1. Directed Brokerage.
a. Under certain circumstances, an investment adviser’s client, or someone authorized to act on the client’s behalf, may instruct the adviser to direct a portion of the brokerage transactions to be effected for its account to a specified broker-dealer. Normally, the client makes this request in return for services provided directly to that client (i.e., research, performance evaluation, other administrative services, discounts or cash rebates).
b. In cases where the client has instructed the investment adviser to direct brokerage to certain broker-dealers, the adviser still has a fiduciary duty to disclose to the client that the client may forgo any benefit from savings on execution costs that the adviser could obtain for its clients through, for example, negotiated discounts or batched orders.
c. Generally, when a client directs where an adviser should place the client’s brokerage, the adviser is relieved of its fiduciary obligation to obtain best price and execution. If, however, the adviser receives some benefit from the direction of brokerage to particular brokers, the adviser retains its duty to disclose its ability to obtain best price and execution.
2. Soft Dollars.
The term “soft dollars” generally is used to describe arrangements where an investment adviser pays for research or other products or services from a broker-dealer or directs trades in client accounts to the broker-dealer through whom the research or their products are supplied, thereby providing the broker-dealer with commission revenue. (When an adviser
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purchases research or other products with its own money, it pays with
“hard dollars.”) The use of soft dollars by an investment adviser poses the question as to whether that adviser is receiving best price and execution and has acted in accordance with its fiduciary duty of loyalty.
a. Section 28(e).
Section 28(e) of the Exchange Act provides a safe harbor for advisers who direct a client’s equity trades to broker-dealers to acquire research and other products and services. Because Section 28(e) is a “safe harbor,” an adviser cannot violate that section. If, however, the soft dollar arrangement falls outside of the section, it may violate the Advisers Act, other federal laws or the adviser’s common law fiduciary duties to the client. Section 28(e) provides that a money manager can use a broker-dealer charging more than the lowest commission rates available (“pay-up”) if the money manager receives research or brokerage services from such broker-dealer.
b. Application of Section 28(e) Depends on the Following:
i. The adviser must be supplied with brokerage and/or research services, not some other products or services.
Something is considered research if it provides lawful and appropriate assistance to the adviser in the performance of its investment decision-making responsibilities. Research and brokerage services do not include overhead or administrative expenses, the correction of trading efforts, or consulting services in marketing aimed at soliciting new clients.
ii. If a broker-dealer provides products to an investment adviser that encompass both research and brokerage services as well as administrative services, the investment adviser must make a good faith effort to allocate the cost of the product according to its use.
iii. The research and/or brokerage services must be provided by the broker-dealer. Brokers may provide research that has been produced by a third party. Third-party research is permitted if the broker-dealer, not the investment adviser, has incurred the obligation to pay the third-party research producer.
iv. The investment adviser must have investment discretion in placing the brokerage.
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1.) Plan sponsors for pension funds are themselves not protected by Section 28(e)’s safe harbor provisions.
2.) Directed brokerage transactions do not fall within the safe harbor of Section 28(e).
v. The commissions paid must be reasonable in relation to the services provided. Section 28(e) requires investment advisers to make a good faith determination that higher brokerage commissions costs resulting from the purchase of brokerage research and services are reasonable.
vi. Commissions must be used to purchase the services.
1.) Section 28(e) deals exclusively with brokerage commissions and does not cover mark-ups/markdowns.
2.) The SEC has historically interpreted Section 28(e) to apply to the amount of commission paid to a broker-dealer acting in an agency capacity only.
Recently, however, the SEC issued an interpretive release that expanded the application of Section 28(e) to certain “riskless” principal transactions, such as those reported under NASD Rules 4632, 4642 or 6420. Specifically, the SEC stated that “we now interpret the term ‘commission’ in Section 28(e) of the Exchange Act to include a markup, markdown, commission equivalent or other fee paid by a managed account to a dealer for executing a transaction where the fee and transaction price are fully and separately disclosed on the confirmation and the transaction is reported under conditions that provide independent and objective verification of the transaction price subject to self-regulatory organization oversight.” The SEC’s release, however, made clear that at this time only the Nasdaq “riskless” principal trades specified above satisfy that standard. Markups, markdowns and commission equivalents on traditional principal trades effected to or from a broker-dealer’s proprietary account inventory and Nasdaq “net”
trades do not qualify for Section 28(e)’s safe harbor.
The SEC also stated that, as other markets develop regulations that ensure transparency equivalent to that ensured by the NASD rules referenced above, transaction charges in those markets that meet the
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requirements of the interpretation will be considered to fall within the interpretation. SEC Exchange Act Release No. 34-45194 (Dec. 27, 2001).
vii. The brokerage placed must be for securities transactions.
Section 28(e) is not available for transactions in commodities or financial futures.
c. Disclosure Requirements.
Section 28(e) requires an investment adviser to disclose its policies and procedures with respect to commissions that will be paid for effecting securities transactions.
i. Registered advisers must disclose certain information regarding their brokerage practices and soft dollar arrangements on Items 12 and 13 of Part II of the Form ADV.
ii. An adviser may need to provide additional information and material to clients where necessary in light of a particular soft dollar activity.
iii. Disclosure of soft dollar arrangements is required under the Investment Company Act, including in certain books and records, in semi-annual reports on Form N-SAR, in investment company registration statements, and pursuant to Section 15 of the Investment Company Act, which requires an investment adviser to an investment company to make certain disclosures concerning its brokerage practices and soft dollar arrangements in advisory contracts and to the board of directors of such companies.
d. The Future of Soft Dollars.
As pressure mounts for increased regulation of the hedge fund and mutual fund industry, there is an expectation that regulators will soon impose stricter standards on the use of soft dollars. In 2003, mutual funds and their advisers cut the use of soft dollars by 18%
in anticipation of increased scrutiny.66 Furthermore, some fund sponsors such as Bank One, Morgan Stanley, Janus and MFS said they would be drastically curbing their use of soft dollars.
In December 2003, the Board of Governors of the Investment Company Institute (“ICI”) requested that the SEC (1) tighten and
66 Will Swarts, Soft Dollars are Falling Hard, The Street.com, May 28, 2004, available at http://biz.yahoo.com/ts/040528/10162837_1.html.
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restrict the definition of soft dollars to narrow the number and type of services that would fall under this category, and (2) eliminate soft dollars for third-party research.67 In his testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs in April 2004, SEC Chairman William Donaldson seemed to agree that the definition of research should be tightened and favored increased transparency of costs.
Although there have not been any specific regulatory actions yet, soft dollars reform is an issue of top priority for the SEC. Changes however, are expected this fall when both the NASD and SEC Task Forces on Soft Dollars will present to the SEC a report with a series of recommendations. In addition to strong calls for reform from investors, the ICI, the NASD and the SEC, Congress has lauded Chairman Donaldson’s aggressive reform efforts and have offered additional support and enhanced authority to the SEC if it is necessary to execute its responsibilities.68
e. AIMR Soft Dollars Standards.
The Association for Investment Management and Research (“AIMR”) has proposed a set of voluntary soft dollar standards to be included in AIMR’s Standards of Practice as voluntary standards for AIMR members. The AIMR Soft Dollar Standards are designed to (1) define “soft dollars,” (2) identify what is
“allowable” research, (3) establish standards for soft dollar use, (4) create “model” disclosure guidelines, and (5) provide guidance for client-directed brokerage arrangements.
AIMR’s proposed Soft Dollar Standards depart from certain well-established practices in the soft dollar area and, if adopted, will impose higher standards of conduct in certain areas on AIMR members that voluntarily elect to comply with the Standards.
Those aspects of AIMR’s Soft Dollar Standards that differ from current practices are highlighted below.
67 ICI Press Release, Dec. 15, 2003, available at
http://www.ici.org/statements/nr/03_news_soft.html#TopOfPage
68 See e.g., Statement of Richard ShelbyReview of Current Investigations and Regulatory Actions Regarding the Mutual Fund Industry: The SEC's Perspective"April, 08 2004, available at
http://banking.senate.gov/index.cfm?Fuseaction=Hearings.Testimony&TestimonyID=549&HearingID=107.
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i. Definitions of Soft Dollar Arrangements.
1.) Proprietary, in Addition to Third-Party, Research.
Traditionally, soft dollar arrangements are understood to address those products or services provided to the investment manager by someone other than the executing broker, commonly known as “third-party” research. Under AIMR’s Soft Dollar Standards, soft dollar arrangements include proprietary, as well as third-party research arrangements, and seek to treat both categories equally.
2.) Principal, in Addition to Agency, Trades.
Traditionally, the term “soft dollars” refers to commissions generated by trades conducted on an agency basis. Under AIMR’s Soft Dollar Standards, soft dollar arrangements include transactions conducted on an agency or principal basis.
ii. Definition of Research.
Traditionally, “allowable” research in the soft dollar context is evaluated by whether it provides lawful and appropriate assistance to the investment adviser in its investment decision-making process. AIMR’s Soft Dollar Standards adopt a definition of research that requires the primary content of the soft dollar product or service, if used by the adviser, to directly assist the adviser in its investment decision-making process and not in the management of the investment firm. Appendix B to the AIMR’s Soft Dollar Standards suggests use of a four-tiered analysis to aid in determining whether a product or service is research.
iii. Enhanced Disclosure.
Under the AIMR’s Soft Dollar Standards, an investment firm claiming compliance must disclose to its clients certain information, some of which the firm is already required to maintain under current law. Moreover, while AIMR’s Soft Dollar Standards require the firm to disclose the availability of additional information, it is not required
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to actually provide that information, unless specifically requested by the client.
iv. Compliance Statement.
Finally, AIMR’s Soft Dollar Standards contemplate the use of a voluntary statement of compliance. An investment manager claiming compliance with the Standards must provide its client with a statement that any brokerage arrangement with respect to that client’s account comports with the mandatory provisions of the Standards.
f. Suggested Compliance Procedures – Broker Selection/Soft Dollar Arrangements.
i. A registered adviser should specifically describe in its Form ADV: (1) what factors are used in selecting brokers, (2) what types of soft dollar arrangements may be entered into and when this may occur, (3) the nature of any directed brokerage arrangements, and (4) any potential conflict of interest concerning brokerage placement.
ii. An investment adviser’s compliance manual should provide that it is the adviser’s policy to adhere to SEC interpretations regarding the permissible use of soft dollars.
It may be advisable to require that (1) the investment adviser’s principals determine which brokers can provide research and brokerage services, (2) the adviser not obligate itself to generate a specified amount of commission from any one or more broker-dealers, and (3) the investment adviser’s compliance officer should periodically review transactions to determine whether the adviser’s polices are being followed.
iii. An investment adviser should monitor and keep accurate records reflecting the performance of brokers that it uses.
Specifically, an investment adviser should: (1) periodically evaluate the execution performance of broker-dealers executing transactions, (2) monitor and record the use of clients’ commission dollars, and (3) monitor and record market-impact costs of different brokers utilized.