OCTOBER 2005
Investment Management
US Securities & Exchange Commission Issues
Proposed Guidance on Soft Dollars
By Michael S. Caccese and Christina H. Lim*
On 19 October 2005, the US Securities and Exchange
Commission (the “SEC” or “Commission”) published for comment a proposed interpretive release
with respect to client commission practices under
Section 28(e) of the US Securities Exchange Act of
1934. The interpretive release, when finalized, will
constitute the Commission’s fourth interpretive
release under Section 28(e) over the past 30 years.
In developing its position, the SEC took into account
the views of other regulators, including the Ontario
Securities Commission, the Australian Securities and
Investments Commission, and in particular the
Financial Services Authority (“FSA”), which has
adopted client commission rules that will be effective
on 1 January 2006 followed by an additional sixmonth transition period. The SEC’s interpretive
guidance, as proposed, is generally consistent with
the FSA’s rules, with a few exceptions. The comment period will end 30 days after the proposed interpretive guidance is published in the Federal Register.
The release provides proposed guidance on six
aspects of the safe harbour: (i) the appropriate framework for analyzing whether a service falls within the
“brokerage and research services” safe harbour; (ii)
the eligibility criteria for “research”; (iii) the eligibility criteria for “brokerage”; (iv) the appropriate treatment of “mixed-use” items; (v) the money manager’s
duty to make a good faith determination as to reasonableness under Section 28(e); and (vi) third-party
research and commission-sharing arrangements. The
SEC is also considering whether to propose require-
ments for disclosure and recordkeeping of client
commission practices and will evaluate whether further action is warranted.
BACKGROUND
Section 28(e) provides a safe harbour for money
managers by shielding money managers from liability for statutory breaches and breaches of fiduciary
duty claims on the basis that more than the lowest
commission rate was paid in order to receive “brokerage and research services.” To be within the safe
harbour, a broker-dealer must make a good faith
determination that the amount of commission paid
was reasonable in relation to the value of brokerage
and research services received. The safe harbour is
available to all persons exercising investment discretion with respect to an account, including fiduciaries
of bank trust funds and investment advisers to separate accounts, mutual funds, hedge funds and pension
plans. Although US money managers cannot violate
Section 28(e), conduct that is not under its protection
may constitute a breach of the manager’s fiduciary
duty under the law of the relevant state and federal
securities laws, including the Investment Advisers
Act of 1940, the Investment Company Act of 1940,
and the Employee Retirement Income Securities Act
of 1974. One of the most significant aspects of the
proposed interpretive release is that it suggests that
the failure to fall within Section 28(e) necessarily
creates a breach of fiduciary duty. The proposed
interpretive release specifically replaces Sections II
and III of its 1986 release with revised interpreta-
* Michael Caccese is a partner in the Boston office of Kirkpatrick & Lockhart Nicholson Graham LLP. He works extensively with investment firms on compliance issues, including
all ofthe CFA Institute standards. He previously was the General Counsel to AIMR and was responsible for overseeing the development of AIMR-PPS, GIPS and other standards
governing theinvestment management profession and investment firms. He can be reached at 617.261.3133 and mcaccese@klng.com. Christina H. Lim is an associate with K&LNG
in the Boston office and can be reached at 617.261.3243 or clim@klng.com.
Kirkpatrick & Lockhart Nicholson Graham
LLP
tions, which give guidance as to third-party research
and the meaning of the phrase “brokerage and
research services” in Section 28(e). These revised
interpretations specifically change the definitions of
“research” and “third-party research” arrangements,
and establish a temporal standard for brokerage services.
FRAMEWORK FOR ANALYZING THE SCOPE OF
“BROKERAGE AND RESEARCH SERVICES”
A money manager may avail itself of the Section
28(e) safe harbour so long as the manager:
■
determines that the product or service is eligible
under the statute;
■
uses the item in performing its decision-making
responsibilities for accounts over which the
manager exercises investment discretion; and
■
makes a good faith determination that the
amount of commissions paid is reasonable in
relation to the value of research or brokerage
product or service received.
RESEARCH SERVICES
Eligibility: Expression of Reasoning or Knowledge
In order for a product or service to constitute
“research services” under the safe harbour, the product or service must constitute “advice,” “analyses” or
“reports” within the meaning of the statute. The proposed interpretive release gives guidance that in
order to constitute “advice,” “analyses” or “reports,”
the money manager must make the determination that
the product or service reflects the “expression of reasoning or knowledge.” Moreover, even if the product
constitutes “advice,” “analysis,” or a “report,” the
money manager must determine that the subject matter of the product or service falls within the categories specified in the statute. That is, advice must
relate 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” and “analyses and reports” must relate to
“issuers, industries, securities, economic factors and
trends, portfolio strategy, and the performance of
accounts.”
Examples of potentially permissible research services
described in the proposed interpretive release
include: traditional research reports, financial
newsletters and trade journals relating to the subject
matter specified in the statute; software that both analyzes securities portfolios and reflects the expression
2 OCTOBER 2005
of reasoning or knowledge; seminars or conferences
on a subject matter specified in the statute, and market or economic data. Services deemed not to reflect
the expression of reasoning and knowledge include
products with inherently tangible or physical attributes, such as telephone lines, office furniture, and
operational overhead expenses. Contrary to the 1986
release, computer hardware and computer accessories
are not eligible for research services since they are
deemed not to reflect substantive content related to
investment decision-making by the manager.
Lawful and Appropriate Assistance
In addition to meeting the statutory criteria, a product
or service must also provide the money manager with
“lawful and appropriate assistance” in making investment decisions. The proposed interpretive release
states that whether a product provides “lawful and
appropriate assistance” is determined largely on how
the eligible product or service is used by the manager. For instance, account performance analyses used
for marketing purposes do not fall within the safe
harbour, but may fall within the safe harbour when
used for investment decision-making purposes.
Where eligible research is used for purposes within
and outside of Section 28(e), the manager must treat
the product or service as a mixed-use item and use
client commissions to pay only the allocable portion
of the item attributable to use for investment decision-making.
BROKERAGE SERVICES
Eligibility: Temporal Standard
Section 28(e) explicitly states that brokerage products
and services that are eligible under the safe harbour
include activities required to effect securities transactions, functions incidental to securities transactions
(e.g., clearance, settlement and custody), and services
that are required by the rules of the SEC or self-regulating organisations. The proposed interpretive
release proposes a temporal standard for “brokerage
services” under Section 28(e) whereby eligible “brokerage services” are those services provided between
the time that an order is transmitted to a broker-dealer and the time that the transaction is cleared and settled (i.e., when funds or securities are delivered or
credited to the advised account or the account holder’s agent). Services provided prior to an order transmission may fall within the research portion of the
safe harbour, but are not eligible under the brokerage
portion of the safe harbour.
KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
Under the proposed temporal standard, communications services related to execution, clearance and settlement and other incidental functions are eligible
brokerage services. Moreover, algorithmic trading
software and trading software used to route orders to
market centers constitute “brokerage” under the safe
harbour. Although peripherals and delivery mechanisms associated with computer hardware (e.g.,
telecommunications lines, transatlantic cables, and
computer cables) are deemed to fall outside of the
“research services” safe harbour, they may be eligible
under the “brokerage services” safe harbour since the
transmission of orders is considered to be a “core part
of the brokerage service.” However, products and
services that are not integral to the execution of
orders by broker-dealers and fall outside of the temporal standard do not qualify as “brokerage” in the
safe harbour. Examples of ineligible products or
services under the proposed temporal standard
include: order management systems used by managers to manage their orders (whether developed inhouse by the manager or by a third-party) and hardware (e.g., telephones or computer terminals); trade
analytics, and surveillance systems. The proposed
interpretive guidance also confirms that error correction trades or related services in connection with
errors made by money managers are not eligible
“brokerage services” under the safe harbour since
they do not benefit the advised account and are separate transactions to correct the manager’s error.
records of these allocations to make a good faith
determination that the amount paid for the mixed-use
item in soft dollars was reasonable in relation to the
value of the research product or service received.
Lawful and Appropriate Assistance
Commission-sharing arrangements may be used by
money managers as a means to acquire research via
commissions. The proposed interpretive release
addressed commission-sharing arrangements. These
arrangements allow managers to execute trades with
one broker-dealer and obtain research or other services from another broker-dealer. Under the proposed
interpretive release, the roles assumed by each broker-dealer will determine whether a commissionsharing arrangement is permissible under Section
28(e). In order for a commission-sharing arrangement under which research and brokerage services
are provided to fall within the safe harbour, the proposed interpretive release requires the following elements to be present:
As with research products and services, eligible brokerage products and services must provide the money
manager with lawful and appropriate assistance in
carrying out its responsibilities and a good faith
determination must be made by the money manager
that the amount of commissions paid is reasonable in
relation to the value of the brokerage product or service received.
MIXED-USE ITEMS
The proposed interpretive release reiterates the SEC’s
guidance in its 1986 release regarding the mixed-use
standard: if a money manager uses a research product
or service for both research and non-research functions, the money manager must make a reasonable
allocation of the cost of the product according to its
use (i.e., the percentage of the product that provides
assistance to the investment decision-making process
may be paid for with soft dollars whereas the other
non-research portion must be paid for by the manager
with hard dollars). The manager must keep adequate
3 OCTOBER 2005
GOOD-FAITH DETERMINATION AS
TO REASONABLENESS
Each money manager seeking to avail itself of the
safe harbour bears the burden of proof that it has
made a good faith determination that the commissions paid are reasonable in relation to the value of
brokerage and research services received, whether in
terms of a particular transaction or the manager’s
overall responsibilities for its discretionary accounts.
The SEC also emphasized that managers must make
a good faith determination that any additional commissions paid for “simply copied, repackaged, or
aggregated” products or services are reasonable.
THIRD-PARTY RESEARCH
In third-party research arrangements, money managers may use client commissions to obtain research
produced by someone other than the executing broker-dealer. The proposed interpretive release clarifies
that research provided under these arrangements is
eligible under Section 28(e) so long as the brokerdealer effecting the trade (e.g., clearance and settlement) is legally obligated to pay for any third party
research provided to a money manager.
COMMISSION-SHARING ARRANGEMENTS
■
The commission-sharing arrangement must be
part of a “normal and legitimate correspondent
relationship” whereby each broker-dealer’s
involvement is more significant than the mere
receipt of commissions paid for research services provided to money managers. This means
that the introducing broker-dealer must:
KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
— be financially responsible to the clearing
broker-dealer for all customer trades until
the clearing broker-dealer receives payment
(or securities);
— make and/or maintain records relating to its
customer trades required by SEC and SRO
rules (e.g., blotters and memoranda of
orders);
— monitor and respond to customer comments
concerning the trading process; and
— generally monitor trades and settlements.
■
The broker-dealer effecting the trade must be
legally obligated to pay for any third-party
research or brokerage services or products provided to a money manager.
CONCLUSION
Comments on the proposed interpretive release must
be submitted to the SEC on or before the thirtieth day
after the release is published in the Federal Register.
Specifically, the SEC is seeking comments on
4 OCTOBER 2005
whether the proposed release is an accurate reflection
of industry practices, whether there are any other significant issues under Section 28(e) that were not
addressed, and whether the interpretive guidance
would affect the level and distribution of costs, and if
so, whether these effects would be beneficial to
investors or otherwise serve the public interest. The
SEC specifically requested comments on the extent
to which client commissions are paid for proxy voting services and mass-marketed publications, and
whether additional guidance from the SEC would be
useful in these areas. The SEC has also requested
comments on whether the final interpretive release
should provide firms time to implement the interpretation.
Michael S. Caccese
mcaccese@klng.com
00 1 617.261.3133
Christina H. Lim
clim@klng.com
00 1 617.261.3243
KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
EXAMPLES OF ELIGIBLE AND INELIGIBLE RESEARCH AND BROKERAGE
PRODUCTS AND SERVICES
ELIGIBLE RESEARCH ITEMS
■
financial newsletters/trade journals*
■
quantitative analytical software and software that
provides analyses of securities portfolios*
■
seminars or conferences*
■
consultant fees for advice on portfolio strategy
■
company financial data
■
economic data (e.g., unemployment and inflation
rates or gross domestic product figures)
■
market data (e.g., stock quotes, last sale prices and
trading volumes)
* Eligible only if the product or service relates to the
subject matter specified in Section 28(e).
ELIGIBLE BROKERAGE SERVICES
■
clearance, settlement and custody services
■
post-trade matching
■
exchange of messages among brokerage dealers,
custodians, and institutions
■
electronic communication of allocation instructions between institutions and broker-dealers
■
routing settlement instructions to custodian banks
and broker-dealers’ clearing agents
■
services required by the SEC or SRO rules (e.g.,
use of electronic confirmation and affirmation of
institutional trades)
■
connectivity service between the money manager
and broker-dealer and other relevant parties such
as custodians (incl. dedicated lines between the
broker-dealer and manager’s order management
system, lines between the broker-dealer and order
management systems operated by a third-party
vendor; dedicated lines providing direct dial-up
service between the money manager and the trading desk at the broker-dealer, message services
used to transmit orders to broker-dealers for execution).
■
trading software operated by a broker-dealer to
route orders to market centers
■
algorithmic trading software
5 OCTOBER 2005
INELIGIBLE RESEARCH ITEMS
■
telephone lines
■
office equipment, furniture and business supplies
■
salaries (incl. 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
■
software to assist with administrative functions (e.g.,
operating systems, word processing)
■
travel expenses, entertainment, meals associated
with attending seminars
■
computer hardware and computer accessories
■
computer peripherals and delivery mechanisms (e.g.,
telecommunications lines, transatlantic cables, computer cables)
■
consultant fees on internal management or operations
INELIGIBLE BROKERAGE SERVICES
■
order management systems (“OMS”) used by
money managers to manage orders (both in-house
and third-party OMS) and hardware (e.g., telephones or computer terminals)
■
trade analytics
■
surveillance systems
■
compliance mechanisms
■
error correction trades or related services in connection with errors by money managers
KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
If you have questions or would like more information about K&LNG’s Investment Management Practice, please contact one of our lawyers listed below:
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