment a proposed interpretative release (the “Proposal Release”) tightening rules regarding soft dollar practices permitted by Section 28(e). [3] Based on comment letters from industry commentators, the Interpretive Release revised and finalized the interpretive rules set forth in the Proposal Release.  In proposing changes to the interpretation of the safe harbor, the Commission sought to clarify the scope of permissible uses of soft dollars by money managers “in the light of evolving technologies and industry practice.” Specifically, the Commission provided guidance with respect to four aspects of the soft dollar safe harbor in the Interpretive Release:

* The appropriate framework for analyzing whether a particular service falls within the “brokerage and research services” safe harbor;

* The eligibility criteria for “research”;

* The eligibility criteria for “brokerage”; and

* The appropriate treatment of mixed-use items.

In particular, the Interpretive Release effects the following interpretations and changes to previous Commission guidance:

* The definition of “research services” subject to the soft dollar safe harbor is restricted to “advice,” “analyses,” and “reports” which provide an “expression of reasoning or knowledge.” Tangible products, such as computer hardware, are explicitly excluded from the definition.

* The definition of “brokerage services” subject to the soft dollar safe harbor is limited by a “temporal standard” under which only products and services that relate to the execution of a trade from the point at which the money manager communicates with the broker-dealer to transmit the order to the point that the funds or securities are delivered to the advised account are eligible for the safe harbor.

* The previously articulated standard for eligibility of brokerage and research services for safe harbor protection was reiterated and remains unchanged as those products and services that provide “lawful and appropriate assistance to the money manager in the carrying out of his responsibilities.”

* The previously articulated standard for allocations of soft dollars for the purchase of mixed-use items and the record-keeping requirements for such allocations was reiterated and remains unchanged.

* Two principals were set forth for the application of the soft dollar safe harbor involving multiple parties:

* Broker-dealers that are parties to a soft dollar arrangements are involved in “effecting” the trade only if they execute, clear, or settle the trade, or perform one of four functions specified in the Interpretive Release (and discussed below) and take steps to allocate the other functions to other broker-dealers.

* Research is “provided by” a broker-dealer only if the broker-dealer (i) prepares the research; (ii) is financially obligated to pay for the research; or (iii) is not financially obligated to pay for the research, but the arrangement has certain attributes, discussed below.

Background

In general, money managers have a fiduciary duty (and often a statutory duty) [4] to act in the best interest of their clients and are prohibited from using client funds for their own benefit without the client’s informed consent.  This duty includes the obligation to obtain the best execution of a client’s transaction under the circumstances of the particular transaction. [5] Thus, it is reasoned, money managers may not cause their clients’ accounts to pay higher than necessary brokerage commissions on managed transactions to benefit themselves. 

Prior to 1975, minimum brokerage commissions on the New York Stock Exchange were fixed according to a published schedule. [6] The fixed rate commission rules prevented money managers from selecting broker-dealers based on commission rates; thus, broker-dealers competed for money managers’ business by adding value to the transactions for money managers through the provision of additional services such as research.  On May 1, 1975 (later to be popularly known as “May Day”), the Commission adopted Exchange Act Rule 19b-3 [7], abolishing fixed commission charges for brokerage transactions, thus allowing broker-dealers to charge any commission for brokerage services.  The May Day commission deregulation significantly changed money managers’ and broker-dealers’ market calculus; brokers were now allowed to compete on price by reducing commissions below the previously controlled price level and money managers could negotiate between broker-dealers for cheaper commissions for their clients’ transactions.  However, to compete profitably at lower pricing levels, broker-dealers needed to minimize the extra costs associated with research and other services traditionally provided with brokerage services to a stripped-down “pure execution” level of brokerage.

Though money managers’ clients benefited from decreases in commissions following May Day, the creation of pure execution brokerage created other concerns.  Primarily, money managers worried that if they used client funds to pay commissions to any broker-dealer other than the cheapest pure execution broker-dealer, they could be accused of breaching their fiduciary duty.  Smaller money managers who lacked the benefit of an in-house research department (and thus relied on broker-dealers to provide research services) were particularly worried that the market would be taken over by the largest money management firms which did not need external services beyond pure execution. 

On the other side of the market, broker-dealers worried that with the advent of the pure execution broker, the market for all other brokerage services would evaporate, especially if money managers were bound by fiduciary duty not to use higher priced alternatives.  Smaller broker-dealers were worried that large brokerage houses would leverage economies of scale from large trade volumes to charge below-market commissions, thus driving smaller competitors out of the market. 

Beyond the competitive issues, there were two universal concerns among broker-dealers, managers, regulators, and legislators.  First was the worry that the changes would decrease the number of players in the market (both money managers and broker-dealers), thus decreasing competition and liquidity in the market. Second was the belief that the changes would incentivize broker-dealers, as a group, to reduce the provision of research to money managers, thus reducing the aggregate amount of information and analysis available in the marketplace. 

Responding to these concerns, in June, 1975, Congress passed the Securities Act Amendments of 1975, [8] including an amendment to the Exchange Act creating the Section 28(e) soft dollar safe harbor. Congress determined that, under limited circumstances, a money manager’s fiduciary duty would not be breached solely because the lowest possible price for a transaction was not obtained, so long as the excess costs were exclusively for the purchase of “brokerage and research services”, [9] defined as those services where the provider:

(a) furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities;

(b) furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts; or

(c) effects securities transactions and performs functions incidental thereto (such as clearance, settlement, and custody) or required in connection therewith by rules of the Commission or a self-regulatory organization of which such person is a member or person associated with a member or in which such person is a participant.

The 1976 Release

In March 1976, the Commission issued its first interpretive release (the “1976 Release”) regarding the soft dollar safe harbor, interpreting for the first time the nature of goods and services which would be eligible for the safe harbor. [10] In issuing the 1976 Release, the Commission expressed concern regarding incidents where money managers used the safe harbor to purchase goods and services with soft dollars beyond the reasonable ambit of brokerage and research services.  Of particular concern to the Commission were incidents where, as an inducement for money managers to accept higher commissions, broker-dealers provided goods unrelated to brokerage or research such as newspapers, magazines and periodicals, directories, computer facilities and software, government publications, electronic calculators, quotation equipment, office equipment, airline tickets, office furniture and business supplies.  However, of even greater concern were arrangements which the Commission labeled “give-up payments” where money managers would direct broker-dealers to forego part of the commission, instead sharing it with a third party broker-dealer for whom the executing broker-dealer was not a normal or legitimate correspondent.

Reviewing the Congressional Conference Committee Report regarding the soft dollars safe harbor, the Commission noted that the Committee had expressed concern that the safe harbor could be used as a shield, behind which money managers and broker-dealers could effect give-up payments and other abusive practices common in the late 1960’s. [11] In reaction to these concerns, the Commission adopted the standard articulated in the Senate report enacting the changes to Section 28(e) which established the soft dollar safe harbor; i.e., for goods and services to be subject to the safe harbor, they must provide “lawful and appropriate assistance to the money manager in the carrying out of his responsibilities.” [12] In interpreting the Senate’s standard, the Commission went further than the Senate had, establishing that the prohibition against soft dollars being used to purchase goods and services unrelated to brokerage and research services (such as those described above) applied to all goods and services which are “customarily available and offered to the general public on a commercial basis.”

Though the Commission emphasized that the safe harbor does not protect give-up payments, the Commission did not find that the provision of goods and services provided under the safe harbor could not come from third parties to the transaction.  However, under such circumstances, the Commission warned that managers should be prepared to demonstrate the good faith determination in connection with such transactions, as required by Section 28(e). 

The 1980 Report

The Commission reiterated the 1976 standard for “brokerage and research services” (lawful and appropriate assistance to the money manager in carrying out his responsibilities which are not customarily available and offered to the general public on a commercial basis) in a 1980 report made pursuant to Section 21(e) of the Act [13] (the “1980 Report”), which modified the rules regarding the provision of research services from third parties.  Specifically, the Commission found that while it is acceptable for a broker-dealer to use a third party to provide research subject to the soft dollar safe harbor, there must exist some connection to the broker-dealer other than simply paying the manager’s obligation to the third party.  The Commission articulated this requirement in the following terms: Though broker-dealers did not need to produce research services in-house, research eligible for the safe harbor needed to be provided by the broker-dealer.  Though a specific standard was not articulated for what it means for research to be “provided by” a broker-dealer, the Commission found that a broker-dealer must do more than simply pay the obligation of the manager to a third party research provider.

Additionally, in the period between 1976 and 1986, the Commission evaluated a number of case-specific issues regarding the soft dollar safe harbor through no-action letters, but generally refrained from significantly modifying the parameters of the safe harbor, as enunciated in the 1976 Release.

The 1986 Release

The Commission’s next significant review of the standards of the soft dollar safe harbor was issued in a 1986 interpretive release (the “1986 Release”), [14] extensively revising the safe harbor’s standard for “brokerage and research services” and taking up several other issues, many of which had not been previously addressed. 

First, in issuing the 1986 Release, the Commission was particularly concerned that confusion over the standard for brokerage and research services was discouraging money managers from using soft dollar arrangements to obtain goods and service which the managers legitimately believed were important in making investment decisions.  In reevaluating the standard, the Commission revisited the legislative history of the safe harbor and, in doing so, determined that the legislative intent was to provide protection for soft dollar activities in the broadest terms, subject to managers’ statutory good faith determinations.  Based on this finding, the Commission withdrew the requirement that research products subject to the safe harbor could not be available to the general public on a commercial basis and focused instead on the statutory standard that “[t]he controlling principle to be used in determining whether something is research is whether it provides lawful and appropriate assistance to the money manager’s investment decision-making responsibilities.”

Second, in the 1986 Release, the Commission addressed for the first time the application of the soft dollar safe harbor to “mixed-use products” - products which have both a permissible research purpose under the safe harbor as well as other non-research purposes not protected by the safe harbor.  For example, the Commission cited the use of management information systems which could be used by a manager both to effect transactions as well as to perform other functions such as accounting or administrative management. [15] The Commission found that in such cases, money managers were required to make a reasonable allocation of the cost of the product based on its use between applications that are protected by the safe harbor and applications that are not; the manager would be allowed to allocate soft dollars only to the percentage of the product’s cost which were used for eligible services.  The Commission also applied the mixed-use standard to travel expenses finding that expenses for research aspects of seminars or similar programs could be paid with soft dollars, while other aspects of travel could not.

Third, in the 1986 Release, the Commission revisited soft dollar arrangements in which a third party provided research services, instead of the broker-dealer.  Specifically, the Commission reviewed the 1980 Report [16] in which the Commission’s staff found it is permissible, under certain circumstances, for a broker-dealer to use soft dollars to pay for research services from a third party research provider.  While acknowledging that the use of soft dollars for third party research is permissible (even under circumstances where the broker-dealer to which commissions are paid is not instrumental in the production of such research), the Commission reiterated its 1980 finding that the broker-dealer must do more than simply pay the manager’s obligation to a third party; the Commission also cautioned that the allowance did not extend to prohibited “give-up” arrangements.

Finally, in the 1986 Release, the Commission articulated that a manager’s best execution obligation is the manager’s duty to find the “best qualitative execution” after considering “the full range and quality of broker-dealer’s service including, among other things, the value of execution capability, commission rate, financial responsibility, and responsiveness to the money manager.”

The 1995 Proposal

In February 1995, the Commission issued a proposal release reinterpreting the soft dollar safe harbor to expand the amount of disclosure required regarding money managers’ safe dollar arrangements (the “1995 Proposal”). [17] Specifically, the Commission proposed Rule 204-4 which would have required any manager who is (i) registered under the Advisers Act, (ii) has brokerage discretion over any client account, and (iii) receives services purchased with soft dollars, to deliver an annual report on proposed Form ADV-B to its clients regarding the manager’s use of client brokerage commissions.  The information required to be provided under the proposed rule included:

(a) the three brokers to whom the adviser directed the largest amounts of commissions exclusively for pure execution services;

(b) the twenty brokers, other than those listed as used for pure execution services, to whom the adviser directed the greatest amounts of soft dollars and information concerning the products and services received for soft dollars;

(c) the aggregate amount of commissions directed by the adviser to each broker, the percentage of the adviser’s total discretionary brokerage such amounts represented, and the percentage represented by client-directed brokerage; and

(d) the average commission rate (in cents per share) paid to each named broker.

In a Division of Investment Management Unified Agenda, published in the Federal Register on November 29, 1996, the Commission announced that it had abandoned proposed Rule 204-4 and proposed Form ADV-B.  In the agenda, the Commission stated that it was withdrawing the proposal because the “commission does not expect to consider the item with the next 12 months,” but warned that “the Commission may consider the item further at some point.” The Commission, however, has not re-proposed the disclosure regimes set forth in the 1995 Proposal and greater disclosure was not a subject of the Proposal Release or the Interpretive Release.

The 2001 Release

The Commission’s next substantive interpretive release regarding the soft dollar safe harbor was issued in December, 2001 (the “2001 Release”).  [18] Unlike the 1976 and the 1986 Releases, the 2001 Release focused not on the kinds of services provided to money managers that were subject to the safe harbor, but rather on the types of payments made to broker-dealers that were subject to the safe harbor.  In the 2001 Release, the Commission expanded the definition of “commission” for the soft dollar safe harbor to apply not only to commissions paid to broker-dealers acting in an agency capacity, but also, in certain circumstances, to transaction costs paid to broker-dealers acting in principal capacity (i.e. markups and markdowns).  Specifically, the Commission allowed soft dollar arrangements for fees for certain “riskless principal transactions” (transactions in which both legs are executed at the same price) which are subject to National Association of Securities Dealer (NASD) trade reporting rules.

The Interpretive Release

As noted above, the Commission issued the Proposal Release in October 2005, with the stated goal of “clarifying the scope of ‘brokerage and research services’ in the light of evolving technologies and industry practice.” [19] As a result of comments received during the Proposal Release comment period the Commission changed a number of its provisions before issuing the Interpretive Release:

* The Proposal Release provided narrower definitions than the Interpretive Release in cases where soft dollars were used to purchase research services provided by a third party including: (i) what steps are necessary to satisfy the requirement that research is “provided by” a broker-dealer and (ii) what steps are necessary to satisfy the requirement that a broker-dealer is “effecting” securities transactions. [20]

* The Interpretive Release explicitly disallows most mass media publications from eligibility as research subject to the safe harbor, an issue which was not addressed in the Proposal Release.

* The Interpretive Release added a specific disallowance, which was not included in the Proposal Release, against using soft dollars for proxy services, except when such services provide guidance for the money manager regarding taking or holding a securities position.

* The Proposal Release included a strict interpretation against the use of soft dollars to pay for managers’ Order Managements Systems (“OMS”) (including OMS developed in-house at the manager and OMS obtained from third-party vendors) as brokerage.  The Interpretive Release (as discussed below) reversed this interpretation, allowing OMS to be eligible for the safe harbor in certain circumstances as either “research” or “brokerage.”

Two catalysts for the Interpretive Release cited by the Commission included a 1998 Office of Compliance Inspections and Examinations (OCIE) Report on brokerage commission practices and a 2004 Report of the NASD’s Mutual Fund Task Force regarding observations and recommendations concerning commission practices and portfolio transaction costs. [21] Both reports made several recommendations regarding changes to the soft dollar safe harbor including changes to the rules to help direct benefits towards money managers’ clients, rather than to money managers themselves.  The Commission expressed concern over a finding in the OCIE Report that a large percentage of both money managers and broker-dealers had engaged in soft dollar transactions which the Commission would have found to be outside the scope of the safe harbor.  Of particular concern was the failure of many money managers to separate overhead expenses from permissible research and brokerage expenses.  As examples of inappropriate overhead expenses, the Commission cited exam review courses, membership dues and professional licensing fees, office rent, utilities, phone service, carpeting, marketing, entertainment, meals, copiers, office supplies, fax machines, couriers, backup generators, electronic proxy voting services, salaries and legal and travel expenses.  The Commission also cited the extensive use of client commission dollars being used to pay for the mechanisms to deliver research or brokerage services (as opposed to the services themselves) including peripheral items that support hardware and software, such as the power to run a computer or the Internet line used to receive information.

The Commission recognized that a need existed to interpret the scope of the term “brokerage and research services” to fulfill Congress’s intention of providing a limited safe harbor in the light of changing technology and industry practice. In the Interpretive Release, the Commission reaffirmed its guidance from the 1986 Release that products and services subject to the safe dollar safe harbor must provide “lawful and appropriate assistance” to money managers in carrying out their investment decision-making responsibilities. 

In light of international standards, particularly those adopted by the United Kingdom’s Financial Services Authority, the Commission sought to clarify the bounds of the Section 28(e) soft dollar safe harbor. Specifically, the Commission provided extensive guidance in the Interpretive Release on the following subjects:

* The appropriate framework for analyzing whether a particular service falls within the “brokerage and research services” safe harbor;

* The eligibility criteria for “research”;

* The eligibility criteria for “brokerage”; and

* The appropriate treatment of “mixed use” items.

Each of these topics is discussed in detail below.

Framework for Analyzing the Scope of the Brokerage and Research Services

In the Interpretive Release, the Commission reaffirmed the three step analysis presented in the Proposal Release that is to be used to assess whether a particular product or service falls within the soft dollar safe harbor:

(1) The manager must determine whether the product or service falls within the specific statutory limits of Section 28(e)(3) (i.e. whether it is eligible “research” under Section 28(e)(3)(A) or (B) or eligible “brokerage” under Section 28(e)(3)(C)).

(2) The manager must determine whether the eligible product or service actually provides lawful and appropriate assistance in the performance of the manager’s investment decision-making responsibilities.

(3) The manager must make a good faith determination that the amount of client commission paid is reasonable in the light of the value of the products or services provided by the broker-dealer.

Statutory Limits - Eligibility of Research Services

Despite a number of comment letters criticizing the breadth of the standard for eligibility of research services for the safe harbor set forth in the Proposal Release, the Commission adopted the definition of research services eligible for safe harbor protection of the Proposal Release, limiting such products and services to “advice,” “analyses,” and “reports” as set forth in Section 28(e)(3) of the Exchange Act.  The Commission further specified that eligible research services must contain a subject matter that falls into one of the categories specified in Section 28(e)(3):

For the purposes of the safe harbor, a person provides… research services insofar as he –

(1) Furnishes advice, either directly or through publications or writing, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities, or

(2) Furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts.

The Commission noted, however, that these statutorily permissible subject matters may “subsume” other topics such as political factors which may have economic implications.  The Commission also noted that an important common element of advice, analyses and reports is that each provides “substantive content” defined as “the expression of reasoning or knowledge.” Thus, the Commission reasoned that in determining whether a product or service is eligible as “research” under the soft dollar safe harbor, the manager must conclude that (i) the research reflects the expression of reasoning or knowledge and (ii) relates to an eligible subject matter.

The Commission provided examples of research services which may be permitted under the soft dollar safe harbor as well as examples which would not be allowed. [22] The products listed as permissible under the “research service” under the soft dollar safe harbor include:

* Traditional research reports analyzing the performance of a particular company or stock;

* Discussions with research analysts;

* Meetings with corporate executives to obtain oral reports on the performance of a company;

* Seminars or conferences (if they provide substantive content relating to eligible subject matter);

* Corporate governance research and corporate governance rating services (if they proved substantive content relating to eligible subject matter);

* Certain financial newsletters and trade journals if they relate to permissible subject matter; and

* Quantitative analytical software and software that provides analyses of securities portfolios (if they reflect the expression of reasoning or knowledge relating to permissible subject matter).

The Commission provided specific guidance regarding whether five specific product types meet the criteria of eligible research:

(1) Mass Market Publications

Citing the understanding articulated in the 1976 Release that the type of research eligible for the soft dollar safe harbor should be limited to products which had been historically provided by Wall Street, the Commission found that mass-marketed publications such as newspapers, magazines and other periodical publication that are in general circulation to the retail public are not included in the safe harbor.  The Commission provided indicia to help in determining whether a certain publication is subject to the safe harbor: (a) the publication is marketed to a narrow audience; (b) the publication is directed to readers with specialized interests in particular industries, products or issuers; and (c) the publication has a high cost.  Trade magazines and technical journals concerning specific industries or products lines are given as examples of eligible research.

(2) Inherently Tangible Products and Services

Products or service with inherently tangible or physical attributes which do not reflect the expression of reasoning or knowledge are not considered “research” for purposes of the safe harbor.  Examples of such ineligible products are travel, entertainment and meals associated with attending seminars, office equipment, office furniture and business supplies, salaries (including research staff), rent, accounting fees and software, website design, e-mail software, Internet service, legal expenses, personnel management, marketing, utilities, membership dues, professional licensing fees, and software which assists with administrative functions.  The Commission specifies that computer hardware and accessories are not eligible research services (even if such products assist in the delivery of eligible research), because “they do not reflect substantive content related in any way to making decision about investing.”

(3) Market Research

The Commission found that research related to the market for securities though various delivery mechanisms (including OMS), are eligible for the soft dollar safe harbor.  Examples of such eligible market research include pre-trade and post-trade analytics, software, and other products that depend on market information to generate market research.

(4) Data

Following the guidance from the 1986 Release, the Commission found data that reflects substantive content related to an eligible subject matter is considered research for the soft dollar safe harbor.  Other forms of data, beyond market data, such as financial data and economic data, may also be eligible.

(5) Proxy Services

Responding to arguments presented in comment letters that proxy services often contain information and analysis which may help money managers in determining whether to invest in or hold a position, the Commission found that, in certain circumstances, mixed-use treatment could be used for some proxy services.  However, the Commission found that products or services provided by a proxy service that handle mechanical aspects of voting (such as casting, counting, recording and reporting) are ineligible for the safe harbor.

Statutory Limits - Brokerage Services

Brokerage services are subject to the safe harbor only insofar as the provider of such services “effects securities transaction and performs functions incidental thereto (such as clearance, settlement, and custody) or required in connection therewith by the rules of the Commission or a self-regulatory organization (“SRO”) of which such person is a member or in which such person is a participant.” [23] In the Proposal Release, the Commission explained that brokerage transactions should be viewed as a process, thus setting forth a “temporal standard” for safe harbor protection of brokerage services.  This standard limits safe harbor protection for “brokerage services” to products and services which relate to the execution of a trade from the point of time at which the money manager communicates with the broke-dealer for purposes of transmitting an order for execution to the point at which the funds or securities are delivered or credited to the holder’s account.  In the Interpretive Release, the Commission adopted the temporal standard, rejecting commentators’ arguments that the bounds of the temporal standard should be expanded either forward (to include pre-trade analytics) or backwards (to include long-term custody); however, the Commission did note that some pre-trade analytics may be subject to the safe harbor as research, but not brokerage.  Additionally, the Commission included in the temporal standard certain post-trade activities under the definition of brokerage services incident to a trade, including:

* Post-trade matching of trade information;

* Exchanges of messages among broker-dealers, custodians, and institutions related to the trade;

* Electronic communications of allocation instructions between institutions and broker-dealers;

* Routing settlement instructions to custodian banks and broker-dealers’ clearing agents; and

* Short-term custody.

Additionally, under the temporal standard, connectivity service between a manager and a broker-dealer or other relevant parties, related to an eligible brokerage purpose may be “brokerage” subject to the soft dollar safe harbor including:

* Dedicated lines between a broker-dealer and a manager’s order management system;

* Lines between a broker-dealer and order management systems operated by a third party vendor;

* Dedicated lines providing direct dial-up service between a manager and a broker-dealer’s trading desk;

* Message services used to transmit order to broker-dealers for execution; and

* Trading software operated by a broker-dealer to route orders to market centers.

However, the Commission specifically distinguishes these examples of permissible connectivity services from “ineligible overhead” such as hardware (including telephones and computer terminals) used for a manager’s OMS and software used for recordkeeping or administrative purposes.  The basis of such distinction is that such ineligible overhead is not sufficiently related to order execution and, thus, falls outside the temporal standard. Similarly, the Commission does not consider compliance mechanisms, trade financing, error correction trades or long term custody to be integral to the execution of clients’ orders and, thus, each falls outside of safe harbor protection.

Lawful and Appropriate Assistance

The second step in the framework presented by the Commission in assessing whether products and services are subject to safe harbor protection is to determine that the products and services provide the money manager with a “lawful and appropriate assistance in carrying out his investment-making responsibilities.” Largely following the Commission’s previous guidance set out in the 1986 Release, the Commission reiterates that regardless of whether products and services are classified as “research” or “brokerage” under Section 28(e), for the soft dollars safe harbor to apply, a manager must also determine that the uses of such products or services meet the applicable criteria.  For example, even if a manager found that a certain research product contained an appropriate subject matter under the statutory standard, he would still be precluded from using soft dollars to purchase it if his purpose for purchasing the research was to use it for marketing.

Good Faith Determination

The third step of the framework for analyzing whether a product or service is subject to the soft dollar safe harbor is for the manager to make a good faith determination that the amount of commissions paid is reasonable in relation to the value of the brokerage product or service received.  The Commission reaffirmed this standard contained in Section 28(e) and noted that no commentator had challenged the need for such a good faith determination.  The Commission also reaffirmed that a manager seeking to avail himself of the soft dollar safe harbor bears the burden of proof in demonstrating the required good faith determination.  However, the Commission provided guidance regarding how to determine the reasonableness of commissions paid to the value of the brokerage and research service received.  In particular, a manager will satisfy his showing of good faith if he can demonstrate that he believes that the amount of commission paid is reasonable in relation to the value of the research or brokerage product or service received, either in terms of the particular transaction or the manager’s overall responsibilities for the discretionary account. 

Mixed-Use Items

As discussed above, mixed-use items were declared partially eligible for the soft dollar safe harbor in the 1986 Release, in which the Commission determined that a manager may make a reasonable allocation of the cost of such an item to soft dollars through a good faith determination of the item’s use between permissible and impermissible uses.  In the Interpretive Release, the Commission reiterates its guidance from the 1986 Release regarding the limited safe harbor protection for mixed-use items.  However, the Commission warns money managers against what it views as questionable mixed-use practices, including lack of documentation for allocation decisions.  Additionally, the Commission warns that the allocation of the costs of mixed-use items itself may give rise to a conflict of interest which should be disclosed to a manager’s client.

Third Party Research

In the Interpretive Release, the Commission acknowledged that third party research arrangements can benefit managed accounts by providing a greater breadth and depth of research, thus giving money managers the ability to choose from a wider array of independent research and to obtain specialized research that is particularly beneficial to the advised account.  Following precedent from the 1976 Release and the 1980 Report, the Commission agreed that research from third parties may be subject to the soft dollar safe harbor.  However, the Commission expressed ongoing concern that the use of third party research under the safe harbor could lead to give-up payments to unaffiliated third parties.  The Commission addressed this concern by stressing the necessary link between the provision of research and the effecting of the transaction giving rise to the commissions. Specifically, pursuant to Section 28 (e)(1), for research to be subject to the soft dollar safe harbor, the research must be “provided by” the same broker-dealer who “effected” the transaction for which commissions are paid.  In the Proposal Release, the Commission had set forth (i) a standard of minimum functions a broker-dealer must perform for research created by a third party to be deemed to have been “provided by” the broker-dealer and (ii) a standard of minimum functions a broker-dealer perform to be deemed to have “effected” a transaction.  In reaction to commentary expressing various concerns that such standards could preclude legitimate arrangements in which broker-dealers facilitate access to valuable information, could result in increased complexity and decreased transparency, and could lead to other market inefficiencies, the Commission relaxed its position from the Proposal Release agreeing that proprietary research services developed by broker-dealers could be treated as equivalent to research by third parties “provided by” the broker-dealer.  In the Interpretive Release, the Commission set forth alternative standards for both “effecting” and “providing” research.

Definition of “Effecting”

The 1986 Release contemplated that in the effecting brokerage transactions under the soft dollar safe harbor, correspondent broker-dealers were required to “be engaged in securities activities of a more extensive nature than merely the receipt of commissions paid to [them] by another broker-dealer for ‘research service’ provided to money managers.” [24] In the Proposal Release, the Commission had identified four minimum criteria a broker-dealer must meet in order to be “effecting” a transaction:

(i) Taking financial responsibility for all customer trades until the clearing broker-dealer has received payment (or securities);

(ii) Making and/or maintaining records relating to customer trades required by Commission and SRO rules including blotters and memoranda of orders;

(iii) Monitoring and responding to customer comments concerning the trading process; and

(iv) Generally monitoring trades and settlements.

In reaction to commentary from the Proposal Release, the Commission loosened the Proposal Release’s requirement that to be deemed to be “effecting” a transaction, a broker-dealer must perform all of the functions.  Instead, the Commission found that broker-dealers must meet at least one of the minimum functions from the Proposal Release and take other steps to see that the other functions have been reasonably allocated to another broker-dealer in the arrangement in a manner that is fully consistent with their obligations under the relevant SRO and Commission rules.
Definition of “Provided By”

Reiterating analysis in the 1976 Release regarding give-up payments, the Commission reaffirmed that it is permitted for a money manager to use soft dollars for research produced by third parties. The Commission also reaffirmed its finding from the 1980 Report that third party research may be sent directly from the third party provider to the money manager.  The Commission explains three ways, the last of which is new, in which research may be “provided by” a broker-dealer:

(i) The broker-dealer produces the research itself;

(ii) The broker-dealer is legally obligated to pay for the research; or

(iii) The broker-dealer pays the research preparers directly and the following two conditions are met:

- - - (a) The broker-dealer reviews the description of the services to be paid for with client commissions under the safe harbor for red flags that indicate the services are not within Section 28(e) and agrees with the money manager to use client commissions only to pay for those items that reasonably fall within the safe harbor; and

- - - (b) The broker-dealer develops and maintains procedures so that research payments are documented and paid for promptly.

The Interpretive Release’s interpretation differs from the proposition set forth in the Proposal Release that for research to be “provided by” a broker-dealer, the broker-dealer must be obligated to pay for the research.  The Interpretive Release takes a looser approach, finding that a broker-dealer’s obligation to pay for research is a sufficient, but not necessary, condition for the research to be considered as provided by the broker-dealer.  As a consequence, it is no longer a requirement that a broker-dealer be contractually obligated to pay for third party research for such research to be subject to the safe harbor.

Order Management Systems

Of particular importance to many money managers is whether OMS are eligible to be purchased with soft dollars within the safe harbor.  In the Proposal Release, the Commission took a rather strict position regarding OMS, finding that the systems “are not sufficiently related to order execution and fall outside the temporal standard” for ‘brokerage’ under the safe harbor.” [25] This disallowance provoked concern by commentators and the Software Industry [26] who argued that OMS are a fundamental part of brokerage services.  The opponents of the proposed restrictions on OMS argued that the line between order management and trade execution has become less meaningful with the advent of technology related to high-frequency, algorithmic trading. [27] The commentators further argued that technology now allows OMS to provide market information to brokers and should, therefore, be also allowed under the safe harbor as research (to the extent that they are not allowed under the safe harbor as brokerage). [28] The Commission largely agreed with these comments in the Interpretive Release, finding that OMS do serve an eligible brokerage function and that eligible market research may be transmitted through OMS.

Accordingly, the Commission clarified its position on the eligibility of OMS as brokerage services under the safe harbor to include trading software used to route orders, provide algorithmic trading strategies, or transmit orders to direct market access (“DMA”) systems or provide connectivity to this software, if such OMS fall within the temporal standard. [29] However, the Commission stopped well short of a blanket allowance for all OMS under the safe harbor.  In particular, the Commission specifically rejected the use of soft dollars for hardware, such as telephones or computer terminals, including those used in connection with OMS and trading software, because such products “fall outside the temporal standard for ‘brokerage’ under the safe harbor.” The Commission further stressed that the function performed by OMS is integral to whether they are going to be allowed under the safe harbor, giving as examples of ineligible overhead “software functionality used for recordkeeping or administrative purposes, such as managing portfolios, and quantitative analytical software used to test “what if” scenarios related to adjusting portfolios, asset allocation, or for portfolio modeling (whether or not provided through OMS).” In cases where OMS are used both for eligible brokerage and research functions as well as other non-eligible functions, the Commission found that the manager must treat the OMS as mix-used items, using soft dollars only for that portion of the OMS used for eligible functions. 

However, it should be noted that the Commission distinguishes between connectivity services and software used for brokerage and those used to deliver research.  The Commission found that connectivity services and software are a core part of brokerage services and, thus, are deemed brokerage services when such services and software meet the temporal standard for brokerage.  Such allowance is not made for connectivity to research services which the Commission found to be separable in that connectivity service and software merely act as a conduit to underlying research, rather than an integral component of it.

The Interpretive Release may require managers and advisers to review their commission and soft dollar activities, as well as their record-keeping practices and disclosure policies related to these activities.  The effective date of the interpretative Release was officially the date it was published in the Federal Register, July 24, 2006.  However, the Commission has instructed that market participants may continue to rely on the prior interpretations of the soft dollar safe harbor until January 24, 2007. The Commission has also announced that it will consider further comment on developments in connection with soft dollar arrangements and, based on comments received, may supplement the guidance contained in the Interpretive Release.

[1] Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, Exchange Act Release No. 34-54165 (July 24, 2006) available at: http://www.sec.gov/rules/interp/2006/34-54165.pdf.

[2] 15 U.S.C. 78bb (e).

[3] Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934 , Exchange Act Release No. 34-52635 (Oct. 19, 2005) available at: http://www.sec.gov/rules/interp/34-52635.pdf.

[4] The fiduciary duty of registered investment advisers is codified in Section 206 of the Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.).  Fiduciary duties are also statutorily imposed on money managers under the ambit of the Employee Retirement Income Security Act of 1974 (“ERISA”)(29 U.S.C.1001 et seq.).  See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170, 51 FR 23170 (released Apr. 23, 1986), 51 FR 6004, 16011(Apr. 30, 1986).

[5] See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 189-191 (1963). 

[6] See Institutional Investor Study Report, H.R. Doc. No. 64, 92d Cong., 1st Sess., Vol. 4, at 2206 (1971). Securities Industry Study: Report of the Subcomm. On Interstate and Foreign Comm., H.R. Rep. No 1519, 92d Cong. 2d Sess. 131 (1972).

[7] 17 C.F.R. § 240.19b-3.

[8] Pub L. No. 94-29, 89 Stat. 97, 107-08 (1975).

[9] 15 U.S.C. § 78bb(e)(3).

[10] See Interpretations of Section 28(e) of the Securities Exchange Act of 1934; Use of Commission Payments by Fiduciaries, Exchange Act Release No. 12251. Release No. 34-12251, 1976 WL 185942, 41 FR 13678 (released March 24, 1976).

[11] Securities Act Amendments of 1975, Conference Report to Accompany S.249. Joint Explanatory Statement of the Comm. of Conference, H.R. Rep. No. 229, 94th Cong., 1st Sess. 108 (1975).

[12] S. Rep. No. 94-75, at 71 (1975).

[13] Report of Investigation in the Matter of Investors Information Inc., Securities Exchange Act Release No. 16679 (Mar. 19, 1980).

[14] See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170, 51 FR 23170 (released Apr. 23, 1986).

[15] Other mixed-use items discussed in the 1986 Release include computer hardware and quotation equipment.

[16] See Release No. 16679, supra.

[17] “Disclosure by Investment Advisers Regarding Soft Dollar Practices, Release No. 34-35375, IA-1469, 17 CFR Parts 275 & 279 (Feb. 14 1995).

[18] Commission Guidance on the Scope of Section 28(e), Exchange Act Release No. 45194 (Dec. 27 2001), 67 FR 6 (Jan. 2, 2002).

[19] See footnote 3.

[20] See pg. 23, infra for a full discussion of the changes effected by the Interpretive Release.

[21] See, NASD Report of the Mutual Fund Task Force, “Soft Dollars and Portfolio Transaction Costs” (Nov. 11, 2004) available at http://www.nasd.com/web/groups/rules_regs/documents/rules_regs/nasdw_012356.pdf.

[22] For a complete list of products and services discussed by the Commission as either eligible or ineligible under the safe harbor, see the tables presented at the end of this report.

[23] 15 U.S.C. 78bb(e)(3)(C) (internal quotes).

[24] 1986 Release, 51 FR at 16007 (quoting Data Exchange Securities, No-Action Letter (Apr. 20,1981)).

[25] See Proposal Release at 35.

[26] See e.g. “Vendors Challenge SEC Soft Dollar Guidance” Compliance Reporter (Nov. 7, 2005) at 4 (quoting software executive Govind Sandhu arguing “It is important for the SEC to realize how order management systems are used at investment advisers.  From an adviser’s point of view, the OMS is part and parcel of the execution system.”).

[27] See e.g. “SEC Soft-Dollar Draft Hits OMS Vendors Hard”, Securities Industry News, (Oct. 31, 2005).

[28] See Interpretive Release at 34, (FN 104).

[29] See Interpretive Release at 41, (FN 124).

For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.