[18195]
November 18, 2004
TO: SEC RULES MEMBERS No. 164-04
EQUITY MARKETS ADVISORY COMMITTEE No. 46-04
CLOSED-END INVESTMENT COMPANY MEMBERS No. 74-04
BOARD OF GOVERNORS No. 76-04
COMPLIANCE ADVISORY COMMITTEE No. 111-04
CHIEF COMPLIANCE OFFICER COMMITTEE No. 26-04
INVESTMENT ADVISER MEMBERS No. 24-04
RE: NASD ISSUES MUTUAL FUND TASK FORCE REPORT
The NASD has issued the report of its Mutual Fund Task Force, which was formed in
May 2004 to consider ways to improve the transparency of mutual fund portfolio transaction
costs and distribution arrangements.1 The Report contains recommendations on methods to
improve the existing regulation of soft dollars and the disclosure of transaction costs. The most
significant aspects of the Report are summarized below.
I. Recommendations Concerning Soft Dollars
A. Scope of Safe Harbor
The Task Force unanimously agreed that the soft dollar safe harbor set forth in Section
28(e) of the Securities Exchange Act of 1934 should be preserved. The Task Force, however,
recommends that the SEC narrow its interpretation of the scope of the safe harbor to protect
only brokerage services as described in Section 28(e)(3) and the “intellectual content” of
research. The Task Force proposes that the SEC define “intellectual content” as “any
investment formula, idea, analysis or strategy that is communicated in writing, orally or
electronically and that has been developed, authored, provided or applied by the broker-dealer
or third-party research provider (other than magazines, periodicals or other publications in
general circulation).” The Report states that under this definition of “research services,” the
safe harbor would not protect the means by which such content is provided.2
1 The Task Force report (“Report”) can be found on the NASD’s website at
http://www.nasd.com/stellent/groups/rules_regs/documents/rules_regs/nasdw_012356.pdf.
2 In particular, the Report states that the proposed definition of research services would not protect such benefits as:
computer hardware and software, unrelated to any research content or analytical tool; phone lines and data
transmission lines; terminals and similar facilities (as distinct from any research content or analytical tool);
2
B. Disclosure to Fund Boards
The Task Force recommends that the SEC mandate expanded disclosure to fund boards
about soft dollar practices to ensure that every fund board understands the types of information
that should be reviewed in exercising effective oversight over an adviser’s soft dollar practices.
Specifically, the Task Force recommends that the SEC mandate that a fund’s adviser provide the
board of directors with, at a minimum, the following information for each fund: portfolio
turnover rate; list of brokers used and total commissions3 paid to each broker; the aggregate
average commission rate per share and the average commission rate per share by broker; the
average commission rate paid to brokers that provide soft dollar services to the fund’s adviser
versus the average rate paid to brokers that do not provide such benefits; list of brokers from
which the fund adviser obtains soft dollar products and services; the conversion ratio or price of
research offered by each broker through which the adviser obtains third-party research benefits;
and the amount of third-party research benefits obtained with fund commissions.4
C. Disclosure to Investors
The Task Force recommends that the SEC mandate expanded disclosure to fund
investors about soft dollar practices. Specifically, the Task Force recommends that the SEC
expand current disclosure requirements5 to require that a fund state whether it obtains third-
party research through soft dollars and whether it obtains proprietary research through soft
dollars. The Report states that Task Force members generally agreed that this additional
disclosure should be included in the fund prospectus and not be relegated to the SAI.
D. Application of Section 28(e) to All Discretionary Advisers
The Task Force recommends that the SEC consider making compliance with Section
28(e) mandatory for all discretionary investment advisers, whether or not registered with the
SEC, and that the SEC recommend to the Department of Labor and the federal banking
regulators that they require all other discretionary investment managers not subject to SEC
jurisdiction to comply with the standards of the safe harbor. The Report notes that mutual fund
and pension fund managers are the only managers that currently must meet the safe harbor,
due to the self-dealing limitations under the 1940 Act and ERISA. Other managers, such as
hedge fund managers, may engage in soft dollar practices that do not fall within the scope of
Section 28(e). The Report states that the same types of conflicts that may arise in the use of soft
dollar arrangements by investment companies also may occur when other fund managers
magazines/newspapers/journals/on-line news services; portfolio accounting services; proxy voting services
unrelated to issuer research; and travel expenses incurred in company visits.
3 For purposes of the Report, the term “commission” refers to traditional commissions, commission equivalents, and
any other remuneration eligible for the Section 28(e) safe harbor.
4 The Task Force also considered whether it is possible for an adviser to provide the board with a good faith estimate
of the total dollar amount of proprietary research obtained with fund brokerage commissions. The Report states that
the Task Force was unable to reach a consensus on this point.
5 Currently, mutual funds disclose in their SAIs how the fund selects brokers and, if a fund considers the receipt of
research services in selecting brokers, the nature of the services.
3
obtain soft dollar benefits and that research obtained by a money manager can serve multiple
advisory clients, such as mutual funds and hedge funds. Applying one set of rules with regard
to mutual fund-related soft dollar transactions and another set of rules with regard to non-fund
or mixed transactions therefore may be difficult for that money manager, and may cause
compliance challenges.
II. Recommendations Concerning Portfolio Transaction Costs
A. Disclosure to Fund Boards
The Task Force recommends that the SEC explicitly require disclosure about transaction
costs to fund boards. At a minimum, the Task Force recommends that the adviser supply fund
boards with its policies and procedures for monitoring transaction costs and brokerage
allocation as well as information concerning the reasonableness of all transaction costs. The
Report states that the board would be expected to use this information to determine whether
the adviser is sufficiently ensuring that the fund does not pay excessive transaction costs and is
adequately monitoring the execution quality of the fund’s transactions.
B. Disclosure to Investors
The Task Force recommends that the SEC require enhanced disclosure about transaction
costs to shareholders. Specifically, the Task Force recommends that funds include a brief
narrative description in their prospectus of the various types of trading costs incurred by the
fund, including commissions, markups and markdowns, market impact costs, and opportunity
costs; the fund’s portfolio turnover rate; the percentage of the total dollar value of all
transactions that were executed on a commission basis; the average commission paid per share;
the total commissions paid as a percentage of total net asset value; and disclosure that the
fund’s performance numbers, but not the fee table, reflect these trading costs. The Task Force
also recommends that the SEC move the existing disclosure concerning total commissions from
the SAI to the prospectus to accompany such additional information and that this data be
presented in chart form covering a five-year period.
Ari Burstein
Associate Counsel