Investment Adviser Soft Dollars

Transcription

1 NSCP 2006 West Coast Regional Membership Meeting Investment Adviser Soft Dollars Mark D. Perlow, Kirkpatrick & Lockhart Nicholson Graham LLP Timothy B. Parker, Matthews International Capital Management, LLP David E. Riggs, Charles Schwab & Co., Inc. Helen Kuo, Kirkpatrick & Lockhart Nicholson Graham LLP

2 I. Statutory Framework Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for managers use of client commissions to purchase certain brokerage and research services from broker-dealers Elements of the Section 28(e): a manager with (1) investment discretion in placing the brokerage for (2) securities transactions uses (3) commissions to purchase (4) brokerage and research services (5) provided by (6) a brokerdealer, and (7) the commission paid is reasonable relative to the services received 2

3 II. Regulatory History Prior SEC Releases: 1976; 1986; SEC OCIE report 2004 NASD Task Force Report 2005 U.K. FSA Release on Soft Dollars 3

4 III. SEC s October 2005 Proposed Interpretative Release on Soft Dollars (the Release ) Published for comment on October 19, 2005 Not legally binding but most definitive SEC statement on soft dollars since 1986 Signals SEC position in final interpretation Implications for SEC s view of safe harbor in examinations and enforcement proceedings Generally consistent with FSA release SEC also considering requirements for disclosure and recordkeeping of soft dollar practices 4

5 III. The Release (cont d) Under the Release, the Section 28(e) safe harbor is available if the manager: 1) determines that the product or service is eligible under the statute; 2) uses the product or service in performing decisionmaking responsibilities for discretionary accounts; and 3) makes a good faith determination that commissions paid are reasonable in relation to the value of research or brokerage products or services received 5

6 III. D. Research Services under the Safe Harbor Eligibility as research services under safe harbor: Advice, analyses or reports reflecting the expression of reasoning or knowledge Subject matter of the product or service must fall within the statutory categories Lawful and appropriate assistance in making investment decisions (determined by use) 6

7 III.E. Brokerage Services under the Safe Harbor Eligibility as brokerage services under safe harbor: Eligible services include (1) activities required to effect securities transactions and (2) functions incidental thereto, e.g., clearance, settlement, and custody, and services required by SEC or SRO rules 7

8 III.E. Brokerage Services under the Safe Harbor (cont d) Temporal standard for brokerage services : from when the adviser communicates with the broker-dealer for the purpose of transmitting order for execution to when the transaction is cleared and settled Lawful and appropriate assistance in carrying out responsibilities Note: Services that are ineligible under the safe harbor as brokerage services may still be eligible as research services and vice versa 8

9 III. The Release (cont d) Mixed-use items: adviser must (1) make reasonable allocation according to use, (2) pay for non-eligible products or services with hard dollars and (3) keep records of allocations Reasonability determination: adviser must make a good faith determination that commissions are reasonable relative to the value of brokerage and research services provided 9

10 III. The Release (cont d) Third party research: Eligible for safe harbor if the executing broker-dealer is legally obligated to pay for any third party research provided to the adviser 10

11 III. The Release (cont d) Commission sharing arrangements: eligible for safe harbor if: 1) the broker-dealer effecting the trade is legally obligated to pay for the third party research or brokerage services; and 2) the arrangement is part of a normal and legitimate correspondent relationship ; introducing broker-dealer complies with certain criteria At risk for customer trades 11

12 IV. Comment Letters to the Release Investment Company Institute Comment Letter Client account type: requested that the SEC adopt a rule prohibiting the use of client commissions outside the safe harbor for all advisers, regardless of client account type Mass publications: suggested general exclusion from the safe harbor of publications that are marketed to the general public OMS: recommended clarification of the definition of OMS and expressly permitting advisers to treat OMS as mixed-use items Temporal standard for brokerage services: generally supported the temporal standard but recommended revising the timeframe to start when the adviser makes an investment or trading decision Proxy voting services: requested clarification that proxy voting services can be mixed-use items in some circumstances Commission sharing arrangements: requested clarification that advisers have no affirmative duties to ensure introducing brokers compliance with the criteria in the Release 12

13 IV. Comment Letters to the Release (cont d) Investment Adviser Association Comment Letter OMS: requested acknowledgment that OMS may qualify for safe harbor or as mixed-use items Post-trade analytics: requested acknowledgment that post-trade analytics are eligible for safe harbor Proxy voting services: sought confirmation that proxy voting services may qualify for safe harbor or as mixed-use items Bundled products: requested reconsideration of discussing bundled products in the mixed-use section of the Release to avoid implication that advisers need to unbundle commissions charged by full-service broker-dealers Unsolicited or incidental products or services: sought clarification that advisers should not have to consider unsolicited or incidental products or services in determining eligibility for safe harbor Commission sharing arrangements: requested confirmation that advisers are not responsible for ensuring broker-dealers compliance with criteria in Release for commission sharing arrangements 13

14 IV. Comment Letters to the Release (cont d) National Society of Compliance Professionals Comment Letter Section 28(e) as safe harbor: urged SEC to clarify that Section 28(e) is a safe harbor and not mandate Unsolicited services: urged SEC to clarify that the safe harbor analysis is not implicated for non-requested bundled research or services Pricing structures and prime brokerage: asked SEC to clarify that advisers are not required to value and pay for those parts of bundled products and services (e.g., prime brokerage services) that are not eligible for safe harbor Temporal standard: urged SEC to reconsider the temporal standard or else expand its scope to include OMS; asked for clarification on the treatment of custody services Relationship between research and brokerage : requested clarification on whether products and services that fail to meet one definition may still qualify for the safe harbor by meeting the other definition Third party research and commission sharing arrangements: expressed concern over the potential negative impact on the market for third party research; requested confirmation of adviser s ability to rely on broker-dealers representations as to compliance; sought guidance on treatment of step outs 14

15 IV. Comment Letters to the Release (cont d) Fidelity Investments Comment Letter Adviser s purchase of research with own hard dollars: urged the SEC to confirm that a brokerdealer who is also a registered adviser may sell research to a fund adviser without triggering Advisers Act Section 206(3) Temporal standard for defining services incidental to brokerage: expressed concern over the temporal standard and urged the adoption of a functional standard instead based on whether the service has a direct causal nexus to trade placement, execution, clearance, or settlement 15

16 IV. Comment Letters to the Release (cont d) Charles Schwab & Co., Inc. Comment Letter Custody services: sought clarification that custody is a brokerage service eligible for the safe harbor Bundled services: recommended retraction of language in Release suggesting that an adviser that receives bundled products and services must allocate and pay own funds for the portion of products and services that is ineligible for the safe harbor; urged that mixed-use analysis should not apply to unsolicited bundled services 16

17 IV. Comment Letters to the Release (cont d) Bloomberg Comment Letter Physical items: generally supported bright line rule to exclude physical items from safe harbor and explained the application of this rule to its products Post-trade analytics: urged the SEC to include posttrade analytics in the safe harbor; disagreed with the suggestion that post-trade analytics be treated as mixeduse items Commission sharing arrangements: requested amending certain statements in Release to clarify and to better permit parties to allocate the risk of default between the clearing broker and introducing broker 17

18 IV. Comment Letters to the Release (cont d) Charles River Brokerage Comment Letter Generally expressed agreement with the Release OMS: strongly urged reconsideration of the stance that OMS do not fall within the safe harbor; argued that OMS provides lawful and appropriate assistance and supports trade execution in multiple ways Mass-market publications: suggested that publications should meet 2 criteria to qualify for the safe harbor: 1) publication provides new insights ; and 2) it can be documented that the publication provides lawful and appropriate assistance 18

19 V. Practical Issues Order Management Systems The Release expressly excludes OMS from brokerage services under the safe harbor. Portions of OMS previously treated as brokerage services or as mixed-use items may no longer qualify for the safe harbor. E.g., connectivity, routing, e-trading Ambiguous as to whether OMS may qualify as research services or as mixed-use items. Advisers seeking to treat OMS components as research services should maintain written support of reasoning or knowledge and lawful and appropriate assistance provided E.g., portfolio modeling/strategy analysis 19

20 V. Practical Issues (cont d) Market and Economic Data The Release expressly includes market and economic data as permissible research services but does not distinguish between raw data and analyzed or manipulated data. In contrast, the FSA expressly excludes raw data from research services and requires raw data to meet the criteria for execution service Advisers with both U.S. and U.K. clients: may not be practical to use only soft dollar credits generated from U.S. client commissions to purchase raw data; prudent to follow the more restrictive FSA approach until further clarification 20

21 V. Practical Issues (cont d) Post-trade Analytics The Release expressly excludes post-trade analytics from the definition of brokerage services under the safe harbor Release is silent on its use as research services but arguably permissible advisers wanting to treat trade analytics as research services should maintain written support of reasoning or knowledge and lawful and appropriate assistance provided 21

22 V. Practical Issues (cont d) Post-trade Analytics (cont d) In contrast, the FSA (1) permits client commissions to be used for trade analytics for purposes of quantifying how well a broker conducted transactions for an adviser, and (2)states that analytical software may qualify as research services Advisers with both U.S. and U.K. clients: prudent to follow more restrictive U.S. approach until further clarification 22

23 V. Practical Issues (cont d) Proxy Services The Release is silent and specifically requested comment on this issue Advisers should prepare for the possibility that proxy services no longer qualify for the safe harbor or as mixed-use items; Advisers seeking to treat proxy services as qualifying for the safe harbor or as mixed-use items maintain written support of reasoning or knowledge and lawful and appropriate assistance provided 23

24 V. Practical Issues (cont d) Custody Custody is explicitly identified in Section 28(e)(3)(C) s definition of eligible incidental brokerage services. However, custody services would appear to fall outside the proposed temporal standard (although not expressly acknowledged in the Release) The SEC will likely clarify this issue 24

25 V. Practical Issues (cont d) Temporal Standard Several commenters expressed concern about the proposed temporal standard for defining which services are incidental to brokerage. textual arguments (e.g., custody) scope of the standard overly narrow, excluding OMS, trade analytics etc. recommended expanding (e.g., to time of investment decision), revising, or abandoning the proposed temporal standard, e.g., in favor of functional or causal nexus standard Will the SEC reconsider? 25

26 V. Practical Issues (cont d) Transition Issues Many commenters requested that the SEC allow ample transition time in light of the fact that many firms have committed to practices, systems, courses of business, and business relationships based on existing interpretations of the safe harbor. The SEC will likely provide an extended transition period. 26