SEC Releases Soft Dollar Guidance

Yesterday, the SEC issued a long-awaited interpretive release concerning the Section 28(e) safe harbor for soft dollars. According to the SEC, a particular goal of the release is to clarify the scope of "brokerage and research services" in light of evolving technologies and industry practice. The SEC is seeking comment on its guidance.

At its September 21 open meeting, the SEC proposed a slightly revised interpretation of The safe harbor found in Section 28(e) of the Securities Exchange Act of 1934 ("Safe Harbor") that will further clarify, and partially restrict, the SEC’s interpretation of the phrase "research and brokerage" within that Safe Harbor. The proposed interpretation largely repeats the standard put forth in the SEC’s 1986 interpretation of the Safe Harbor (1986 Release) that the term "research” includes an item that provides lawful and appropriate assistance to a money manager in its investment decision-making. The release will not impact the discussions of best execution, third-party research or mixeduse items in the 1986 Release. A few items of note include:

• The proposal largely adopts the November 11, 2004 recommendation of the NASD’s Mutual Fund Task Force (NASD Task Force) to limit the scope of the Safe Harbor to the “intellectual content” of research;
• The proposal would narrow the definition of “research” to exclude most computer hardware and order management systems;
• Market data and mass marketed publications would remain within the Safe Harbor if used to aid the money manager’s investment decision-making;
• The lack of discussion on unbundling of commissions should indicate that the SEC would not force unbundling under its proposal; and
• The SEC will emphasize that for transactions to fall within the Safe Harbor, broker-dealers must be financially responsible for the research and brokerage they provide, and they must effect transactions generating the commissions paying for brokerage and research.

Discussions at an open meeting provide only a brief sketch of what the SEC’s proposal contains. Further details will have to await its publication on the SEC website and in the Federal Register. Below is a description of statements by the SEC and its Staff at yesterday’s open meeting.

Under the SEC’s proposed interpretation, the term "research" would be limited to advice, analysis or reports with intellectual content (including market data). The term therefore would not include computer hardware, order management systems, operational expenses, and salaries of research staff or other general overhead items. The staff indicated that, in the years since the 1986 Release, computer hardware has become commonplace and is no longer linked to the analytical content it may provide. In a sense, computer hardware has become more like typewriters and telephones, as a general overhead item, rather than a specialized form of equipment reasonably within the Safe Harbor. Under the proposed interpretation, the term "brokerage" would be limited to items beginning from the point at which a money manager makes an investment decision through settlement of the resulting transaction. Long term custody of assets therefore would not be within the Safe Harbor.

The SEC’s release will also reiterate that the payment for mixed-use items (those with both a research and a non-research use) must be reasonably allocated by the money manager relying on the Safe Harbor and that allocation must be documented by the money manager. In a proposed position that, if approved, may prompt the restructuring of some soft dollar arrangements, the SEC proposed to say that in order for a transaction to fall within the Safe Harbor, a broker-dealer must be financially responsible for the research and brokerage it provides and must effect the transaction (i.e., must perform more than a nominal role).

The SEC stated that mass marketed commercial publications would remain within the Safe Harbor, because it was too difficult to develop a clear standard reasonably distinguishing mass marketed publications from publications of more restricted circulation. Although some commenters thought that mass marketed publications were more properly categorized as overhead, the SEC determined that because relatively few money managers use soft dollars to pay for these items, and they are often inexpensive, these factors coupled with the difficulty in developing a clear standard argued against addressing their status in the proposed interpretation.

According to Larry Bergmann (Associate Director, Division of Market Regulation), the interpretation the SEC will propose is similar to the approach of the United Kingdom’s Financial Services Authority (FSA), whose approach would require materials to reflect "original thought and intellectual rigor" to be paid for with brokerage commissions. Mr. Bergmann continued that unlike the FSA, the SEC interpreted a statue in developing its proposal, while the FSA started with concerns about conflicts of interest and developed its approach from that vantage point. Some distinctions between the FSA’s rules and the SEC’s proposed interpretation is that the FSA’s rules exclude market data from items that may be purchased with commissions, while the SEC’s proposal would permit market data to remain within the Safe Harbor, provided it is used to assist a money manager in its investment decision-making. Another difference is that the FSA’s rules would exclude seminars from items that may be paid for with commissions, whereas the SEC’s proposal would allow seminars to be within Safe Harbor. The SEC’s proposed interpretation would not permit related travel expenses to be included within the Safe Harbor, however.

Mr. Bergmann also said the proposed interpretation largely followed the recommendations of the NASD Task Force and the industry’s comments. For example, the NASD Task Force recommended that a variety of items be excluded from the Safe Harbor, such as computer hardware and software without intellectual content.

In response to questions, Robert Colby (Acting Director, Division of Market Regulation) stated that post-trade analytic software may be research if a money manager determines it helps with its investment decision-making process. Order management systems, however, would be treated as overhead, and therefore outside the Safe Harbor. Mr. Colby also stated that the release would not impact the 1986 Release’s discussion of best execution, mixed-use items or third-party research.

Meyer Eisenberg (Acting Director, Division of Investment Management) said to expect a recommendation on enhanced disclosure of soft dollar practices by mutual funds soon, but he was not able to provide a timeframe. He called it "an urgent matter," however.

Commissioner Annette Nazareth cited a concern that the release does not provide for sufficient transparency about how money managers are spending commission dollars. She therefore stressed the need to keep fund boards of directors well informed about the details of the use of fund commissions for soft dollar research. She also stated her strongly held views that market data is squarely within the definition of research under the Safe Harbor.

The comment period for the interpretation will be 30 days from the date of publication in the Federal Register. The SEC did not indicate when it expected that publication to occur. The release will seek comment on such items as whether market data should be included in the Safe Harbor, whether post-trade analytics should be included in the Safe Harbor, and how much time firms will have to come into compliance with the new interpretation. Morgan, Lewis will provide a more detailed analysis of the SEC’s proposal after it is published.

Securities Industry FYI is a service of the BrokerDealer and Investment Management Practices of Morgan Lewis. If you have any questions concerning these important legal developments, please contact any of the following Morgan Lewis attorneys:

Washington, D.C.
Steven W. Stone
202.739.5453
sstone@morganlewis.com

Mark D. Fitterman
202.739.5019
mfitterman@morganlewis.com

John V. Ayanian
202.739.5946
jayanian@morganlewis.com

Jack P. Drogin
202.739.5380
jdrogin@morganlewis.com

T.R. Lazo
202.739.5350
tlazo@morganlewis.com