©2006 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.
[20215]
July 28, 2006
TO: CLOSED-END INVESTMENT COMPANY MEMBERS No. 33-06
EQUITY MARKETS ADVISORY COMMITTEE No. 14-06
INVESTMENT ADVISER MEMBERS No. 21-06
SEC RULES MEMBERS No. 65-06
SMALL FUNDS MEMBERS No. 53-06
RE: SEC ISSUES FINAL INTERPRETIVE GUIDANCE REGARDING CLIENT
COMMISSION PRACTICES
The Securities and Exchange Commission has published an interpretive release on the scope of
brokerage and research services and client commission arrangements under Section 28(e) of the
Securities Exchange Act of 1934.1 The Release provides guidance with respect to: (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. The Release also discusses a money manager’s
statutory requirement to make a good faith determination that the commissions paid are reasonable in
relation to the value of the brokerage and research services received. Finally, the Release includes
guidance on third-party research and client commission arrangements and seeks further comment
relating to client commission arrangements.2 The effective date of the interpretive release is July 24,
2006, although market participants may continue to rely on the SEC’s prior interpretations of Section
28(e) until January 24, 2007.
The Release makes several changes to the SEC’s proposed interpretive release3 based on
comments received on the proposal. The most significant aspects of the Release, and changes made
from the proposed interpretive release, are summarized below.
1 SEC Release No. 34-54165 (July 18, 2006), 71 FR 41978 (July 24, 2006) (“Release”). The Release can be found on the
SEC’s website at http://www.sec.gov/rules/interp/2006/34-54165.pdf.
2 Comments on this aspect of the interpretive release must be filed with the SEC on or before September 7, 2006.
3 SEC Release No. 34-52635 (October 19, 2005), 70 FR 61700 (October 25, 2005).
2
Framework for Analyzing the Scope of “Brokerage and Research Services”
The Release states that 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) (i.e., whether it is eligible “research”
under Section 28(e)(3)(A) or (B) or eligible “brokerage” under Section 28(e)(3)(C)).4 Second, the
manager must determine whether the eligible product or service provides “lawful and appropriate
assistance” in the performance of its 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”
In determining that a particular product or service qualifies as “research services” under the safe
harbor, the money manager must conclude that it constitutes “advice,” “analyses,” or “reports” within
the meaning of Section 28(e) and that its subject matter falls within the categories specified in Section
28(e)(3)(A) and (B). The Release states that, in evaluating whether a product or service qualifies as
“research,” an important common element among “advice,” “analyses,” and “reports” is that each
reflects substantive content, i.e., the expression of reasoning or knowledge. Therefore, in determining
whether a product or service is eligible as “research” under Section 28(e), the 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).
Examples of eligible “research” delineated in the Release include: (1) traditional research reports
analyzing the performance of a particular company or stock; (2) discussions with research analysts; (3)
meetings with corporate executives to obtain oral reports on the performance of a company; (4)
seminars or conferences (if they provide substantive content relating to the subject matter in the
statute, such as issuers, industries, and securities); (5) software that provides analyses of securities
portfolios; and (6) corporate governance research (including corporate governance analytics) and
corporate governance rating services (if they provide reports and analyses about issuers, which can have
a bearing on the companies’ performance outlook).
4 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
Mass Marketed Publications
In response to comments received on the proposed interpretive release, including the
Institute’s, the Release clarifies that the safe harbor does not protect the money manager’s purchase of
publications that are mass-marketed, i.e., those publications that are intended for and marketed to a
broad, public audience. Indicia of mass-marketed publications include, among other things, that they
are circulated to a wide audience, intended for and marketed to the public, and have low cost.
Tangible Products and Services
The Release clarifies that products or services that do not reflect the expression of reasoning or
knowledge, including products with inherently tangible or physical attributes (such as telephone lines
or office furniture), are not eligible as research under the safe harbor. Examples of such products or
services include expenses for travel, entertainment, and meals associated with attending seminars.
Travel and related expenses associated with arranging trips to meet corporate executives, analysts, or
other individuals who may provide eligible research orally also are not eligible under the safe harbor.
Similarly, salaries (including for research staff), rent, accounting fees, internet service, legal expenses,
membership dues (including initial and maintenance fees paid on behalf of the money manager or any
of its employees to any organization or representative or lobbying group or firm), and professional
licensing fees are some examples of overhead items delineated in the Release that the SEC believes
would not meet the statutory criteria for “research” and therefore are not eligible under the safe harbor.5
Market Research
Consistent with the Institute’s comments on the proposed interpretive release, the Release
states that the SEC believes that technology now permits managers to obtain research related to the
market for securities from many sources and products, and through many delivery mechanisms,
including order management systems and trade analytical software. The Release therefore clarifies that
market research may be eligible under the safe harbor if it otherwise satisfies the standards for
“research.” For example, market research that may be eligible under Section 28(e) can include pre-trade
and post-trade analytics, software, and other products that depend on market information to generate
market research, including research on optimal execution venues and trading strategies. In addition,
advice from broker-dealers on order execution, including advice on execution strategies, market color,
and the availability of buyers and sellers (and software that provides these types of market research) may
qualify as “research” under the safe harbor.
5 The Release notes that, although certain tangible products and services may not qualify as “research” under Section 28(e),
they may be eligible under the safe harbor as brokerage products if they relate to trade execution and satisfy the other
requirements for brokerage.
4
Data
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 as eligible “research” provided that they satisfy the subject
matter categories identified in Section 28(e) and provide lawful and appropriate assistance in the
investment decision-making process. Examples of market data include stock quotes, last sale prices,
trading volumes, and other data reflecting substantive content related to the subject matter identified in
the statute (e.g., company financial data and economic data such as unemployment and inflation rates
or gross domestic product figures).
Proxy Services
Based on comments received on the proposed interpretive release, including the Institute’s, the
Release clarifies that proxy services may be treated as mixed-use items, as appropriate. For example,
reports and analyses on issuers, securities, and the advisability of investing in securities that are
transmitted through a proxy service may fall within Section 28(e). Nevertheless, the Release notes that
products or services offered by a proxy service provider that handle the mechanical aspects of voting,
such as casting, counting, recording, and reporting votes, would be administrative overhead expenses of
the manager and are not eligible under Section 28(e).
Eligibility Criteria for “Brokerage”
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 SRO rules (such as electronic confirmation or affirmation of institutional trades in
connection with settlement processing). The Release discusses this standard and provides additional
guidance to assist money managers in determining whether items are eligible as “brokerage services”
under the safe harbor.
Temporal Standard
The Release states that “brokerage” services under the safe harbor must relate to the execution
of securities transactions. Specifically, 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 establishing such a temporal standard, the SEC believes it can properly
distinguish between “brokerage” services that are eligible under Section 28(e) and those products and
services, such as overhead, that are not eligible.
The Release clarifies that under this temporal standard, eligible “brokerage” services include
communications services related to the execution, clearing, and settlement of securities transactions and
other functions incidental to effecting securities transactions, i.e., connectivity service between the
5
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 and
lines between the broker-dealer and order management systems operated by a third-party vendor).6 In
addition, trading software used to route orders to market centers, software that provides algorithmic
trading strategies, and software used to transmit orders to direct market access (“DMA”) systems are
within the temporal standard and therefore are eligible “brokerage” under the safe harbor.
Ineligible Overhead
The Release discusses several products and services that should be categorized as “overhead,” i.e.,
part of the manager’s cost of doing business, and that do not qualify as “brokerage” under Section 28(e).
Specifically, the Release clarifies that hardware, such as telephones or computer terminals, including
those used in connection with order management systems and trading software, are not eligible for the
safe harbor because they are not sufficiently related to order execution and fall outside the temporal
standard. In addition, software functionality used for recordkeeping or administrative purposes, such as
managing portfolios, and quantitative analytical software used to test “what if” scenarios related to
adjusting portfolios, asset allocation, or for portfolio modeling (whether or not provided through order
management systems) do not qualify as “brokerage” because they are not integral to the execution of
orders by the broker-dealers. The Release also states that managers may not use client commissions
under the safe harbor to meet their compliance responsibilities, such as: (1) performing compliance
tests that analyze information over time in order to identify unusual patterns; (2) creating trade
parameters for compliance with regulatory requirements, prospectus disclosure, or investment
objectives; or (3) stress-testing a portfolio under a variety of market conditions or to monitor style drift.
Finally, trade financing, such as stock lending fees, and capital introduction and margin services, as well
as error correction trades or related services in connection with errors made by money managers, are not
eligible “brokerage” services under the safe harbor.
Custody
The Release clarifies that short-term custody related to effecting particular transactions and
clearance and settlement of those trades is included within the statute because it is tied to processing the
trade between the time the order is placed and settlement of the trade. In contrast, custodial services,
such as long-term custody and custodial recordkeeping, provided in connection with accounts after
clearance and settlement of transactions, are not incidental to effecting securities transactions and are
not included under the safe harbor.
“Mixed-Use” Items
The Release reaffirms the SEC’s belief that the guidance provided in the SEC’s 1986
interpretive release on “mixed-use” items continues to be appropriate. Specifically, the mixed-use
6 The Institute, in its comment letter on the proposed interpretive release, recommended expanding the temporal standard
on the front end to include order management systems.
6
approach requires a money manager to make a reasonable allocation of the cost of a product between
research and non-research functions. A money manager also must keep adequate books and records
concerning allocations so as to be able to make the required good faith showing that the amount paid
for the mixed-use item in client commissions was reasonable in relation to the value of the research
product or service received. 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 that is used for marketing purposes.
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 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
Section 28(e) is available only where a broker-dealer that receives commissions “effects” the
money manager’s trades and “provides” the research. The Release discusses the functions an executing
broker-dealer must provide in order to “provide” the research and what services an introducing broker-
dealer must provide in order to “effect” the money manager’s trade. The Release also reiterates the
SEC’s position that the safe harbor applies equally to arrangements involving client commissions paid
for proprietary research and to third-party research arrangements where the research services and/or
products are developed by third parties and “provided by” a broker-dealer that participates in
“effecting” the transaction.
The Release states that comments received on client commission arrangements highlighted the
considerable variety of arrangements under Section 28(e) that the industry has developed. Based on the
additional information regarding current industry practices provided by these comments and
consideration of congressional intent behind Section 28(e), the Release states that the SEC is revising
its interpretation of the safe harbor to permit the industry to structure arrangements that are consistent
with the statute and that best serve investors in a more flexible manner. The SEC also is requesting
additional comment on whether the guidance in this area is sufficient to address the many variations
and complexity of these arrangements.
7
“Effecting” Transactions Requirement
The proposed interpretive guidance identified four minimum functions that an introducing
broker-dealer must satisfy in order to be “effecting” transactions. The four functions are: (1) taking
financial responsibility for all customer trades until the clearing broker-dealer has received payment (or
securities); (2) making and/or maintaining records relating to customer trades required by SEC and
SRO rules; (3) monitoring and responding to customer comments concerning the trading process; and
(4) generally monitoring trades and settlements. The Release modifies the “effecting” transactions
requirement by clarifying that, in order for the money manager to use the safe harbor, a broker-dealer
that is “effecting” the trade must perform at least one of four minimum functions and take steps to see
that the other functions have been reasonably allocated to another broker-dealer in a manner consistent
with its obligations under SEC and SRO rules.
“Provided by” Requirement
The Release reiterates the SEC’s view that broker-dealers “provide” research if they (1) prepare
the research or (2) are financially obligated to pay for the research. The Release clarifies, however, that
the safe harbor also is available in situations where a broker-dealer pays for eligible research and
brokerage for which it is not directly obligated to pay if the broker-dealer pays the research preparer
directly and takes steps to assure itself that the client commissions that the manager directs it to use to
pay for such services are used only for eligible brokerage and research. Such steps include: (1) reviewing
the description of the services to be paid for with client commissions under the safe harbor for red flags
that indicate the services are not within Section 28(e) and agreeing with the money manager to use
client commissions only to pay for those items that reasonably fall within the safe harbor; and (2)
developing and maintaining procedures so that research payments are documented and paid for
promptly.
Ari Burstein
Associate Counsel