©2005 Investment Company Institute. All rights reserved. Information may be abridged and therefore incomplete.
Communications from the Institute do not constitute, and should not be considered a substitute for, legal advice.
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October 21, 2005
TO: CLOSED-END INVESTMENT COMPANY COMMITTEE No. 38-05
EQUITY MARKETS ADVISORY COMMITTEE No. 38-05
INVESTMENT ADVISERS COMMITTEE No. 11-05
SEC RULES COMMITTEE No. 57-05
SMALL FUNDS COMMITTEE No. 30-05
RE: PROPOSED SEC SOFT DOLLARS GUIDANCE
The Securities and Exchange Commission has published for comment an interpretive
release concerning client commission practices under Section 28(e) of the Securities Exchange
Act of 1934.1 The Release is summarized below.
Comments on the Release are due 30 days after its publication in the Federal Register.
We will hold a conference call on Thursday, October 27th, at 4:00 p.m. Eastern time, to discuss
the Release. The dial-in number for the call is 877-709-5343 and the pass code is 68202.
Please send an e-mail to Laura Maurer at tlegal@ici.org to let us know if you plan to
participate on the call.
The Release states that Section 28(e) establishes a safe harbor that allows money
managers to use client funds to purchase “brokerage and research services” for their managed
accounts under certain circumstances without breaching their fiduciary duties to clients. The
Release explains that the SEC is proposing to provide further guidance in this area in light of its
experience with Section 28(e) and in recognition of changing market conditions.
By way of background, the Release briefly summarizes (1) the history of Section 28(e),
(2) previous SEC guidance on the scope of Section 28(e), (3) a 1998 report of the Office of
Compliance Examinations and Inspections (OCIE) on examination findings regarding the range
of products and services that advisers obtain under their client commission arrangements, (4)
the 2004 recommendations of the NASD Mutual Fund Task Force concerning client commission
practices and portfolio transaction costs, and (5) the United Kingdom Financial Services
Authority’s recently adopted client commission rules.
1 SEC Release No. 34-52635 (Oct. 19, 2005) (“Release”). The Release is available on the SEC’s website at:
http://www.sec.gov/rules/interp/34-52635.pdf.
2
Proposed Interpretive Guidance
The Release indicates that the SEC has revisited its previous guidance as to the meaning
of the phrase “brokerage and research services” in Section 28(e) and is proposing a revised
interpretation that would replace some of the guidance it provided in a 1986 interpretive
release.2 The revised interpretation addresses (1) the appropriate framework for analyzing
whether a particular service falls within the “brokerage and research services” safe harbor, (2)
the eligibility criteria for “research,” (3) the eligibility criteria for “brokerage,” and (4) the
appropriate treatment of “mixed-use” items. It also discusses a money manager’s statutory
requirement to make a good faith determination that client commissions paid are reasonable in
relation to the value of the brokerage and research services received, and provides guidance on
third-party research and commission-sharing arrangements.
Framework for Analyzing the Scope of the “Brokerage and Research Services” under
Section 28(e)
According to the Release, the analysis of whether a particular product or service falls
within the Section 28(e) safe harbor should involve three steps. First, the money manager must
determine whether the product or service is eligible under Section 28(e)(3)(A), (B), or (C).3
Second, the manager must determine whether the eligible product or service provides “lawful
and appropriate assistance” in the performance of his investment decision-making
responsibilities. Third, the manager must make a good faith determination that the amount of
client commissions paid is reasonable in light of the value of products or services provided by
the broker-dealer.
Eligibility Criteria for “Research Services”
To qualify as research services under the safe harbor, a product or service must
constitute “advice,” “analyses,” or “reports” within the meaning of Section 28(e) and its subject
matter must fall within the categories specified in Section 28(e)(3)(A) or (B). The Release notes
that some of these categories subsume other topics and thus, for example, a report containing
political factors that are interrelated with economic factors could fall within the scope of the safe
harbor.
2 The proposed guidance would replace Sections II and III of the 1986 release; it would not replace other sections of
that release.
3 Section 28(e)(3) states that:
a person provides brokerage and research services insofar as he –
(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.
3
The Release states that in determining whether a product or service is eligible as
“research,” a money manager must conclude that it reflects the expression of reasoning or
knowledge and relates to the subject matter identified in Section 28(e)(3)(A) or (B). In addition
to traditional research reports analyzing the performance of a particular company or stock,
examples of items that could be eligible include:
• financial newsletters and trade journals if they relate to the subject matter of Section
28(e)(A) or (B);
• quantitative analytical software and software that provides analyses of securities
portfolios if they reflect the expression of reasoning or knowledge relating to subject
matter included in Section 28(e)(3)(A) and (B); and
• seminars or conferences where the content satisfies the above-mentioned “expression of
reasoning or knowledge” and subject matter criteria.
Products that do not reflect the expression of reasoning or knowledge, such as
operational overhead expenses, are not eligible “research services.” Examples of ineligible
items include:
• travel expenses, entertainment, and meals associated with attending seminars;
• office equipment, office furniture and business supplies, telephone lines, salaries
(including research staff), rent, accounting fees and software, website design, e-mail
software, internet service, legal services, personnel management, marketing, utilities,
membership dues, professional licensing fees, and software to assist with administrative
functions such as managing back-office functions, operating systems, and word
processing; and
• computer hardware and accessories, and the “peripherals” and delivery mechanisms
associated with computer hardware (e.g., telecommunications lines, transatlantic cables,
and computer cables).
The Release states that data services, such as those that provide market data or economic
data, could fall within the scope of the safe harbor if they satisfy the subject matter criteria.
Thus, under the proposed interpretation, market data such as stock quotes, last sale prices, and
trading volumes, and other data reflecting substantive content, such as company financial data
and economic data (e.g., unemployment and inflation rates or gross domestic product figures)
would be eligible as “research services.”
The Release notes that to be within the safe harbor, a product or service not only must
satisfy the specific criteria of Section 28(e), but also must provide the money manager with
lawful and appropriate assistance in making investment decisions. According to the Release,
this standard focuses on how the manager uses the eligible research. For example, while
analyses of performance of accounts are eligible research items, they are not within the safe
harbor if used for marketing purposes.
Eligibility Criteria for “Brokerage”
4
Under Section 28(e)(3)(C), eligible brokerage products and services include not only
activities required to effect securities transactions but also functions “incidental thereto” and
functions required by SEC or self-regulatory organization (SRO) rules (such as electronic
confirmation or affirmation of institutional trades in connection with settlement processing).
The Release states that, in addition to clearance and settlement services, the following post-
trade services are examples of incidental functions that are eligible as “brokerage services”:
• post-trade matching;
• exchange of messages among broker-dealers, custodians, and institutions;
• electronic communication of allocation instructions between institutions and broker-
dealers; and
• routing settlement instructions to custodian banks and broker-dealers’ clearing agents.
The Release notes that the 1998 OCIE Report recommended that the SEC provide further
guidance on the scope of the safe harbor concerning the use of items that may facilitate trade
execution. It also mentions a potential risk that, in the absence of such guidance, the proposed
narrowing of the scope of eligible research under the safe harbor could lead to inappropriate
reclassification of services and products as brokerage that previously were classified as
research. For these reasons, the Release provides additional guidance to assist money managers
in determining whether items are eligible as “brokerage services” under the safe harbor.
The Release proposes a new “temporal standard” to distinguish between “brokerage
services” that are eligible under Section 28(e) and those products and services, such as
overhead, that are not eligible. According to the Release, for purposes of the safe harbor,
“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 holder’s agent.” By contrast, the Release
points out, research services include services provided before the communication of an order.
Under the proposed temporal standard, eligible “brokerage services” include:
• communications services related to the execution, clearing, and settlement of securities
transactions and other incidental functions, i.e., connectivity service between the money
manager and the broker-dealer and other relevant parties such as custodians (including
dedicated lines between the broker-dealer and the money 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; and message services used to
transmit orders to broker-dealers for execution);
• trading software operated by a broker-dealer to route orders to market centers; and
• algorithmic trading software.
Items properly characterized as “overhead” and not eligible as “brokerage services”
include:
• order management systems used by money managers (whether developed in-house or
obtained from third party vendors);
• hardware, such as telephones or computer terminals;
5
• trade analytics,4 surveillance systems, or compliance mechanisms; and
• error correction trades or related services in connection with errors made by money
managers.
The Release reiterates that in order to obtain safe harbor protection for products or
services that are eligible brokerage services, the money manager must (1) be able to show that
the product or service provides lawful and appropriate assistance to the manager in carrying
out his or her responsibilities and (2) make a good faith determination that the amount of
commissions paid is reasonable in relation to the value of the research and brokerage product or
service received.
“Mixed-Use” Items
The SEC’s 1986 interpretive release introduced the concept of “mixed use” and stated
that where a product has a mixed use, a money manager should make a “reasonable allocation”
of the cost of the product according to its use. It also emphasized that the money manager must
keep adequate books and records concerning allocations in order to make the required good
faith determination.
The Release states that the SEC continues to believe that the mixed use approach is
appropriate, and reiterates the mixed-use standard in the 1986 release (i.e., “The money
manager must keep adequate books and records concerning allocations so as to be able to make
the required good faith showing.”). As an example related to the “reasonable allocation”
requirement, the Release notes that an allocable portion of the cost of portfolio performance
evaluation services or reports may be eligible as research, but that money managers must use
their own funds to pay for the allocable portion of such services or reports used for marketing
purposes. Similarly, according to the Release, if the money manager receives both eligible and
ineligible products and services for a bundled commission rate, the manager must use his own
funds to pay for the allocable portion of the cost of products and services that are not within the
safe harbor. The Release mentions that the SEC may further address the documentation of
mixed-use items at a later time.
Good Faith Determination as to Reasonableness Under Section 28(e)
The Release reaffirms a money manager’s “essential obligation” under Section 28(e) to
make a good faith determination that the commissions paid are reasonable in relation to the
value of the brokerage and research services received, and adds that the burden of proof in
demonstrating this determination rests on the money manager.
The Release cautions that a money manager may not obtain eligible products, such as
market data, to camouflage the payment of higher commissions to broker-dealers for ineligible
services, such as shelf space. It explains that in this instance, the money manager could not
make the determination, in good faith, that the commission rate was reasonable in relation to
4 The Release notes that trade analytics may be used both for research and to assist a money manager in fulfilling
contractual obligations to a client or to assess compliance with regulatory or fiduciary obligations. In this case, the
trade analytical software is a mixed-use product and the money manager must use its own funds to pay for the
allocable portion of the cost of the software that is not within the safe harbor.
6
the value of the Section 28(e) eligible products because the commission would incorporate a
payment for the non-Section 28(e) services.
Third-Party Research and Commission-Sharing Arrangements
The Release states that third-party research arrangements can benefit advised accounts
by providing greater breadth and depth of research. Noting that Section 28(e) requires that the
broker-dealer receiving commissions must “provide” brokerage or research services, the
Release reiterates the SEC’s position that money managers may use client commissions to pay
for research produced by someone other than the executing broker-dealer (i.e., third-party
research), provided that the broker-dealer has the direct legal obligation to pay for the research.
As the SEC has previously indicated, third-party research is eligible even if the money manager
participates in selecting the research services or products that the broker-dealer will provide,
and the third party may send the research directly to the broker-dealer’s customer, so long as
the broker-dealer has the obligation to pay for the services. The Release reminds money
managers and broker-dealers that arrangements whereby broker-dealers pay for research or
brokerage services for which money managers are obligated to pay a third party are not eligible
for the Section 28(e) safe harbor.
The Release discusses Section 28(e)’s requirement that the broker-dealer providing the
research also be involved in “effecting” the trade, noting that it is principally intended to
preclude the practice of paying “give-ups.”5 Although Section 28(e) does not apply if a money
manager makes payment to one broker-dealer for the services provided by another broker
dealer, the SEC’s 1986 interpretive release clarified that payment of a part of a commission to a
broker-dealer who is a “normal and legitimate correspondent” of the executing or clearing
broker-dealer would not necessarily be outside the safe harbor.
The Release describes certain commission-sharing arrangements.6 It reiterates the SEC’s
view that where more than one broker-dealer is involved in a commission-sharing arrangement,
the “introducing broker [must be] engaged in securities activities of a more extensive nature
than merely the receipt of commissions paid to it by other broker-dealers for ‘research services’
provided to money managers.” It states that while commission-sharing arrangements typically
involve clearing agreements pursuant to SRO rules, a clearing agreement that satisfies SRO
rules does not necessarily satisfy the criteria of Section 28(e). Further, “[e]ach broker-dealer
must play a role in effecting securities transactions that goes beyond the mere provision of
research services to money managers,” and the nature of the activities actually performed
determines whether the commission-sharing arrangement qualifies for the safe harbor.
5 The Release explains that when brokerage commissions were fixed before 1975, a “give-up” was a payment to
another broker-dealer of a portion of the commission required to be charged by the executing broker-dealer. The
broker-dealer receiving the give-up may have had no role in the transaction generating the commission and may not
even have known where or when the trade was executed. The SEC found that these arrangements violated the
securities laws because the portion of the commission “given up” is a charge above the cost of execution on client
accounts and because the broker-dealer receiving the “give up” did nothing in connection with the securities trade to
benefit investors.
6 The Release differentiates “step-outs” from commission-sharing arrangements. According to the Release,
“[p]rovided that each broker in a step-out performs substantive functions in effecting trades, e.g., clearance and
settlement, such arrangements may be eligible for the safe harbor.
7
According to the Release, the following elements are necessary for a commission-sharing
arrangement under which research and brokerage services are provided under the safe harbor:
• The commission-sharing arrangement must be part of a normal and legitimate
correspondent relationship in which each broker-dealer is engaged in securities
activities of a more extensive nature than merely the receipt of commissions paid to it by
other broker-dealers for research services provided to money managers. The SEC
believes that, at a minimum, this means that the introducing broker-dealer must: (1) be
financially responsible to the clearing broker-dealer for all customer trades until the
clearing broker-dealer has received payment (or securities); (2) make and/or maintain
records relating to its customer trades required by SEC and SRO rules; (3) monitor and
respond to customer comments concerning the trading process; and (4) generally
monitor trades and settlements; and
• a broker-dealer effecting the trade (if not providing research and brokerage services
directly) must be legally obligated to a third-party producer of research or brokerage
services to pay for the service ultimately provided to a money manager.
Request for Comments
The SEC seeks comment generally on its proposed interpretive guidance, including
whether the proposed guidance has accurately identified the industry practices for which
guidance would be most useful, and whether the guidance would significantly affect the level
and distribution of costs among industry participants and, if so, whether these effects would be
beneficial to investors or otherwise serve the public interest. The Release also includes a list of
specific questions on which the SEC solicits comment. These questions address, among other
topics, whether there are types of products or services that are commonly paid for with client
commissions for which additional guidance would be useful (e.g., proxy voting services),
whether the SEC should provide additional guidance concerning mass-marketed publications,
and whether the SEC should afford firms time to implement the interpretation. Regarding the
latter, the Release requests specific examples of any potential implementation issues.
Frances M. Stadler
Deputy Senior Counsel