[18230]
November 23, 2004
TO: INDEPENDENT DIRECTORS COUNCIL No. 12-04
RE: NASD ISSUES MUTUAL FUND TASK FORCE REPORT
Last week the NASD issued its Mutual Fund Task Force Report containing
recommendations to improve the existing regulation of soft dollars and disclosure of
transaction costs.1 The Task force was formed in May 2004 to consider and make
recommendations to the SEC on ways to improve the transparency of mutual fund portfolio
transaction costs and distribution arrangements.
In summary, the NASD Task Force recommends that the soft dollar safe harbor of
Section 28(e) of the Securities Exchange Act of 1934 be preserved but that the SEC narrow of the
harbor’s scope and mandate certain expanded disclosure to fund boards and investors,
respectively, about soft dollar practices and transaction costs. The Task Force also recommends
consideration of making compliance with Section 28(e) mandatory for all discretionary advisers,
whether or not registered with the SEC.
I. Recommendations Concerning Soft Dollars
A. Scope of Safe Harbor
The Task Force recommends that the SEC narrow its interpretation of the scope of the
safe harbor of Section 28(e) 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: 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);
magazines/newspapers/journals/on-line news services; portfolio accounting services; proxy voting services
unrelated to issuer research; and travel expenses incurred in company visits.
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 expressed in dollars and
basis points;
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
(proprietary and/or third party research) that includes a description of the products or
services received, total commissions directed to the broker by the fund and all of the
advisers’ clients;
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 expressed
in dollars and in basis points.
This recommendation is intended to establish minimum information standards across the
industry and to support a more rigorous discipline on the purchase of research and brokerage
services with soft dollars, particularly in connection with board consideration of the advisory
fee.
The Task Force would treat the disclosure of information about third party research
differently from information about proprietary research. The Report recommended disclosure
of the dollar amount of third party research obtained with fund commissions because this
number is readily available to advisers and brokers. The Task Force considered but did not
reach a consensus on whether advisers should provide the board with an analogous good faith
estimate of the total dollar amount of proprietary research obtained with fund brokerage
commissions. While a substantial number of Task Force members supported such a
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.
3
requirement, a majority believed these estimates would be of illusory benefit to fund boards
because they would be arbitrary and subjective, and, thus, vary significantly among advisers.
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 requirements4 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
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 to assist boards in exercising their duties to oversee fund portfolio trading
practices. At a minimum, the adviser should be required to supply fund boards with (a) its
policies and procedures for monitoring transaction costs and brokerage allocation, and (b)
information concerning the reasonableness of all transaction costs including commissions,
commission equivalents, mark-ups and mark-downs, market impact costs, opportunity costs,
4 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.
4
and other intangible trading 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.
Mary S. Podesta
Senior Counsel