January 27, 1994
TO: COMPLIANCE COMMITTEE NO. 1-94
INVESTMENT ADVISER ASSOCIATE MEMBERS NO. 7-94
INVESTMENT ADVISER MEMBERS NO. 7-94
SOFT DOLLARS TASK FORCE
RE: TWO SEC CASES RELATED TO SOFT DOLLAR PRACTICES
__________________________________________________________
The Securities and Exchange Commission recently imposed sanctions in one
settled case and affirmed an appeal from an administrative law judge decision in
another case, both of which related to soft dollar practices. A copy of both
cases is attached.
1. Commission Settlement
The Commission sanctioned an investment adviser and its president and
majority shareholder in connection with their acceptance of "soft dollar"
payments for investment advisory services.
Specifically, the Commission found that, among other things, the investment
adviser had entered into advisory service contracts providing that fees could be
paid either in cash or with soft dollars. Clients who chose to pay in soft
dollars were told that they could pay $1 in cash for every dollar of service
purchased or $2 in soft dollars for the same services. The Commission found that
the adviser failed to disclose in its Form ADV how fees were charged, including
the fact that fees payable in soft dollars were twice the amount of fees payable
in cash, and that the adviser received 15-20% more revenue for the same services
when payment was made in soft dollars rather than hard dollars. The Commission
also found that the adviser had failed to disclose the terms of its soft dollar
arrangements with the relevant broker-dealers. The Commission found that the
adviser willfully violated Sections 204 and 207 of the Investment Advisers Act
and Rule 204-1(b) thereunder and that the president willfully violated Section
207 and willfully aided and abetted the other violations.
The Commission also found that certain of the adviser's soft dollar clients
had enough trading volume to generate more directed brokerage commissions than
the amount needed to pay the adviser for its advisory services. The adviser
offered to maintain bank accounts for these clients, and used the accounts to pay
invoices for products and services at client direction. The adviser charged
these clients 5% of the gross commissions generated for these services. The
Commission found that the adviser thereby obtained custody of client funds but
did not obtain surprise annual examination of the funds by an independent
accountant, and failed to make certain related disclosure in its Form ADV. The
Commission found that the adviser thus willfully violated Sections 204 and 206(4)
of the Investment Advisers Act and Rules 204-1(b) and 206(4)-2 thereunder.
Without admitting or denying the allegations, the adviser and the president
consented to a cease and desist order, payment of civil penalties, registration
of a brokerage subsidiary, and an independent audit of client funds in custody.
2. Commission Ruling on Appeal
A registered investment adviser and one of its former principals appealed
a decision from an administrative law judge, which found that the adviser, aided
and abetted by the principal, had improperly used soft dollars. Specifically,
the law judge found that the adviser's use of soft dollars to pay a consultant
who assisted the adviser in hiring and training a new client services director
was in violation of the antifraud, reporting and disclosure requirements of the
Advisers Act.
In responding to the respondents' assertion that the soft dollar
arrangement was not in violation of the Advisers Act because it did not involve
"paying up", the Commission concluded that nevertheless the adviser had an
undisclosed conflict of interest. The respondents also argued that disclosure
about the arrangement was not required because the amount of commissions used to
satisfy the adviser's soft dollars obligations was not material in that thesoft
dollar commissions constituted less than 1% of total commissions generated by the
customer accounts for the year in issue. The Commission disagreed, concluding
that the existence of this potential conflict of interest was a material fact
that should have been disclosed to the adviser's clients.
In addition, the Commission found that the services paid for by the soft
dollars were not within the scope of the safe harbor in Section 28(e) of the
Securities Exchange Act in that the adviser did not receive "brokerage and
research services" and the services it did receive were not "provided by" a
broker or a third party who had contracted with a broker.
Based on the foregoing, the Commission agreed with the law judge that a
censure of the adviser is appropriate in the public interest. The Commission,
however, dismissed the proceedings with respect to the adviser's principal noting
that he had an
otherwise unblemished record after thirty years, was suffering from a
progressive, terminal disease and is no longer in the business.
Thomas M. Selman
Assistant Counsel
Attachments