Securities and Exchange Commission Issues Final Interpretive Guidance Regarding Soft Dollar Arrangements

On July 18, 2006, the Securities and Exchange Commission (the "Commission") published final interpretive guidance (the "Interpretive Release") regarding the "soft dollar" ¹ safe harbor of Section 28(e) of the Securities Exchange Act of 1934 ("Section 28(e)"). The stated goal of the Interpretive Release is to clarify the scope of the safe harbor in light of evolving technologies and industry practices.²

In the Interpretive Release, the Commission also solicits additional comment regarding the treatment of commission sharing arrangements under the safe harbor.

The Interpretative Release is effective July 24, 2006, but compliance is not required until January 24, 2007. Comments on commission sharing arrangements must be filed by September 7, 2006.

In most respects the Interpretive Release follows the guidance delineated in the proposal issued in October 2005.³ Notably, the Commission changed direction in several areas in the Interpretive Release including the following:

• Excluding mass-marketed publications from the safe harbor;

• Treating order management systems as a mixed-use product;

• Eliminating the requirement that a broker-dealer be contractually obligated to pay a thirdparty research provider; and

• Taking a less restrictive approach to commission sharing arrangements.

The Interpretive Release builds upon and supersedes prior Commission guidance regarding soft dollar arrangements. For example, prior Commission guidance regarding certain riskless principle transactions and mixed use products and services remains valid.

Other, prior interpretations, however, have been superseded or amended by the guidance included in the Interpretive Release such as:

• The definition of research included in the 1986 Release has been changed to include an "expression of reasoning or knowledge" requirement;⁴

• The definition of brokerage included in the 1986 Release has been changed to include a temporal standard; and

• The requirements of third-party research arrangements have been expanded beyond that delineated in the 1986 Release — including eliminating the requirement that a brokerdealer be contractually obligated to pay a third-party research provider.

In order to make the securities markets more competitive, the Commission, effective May 1, 1975, abolished the system of fixed commissions and implemented the present system of negotiated commission rates. Soon thereafter, Congress enacted Section 28(e) as part of the Securities Acts Amendments of 1975. Congress acted, at least in part, in response to concerns expressed by securities industry participants that, under the newly instituted system of negotiated commission rates, if an investment adviser caused a client account to pay anything but the lowest commission rate available to obtain research, the investment adviser would be held in breach of its fiduciary duty to its clients.⁵ Section 28(e) generally provides that a person who exercises investment discretion with respect to an account shall not be deemed to have acted unlawfully or to have breached a fiduciary duty under federal or state law solely by reason of such person having caused the account to pay more than the lowest available commission if such person determines in good faith that the amount of the commission paid is reasonable in relation to the value of the brokerage and research services received.⁶

Section 28(e)(3) defines when a person is deemed to be providing brokerage and research services. Generally, a person provides brokerage and research services insofar as such person:

• Furnishes advice directly, or through publications, as to the value of securities, the advisability of investing in, purchasing or selling securities, or the availability of purchasers or sellers of securities;

• Furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy and performance of accounts; or

• Effects securities transactions and performs functions incidental thereto (such as clearance, settlement, and custody) or required therewith by rules of the Commission or a self-regulatory organization ("SRO") of which such person is a member or person associated with a member or in which such person is a participant.⁷

Since 1976, the Commission has issued various no-action letters,⁸ releases⁹ and reports¹⁰ attempting to provide interpretive guidance on the types of products and services that fall within the Section 28(e) safe harbor. The Interpretive Release in some respects builds upon and in other respects supersedes this prior guidance.

In the Interpretive Release the Commission maintains the core analytical process proposed in October 2005. In particular, investment advisers must use the following three-step process to determine whether a particular arrangement falls within the safe harbor:

• Step 1: Does a brokerage or research service fall within the limits of Section 28(e)(3)?

• Step 2: Does the product or service actually provide lawful and appropriate assistance to the investment adviser in the performance of his/her investment decision-making responsibilities? (Where a product or service has a mixed use the investment adviser must make a reasonable allocation of the costs of the item according to such use.)

• Step 3: Are (based on a good faith determination) the amount of client commissions paid reasonable in light of the value of the products or services provided by the broker-dealer?

Unlike prior releases, the Commission in the Interpretive Release includes several references to particular products and services and whether or not such products or services qualify for the safe harbor as either brokerage or research. Attached to this advisory is a representative list of some of the particular products and services mentioned by the Commission in the Interpretive Release.

The Commission’s willingness to openly opine on particular products and services in the Interpretive Release might signal a change in the Commission’s regulatory approach to provide more specific and practical guidance to regulated entities.

The Interpretive Release provides a reinterpretation of the meaning of "brokerage and research services." Under the Interpretive Release, research services eligible for the safe harbor include "advice," an "analysis" or a "report" that concerns one or more of the subject matter categories described in Section 28(e)(3)(A) and (B). For example, eligible research includes advice, analyses or reports regarding the value of securities, the advisability of investing in or selling securities, economic factors and trends, portfolio strategy, and the performance of managed accounts.

The Interpretive Release continues earlier guidance that the categories enumerated in Section 28(e)(3)(A) and (B) "subsume" other topics related to securities and financial markets, so that, for example, a report concerning political factors could fall within the scope of the safe harbor.

The Commission notes that how research is delivered (e.g., electronic, paper, or oral) is irrelevant to the analysis of eligibility under the safe harbor.

"Advice," "analyses" and "reports" qualify for the safe harbor if they contain an "expression of reasoning or knowledge" that relates to one of the subject matter categories contained in Section 28(e)(3)(A) and (B). This includes original research or a synthesis, analysis or compilation of the research of others.

Traditional research reports analyzing the performance of a particular company or stock, discussions with research analysts, meetings with corporate executives to obtain information about the performance of a company (e.g., a report concerning an issuer) and software that provides analysis of securities portfolios all qualify for the safe harbor.

Seminars or conferences and corporate governance research and rating services also may be eligible under the safe harbor if they (a) reflect the expression of reasoning or knowledge, and 07.2006 | 04 (b) relate to or are subsumed in one or more of the subject matter categories included in Section 28(e)(3)(A) and (B).

Third-party services that provide market data or economic data are eligible services under the safe harbor, but only if the subject matter criteria of the safe harbor are met. For example, market data, such as stock quotes, last sales prices and trading volumes, may qualify for the safe harbor if it contains substantive content and constitutes a "report concerning . . . securities." Market data that is used exclusively to value client accounts, however, likely would not qualify for the safe harbor. Research related to securities markets is specifically identified as being eligible for the safe harbor — e.g., trade analytics available through order management systems and advice regarding market color and execution strategies.

Proxy services, however, are identified as being a mixed use product. The portion of a proxy service used by an adviser in making investment decisions is eligible for the safe harbor, but to the extent the proxy service relates to vote processing/handling, the service is not eligible for the safe harbor and is going to be considered non-eligible overhead.

The release clarifies that "mass-marketed publications" are not eligible as research under the safe harbor. This includes daily or monthly periodicals such as the Wall Street Journal and Fortune. More narrowly tailored periodicals, such as particular trade or industry publications or journals, may qualify for the safe harbor.

The Commission notes that the method of distribution is not determinative and provides some general characteristics to assist advisers in determining what types of publications might qualify for the safe harbor:

• Is the publication circulated or marketed to a narrow audience (as opposed to the general public);

• Is the publication directed to readers in particular industries with specialized interests; and

• Is the publication costly?

If a publication possesses these characteristics it may be eligible for the safe harbor.

The Commission states that products or services that have "inherently tangible or physical attributes" are not eligible research under the safe harbor. For example, office equipment and furniture and business supplies are not research for purposes of the safe harbor. The Commission states that these items, more appropriately viewed as "overhead," do not reflect the expression of reasoning or knowledge relating to the subject matter categories described in Section 28(e)(3)(A) and (B) and, therefore, are not eligible for the safe harbor. In particular, the Commission clarifies that computer hardware, including computer terminals and computer accessories, and telecommunication lines and computer cables, are not eligible research services. The data and services provided through such devices, however, may be eligible if they meet the criteria set forth in the Interpretive Release.

The Interpretive Release defines the parameters of permissible brokerage services under Section 28(e) by using a temporal standard.

Under the Interpretive Release, the Commission recognizes that execution of a trade is a process that begins at the point at which the money manager communicates with the brokerdealer for the purpose of transmitting an order for execution through the point at which funds or securities are delivered or credited to the advised account or account holder’s agent.¹¹

Products and services that relate to this process and that meet the other requirements of the Interpretive Release qualify for the safe harbor.

Products or services that are not sufficiently related to order execution fall outside the temporal standard and are not eligible under the safe harbor.

Communication services between an investment adviser and a broker-dealer or a custodian, such as dedicated lines between the broker-dealer and the adviser’s order management system and message services used to transmit orders to broker-dealers for execution, are eligible brokerage services under the safe harbor.

In the Interpretive Release, the Commission clarifies that telephones, computer terminals, surveillance systems, compliance mechanisms, and error correction trades or similar services do not fall within the temporal standard and are more appropriately characterized as overhead. In addition, short-term custody qualifies for the safe harbor, but long-term custody does not.

Of particular note is the Commission’s treatment of order management systems. Under the proposing release the Commission considered treating all order management systems as ineligible under the safe harbor. In the Interpretive Release the Commission changes direction and states that order management systems may be treated as mixed use products.¹² Therefore, elements of an order management system that relate to permissible research or brokerage services may be treated as eligible services under the safe harbor.

Under Step 2 of the analysis outlined in the Interpretive Release, an investment adviser must determine that the research or brokerage service provides "lawful and appropriate assistance" in the performance of the adviser’s decision-making responsibilities. The Commission’s interpretation of lawful and appropriate assistance follows its earlier guidance in this area.¹³ Therefore, while a product or service may fall within the definition of brokerage or research, if it does not provide the adviser with lawful and appropriate assistance in meeting the adviser’s obligations to his/her client the product or service will not qualify for the safe harbor.

The Interpretive Release continues the Commission’s mixed-use standard. Where a mixed-use product or service is obtained with client commissions, the investment adviser must make a reasonable allocation of the cost of the product or service according to its use and must keep adequate books and records that support a good faith allocation determination.

The third step of the Commission’s Section 28(e) analytical process requires that the adviser make a good faith determination that commissions paid are reasonable in relation to the value of brokerage and research services received, either in terms of the particular transaction or the adviser’s overall responsibilities with respect to client accounts. This approach continues existing Commission guidance.

The Interpretive Release reaffirms and builds upon the Commission’s earlier guidance that client commissions may be used to pay for third-party research. The Commission further states, however, that third-party research will be considered to be "provided by" a brokerdealer even if the broker-dealer is not directly obligated to pay for such research if the brokerdealer pays the research preparer directly and takes steps to assure itself that the client commissions that the manager directs the broker-dealer to use to pay for such services are used only for eligible brokerage and research.

In the Interpretive Release, the Commission lists various "attributes" that will assist an investment adviser and a broker-dealer in determining whether the broker-dealer that is effecting transactions for an advised account and is using a third-party research provider has satisfied the "provided by" element of the safe harbor. These attributes include:

• The broker-dealer pays the research preparer directly;

• The broker-dealer reviews the description of the services to be paid for with client commissions under the safe harbor for red flags that indicate the services are not within Section 28(e) and agrees with the money manager to use client commissions only to pay for those items that reasonably fall within the safe harbor; and

• The broker-dealer develops and maintains procedures so that research payments are documented and paid for promptly.

This approach deviates from the Commission’s prior position that a broker-dealer had to be directly — for example, through contract — obligated to compensate a third-party research provider.

The Commission received numerous comments on its proposed treatment of commission sharing arrangements under the safe harbor. In recognition of the various and complex commission sharing arrangements that have evolved over time, the Commission is soliciting additional comment on how these arrangements should be treated under the safe harbor. The comment period closes on September 7, 2006.

In the Interpretive Release the Commission states that "we recognize the benefit to investors of money managers being able to functionally separate trade execution from access to valuable research."¹⁴ The uncoupling of trade execution from research, however, is limited by the statutory language of Section 28(e) which generally requires that the broker-dealer "effecting" the securities transaction that generates soft dollar credits also must "provide" the brokerage or research products acquired with the soft dollar credits.

In the October 2005 proposing release the Commission proposed to address these statutory limitations by requiring the third-party broker-dealer that provides research to perform, at a minimum, the following four functions:

• Be financially at risk to the clearing broker-dealer for its customers’ failure to pay;

• Keep records of customer trades in accordance with Commission and SRO rules, including blotters and memoranda of orders;

• Monitor and respond to customer comments concerning the trading process, and

• Generally monitor trades and settlements.

In response to commenters’ requests, the Commission has decided to take a less restrictive approach toward commission sharing arrangements. In particular, in order for an investment adviser to use the safe harbor in a commission sharing arrangement, a broker-dealer that is effecting a client transaction must perform at least one of the four functions listed above and take steps to determine that the other functions have been allocated to the other brokerdealer(s) in the arrangement.

The Commission clarifies in the Interpretive Release that a broker-dealer that is executing, clearing, or settling a trade is "effecting" the transaction.

The Commission states in the Interpretive Release that the purpose of the "effecting" and "providing" requirements is to ensure that broker-dealers and investment advisers do not engage in impermissible give-up arrangements.

In light of the Interpretive Release, advisers should review their soft dollar practices, including related compliance policies and procedures and disclosure practices. Broker-dealers, in turn, should review their soft dollar practices. Please do not hesitate to contact the attorneys listed below or any other member of the Broker-Dealer or Investment Management Practice Groups for additional information, or if you would like to discuss the impact of the Interpretive Release.

Circular 230 Disclosure: Internal Revenue Service regulations provide that, for the purpose of avoiding certain penalties under the Internal Revenue Code, taxpayers may rely only on opinions of counsel that meet specific requirements set forth in the regulations, including a requirement that such opinions contain extensive factual and legal discussion and analysis. Any tax advice that may be contained herein does not constitute an opinion that meets the requirements of the regulations. Any such tax advice therefore cannot be used, and was not intended or written to be used, for the purpose of avoiding any federal tax penalties that the Internal Revenue Service may attempt to impose.