AGENDA. VII(f) GI - Soft Dollars and Commission Sharing Arrangements for BDs and IAs. I. Soft Dollars: A Brief Primer (See Outline, Sections I-III)

Transcription

1 AGENDA VII(f) GI - Soft Dollars and Commission Sharing Arrangements for BDs and IAs David C. Franceski, Jr. Stradley Ronon Stevens & Young, LLP Scott E. Richter JPMorgan Asset Management David M. Sobel Abel/Noser Corp. October 23, 2012 I. Soft Dollars: A Brief Primer (See Outline, Sections I-III) A simple definition classic soft dollars [Fig. 1] directed brokerage [Fig. 2] Conflict of interest, best execution and breach of fiduciary duty Section 28(e) safe harbor (See Outline, Section V) Permissible v. impermissible use of soft dollars: some examples The good faith determination obligation: reasonable relation to value Other variations on the soft dollar theme Commission recapture, commission pools, and expense reimbursement [Fig. 3] Step-out trades [Fig. 4] Client commission arrangements [Fig. 5] Figures reprinted by permission of, and with gratitude to, Gerald T. Lins from materials for 2011 National Meeting, Workshop VI, Commission Sharing Arrangements vs. Traditional Soft Dollar Agreements: What has Changed. See also Soft Dollars and Other Trading Activities, Lemke and Lins, Edition, Securities Law Handbook Series, 2011 Thomson Reuters/West. # v. 1 NSCP National Membership Meeting Washington DC- October 22-24, 2012

2 II. Commission Sharing and Commission Aggregation Arrangements (See Outline, Section IV) Registration requirements What are they and how are they accomplished Separating execution and research Availability of third-party research III. How to Monitor and Oversee Soft Dollar Use Compliance best practices Form ADV Disclosure Requirements (See Outline, Sections VI, IX) Record-keeping obligations Software and service solutions Internal audit and regulatory exam priorities IV. How Mixed-Use Products are Evaluated (See Outline, Section VII) Examples of mixed use products 2006 SEC Release No good faith allocation of use Internal record-keeping V. Current Issues from the BD and IA Perspective (See Outline, Sections VIII, X) Use of third party research Portability of soft dollars and soft dollar credits Sharing research with affiliates SEC Rule 206(4)-5 and compensation to placement agents # v. 1

3 OUTLINE VII(f) GI - Soft Dollars and Commission Sharing Arrangements for BDs and IAs I. Definition of Soft Dollars By: David C. Franceski, Jr. Scott E. Richter David M. Sobel Prepared for: National Society of Compliance Professionals October 23, 2012 Generally Soft Dollars refers to payments from an advisor, in the form of commission dollars, for research or brokerage products or services exchanged for placing securities transactions with that broker-dealer. Often, the exchange involves a payment that is greater than the lowest possible commission rate (thus the name, soft dollars), and unless otherwise permitted by statute or rule might constitute a breach of the advisor s fiduciary duty by using client assets for the advisor s direct benefit. II. Permissible Uses (a) Research Services - Such services may include: Research reports on a particular company or stock; Research analyst discussions; Meetings with corporate executives regarding company performance; Seminars or conferences which include content related to issuers, industries, securities or the similar matters; Portfolio analysis software; Corporate governance research, analytics and rating services reflecting substantive content and bearing on company performance outlook. (b) Market Research - Whether provided directly from a broker-dealer or via order management systems ( OMS ), trade analytical software or other products, the following generally are considered eligible forms of research information: Market color; # v. 1

4 Execution and trading strategy; Pre-trade and post-trade analytics; Optimal execution venues; and Availability of buyers and sellers. (c) Data Services - Provided they contain substantive comment expressing reasoning or knowledge that a service reports such as: Stock quotes; Last sale price; Trading volumes; Company financial data and economic data such as unemployment and GDP figures. (d) Proxy Services - Such services may offer a range of products which satisfy safe harbor standards by providing assistance in investment decision making, including reports on issuers, securities and the wisdom of investing in securities, and corporate governance research and rating services. However, proxy voting services involving the mechanical aspects of voting, such as casting votes, counting, recording and reporting votes, and research guidance in deciding how to vote, are not eligible safe harbor services. Proxy services may qualify as mixeduse items. See Mixed-use Products and Services, infra. III. Typical Soft Dollar Arrangements (a) Classic Soft Dollar Arrangements - The classic soft dollar arrangement is a triangular arrangement among an advisor, its client and the broker-dealer through whom client trades are placed. In return for commission payments which are higher than the lowest rate available, the advisor or money manager receives research and brokerage services from the broker-dealer. The soft dollar arrangement is expressly protected by the safe harbor provisions of Section 28(e) of the Securities Exchange Act of 1934 ( 1934 Act ). See Section 28(e) of the 1934 Act: Soft Dollar Safe Harbor, infra. (b) Directed Brokerage Arrangements - In a directed brokerage arrangement, the client, often a pension plan, mutual fund or private account directs the money manager to execute all or a portion of the client s trades through a particular broker-dealer. In return for the brokerage-commissions from such transactions, the broker-dealer provides services directly to the client or pays eligible client expenses. A number of states and municipalities require that a certain portion of commissions generated by their accounts be directed to broker-dealers located in the state or municipality, and certain clients may require that a portion of # v. 1

5 commissions be directed to broker-dealers with specific diversity profiles - such as businesses owned by women or minorities. Directed brokerage arrangements do not implicate a potential conflict of interest between the money manager and the client and, therefore, do not fall within the safe harbor of Section 28(e) of the 1934 Act, but are nonetheless generally permitted. IV. Variations on Soft Dollar and Directed Brokerage Arrangements (a) Commission Sharing/Commission Aggregation - Under this form of soft dollar arrangement, the money manager s executing broker maintains a commission sharing arrangement with a second broker-dealer, which may provide or pay for third-party research through the use of a commission pool. The money manager bears the burden of making a good faith determination that the commissions paid are reasonable in relation to the value of brokerage and research services provided. Under these arrangements the second broker-dealer, typically the one providing research or brokerage services, will be deemed to be effecting the transaction within the meaning of Section 28(e) if it executes, clears or settles the trade, or performs at least one of the following functions: taking financial responsibility for customer trades; maintaining records relating to customer trades; monitoring and responding to customer comments concerning the trading process; or monitoring trades and settlements. (b) Expense Reimbursement - In this form of directed brokerage the broker-dealer through whom the trades are placed and to whom commissions are paid, in turn, pays certain of the accounts expenses directly. (c) Commission Recapture - Under this variation of directive brokerage, the brokerdealer rebates a portion of an account s brokerage commissions directly to the account. Like expense reimbursement, commission recapture often involves multiple executing broker-dealers and a single coordinating broker-dealer serving as a conduit for the broker-dealers making the rebates or expense reimbursements. (d) Give-ups and Step-out Trades - Prior to 1975 brokers sometimes engaged in commission sharing arrangements known as give-ups, through which a money manager directed a portion of executing broker commissions to another broker in exchange for referrals or fund share sales that did not benefit the client. Such arrangements do not fall within the safe harbor of Section 28(e). Step-out trades, in which the money manager directs the executing broker to allocate all or part of a trade to another broker-dealer for clearance and settlement, do come within the safe harbor, so long as the money manager can demonstrate that the broker-dealer to whom any or all of the trade has been stepped-out is providing a tangible benefit, such as research or improved execution, to the client. A typical step-out arrangement is depicted in Figure 4. # v. 1

6 V. Section 28(e) of the 1934 Act: Soft Dollar Safe Harbor Section 28(e), enacted in 1975 in the wake of the elimination of fixed dollar commissions, provides a safe harbor for soft dollar arrangements, notwithstanding a money manager s common law fiduciary duty to avoid conflicts of interest with its clients, and as follows in pertinent part: (e)(1) no person using the mails or any means or instrumentality of interstate commerce, in the exercise of investment discretion with respect to an account shall be deemed to have acted unlawfully or to have breached a fiduciary duty under State or Federal law unless expressly provided to the contrary by a law enacted by Congress or any State subsequent to June 4, 1975, solely by reason of having caused the account to pay a member of an exchange, broker or dealer an amount of commission for effecting a securities transaction in excess of the amount of commission another member of an exchange, broker, or dealer would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by such member, broker, or dealer, viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion. Subsection (e)(2) of Section 28 outlines the disclosure obligations of a person exercising investment discretion with respect to an account and soft dollar arrangements. Subsection (e)(3) defines in general terms brokerage and research services. And Subsection (e)(4) makes the safe harbor provision inapplicable to futures products. The Section 28(e) safe harbor provision of the 1934 Act presents a number of legal and compliance issues, including but not limited to: (1) The meaning of investment discretion and whether the term relates only to advisory authority to make recommendations, or extends to the power to terminate an investment manager (e.g. pension plan managers), or the management of index funds. (2) What constitutes brokerage and research services, and specifically, what services of typical institutional, retail, clearing or executing brokers are traditional brokerage and which are merely administrative or operational, and as to research, what constitutes substantive content or expression of reasoning or knowledge, and whether third-party research is covered and as to introducing brokers what level of service justifies commission splitting. (3) The nature of the money manager s good faith determination obligations, as to (a) value for commissions (and whether measured by an object or a subjective # v. 1

7 standard), (b) appropriate mixed use allocations, and (c) use of an affiliated broker-dealer to obtain proprietary research. (4) How to allocate mixed-use, and whether such allocation is based on percentage of time or proportionate share (cost) based on separate usage. (5) The definition of, distinction between and legitimacy of give-ups, step-outs and other client commission arrangements. (6) The continuing obligation to obtain best execution and related issues such as money manager determination based on price or commission, bundled versus unbundled orders, and trade sequencing issues. (7) Permissible v. impermissible use of soft dollar arrangements: Some Examples Permissible Research Services Market Research Data Services Proxy Services Impermissible Meals, travel, entertainment Office equipment and furnishings Communication lines, devices and peripherals Utilities Salaries Membership Dues Computer Hardware VI. Form ADV Disclosure Obligations Section 28(e) s safe harbor for engaging in soft dollar transactions does not relieve an investment adviser of its obligation to disclose such practices to its clients. Item 8 of Part 1A of Form ADV, the uniform adviser registration form utilized by the SEC and most states, requires an adviser to disclose whether it or a related person has discretionary authority to determine, among other things, what brokers to use, commission rates paid for client transactions, whether the adviser recommends brokers to clients and whether the adviser receives research or other products from or as a result of client transactions. Form ADV-Part 2, which SEC rules require advisers to deliver to their clients upon entering into an advisory agreement, and to deliver or offer to deliver to the clients every year thereafter, has even more specific disclosure requirements regarding soft dollar # v. 1

8 arrangements. In July 2010, the SEC adopted extensive amendments to Form ADV-Part 2, which became effective in early See IA-3221 (June 22, 2011) Rules Implementing Amendments to the Investment Advisers Act of 1940 (Corrected) File No.: Among the most important changes to the disclosure requirements, Form ADV-Part 2, which may now be provided in summary form to clients as a brochure, must disclose: all existing and potential conflicts of interest; all additional fees incurred (including mark-ups, mark-downs and spreads on securities transactions); the factors considered by the adviser when selecting or recommending a broker; if the advisor receives research or other products or services in exchange for soft dollars, specifics about the nature, extent, cost and allocation across clients of such benefits; whether the adviser s clients pay higher commissions for such products or services; specifics about the adviser s policies and procedures regarding transactions directed to particular brokers during the prior fiscal year; policies, procedures and practices on directed brokerage; order aggregation practices, and if orders are not aggregated, the cost of not doing so; any arrangement oral or written by which the adviser or anyone related to the adviser receives additional compensation or economic benefit (i.e. soft dollar benefits); any compensation paid for client referrals and the policies and procedures for doing so. Of particular significance, in finalizing the changes, the SEC rejected several commenters request that advisers be permitted to answer the Form ADV soft dollar questions based on an adviser s reasonable belief that the benefits received are eligible research and brokerage services subject to the safe harbor protections of Section 28(e). According to the Commission, the safe harbor itself does not include a reasonable belief standard and the Form ADV changes were intended to track the language of the statute. # v. 1

9 VII. SEC Guidance on Soft Dollars and Section 28(e) (a) SEC Release No (1976) The first of four major releases by the commission interpreting Section 28(e) and addressing the use of commission payments by fiduciaries, Release No , just five paragraphs long, (i) identified a number of soft dollar uses, including give-ups, that the Commission did not regard as part of the brokerage or research services covered by Section 28(e), (ii) reiterated the general principal of Section 28(e) that a money manager does not breach fiduciary duties under state or federal law solely by paying brokerage commissions in excess of the amount another broker-dealer would have charged if the manager determines in good faith that the commission is reasonable in relation to the value of brokerage and research services received, (iii) noted the competitive research and brokerage practices which had existed prior to the elimination of minimum exchange commission rates in May, 1975, (iv) emphasized that soft dollars may not be used to pay for products or services customarily available and offered to the general public on a commercial basis, or for give-ups and (v) underscored that inappropriate soft dollar practices and arrangements may constitute fraudulent acts and practices by fiduciaries. (b) SEC Release No (1986) In 1986, based on the prior ten year history and an examination of client commission practices in , the Commission concluded that the 1976 standard announced in Release No was difficult to apply and unduly restrictive in some circumstances, as research products and brokerage services and their method of delivery had, in the interim, proliferated and become more complex, thus impeding money managers from obtaining, for commission dollars, the necessary research and brokerage goods and services to aid them in making informed investment decisions for their clients. Thus, the Commission withdrew the blanket prohibition against the use of soft dollars for products or services that were readily and customarily available and offered to the general public in favor of a more flexible good faith standard. The 1986 release also reaffirmed that, under appropriate circumstances, money managers might use client commissions to obtain third-party research, that is, research produced by someone other than the executing broker-dealer, emphasized the importance of written disclosure of commission arrangements to clients and reiterated an advisor s duty to seek best execution. The 1986 Release also introduced the concept of mixed-use, that is, a product or service obtained with client commissions, such as accounting or marketing, that may serve functions unrelated to the investment decision-making process. The 1986 Release made clear that for such products, a money manager needed to make a reasonable allocation of the cost of the product according to its use, and keep adequate books and records regarding such allocations. Any conflict of interest posed by such allocations must be disclosed to the client. Finally, the 1986 Release specifically endorsed the use of soft dollars to acquire third-party research under appropriate circumstances. # v. 1

10 (c) SEC Release No (2001) Prior to 2001, according to the Commission, the safe harbor provisions of Section 28(e) applied only to commissions paid to, and soft dollars generated from, a broker-dealer acting in an agency capacity. In 2001, following a request for reconsideration from the NASDAQ stock market, the commission in Release No expanded the safe harbor of Section 28(e) to certain riskless principal transactions effected by NASD members and reported in accordance with NASD trade reporting and disclosure rules. (d) SEC Release No (2006) In July 2006, the SEC issued its most comprehensive release relating to Section 28(e) and soft dollar use. While reaffirming its long held position that Section 28(e) applies equally to proprietary research (typically from full service broker-dealers) and third-party research (generated by parties other than the broker-dealer), the 2006 Release revises certain earlier SEC guidance, narrowing the safe harbor of Section 28(e) with respect to certain brokerage and research services. Specifically, the 2006 Release provided guidance with respect to (i) the appropriate framework for analyzing whether a particular service falls within the research services safe harbor; (ii) the eligibility criteria for research ; (iii) the eligibility criteria for brokerage ; and (iv) the appropriate treatment of mixed-use items. The 2006 Release set forth a three step process for determining whether a particular product or service comes within the safe harbor: (1) whether the product or service falls within the specific statutory limits of Section 28(e)(3); (2) whether the eligible product or service provides lawful and appropriate assistance in the performance of an advisor s decision making responsibilities, including a reasonable allocation with respect to mixed-used products; and (3) the performance of a good faith determination that the amount of client commissions paid is reasonable in light of the value of the products or services provided by the broker-dealer. With respect to research the Commission underscored the traditional indicia of advice, analysis and reports, underscoring the need for substantive content in the form of the expression of reasoning or knowledge. The Commission maintained its view that mass marketed publications were not research, while underscoring that the method of delivery did not determine whether a product is mass marketed. Products or services that do not reflect expression of reasoning or knowledge, including products with inherently tangible or physical attributes, do not qualify as research eligible for the safe harbor of Section 28(e). On the other hand, the 2006 Release, noting the quick pace of technological change, embraces as market research an array of services such as order management systems, trade analytical software, market data services and certain aspects of proxy services which otherwise may be treated as mixed-use items. Noting the significance to the issue of what constitutes eligible brokerage under Section 28(e)(3), the 2006 Release established a temporal standard under which execution is treated as a process and service which begins when an order is transmitted to a broker-dealer and ends at the conclusion of clearance and settlement of the transaction. Under this standard, communications services related to the execution, clearing and settlement of securities # v. 1

11 transactions and other functions incidental to such transactions are eligible for safe harbor treatment. The 2006 Release, however, maintained the distinction for ineligible overhead such as telephones or computer terminals, record-keeping or administrative software functionality and the like. Managers may not use client commissions to meet compliance responsibilities. The Release also distinguished between short term custody (eligible) and long term custody (ineligible). Finally, the 2006 Release provided additional guidance with respect to client commission arrangements under Section 28(e), and in particular with respect to the statutory references to provided by effecting, and with respect to the issue of give-ups. VIII. Recent Case Law on Soft Dollar Issues In re Lehman Brothers, Inc., 2012 WL (Bkrtcy S.D.N.Y.) (soft dollar credits held for customers in soft dollar accounts are not entitled to protection as customer claims under SIPA. Such credits are a creature of contract and are, therefore, treated as unsecured contract claims). SEC v. Kurt S. Hovan et al., Litigation Release No , 2011 WL (S.E.C. Release No.) SEC Charges Bay Area Investment Advisor for Defrauding Clients and Falsifying Documents During SEC Exam (alleged misappropriation of more than $178,000 in soft dollars, claimed to be used for legitimate research but instead funneled to undisclosed rises such as office rent, computer hardware, and brother s salary). IX. Soft Dollar Compliance (a) Principal compliance concerns (b) How to implement effective soft dollar compliance (c) Regulatory oversight and concerns X. Current Issues with Soft Dollars (a) Use of third party research (b) Portability of soft dollars and soft dollar credits (c) Sharing research with affiliates (d) SEC Rule 206(4)-5 and compensation to placement agents # v. 1

12 Execution and trading strategy; Pre-trade and post-trade analytics; Optimal execution venues; and Availability of buyers and sellers. (c) Data Services - Provided they contain substantive comment expressing reasoning or knowledge that a service reports such as: Stock quotes; Last sale price; Trading volumes; Company financial data and economic data such as unemployment and GDP figures. (d) Proxy Services - Such services may offer a range of products which satisfy safe harbor standards by providing assistance in investment decision making, including reports on issuers, securities and the wisdom of investing in securities, and corporate governance research and rating services. However, proxy voting services involving the mechanical aspects of voting, such as casting votes, counting, recording and reporting votes, and research guidance in deciding how to vote, are not eligible safe harbor services. Proxy services may qualify as mixeduse items. See Mixed-use Products and Services, infra. III. Typical Soft Dollar Arrangements (a) Classic Soft Dollar Arrangements - The classic soft dollar arrangement is a triangular arrangement among an advisor, its client and the broker-dealer through whom client trades are placed. In return for commission payments which are higher than the lowest rate available, the advisor or money manager receives research and brokerage services from the broker-dealer. The soft dollar arrangement is expressly protected by the safe harbor provisions of Section 28(e) of the Securities Exchange Act of 1934 ( 1934 Act ). See Section 28(e) of the 1934 Act: Soft Dollar Safe Harbor, infra. (b) Directed Brokerage Arrangements - In a directed brokerage arrangement, the client, often a pension plan, mutual fund or private account directs the money manager to execute all or a portion of the client s trades through a particular broker-dealer. In return for the brokerage-commissions from such transactions, the broker-dealer provides services directly to the client or pays eligible client expenses. A number of states and municipalities require that a certain portion of commissions generated by their accounts be directed to broker-dealers located in the state or municipality, and certain clients may require that a portion of # v. 1

13 commissions be directed to broker-dealers with specific diversity profiles - such as businesses owned by women or minorities. Directed brokerage arrangements do not implicate a potential conflict of interest between the money manager and the client and, therefore, do not fall within the safe harbor of Section 28(e) of the 1934 Act, but are nonetheless generally permitted. IV. Variations on Soft Dollar and Directed Brokerage Arrangements (a) Commission Sharing/Commission Aggregation - Under this form of soft dollar arrangement, the money manager s executing broker maintains a commission sharing arrangement with a second broker-dealer, which may provide or pay for third-party research through the use of a commission pool. The money manager bears the burden of making a good faith determination that the commissions paid are reasonable in relation to the value of brokerage and research services provided. Under these arrangements the second broker-dealer, typically the one providing research or brokerage services, will be deemed to be effecting the transaction within the meaning of Section 28(e) if it executes, clears or settles the trade, or performs at least one of the following functions: taking financial responsibility for customer trades; maintaining records relating to customer trades; monitoring and responding to customer comments concerning the trading process; or monitoring trades and settlements. (b) Expense Reimbursement - In this form of directed brokerage the broker-dealer through whom the trades are placed and to whom commissions are paid, in turn, pays certain of the accounts expenses directly. (c) Commission Recapture - Under this variation of directive brokerage, the brokerdealer rebates a portion of an account s brokerage commissions directly to the account. Like expense reimbursement, commission recapture often involves multiple executing broker-dealers and a single coordinating broker-dealer serving as a conduit for the broker-dealers making the rebates or expense reimbursements. (d) Give-ups and Step-out Trades - Prior to 1975 brokers sometimes engaged in commission sharing arrangements known as give-ups, through which a money manager directed a portion of executing broker commissions to another broker in exchange for referrals or fund share sales that did not benefit the client. Such arrangements do not fall within the safe harbor of Section 28(e). Step-out trades, in which the money manager directs the executing broker to allocate all or part of a trade to another broker-dealer for clearance and settlement, do come within the safe harbor, so long as the money manager can demonstrate that the broker-dealer to whom any or all of the trade has been stepped-out is providing a tangible benefit, such as research or improved execution, to the client. A typical step-out arrangement is depicted in Figure 4. # v. 1

14 V. Section 28(e) of the 1934 Act: Soft Dollar Safe Harbor Section 28(e), enacted in 1975 in the wake of the elimination of fixed dollar commissions, provides a safe harbor for soft dollar arrangements, notwithstanding a money manager s common law fiduciary duty to avoid conflicts of interest with its clients, and as follows in pertinent part: (e)(1) no person using the mails or any means or instrumentality of interstate commerce, in the exercise of investment discretion with respect to an account shall be deemed to have acted unlawfully or to have breached a fiduciary duty under State or Federal law unless expressly provided to the contrary by a law enacted by Congress or any State subsequent to June 4, 1975, solely by reason of having caused the account to pay a member of an exchange, broker or dealer an amount of commission for effecting a securities transaction in excess of the amount of commission another member of an exchange, broker, or dealer would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by such member, broker, or dealer, viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion. Subsection (e)(2) of Section 28 outlines the disclosure obligations of a person exercising investment discretion with respect to an account and soft dollar arrangements. Subsection (e)(3) defines in general terms brokerage and research services. And Subsection (e)(4) makes the safe harbor provision inapplicable to futures products. The Section 28(e) safe harbor provision of the 1934 Act presents a number of legal and compliance issues, including but not limited to: (1) The meaning of investment discretion and whether the term relates only to advisory authority to make recommendations, or extends to the power to terminate an investment manager (e.g. pension plan managers), or the management of index funds. (2) What constitutes brokerage and research services, and specifically, what services of typical institutional, retail, clearing or executing brokers are traditional brokerage and which are merely administrative or operational, and as to research, what constitutes substantive content or expression of reasoning or knowledge, and whether third-party research is covered and as to introducing brokers what level of service justifies commission splitting. (3) The nature of the money manager s good faith determination obligations, as to (a) value for commissions (and whether measured by an object or a subjective # v. 1

15 standard), (b) appropriate mixed use allocations, and (c) use of an affiliated broker-dealer to obtain proprietary research. (4) How to allocate mixed-use, and whether such allocation is based on percentage of time or proportionate share (cost) based on separate usage. (5) The definition of, distinction between and legitimacy of give-ups, step-outs and other client commission arrangements. (6) The continuing obligation to obtain best execution and related issues such as money manager determination based on price or commission, bundled versus unbundled orders, and trade sequencing issues. (7) Permissible v. impermissible use of soft dollar arrangements: Some Examples Permissible Research Services Market Research Data Services Proxy Services Impermissible Meals, travel, entertainment Office equipment and furnishings Communication lines, devices and peripherals Utilities Salaries Membership Dues Computer Hardware VI. Form ADV Disclosure Obligations Section 28(e) s safe harbor for engaging in soft dollar transactions does not relieve an investment adviser of its obligation to disclose such practices to its clients. Item 8 of Part 1A of Form ADV, the uniform adviser registration form utilized by the SEC and most states, requires an adviser to disclose whether it or a related person has discretionary authority to determine, among other things, what brokers to use, commission rates paid for client transactions, whether the adviser recommends brokers to clients and whether the adviser receives research or other products from or as a result of client transactions. Form ADV-Part 2, which SEC rules require advisers to deliver to their clients upon entering into an advisory agreement, and to deliver or offer to deliver to the clients every year thereafter, has even more specific disclosure requirements regarding soft dollar # v. 1

16 arrangements. In July 2010, the SEC adopted extensive amendments to Form ADV-Part 2, which became effective in early See IA-3221 (June 22, 2011) Rules Implementing Amendments to the Investment Advisers Act of 1940 (Corrected) File No.: Among the most important changes to the disclosure requirements, Form ADV-Part 2, which may now be provided in summary form to clients as a brochure, must disclose: all existing and potential conflicts of interest; all additional fees incurred (including mark-ups, mark-downs and spreads on securities transactions); the factors considered by the adviser when selecting or recommending a broker; if the advisor receives research or other products or services in exchange for soft dollars, specifics about the nature, extent, cost and allocation across clients of such benefits; whether the adviser s clients pay higher commissions for such products or services; specifics about the adviser s policies and procedures regarding transactions directed to particular brokers during the prior fiscal year; policies, procedures and practices on directed brokerage; order aggregation practices, and if orders are not aggregated, the cost of not doing so; any arrangement oral or written by which the adviser or anyone related to the adviser receives additional compensation or economic benefit (i.e. soft dollar benefits); any compensation paid for client referrals and the policies and procedures for doing so. Of particular significance, in finalizing the changes, the SEC rejected several commenters request that advisers be permitted to answer the Form ADV soft dollar questions based on an adviser s reasonable belief that the benefits received are eligible research and brokerage services subject to the safe harbor protections of Section 28(e). According to the Commission, the safe harbor itself does not include a reasonable belief standard and the Form ADV changes were intended to track the language of the statute. # v. 1

17 VII. SEC Guidance on Soft Dollars and Section 28(e) (a) SEC Release No (1976) The first of four major releases by the commission interpreting Section 28(e) and addressing the use of commission payments by fiduciaries, Release No , just five paragraphs long, (i) identified a number of soft dollar uses, including give-ups, that the Commission did not regard as part of the brokerage or research services covered by Section 28(e), (ii) reiterated the general principal of Section 28(e) that a money manager does not breach fiduciary duties under state or federal law solely by paying brokerage commissions in excess of the amount another broker-dealer would have charged if the manager determines in good faith that the commission is reasonable in relation to the value of brokerage and research services received, (iii) noted the competitive research and brokerage practices which had existed prior to the elimination of minimum exchange commission rates in May, 1975, (iv) emphasized that soft dollars may not be used to pay for products or services customarily available and offered to the general public on a commercial basis, or for give-ups and (v) underscored that inappropriate soft dollar practices and arrangements may constitute fraudulent acts and practices by fiduciaries. (b) SEC Release No (1986) In 1986, based on the prior ten year history and an examination of client commission practices in , the Commission concluded that the 1976 standard announced in Release No was difficult to apply and unduly restrictive in some circumstances, as research products and brokerage services and their method of delivery had, in the interim, proliferated and become more complex, thus impeding money managers from obtaining, for commission dollars, the necessary research and brokerage goods and services to aid them in making informed investment decisions for their clients. Thus, the Commission withdrew the blanket prohibition against the use of soft dollars for products or services that were readily and customarily available and offered to the general public in favor of a more flexible good faith standard. The 1986 release also reaffirmed that, under appropriate circumstances, money managers might use client commissions to obtain third-party research, that is, research produced by someone other than the executing broker-dealer, emphasized the importance of written disclosure of commission arrangements to clients and reiterated an advisor s duty to seek best execution. The 1986 Release also introduced the concept of mixed-use, that is, a product or service obtained with client commissions, such as accounting or marketing, that may serve functions unrelated to the investment decision-making process. The 1986 Release made clear that for such products, a money manager needed to make a reasonable allocation of the cost of the product according to its use, and keep adequate books and records regarding such allocations. Any conflict of interest posed by such allocations must be disclosed to the client. Finally, the 1986 Release specifically endorsed the use of soft dollars to acquire third-party research under appropriate circumstances. # v. 1

18 (c) SEC Release No (2001) Prior to 2001, according to the Commission, the safe harbor provisions of Section 28(e) applied only to commissions paid to, and soft dollars generated from, a broker-dealer acting in an agency capacity. In 2001, following a request for reconsideration from the NASDAQ stock market, the commission in Release No expanded the safe harbor of Section 28(e) to certain riskless principal transactions effected by NASD members and reported in accordance with NASD trade reporting and disclosure rules. (d) SEC Release No (2006) In July 2006, the SEC issued its most comprehensive release relating to Section 28(e) and soft dollar use. While reaffirming its long held position that Section 28(e) applies equally to proprietary research (typically from full service broker-dealers) and third-party research (generated by parties other than the broker-dealer), the 2006 Release revises certain earlier SEC guidance, narrowing the safe harbor of Section 28(e) with respect to certain brokerage and research services. Specifically, the 2006 Release provided guidance with respect to (i) the appropriate framework for analyzing whether a particular service falls within the research services safe harbor; (ii) the eligibility criteria for research ; (iii) the eligibility criteria for brokerage ; and (iv) the appropriate treatment of mixed-use items. The 2006 Release set forth a three step process for determining whether a particular product or service comes within the safe harbor: (1) whether the product or service falls within the specific statutory limits of Section 28(e)(3); (2) whether the eligible product or service provides lawful and appropriate assistance in the performance of an advisor s decision making responsibilities, including a reasonable allocation with respect to mixed-used products; and (3) the performance of a good faith determination that the amount of client commissions paid is reasonable in light of the value of the products or services provided by the broker-dealer. With respect to research the Commission underscored the traditional indicia of advice, analysis and reports, underscoring the need for substantive content in the form of the expression of reasoning or knowledge. The Commission maintained its view that mass marketed publications were not research, while underscoring that the method of delivery did not determine whether a product is mass marketed. Products or services that do not reflect expression of reasoning or knowledge, including products with inherently tangible or physical attributes, do not qualify as research eligible for the safe harbor of Section 28(e). On the other hand, the 2006 Release, noting the quick pace of technological change, embraces as market research an array of services such as order management systems, trade analytical software, market data services and certain aspects of proxy services which otherwise may be treated as mixed-use items. Noting the significance to the issue of what constitutes eligible brokerage under Section 28(e)(3), the 2006 Release established a temporal standard under which execution is treated as a process and service which begins when an order is transmitted to a broker-dealer and ends at the conclusion of clearance and settlement of the transaction. Under this standard, communications services related to the execution, clearing and settlement of securities # v. 1

19 transactions and other functions incidental to such transactions are eligible for safe harbor treatment. The 2006 Release, however, maintained the distinction for ineligible overhead such as telephones or computer terminals, record-keeping or administrative software functionality and the like. Managers may not use client commissions to meet compliance responsibilities. The Release also distinguished between short term custody (eligible) and long term custody (ineligible). Finally, the 2006 Release provided additional guidance with respect to client commission arrangements under Section 28(e), and in particular with respect to the statutory references to provided by effecting, and with respect to the issue of give-ups. VIII. Recent Case Law on Soft Dollar Issues In re Lehman Brothers, Inc., 2012 WL (Bkrtcy S.D.N.Y.) (soft dollar credits held for customers in soft dollar accounts are not entitled to protection as customer claims under SIPA. Such credits are a creature of contract and are, therefore, treated as unsecured contract claims). SEC v. Kurt S. Hovan et al., Litigation Release No , 2011 WL (S.E.C. Release No.) SEC Charges Bay Area Investment Advisor for Defrauding Clients and Falsifying Documents During SEC Exam (alleged misappropriation of more than $178,000 in soft dollars, claimed to be used for legitimate research but instead funneled to undisclosed rises such as office rent, computer hardware, and brother s salary). IX. Soft Dollar Compliance (a) Principal compliance concerns (b) How to implement effective soft dollar compliance (c) Regulatory oversight and concerns X. Current Issues with Soft Dollars (a) Use of third party research (b) Portability of soft dollars and soft dollar credits (c) Sharing research with affiliates (d) SEC Rule 206(4)-5 and compensation to placement agents # v. 1

20 Soft Dollars and Client Commission Arrangements This presentation is taken from chapters in T. Lemke & G. Lins, Soft Dollars and Other Trading Activities (Thomson West, 2010) and is reprinted by permission. Introduction and Overview The term soft dollars is not specifically defined in any rule or statute and at times is used expansively to describe a variety of brokerage trading practices. Generally speaking, a soft dollar arrangement involves an agreement or understanding by which a discretionary money manager receives research or other services from a broker-dealer in addition to transaction execution, and does so in exchange for the brokerage commissions from transactions for discretionary clients accounts. In providing research services, the broker-dealer may produce these in-house or obtain them externally from third parties. Frequently, the broker-dealer specifies a level of commissions, known as a conversion ratio, that is necessary to purchase various research or brokerage services. For example, for every $1.60 in commissions the broker receives, the money manager may receive credit to obtain approximately $1.00 of various research or brokerage services. 1 The conversion ratio for a particular money manager will depend on several factors, such as the size of the accounts, total business done with the broker-dealer and the types or desirability of the trading orders. In some situations, the money manager s soft dollar credits may be used for an indefinite time; in other cases, they may have a definite life (e.g., expiring after some time period, such as a year). In other cases, particularly those involving full service broker-dealers, the broker-dealer may provide research or execution services to money managers without a formal or informal system of credits. Whatever the nature of the specific arrangement, the broker-dealer usually provides the money manager with research or brokerage services with an expectation, but not necessarily an explicit agreement or contract, that the money manager will use the broker-dealer to execute client transactions in the future. In these situations, the money manager may cause its client accounts to pay the broker-dealer a commission that is higher than the lowest commission rate available from other broker-dealers for providing only basic execution services. 1 According to the staff of the Securities and Exchange Commission ( SEC ), soft dollar users typically pay commissions in a range of ratios from 1.2:1 to 5.1:1 dollars in commissions for every dollar of research provided, with the average rate being 1.7 to 1 (e.g., a money manager receives a soft dollar credit of $1 for each $1.70 in commissions it pays to a broker-dealer). See SEC Office of Compliance Inspections and Examinations, Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22, 1998). # v. 1

21 Soft dollars may be viewed as that portion of the brokerage commission that exceeds the lowest rate available from other broker-dealers for basic execution services. In essence, the money manager uses these soft dollars, which are generated by discretionary clients trades, to pay for the research or enhanced execution services the money manager receives from or through the broker-dealer. By contrast, when a money manager pays for research or ancillary brokerage services directly with its own money, rather than using commissions from client accounts, the manager is said to be paying for the research with hard dollars. A money manager who uses commissions to obtain research or ancillary brokerage services is sometimes said to be paying up, based on the presumption that the broker-dealer is providing the services because the money manager is paying more than the lowest commission rate for basic execution of the trade. 2 Most commonly, soft dollar and other brokerage arrangements take one of three basic forms: (i) classic soft dollar arrangements; 5 (ii) directed brokerage arrangements (which include expense reimbursement or commission recapture arrangements); or (iii) other limited and specialized soft dollar arrangements. Classic soft dollar arrangements Under a classic arrangement, a money manager receives research or brokerage services from a broker-dealer and pays for these services with commissions from transactions for client accounts managed by the money manager. Assuming the manager causes the client account to pay a commission rate that is higher than the lowest rate available from another broker-dealer for execution of the trade, the manager may be said to be paying for the research or brokerage services with soft dollars, or simply to be paying up. The specific details of the arrangement, such as the commission rate, conversion ratio, and types of products or services provided, are generally negotiated on a customer-by-customer basis. One observer has aptly described the classic soft dollar arrangement as focusing on the triangular relationship between a money manager, his accounts and the broker. 3 A money manager s decision under a classic soft dollar arrangement to pay more than the lowest commission in return for research or brokerage services is expressly protected by the safe harbor in Section 28(e) of the Securities Exchange Act of 1934 ( 1934 Act ). Directed brokerage arrangements A second brokerage trading activity often included under the soft dollar heading, but quite different in concept and regulatory treatment from a classic soft dollar arrangement, is the directed brokerage arrangement. 2 As a technical matter, a money manager may pay up for either research or brokerage services (or both), although clearly most fiduciary issues arise when a manager pays up for research services. 3 See Pickard, Institutional Portfolio Execution: Soft Dollar Arrangements, 4 Insights 22 (Aug. 1990). # v. 1