SEC Issues New Soft Dollar Guidance

Edward L. Pittman of Thelen Reid & Priest LLP

6 minutes to read

On July 12, 2006, the SEC issued new interpretative guidance on the scope of permissible commission practices under Section 28(e) of the Securities Exchange Act of 1934. Section 28(e) provides a "safe harbor" for advisors who pay higher than the lowest available commission rates in return for brokerage and research services.

What has Changed?

With some exceptions, the new guidance from the SEC will not alter most of the existing practices for most hedge fund managers, traditional investment advisors, or brokers. Nevertheless, there are aspects of the new analysis that merit attention. Each of these items is discussed below, but in summary they are: the requirement that all research reflect intellectual content; the elimination of mass-marked publications and tangible goods, such as computer hardware, from the definition of research; the announcement of new "temporal standards for measuring brokerage; and the incorporation of a new standard of liability for brokers making payment for research at the direction of clients. While the SEC formally rejected commenters requests for lists of permissible practices, it comes close to creating such a list with numerous illustrations of items that do or do not fall within the safe-harbor.

What is "Research?" The Reasoning and Knowledge Standard

The new standard for determining whether an item is permissible research is whether it constitutes "advice," analyses," or "reports" that "reflect(s) the expression of reasoning or knowledge." Items that the SEC clearly defines as research include traditional research reports-whether provided by a brokerage firm or a third-party provider-as well as trade analytics, market data, and advice on market color and execution strategies. What now clearly is not research are "inherently tangible products and services," including computer hardware. For example, data terminals themselves are no longer considered research, even though a subscription for the content may be research. Mass-marketed publications, such as the Wall Street Journal, also are no longer considered research, while industry-specific publications, such as Rock and Gravel News, and specialized financial newsletters (assuming they reflect some reasoning) may still be obtained with client commissions. Advisors will continue to be permitted to make allocations for "mixed use" products, such as proxy services, that serve both investment management and administrative functions.

A New Standard of Care for Brokers?

Equally important, in the case of research, is the requirement that the research has been "provided by" the broker receiving the client commissions. The SEC asserts a warning in the release that a broker may be considered to have "aided and abetted" an advisor's fraud, if the broker "knows" that the advisor has represented that it will operate solely within the safe harbor, and then subsequently pays for goods and services that are not permitted. Where the broker has not participated with the advisor in selecting the research supplier, and does not have a contract with the research provider, the SEC stated that the broker should:

  1. Pay the research preparer directly;
  2. Review a description of the research services for "red flags" indicating the services are not within Section 28(e) and agree with the money manager to use client commissions only to pay for those items that reasonably fall within the safe harbor; and
  3. Develop and maintain procedures so that research payments are documented and paid for promptly.

This new standard likely will force brokers to pay greater attention to many "mixed use" items and also generate debates about what expenses are paid from research credits carried by the broker, versus accounts maintained to recapture client commissions.

What is Brokerage? A New Temporal Standard

Most of the regulatory attention in recent years has been focused on the definition of research. However, the safe harbor also includes commissions spent for brokerage. Brokerage specifically includes executing transactions, as well as providing clearance, settlement, and custody. Under the new "temporal" standard announced in the interpretive release, systems that are used by advisors in connection with transactions will only be considered to fall within the term "brokerage" from the point that the order is transmitted to the broker for execution, through the end of the clearance and settlement process. More specifically, the SEC states that "brokerage begins when the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution and ends when funds or securities are delivered or credited to the advised account or the account of the holder's agent." Thus, pre-trade analytics must fall within the term "research," and may not be considered "brokerage." However, order management systems and direct market access systems are considered brokerage.

Who Must Provide the Brokerage?

In order to receive commissions under the safe harbor, the broker must be considered to have "effected" the transaction. This requirement has generated questions when a broker, such as an introducing broker, receives a portion of the commissions when it has not executed the transaction. In the new guidance, the SEC clarifies that even if the broker does not execute the transaction (including clearing and settling the trade), it may have commission dollars directed to it so long as it serves one of the four following functions:

  1. Taking financial responsibility for all customer trades until the clearing broker-dealer has received payment (or securities), i.e., one of the broker-dealers in the arrangement must be at risk for the customer's failure to pay;
  2. Making and/or maintaining records relating to customer trades required by SEC and SRO rules, including blotters and memoranda of orders;
  3. Monitoring and responding to customer comments concerning the trading process; and
  4. Generally monitoring trades and settlements.

Conclusion

While the new guidance will not affect the core activities of brokers, traditional advisors, or hedge fund managers, it does formulate new standards for analyzing many different products and services common in the investment industry. It also clearly outlaws certain items that had routinely been paid for with soft dollars. Portions of the release proposing a new standard of care for brokers are troubling. However, the SEC has invited further comment, and is allowing a six-month grace period for brokers and advisors to adjust their practices to come into conformity with the new guidance.


Edward L. Pittman

Of Counsel - Washington, DC

202.508.4018

epittman@thelenreid.com

¸2006 by Thelen Reid & Priest LLP. The Hedge Fund e-Alert is published as an information service for clients and friends. Please recognize that the information is general in nature and must not be relied upon as legal advice. The authors or your Thelen Reid contact would be pleased to discuss this information and its application to your specific situation in greater detail. We welcome your comments and suggestions.

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