SEC Adopts Revised Soft Dollars Safe Harbor

On July 12, 2006, the SEC adopted a revised interpretation of Section 28(e) of the Securities Exchange Act of 1934, substantially as proposed in October 2005. The details of the SEC’s action remain sketchy in many areas pending issuance of the formal release adopting the interpretation. The following summary is based on the discussions in the SEC’s open meeting regarding the proposed interpretation.

Significant points from yesterday’s meeting include:

• The SEC relaxed the four factor test for multibroker arrangements and endorsed commission sharing arrangements following the UK approach, but the details remain murky pending issuance of the adopting release. (The SEC will request further comment on commission-sharing arrangements.)
• The SEC clarified that, as in the UK, broker-dealers will be able to pool commission credits received from a money manager until the money manager directs the broker-dealer to pay for research.
• The SEC appeared to impose on broker-dealers responsibilities (suggested previously by members of the staff) to review research they provide (presumably to form a reasonable basis that the research is eligible for the safe harbor), to enter into agreements with money managers to use client commissions only to pay for items within the safe harbor, and to implement procedures to help ensure and document compliance with the safe harbor.
• Mass-marketed, widely available newspapers and magazines are not eligible for the safe harbor, in a shift from the proposed interpretation.
• The presentations and discussions at the open meeting did not touch on order management systems, which the SEC had proposed to exclude from the concept of brokerage.
• The new interpretation goes into effect six months after publication, but firms may rely on it now.
• The SEC’s Division of Investment Management intends to address soft dollar disclosures later this year.

Research

The SEC generally adopted the interpretation of research it proposed in October. In particular, the SEC emphasized that third-party research is eligible for the safe harbor under substantially the same terms as proprietary research.

To constitute Section 28(e) research, an item must meet a three-part test:

1. Item must fall within the categories for research and brokerage in the Exchange Act;
2. Item must assist the money manager in its investment decisionmaking; and
3. Money manager must make a good-faith determination that the amount of commissions paid is reasonable in relation to the value of the research received.

To constitute Section 28(e) research, an item must be either advice or an analysis or report, in each case including substantive content. Examples of research therefore may include:

• Traditional research reports;
• Financial newsletters and trade journals; and
• Tuition for seminars and conferences.

Items not constituting research may include:

• Computer hardware;
• Office overhead;

• Travel expenses relating to seminars and conferences.

   

   

   

Massmarketed, widely available newspapers and magazines are not eligible for the safe harbor, a change from the proposed interpretation.

Brokerage

Under the adopted interpretation, brokerage generally constitutes trade execution and incidental services, such as clearance, settlement, and custody. As proposed in October, brokerage will be limited by a temporal standard beginning when a money manager communicates with the broker-dealer for the purpose of transmitting an order and ending when funds or securities are delivered to the advised account or its agent. Examples of brokerage may therefore include:

• Services transmitting messages between a money manager and a broker-dealer;
• Dedicated transmission lines from a money manager to a broker-dealer;
• Post-trade services, such as providing allocation instructions to clearing brokers; and
• Services required by SEC or SRO rules, such as trade matching services.

Mixed-Use Items

On mixed-use items, the SEC stressed the need for:

• Proper allocation of such items as research, brokerage, or as items the money manager must pay for in hard dollars; and
• Adequate recordkeeping by the money manager to support such allocation.

Commission Sharing

The most significant—but least clearly explained—change from the October proposal related to commission-sharing arrangements. To give money managers greater flexibility in obtaining both best execution and research, the SEC will only require broker-dealers providing research to provide any one of the following services:

• Execution;
• Clearing, settlement, or custody; or

• One of four core functions (presumably):

   

   

1. Being financially responsible for settlement;
2. Creating or maintaining records as required by SEC or SRO rules;
3. Monitoring and responding to customer comments during the trading process; or

4. Generally monitoring trades and settlement.

    

    

The broker-dealer providing research within the safe harbor also must:

• Be obligated to pay or actually pay the research preparer;
• Review the description of the research (presumably to ensure its eligibility for the safe harbor);
• Agree with the money manager to use client commissions only to pay for items within the safe harbor; and
• Develop and maintain procedures to help ensure and document that research is paid for properly.

The SEC also clarified that, just as permitted in the UK, broker-dealers will be able to pool commissions received from a money manager until the money manager directs the broker-dealer to pay for research.

Effective Date

The revised interpretation of Section 28(e) becomes effective six months after its date of publication in the Federal Register. Until then, firms may rely on either the prior interpretation or yesterday’s adopted interpretation.

Investment Management FYI is a service of the Investment Management Practice Group of Morgan Lewis. If you have any questions concerning the important legal developments reflected herein, please contact any member of Morgan Lewis’ Investment Management Practice Group, including:

Washington, D.C.
Steve Stone
202.739.5453
sstone@morganlewis.com

Mark Fitterman
202.739.5019
mfitterman@morganlewis.com

Jack Drogin
202.739.5380
jdrogin@morganlewis.com

Theodore R. Lazo
202.739.5250
tlazo@morganlewis.com