Investment Management

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1 OCTOBER 2005 Investment Management US Securities & Exchange Commission Issues Proposed Guidance on Soft Dollars By Michael S. Caccese and Christina H. Lim* On 19 October 2005, the US Securities and Exchange Commission (the SEC or Commission ) published for comment a proposed interpretive release with respect to client commission practices under Section 28(e) of the US Securities Exchange Act of The interpretive release, when finalized, will constitute the Commission s fourth interpretive release under Section 28(e) over the past 30 years. In developing its position, the SEC took into account the views of other regulators, including the Ontario Securities Commission, the Australian Securities and Investments Commission, and in particular the Financial Services Authority ( FSA ), which has adopted client commission rules that will be effective on 1 January 2006 followed by an additional sixmonth transition period. The SEC s interpretive guidance, as proposed, is generally consistent with the FSA s rules, with a few exceptions. The comment period will end 30 days after the proposed interpretive guidance is published in the Federal Register. The release provides proposed guidance on six aspects of the safe harbour: (i) the appropriate framework for analyzing whether a service falls within the brokerage and research services safe harbour; (ii) the eligibility criteria for research ; (iii) the eligibility criteria for brokerage ; (iv) the appropriate treatment of mixed-use items; (v) the money manager s duty to make a good faith determination as to reasonableness under Section 28(e); and (vi) third-party research and commission-sharing arrangements. The SEC is also considering whether to propose requirements for disclosure and recordkeeping of client commission practices and will evaluate whether further action is warranted. BACKGROUND Section 28(e) provides a safe harbour for money managers by shielding money managers from liability for statutory breaches and breaches of fiduciary duty claims on the basis that more than the lowest commission rate was paid in order to receive brokerage and research services. To be within the safe harbour, a broker-dealer must make a good faith determination that the amount of commission paid was reasonable in relation to the value of brokerage and research services received. The safe harbour is available to all persons exercising investment discretion with respect to an account, including fiduciaries of bank trust funds and investment advisers to separate accounts, mutual funds, hedge funds and pension plans. Although US money managers cannot violate Section 28(e), conduct that is not under its protection may constitute a breach of the manager s fiduciary duty under the law of the relevant state and federal securities laws, including the Investment Advisers Act of 1940, the Investment Company Act of 1940, and the Employee Retirement Income Securities Act of One of the most significant aspects of the proposed interpretive release is that it suggests that the failure to fall within Section 28(e) necessarily creates a breach of fiduciary duty. The proposed interpretive release specifically replaces Sections II and III of its 1986 release with revised interpreta- * Michael Caccese is a partner in the Boston office of Kirkpatrick & Lockhart Nicholson Graham LLP. He works extensively with investment firms on compliance issues, including all ofthe CFA Institute standards. He previously was the General Counsel to AIMR and was responsible for overseeing the development of AIMR-PPS, GIPS and other standards governing theinvestment management profession and investment firms. He can be reached at and mcaccese@klng.com. Christina H. Lim is an associate with K&LNG in the Boston office and can be reached at or clim@klng.com. Kirkpatrick & Lockhart Nicholson Graham LLP

2 tions, which give guidance as to third-party research and the meaning of the phrase brokerage and research services in Section 28(e). These revised interpretations specifically change the definitions of research and third-party research arrangements, and establish a temporal standard for brokerage services. FRAMEWORK FOR ANALYZING THE SCOPE OF BROKERAGE AND RESEARCH SERVICES A money manager may avail itself of the Section 28(e) safe harbour so long as the manager: determines that the product or service is eligible under the statute; uses the item in performing its decision-making responsibilities for accounts over which the manager exercises investment discretion; and makes a good faith determination that the amount of commissions paid is reasonable in relation to the value of research or brokerage product or service received. RESEARCH SERVICES Eligibility: Expression of Reasoning or Knowledge In order for a product or service to constitute research services under the safe harbour, the product or service must constitute advice, analyses or reports within the meaning of the statute. The proposed interpretive release gives guidance that in order to constitute advice, analyses or reports, the money manager must make the determination that the product or service reflects the expression of reasoning or knowledge. Moreover, even if the product constitutes advice, analysis, or a report, the money manager must determine that the subject matter of the product or service falls within the categories specified in the statute. That is, advice must relate 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 and analyses and reports must relate to issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts. Examples of potentially permissible research services described in the proposed interpretive release include: traditional research reports, financial newsletters and trade journals relating to the subject matter specified in the statute; software that both analyzes securities portfolios and reflects the expression of reasoning or knowledge; seminars or conferences on a subject matter specified in the statute, and market or economic data. Services deemed not to reflect the expression of reasoning and knowledge include products with inherently tangible or physical attributes, such as telephone lines, office furniture, and operational overhead expenses. Contrary to the 1986 release, computer hardware and computer accessories are not eligible for research services since they are deemed not to reflect substantive content related to investment decision-making by the manager. Lawful and Appropriate Assistance In addition to meeting the statutory criteria, a product or service must also provide the money manager with lawful and appropriate assistance in making investment decisions. The proposed interpretive release states that whether a product provides lawful and appropriate assistance is determined largely on how the eligible product or service is used by the manager. For instance, account performance analyses used for marketing purposes do not fall within the safe harbour, but may fall within the safe harbour when used for investment decision-making purposes. Where eligible research is used for purposes within and outside of Section 28(e), the manager must treat the product or service as a mixed-use item and use client commissions to pay only the allocable portion of the item attributable to use for investment decision-making. BROKERAGE SERVICES Eligibility: Temporal Standard Section 28(e) explicitly states that brokerage products and services that are eligible under the safe harbour include activities required to effect securities transactions, functions incidental to securities transactions (e.g., clearance, settlement and custody), and services that are required by the rules of the SEC or self-regulating organisations. The proposed interpretive release proposes a temporal standard for brokerage services under Section 28(e) whereby eligible brokerage services are those services provided between the time that an order is transmitted to a broker-dealer and the time that the transaction is cleared and settled (i.e., when funds or securities are delivered or credited to the advised account or the account holder s agent). Services provided prior to an order transmission may fall within the research portion of the safe harbour, but are not eligible under the brokerage portion of the safe harbour. 2 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

3 Under the proposed temporal standard, communications services related to execution, clearance and settlement and other incidental functions are eligible brokerage services. Moreover, algorithmic trading software and trading software used to route orders to market centers constitute brokerage under the safe harbour. Although peripherals and delivery mechanisms associated with computer hardware (e.g., telecommunications lines, transatlantic cables, and computer cables) are deemed to fall outside of the research services safe harbour, they may be eligible under the brokerage services safe harbour since the transmission of orders is considered to be a core part of the brokerage service. However, products and services that are not integral to the execution of orders by broker-dealers and fall outside of the temporal standard do not qualify as brokerage in the safe harbour. Examples of ineligible products or services under the proposed temporal standard include: order management systems used by managers to manage their orders (whether developed inhouse by the manager or by a third-party) and hardware (e.g., telephones or computer terminals); trade analytics, and surveillance systems. The proposed interpretive guidance also confirms that error correction trades or related services in connection with errors made by money managers are not eligible brokerage services under the safe harbour since they do not benefit the advised account and are separate transactions to correct the manager s error. Lawful and Appropriate Assistance As with research products and services, eligible brokerage products and services must provide the money manager with lawful and appropriate assistance in carrying out its responsibilities and a good faith determination must be made by the money manager that the amount of commissions paid is reasonable in relation to the value of the brokerage product or service received. MIXED-USE ITEMS The proposed interpretive release reiterates the SEC s guidance in its 1986 release regarding the mixed-use standard: if a money manager uses a research product or service for both research and non-research functions, the money manager must make a reasonable allocation of the cost of the product according to its use (i.e., the percentage of the product that provides assistance to the investment decision-making process may be paid for with soft dollars whereas the other non-research portion must be paid for by the manager with hard dollars). The manager must keep adequate records of these allocations to make a good faith determination that the amount paid for the mixed-use item in soft dollars was reasonable in relation to the value of the research product or service received. GOOD-FAITH DETERMINATION AS TO REASONABLENESS Each money manager seeking to avail itself of the safe harbour bears the burden of proof that it has made a good faith determination that the commissions paid are reasonable in relation to the value of brokerage and research services received, whether in terms of a particular transaction or the manager s overall responsibilities for its discretionary accounts. The SEC also emphasized that managers must make a good faith determination that any additional commissions paid for simply copied, repackaged, or aggregated products or services are reasonable. THIRD-PARTY RESEARCH In third-party research arrangements, money managers may use client commissions to obtain research produced by someone other than the executing broker-dealer. The proposed interpretive release clarifies that research provided under these arrangements is eligible under Section 28(e) so long as the brokerdealer effecting the trade (e.g., clearance and settlement) is legally obligated to pay for any third party research provided to a money manager. COMMISSION-SHARING ARRANGEMENTS Commission-sharing arrangements may be used by money managers as a means to acquire research via commissions. The proposed interpretive release addressed commission-sharing arrangements. These arrangements allow managers to execute trades with one broker-dealer and obtain research or other services from another broker-dealer. Under the proposed interpretive release, the roles assumed by each broker-dealer will determine whether a commissionsharing arrangement is permissible under Section 28(e). In order for a commission-sharing arrangement under which research and brokerage services are provided to fall within the safe harbour, the proposed interpretive release requires the following elements to be present: The commission-sharing arrangement must be part of a normal and legitimate correspondent relationship whereby each broker-dealer s involvement is more significant than the mere receipt of commissions paid for research services provided to money managers. This means that the introducing broker-dealer must: 3 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

4 be financially responsible to the clearing broker-dealer for all customer trades until the clearing broker-dealer receives payment (or securities); make and/or maintain records relating to its customer trades required by SEC and SRO rules (e.g., blotters and memoranda of orders); monitor and respond to customer comments concerning the trading process; and generally monitor trades and settlements. The broker-dealer effecting the trade must be legally obligated to pay for any third-party research or brokerage services or products provided to a money manager. CONCLUSION Comments on the proposed interpretive release must be submitted to the SEC on or before the thirtieth day after the release is published in the Federal Register. Specifically, the SEC is seeking comments on whether the proposed release is an accurate reflection of industry practices, whether there are any other significant issues under Section 28(e) that were not addressed, and whether the interpretive guidance would affect the level and distribution of costs, and if so, whether these effects would be beneficial to investors or otherwise serve the public interest. The SEC specifically requested comments on the extent to which client commissions are paid for proxy voting services and mass-marketed publications, and whether additional guidance from the SEC would be useful in these areas. The SEC has also requested comments on whether the final interpretive release should provide firms time to implement the interpretation. Michael S. Caccese mcaccese@klng.com Christina H. Lim clim@klng.com OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

5 EXAMPLES OF ELIGIBLE AND INELIGIBLE RESEARCH AND BROKERAGE PRODUCTS AND SERVICES ELIGIBLE RESEARCH ITEMS financial newsletters/trade journals* quantitative analytical software and software that provides analyses of securities portfolios* seminars or conferences* consultant fees for advice on portfolio strategy company financial data economic data (e.g., unemployment and inflation rates or gross domestic product figures) market data (e.g., stock quotes, last sale prices and trading volumes) * Eligible only if the product or service relates to the subject matter specified in Section 28(e). ELIGIBLE BROKERAGE SERVICES clearance, settlement and custody services post-trade matching exchange of messages among brokerage dealers, custodians, and institutions electronic communication of allocation instructions between institutions and broker-dealers routing settlement instructions to custodian banks and broker-dealers clearing agents services required by the SEC or SRO rules (e.g., use of electronic confirmation and affirmation of institutional trades) connectivity service between the money manager and broker-dealer and other relevant parties such as custodians (incl. dedicated lines between the broker-dealer and 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, message services used to transmit orders to broker-dealers for execution). trading software operated by a broker-dealer to route orders to market centers algorithmic trading software INELIGIBLE RESEARCH ITEMS telephone lines office equipment, furniture and business supplies salaries (incl. research staff) rent accounting fees and software website design software internet service legal expenses personnel management marketing utilities membership dues professional licensing fees software to assist with administrative functions (e.g., operating systems, word processing) travel expenses, entertainment, meals associated with attending seminars computer hardware and computer accessories computer peripherals and delivery mechanisms (e.g., telecommunications lines, transatlantic cables, computer cables) consultant fees on internal management or operations INELIGIBLE BROKERAGE SERVICES order management systems ( OMS ) used by money managers to manage orders (both in-house and third-party OMS) and hardware (e.g., telephones or computer terminals) trade analytics surveillance systems compliance mechanisms error correction trades or related services in connection with errors by money managers 5 OCTOBER 2005 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP

6 If you have questions or would like more information about K&LNG s Investment Management Practice, please contact one of our lawyers listed below: BOSTON Michael S. Caccese mcaccese@klng.com Mark P. Goshko mgoshko@klng.com Thomas Hickey III thickey@klng.com Nicholas S. Hodge nhodge@klng.com George Zornada gzornada@klng.com LONDON Philip Morgan pmorgan@klng.com LOS ANGELES William P. Wade wwade@klng.com NEW YORK Robert J. Borzone, Jr rborzone@klng.com Jeffrey M. Cole jcole@klng.com Ricardo Hollingsworth rhollingsworth@klng.com Beth R. Kramer bkramer@klng.com Richard D. Marshall rmarshall@klng.com Keith W. Miller kmiller@klng.com Scott D. Newman snewman@klng.com SAN FRANCISCO Eilleen M. Clavere eclavere@klng.com Jonathan D. Joseph jjoseph@klng.com David Mishel dmishel@klng.com Timothy B. Parker tparker@klng.com Mark D. Perlow mperlow@klng.com Richard M. Phillips rphillips@klng.com WASHINGTON Clifford J. Alexander Diane E. Ambler Mark C. Amorosi calexander@klng.com dambler@klng.com mamorosi@klng.com Catherine S. Bardsley cbardsley@klng.com Arthur J. Brown Arthur C. Delibert Jennifer R. Gonzalez Robert C. Hacker Kathy Kresch Ingber Michael J. King Rebecca H. Laird Deborah A. Linn Cary J. Meer abrown@klng.com adelibert@klng.com jgonzalez@klng.com rhacker@klng.com kingber@klng.com mking@klng.com rlaird@klng.com dlinn@klng.com cmeer@klng.com R. Charles Miller cmiller@klng.com Dean E. Miller Charles R. Mills Jean E. Minarick dmiller@klng.com cmills@klng.com jminarick@klng.com R. Darrell Mounts dmounts@klng.com C. Dirk Peterson dpeterson@klng.com David Pickle Alan C. Porter Theodore L. Press dpickle@klng.com aporter@klng.com tpress@klng.com Francine J. Rosenberger francine.rosenberger@klng.com Robert H. Rosenblum rrosenblum@klng.com William A. Schmidt william.schmidt@klng.com Lori L. Schneider lschneider@klng.com Lynn A. Schweinfurth lschweinfurth@klng.com Donald W. Smith dsmith@klng.com Martin D. Teckler mteckler@klng.com Robert A. Wittie rwittie@klng.com Robert J. Zutz rzutz@klng.com www. klng. com BOSTON DALLAS HARRISBURG LONDON LOS ANGELES MIAMI NEWARK NEW YORK PALO ALTO PITTSBURGH SAN FRANCISCO WASHINGTON Kirkpatrick & Lockhart Nicholson Graham (K&LNG) has approximately 1,000 lawyers and represents entrepreneurs, growth and middle market companies, capital markets participants, and leading FORTUNE 100 and FTSE 100 global corporations nationally and internationally. K&LNG is a combination of two limited liability partnerships, each named Kirkpatrick & Lockhart Nicholson Graham LLP, one qualified in Delaware, U.S.A. and practicing from offices in Boston, Dallas, Harrisburg, Los Angeles, Miami, Newark, New York, Palo Alto, Pittsburgh, San Francisco and Washington and one incorporated in England practicing from the London office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1988 We may contact you from time to time with information on Kirkpatrick & Lockhart Nicholson Graham LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please cgregory@klng.com if you would prefer not to receive this information KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP. ALL RIGHTS RESERVED.