July 2006 StayCurret A Cliet Alert from Paul Hastigs SEC Issues Fial Soft Dollar Guidace Iterpretative Guidace Limits, But Does Not Prohibit, Use of Soft Dollars Fial Release Makes Importat Chages From Proposed Iterpretative Release Issued i October 2005 From the Ivestmet Maagemet Practice Group The Securities ad Exchage Commissio ( SEC ) has issued iterpretative guidace o soft dollars (the 2006 Release ) that limits, i importat respects, the scope of the safe harbor i Sectio 28(e) of the Securities Exchage Act of 1934 ( Sectio 28(e) ) for both research ad brokerage services ad provides a ew iterpretatio with respect to the applicability of the Sectio 28(e) safe harbor to third party commissio sharig arragemets.1 The 2006 Release follows the SEC s issuace of proposed iterpretative guidace (the Proposed Release ) o October 19, 20052 ad takes ito accout the commets received by the SEC durig the commet period. The 2006 Release was developed after substatial idustry iput3 ad follows the adoptio of ew stadards i the Uited Kigdom by the Fiacial Services Authority (the FSA Policy Statemet ).4 The 2006 Release retais, i substatial form, the eligibility of brokerage ad research services for the Sectio 28(e) safe harbor, particularly as set forth i the SEC s 1986 iterpretative release o Soft Dollar Arragemets, Rel. No. 34-23170, April 23, 1986 (the 1986 Release ). The 2006 Release, however, i geeral, limits the availability of the safe harbor i two respects. First, with respect to research, the availability of the safe harbor exteds oly to advice, aalyses ad reports (thereby precludig its availability for items like computer hardware ad overhead). Secod, the 2006 Release establishes a ew temporal test for determiig the availability of the safe harbor for brokerage services. Pursuat to this test, oly products ad services relatig to the executio of a trade, determied from the time that the moey maager commuicates with the broker for purposes of trasmittig a order through the coclusio of clearace ad settlemet of the trasactio, may be cosidered to fall withi the safe harbor. The 2006 Release also sets forth a coceptual framework, or checklist, which the SEC believes should be followed i aalyzig whether a particular product or service falls withi the safe harbor. Moey maagers would be wise to review all of their soft dollar practices through the prism of the SEC s aalytical framework ad documet how each product or service satisfies the stadards of the Fial Release. Fially, the 2006 Release adopts a ew iterpretatio relatig to commissio sharig arragemets, abadoig its former iterpretatio which required that (i) i order for research to be cosidered to be provided by the commissio broker-dealer (ad therefore eligible for the Sectio 28(e) safe harbor), the commissio broker-dealer must have the direct legal obligatio to pay for the research, ad (ii) requirig that i order for a broker-dealer to be deemed to be effectig a trasactio (ad therefore eligible for the Sectio 28(e) safe harbor), each broker-dealer must play a role i effectig securities trasactios that goes beyod the mere provisio of research services to moey maagers. Istead, the 2006 Release sets forth a set of factors to be cosidered whe determiig whether the requiremets relatig to the providig of research ad effectig trasactios are met. The 2006 Release is effective upo its publicatio i the Federal Register (most likely i August). Market participats may however cotiue to rely o the SEC s prior iterpretatios of Sectio 28(e) util 6 moths after the publicatio of the 2006 Release i the Federal Register. While the ew guidace relatig to third party commissio sharig arragemets is also fial, the SEC is solicitig commet o its ew iterpretatio. Commets must be received o or before 45 days of the publicatio of the 2006 Release i the Federal Register. Paul Hastigs atioally recogized Ivestmet Maagemet Practice Group cotiues to be highly raked amog the top law firms by et assets of all mutual fud cliets as reported by Lipper, a Reuters Compay.
StayCurret Backgroud Sectio 28(e) establishes a safe harbor that allows moey maagers to use cliet assets, i the form of brokerage commissios, to purchase brokerage ad research services for their maaged accouts without breachig their fiduciary duty to their cliets. Abset the safe harbor provided by Sectio 28(e), the use of cliet commissios to purchase brokerage or research services may have bee deemed to be a breach of fiduciary duty if the moey maager paid more tha the lowest commissio rate available to execute a trade. The Sectio 28(e) safe harbor was eacted i 1975, ad for more tha thirty years ow Cogress ad the SEC have recogized the value of research to moey maagers i maagig cliet accouts ad the appropriateess of usig cliet commissios to pay for that research. Through various iterpretative releases issued over the years, the parameters of the Sectio 28(e) safe harbor have expaded ad cotracted from time to time.5 The market for soft dollar products has also developed ad grow, resultig i a far greater array of products ad services available today tha was the case i 1975. The 2006 Release - The Aalytical Framework for Applyig Sectio 28(e) The 2006 Release retais the stadard first adopted by the SEC i the 1986 Release requirig that i order for a product or service to satisfy the safe harbor of Sectio 28(e), the product or service must provide lawful ad appropriate assistace to the moey maager i the carryig out of his resposibilities. The 2006 Release makes clear that this stadard applies ot oly to research services but also to brokerage services.6 The 2006 Release also sets forth a three prog test for both research ad brokerage that the SEC believes moey maagers should follow i determiig whether a product or service falls withi the Sectio 28(e) safe harbor. A. Test 1 Does the product or service fall withi the specific statutory limits of Sectio 28(e)(3)(A), (B), or (C). This prog of the test must be aalyzed separately for research ad brokerage services. Research Services The Advice, Aalyses ad Reports test. Sectio 28(e) defies the ature of permitted research services as either (i) advice, either directly or through publicatios or writigs, as to the value of securities, the advisability of ivestig i, purchasig or sellig securities, ad the availability of securities or purchasers or sellers of securities, or (ii) aalyses ad reports cocerig issuers, idustries, securities, ecoomic factors ad treds, portfolio strategy, ad the performace of accouts.7 I determiig whether research satisfies the advice, aalyses ad reports test, the 2006 Release states that the research must reflect expressios of reasoig or kowledge ad that the reasoig or kowledge must relate to the subject matter idetified i Sectio 28(e).8 The cotet may be origial research or a sythesis, aalysis or compilatio of the research of others. The 2006 Release states that products ad services with iheretly tagible ad physical attributes (ad without research cotet) do ot satisfy this test. Products or Services That Satisfy the Advice, Aalyses ad Reports Test traditioal research reports aalyzig a compay or stock, discussios with research aalysts, meetigs with corporate executives to obtai oral reports o a issuer, certai fiacial ewsletters ad trade jourals relatig to the subject matter of Sectio 28(e) that are ot mass-marketed (see discussio below regardig mass-marketed publicatios), quatitative aalytical software, order maagemet systems, ad software that provides aalysis relatig to the subject matter of Sectio 28(e) (see discussio below relatig to market research reports), corporate goverace research (icludig corporate goverace aalytics) ad corporate goverace ratig services if they reflect the expressio or reasoig or kowledge ad they relate to the subject matter of Sectio 28(e), market data reports, icludig stock quotes, last sale price reports, tradig volume whether or ot the data has bee aalyzed or maipulated by the provider, compay fiacial data, ecoomic data such as uemploymet reports, iflatio rates or gross domestic product figures, certai proxy services that provide reports ad aalysis o issuers, securities ad the advisability of ivestig i securities if it relates to the ivestmet fuctio, ad semiars ad cofereces where the cotet satisfies the above requiremets.
StayCurret Products or Services That Do Not Satisfy the Advice, Aalyses ad Reports Test office equipmet, icludig office furiture, busiess supplies, telephoe lies, salaries (icludig research staff), ret, accoutig fees ad software, website desig, e-mail software, iteret service, legal expeses, persoel maagemet, marketig, utilities, membership dues (icludig iitial ad maiteace fees paid o behalf of the moey maager or ay of its employees to ay orgaizatio or represetative or lobbyig group or firm), professioal licesig fees, software to assist with the admiistrative fuctio (such as maagig back-office fuctios, operatig systems ad word processig) ad equipmet maiteace ad repair services, operatioal overhead, icludig travel expeses, etertaimet, meals associated with attedig cofereces or semiars or associated with arragig trips to meet corporate executives, aalysts or other idividuals who may be providig research orally, computer hardware (icludig computer termials) ad computer accessories, icludig telecommuicatio lies, trasatlatic cables ad computer cables, Mass-marketed publicatios (see discussio below), ad Proxy services relatig to the mechaical aspects of votig, such as castig, coutig, recordig, ad reportig votes or services that provide research that assist the maager i determiig how to vote a proxy. Market Research. The 2006 Release provides that market research may fall withi the Sectio 28(e) safe harbor eve if provided through order maagemet systems ad trade aalytical software. For example, the 2006 Release otes that such research may iclude pre-trade aalytics, software ad other products that deped o market iformatio to geerate research, icludig research o optimal executio veues ad tradig strategies. I additio, advice from broker-dealers o order executio, icludig advise o tradig strategies, market color, ad the availability of buyers ad sellers (ad software that provides this iformatio) may be eligible.9 Mass-marketed publicatios. With respect to mass-marketed publicatios, the 2006 Release states that the Sectio 28(e) safe harbor is ot available because the cost of these publicatios should be cosidered to be overhead. Mass-marketed publicatios are defied as those publicatios that are iteded for ad are marketed to a broad public audiece, as opposed to publicatios that are desiged to serve a specialized group (these latter publicatios ca be cosidered research). The method of distributio is ot relevat so that, for example, the fact that a trade joural is available over the iteret to the geeral public does ot make it mass-marketed. The 2006 Release states that the test is whether the trade magazie or techical joural, for example, is marketed to, ad iteded to serve the iterests of, a arrow audiece rather tha the geeral public. Obviously this defiitio leaves ample room for factual iterpretatio ad is likely to be a source of some difficulty i certai circumstaces. As we discussed above, i each case it is ot eough that the product or service costitute advice, aalyses ad reports to satisfy the first prog of the test. I additio, the product or service must relate to the the value of securities, the advisability of ivestig i, purchasig or sellig securities, the availability of securities or purchasers or sellers of securities or cocer issuers, idustries, ecoomic factors ad treds, portfolio strategy, ad the performace of accouts. So, for example, a cosultig service with respect to portfolio strategy would satisfy the first prog of the test, but a cosultig service relatig to the moey maager s admiistratio or operatios would ot. Brokerage Services The Temporal Test. Uder this test, oly brokerage services that relate to the executio of securities trasactios ad that occur betwee the time a order is trasmitted to a broker-dealer ad the ed of the clearace ad settlemet of the trasactio are eligible for the safe harbor.10 This test is desiged to distiguish betwee brokerage services that are eligible for the safe harbor ad overhead-related services which are ot. Eligible brokerage products ad services iclude ot oly products ad services required to effect securities trasactios, but also products ad services that are icidetal to these fuctios ad products ad services relatig to fuctios required by the SEC or by the rules of a self-regulatory body ( SRO ). Brokerage Services That Satisfy the Temporal Test executio clearig ad settlemet services, post trade matchig of trade iformatio, exchage of messages amog broker-dealers, custodias ad istitutios related to the trade, electroic commuicatio of allocatio istructios betwee istitutios ad broker-dealer, routig settlemet istructios to custodia baks ad clearig agets, electroic cofirmatio ad affirmatio of istitutioal trades,
StayCurret short-term custody related to effectig particular trasactios i relatio to clearace ad settlemet of the trade, commuicatio services related to the executio, clearig ad settlemet of securities trasactios ad other icidetal services (i.e., coectivity service betwee the moey maager ad the broker-dealer ad other relevat parties such as the custodia), such as dedicated lies betwee the broker-dealer ad the moey maager s order maagemet system, dedicated lies betwee a broker-dealer ad the order maagemet system of a third party, dedicated direct dial lies with the tradig desk of a broker-dealer, message services used to trasmit orders to brokerdealers for executio, or tradig software to route orders, algorithmic tradig software, ad software used to trasmit orders to direct market access systems. Brokerage Services Do Not Satisfy the Temporal Test order maagemet systems used to maage orders (as oted, such systems may be permitted uder the research prog of Sectio 28(e)), hardware, such as telephoes ad computer termials (icludig those used to coect with order maagemet systems ad tradig software), software fuctioality used for recordkeepig or admiistrative purposes, such as maagig portfolios, ad quatitative aalytical software used to test what if scearios related to adjustig portfolios, asset allocatio or portfolio modelig, surveillace systems ad compliace mechaisms (such as systems that perform compliace tests to idetify uusual tradig patters, aalysis of brokerage executio, portfolio turover rate, aalysis of comparative performace of similarly maaged accouts, compliace with ivestmet parameters, stress testig or aalysis to idetify style drift), trade fiacig, such as stock ledig fees, capital itroductio ad margi services, log term custody arragemets ad custodial recordkeepig provided i coectio with accouts after clearace ad settlemet, or B. Test 2 - The Lawful ad Appropriate Assistace Test. Oce a product or service has bee determied to have satisfied the advice, aalyses ad reports test, for research, or the temporal test, for brokerage, the moey maager must review how it uses the product or service to determie if the product or service meets the secod test, the lawful ad appropriate assistace test. For example, with respect to research, i order to satisfy the lawful ad appropriate assistace test, the research must be used by the moey maager i performig its ivestmet decisio-makig fuctio. So, for example, while software that performs aalysis of the performace of accouts satisfies the advice, aalyses ad reports test, if that software is used to geerate marketig reports, rather tha to maage the accout, the it falls outside the 28(e) safe harbor because it fails the lawful ad appropriate assistace test. C. Test 3 The Cost Test. The third prog of the aalysis is whether the moey maager ca determie, i good faith, that the amout of cliet commissios paid for the product or service is reasoable i light of the value of the products or services provided by the broker dealer to the moey maager. The 2006 Release states the burde of proof i demostratig compliace with this test rests with the moey maager ad provides a umber of cautios to moey maagers, otig that they caot acquire eligible products, such as market data, to camouflage the paymet to broker-dealers for ieligible services, such as self space. I additio, the 2006 Release otes that i performig this cost aalysis, the moey maager should take ito accout the reasoableess of the commissios paid for products or services that are merely repackaged, copied or aggregated. Mixed Use Items The 2006 Release cotiues to permit the use of mixeduse items first recogized i the 1986 Release. The 2006 Release reiterates the guidace provided i the 1986 Release relatig to mixed-use items, emphasizig agai that moey maagers must keep adequate books ad records to support the allocatio of the cost of mixed use products ad otes agai that such allocatio must be made o the basis of use of such products. For example, portfolio performace evaluatio products ad services are ofte mixed-use items, as they are used for both research ad marketig purposes. The moey maager must documet i writig the basis for allocatig the cost of these items based o the maager s use of these services for each fuctio. error correctio services.
StayCurret Third Party Research ad Commissio Sharig Arragemets I a departure from the Proposig Release, the 2006 Release sets forth a ew iterpretatio relatig to third party research commissio sharig arragemets. The 2006 Release also solicits commet from the public as to whether its ew iterpretatio requires further clarificatio. As backgroud, Sectio 28(e) requires that the broker-dealer providig the research also be ivolved i effectig the trade. I its 1986 Release, the SEC had established the stadard that such research must be provided by the commissio broker-dealer i order to be eligible for the 28(e) safe harbor. Third party research was cosidered to be provided by the commissio broker-dealer if that broker-dealer had the direct legal obligatio to pay for the research. The 1986 Release provided that the moey maager may participate i selectig the third party research services or products to be provided ad that the third party may sed the research directly to the moey maager so log as the commissio broker-dealer had the legal obligatio to pay for such research.11 The 1986 Release further provided that the broker-dealer providig the research to the moey maager (whether the broker-dealer s ow research or research from a third party) must be ivolved i some maer i effectig the moey maager s trade.12 I the cotext of commissio sharig arragemets ivolvig third party research, the 1986 Release oted that the itroducig broker must be egaged i securities activities of a more extesive ature tha merely the receipt of commissios for research services ad that [e]ach broker- dealer must play a role i effectig securities trasactios that goes beyod the mere provisio of research services to moey maagers. The 1986 Release further oted that a clearig agreemet that satisfies the SRO rule requiremets is ot ecessarily sufficiet to satisfy Sectio 28(e).13 The Proposig Release had proposed to retai these stadards. The 2006 Release departs from these stadards. With respect to effectig trasactios, the 2006 Release provides that i order to be deemed to be effectig a trade, the broker-dealer must perform at least oe of the followig four fuctios (1) takig fiacial resposibility for all customer trades util the clearig broker-dealer has received paymet (or securities), i.e., oe of the broker-dealers i the arragemet must be at risk for the customer s failure to pay, (2) makig or maitaiig records relatig to the customer s trade as required by the SEC or the SRO, (3) moitorig ad respodig to customer commets cocerig the tradig process, ad (4) geerally moitorig trades ad settlemets. I additio, a broker-dealer is deemed to be effectig a trade if it is executig, clearig or settlig the trade. With respect to the providig of research, a broker-dealer may be deemed to be providig research if it is (1) legally obligated to pay for the research, (2) it is ot obligated to pay for the research but (a) it pays the research provider directly, (b) it reviews the descriptio of services to be paid for with cliet commissios uder the safe harbor for red flags that idicate that the service is ot eligible for the safe harbor ad agrees with the moey maager to use cliet commissios oly to pay for those items that reasoably fall withi the safe harbor, ad (c) the broker-dealer develops ad maitais procedures so that research paymets are documeted ad paid for promptly. Legal Obligatios of Parties uder Sectio 28(e) The 2006 Release remids market participats that ot oly moey maagers, but also broker-dealers may be subject to liability uder Sectio 28(e). The 2006 Release otes that if a broker-dealer kows that a moey maager has represeted to its cliet that it will operate solely withi Sectio 28(e) ad the moey maager asks for products or services that are ot withi the scope of the safe harbor, the the broker-dealer may be cosidered to be aidig ad abettig a violatio of the federal securities laws. NOTES 1 SEC Release No. 34-54165, July, 2006. 2 SEC Release No. 34-52635, October, 2005. 3 Such iput icluded the NASD s November 2004 Report of Soft Dollars ad Portfolio Trasactio Costs. 4 See, U.K. Fiacial Services Authority, Policy Statemet 05/9, Budled Brokerage ad Soft Dollar Commissio Arragemets (July 2005) available at http://www.fsa.gov.uk/pages/library/policy/policy/2005/05_09.shtml. 5 For example, the 1986 Release liberalized certai coditios imposed o soft dollars by the SEC i a 1976 release by expadig the availability of the safe harbor to ecompass products ad services that were readily ad customarily available to the geeral public o a commercial basis. The 1986 Release also itroduced the cocept of mixed-use products. I 2001, the SEC modified its iterpretatio of commissios to ecompass certai riskless pricipal trasactios. 6 The 2006 Release expressly replaces the guidace provided i Sectios II ad III of the 1986 Release. 7 The 2006 Release makes clear that the form i which the advice, aalyses or reports are give (e.g., electroic or writte) is irrelevat. 8 The subject matter of Sectio 28(e) meas the value of securities, the advisability of ivestig i, purchasig or sellig securities, ad the availability of securities or purchasers or sellers of securities, ad issuers, idustries, securities, ecoomic factors ad treds, portfolio strategy, ad the performace of accouts. These categories may subsume other categories, so that, for example, a report regardig political factors could fall withi the scope of these categories if these political factors are iterrelated with ecoomic factors. 9 Sice may of these services are provided outside of the temporal test set forth for permissible brokerage services (discussed below), may commetators o the Proposig Release addressed the area. The 2006 Release, while retaiig the temporal test for brokerage services, has attempted to address these cocers by clarifyig that these types of services may costitute research, which is ot subject to a temporal test. 10 Ulike brokerage, research services ca iclude services provided before the commuicatio of a order or after settlemet ad clearace. 11 I cotrast, a moey maager could ot rely o Sectio 28(e) if the broker-dealer merely pays a obligatio the moey maager has icurred to a third party. 12 The 1986 Release otes that this requiremet is iteded to preclude the practice of give-ups where the executig broker-dealer would pay a portio of a commissio to aother broker-dealer that had o role i the trasactio geeratig the commissio. 13 Step-out programs where the moey maager directs the executig broker to allocate a portio of a trade to aother broker-dealer - are eligible for the Sectio 28(e) safe harbor provided that each broker ivolved i the step-out performs substative fuctios i effectig the trade.
StayCurret If you have ay questios about the SEC s fial guidace, or about ivestmet maagemet matters i geeral, please do ot hesitate to cotact ay member of our Ivestmet Maagemet Practice Group: Our Seior Maagemet Team: Michael R. Rosella 212-318-6800 Chair Ivestmet Maagemet Practice Group mikerosella@paulhastigs.com David A. Hearth 415-856-7007 Vice Chair Ivestmet Maagemet Practice Group davidhearth@paulhastigs.com Julie Allecta 415-856-7006 julieallecta@paulhastigs.com Robert E. Carlso 213-683-6299 robertcarlso@paulhastigs.com Wedell M. Faria 202-508-9574 wedellfaria@paulhastigs.com Christopher J. Tafoe 212-318-6713 christophertafoe@paulhastigs.com Michael Glazer 213-683-6207 michaelglazer@paulhastigs.com Jacquelie A. May 212-318-6282 jacqueliemay@paulhastigs.com Mitchell E. Nichter 415-856-7009 mitchellichter@paulhastigs.com Domeick Pugliese 212-318-6295 domeickpugliese@paulhastigs.com Gary D. Rawitz 212-318-6877 garyrawitz@paulhastigs.com Arthur L. Zwickel 213-683-6161 arthurzwickel@paulhastigs.com StayCurret is published solely for the iterests of frieds ad cliets of Paul, Hastigs, Jaofsky & Walker LLP ad should i o way be relied upo or costrued as legal advice. For specific iformatio o recet developmets or particular factual situatios, the opiio of legal cousel should be sought. Paul Hastigs is a limited liability partership. Copyright 2006 Paul, Hastigs, Jaofsky & Walker LLP. 17 Offices Worldwide Paul, Hastigs, Jaofsky & Walker llp www.paulhastigs.com