Compliance Solutions for Investment Advisers

FAQs — Soft Dollars

 

Background

What is a soft dollar arrangement?

Soft dollar arrangements generally arise when an investment adviser receives research or brokerage products or services from a broker-dealer in exchange for placing securities transactions with that broker-dealer. In order to receive the products or services, the adviser may pay more than the lowest possible commission rate.

Is a soft dollar arrangement a breach of an adviser’s fiduciary duty to obtain best execution for advisory clients’ transactions?

Section 28(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), establishes a safe harbor that allows an investment adviser to use client funds to purchase “brokerage and research services” for its discretionary accounts under certain circumstances without breaching its fiduciary duties to clients.

Is an investment adviser relieved of its best execution responsibility when using soft dollars?

Absolutely not. Advisers must still make a good faith determination that the amount of client commissions paid is reasonable in light of the value of the brokerage or research product provided by the broker-dealer.

What are the elements of the Section 28(e) safe harbor?

The Section 28(e) safe harbor requires that an investment adviser with (i) investment discretion in placing the brokerage for (ii) securities transactions uses (iii) commissions to purchase (iv) brokerage and research services (v) provided by (vi) a broker-dealer, and (vii) the commission paid is reasonable relative to the services received.

How does an investment adviser determine whether a particular brokerage or research product or service falls within the Section 28(e) safe harbor?

The SEC has developed a three-step analysis of whether a particular brokerage or research product or service falls within the Section 28(e) safe harbor:

  1. The adviser must determine whether the product or service is eligible “research” or eligible “brokerage”;
  2. The investment adviser must determine whether the product or service actually provides lawful and appropriate assistance in the performance of the adviser’s investment decision-making responsibilities; and
  3. The investment adviser must make 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.

 

Eligible Research

What is considered eligible research?

In determining whether a product or service is eligible as research, the investment adviser must conclude that it is advice, analyses or reports that reflect substantive content – that is, the expression of reasoning or knowledge.

Are there other eligibility requirements for research?

The research must relate to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities, and the analyses or reports must relate to issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts.

What types of research services are considered eligible under Section 28(e)?

The SEC has held that the following research services are eligible for the Section 28(e) safe harbor:

  • Trade analytics including analytics available through order management systems and advice on market color and execution strategies;
  • Financial newsletters and trade journals that are not mass-marketed;
  • Discussions with research analysts relating to the advisability of investing in securities;
  • Research reports analyzing the performance of a particular company or stock;
  • Quantitative analytical software, and software that provides analyses of securities portfolios;
  • Meetings with corporate executives to obtain oral reports on the performance of a company; and
  • Seminars or conferences that provide substantive content relating to a permissible subject matter, such as issuers, industries and securities.

What types of research products and services are considered to be outside the Section 28(e) safe harbor?

Products or services that do not reflect the expression of reasoning or knowledge are not eligible under the safe harbor. These typically include tangible items, such as:

  • Meals, travel and entertainment;
  • Office equipment, office furniture and business supplies;
  • Salaries (including research staff) and rent;
  • Accounting fees and software;
  • Website design, e-mail software and internet services;
  • Legal expenses;
  • Personnel management;
  • Marketing;
  • Utilities;
  • Membership dues;
  • Professional licensing fees;
  • Software to assist with administrative functions (such as managing back-office functions, operating systems and word processing);
  • Computer hardware, including terminals, accessories, peripherals and delivery mechanisms; or
  • Equipment maintenance and repair services.

Are publications such as the Wall Street Journal or the New York Times considered eligible research under the Section 28(e) safe harbor?

The Section 28(e) safe harbor does not protect an investment adviser’s purchase of publications – such as the Wall Street Journal or the New York Times – that are “mass-marketed.” The SEC has defined “mass-marketed” publications as those publications that are intended for and marketed to a broad, public audience.

Are financial newspapers considered eligible research under the Section 28(e) safe harbor?

Publications such as financial newspapers may be eligible research under the safe harbor. The SEC has stated that the focus of the marketing and not the availability or the method of distribution of the publication is the key criterion for determining the applicability of the safe harbor.

What are some of the factors that would tend to indicate that a publication is mass marketed?

Factors that tend to indicate that a publication is mass-marketed include whether it is (i) circulated to a wide audience; (ii) intended for and marketed to the general public; and (iii) low cost.

What are some of the factors that would tend to indicate that a publication is not mass marketed?

Factors that tend to indicate that a publication is not mass-marketed include whether it is (i) marketed to a narrow audience; (ii) directed to readers with specialized interests in particular industries, products, or issuers; and (iii) high cost.

Is “market research” eligible under the Section 28(e) safe harbor?

The SEC has stated that market research may be eligible under the Section 28(e) safe harbor. The SEC permits an investment adviser to treat reports, analysis and advice regarding the following subject matter as eligible research under the safe harbor:

  • Market color;
  • Execution and trading strategies;
  • Pre-trade and post-trade analytics;
  • Optimal execution venues; and
  • Availability of buyers and sellers.

Are “data services” considered eligible research under the Section 28(e) safe harbor?

Data services, such as those that provide market data or economic data, do fall within the Section 28(e) safe harbor as eligible “reports” provided they contain substantive content.

What are some examples of eligible data services?

Eligible data services include:

  • Stock quotes;
  • Last sale prices;
  • Trading volumes; and
  • Company financial data and economic data (e.g., unemployment and GDP figures).

Are “proxy services” considered eligible research under the Section 28(e) safe harbor?

Only those proxy services that provide an investment adviser with lawful and appropriate assistance in investment decision-making are considered eligible research.

What are some eligible proxy services?

Eligible proxy services would include (i) reports and analysis on issuers, securities and the advisability of investing in securities and (ii) corporate governance research and corporate governance rating services.

What are some examples of proxy services that would not be eligible for the Section 28(e) safe harbor?

Eligible proxy services would not include offers by a proxy voting service provider to handle the mechanical aspects of voting such as the actual casting of votes or the counting, recording and reporting of votes.

How does an investment adviser determine whether the product or service actually provides lawful and appropriate assistance in the performance of the adviser’s investment decision-making responsibilities?

This standard focuses on how the investment adviser uses the eligible research.  For example, if an investment adviser uses client commissions to pay for analysis of account performance, that would be considered eligible research. However, if the adviser then uses that same account performance for marketing purposes, it would not fall with the Section 28(e) safe harbor because it is not providing lawful and appropriate assistance in the performance of the adviser’s investment decision-making responsibilities.

 

Eligible Brokerage

What types of brokerage services are fall within the Section 28(e) safe harbor?

Brokerage services within the safe harbor are those products and services that relate to the execution of the trade from the point at which the investment adviser communicates with the broker-dealer 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.

What are some examples of eligible brokerage products and services?

Communication services related to the execution, clearing and settlement of securities transactions and other functions incidental to effecting securities transactions are eligible “brokerage services” under the safe harbor: Examples of eligible brokerage products and services include:

  • Trading software used to route orders to market centers;
  • Software that provides algorithmic trading strategies; and
  • Software used to transmit orders to direct market access systems.

What are some examples of brokerage products and services that are not eligible under the Section 28(e) safe harbor?

The following brokerage products and services – considered “overhead” by the SEC – are not sufficiently related to order execution and therefore, fall outside the Section 28(e) safe harbor:

  • Hardware (e.g., telephones, computer terminals);
  • Recordkeeping, administrative, portfolio management, quantitative analytical, asset allocation and portfolio modeling software;
  • Compliance responsibilities, including setting parameters, stress testing, analyzing patterns and monitoring style drift;
  • Trade financing, such as stock lending fees and margin services;
  • Capital introduction; and
  • Error correction trades.

 

Mixed-Use Items

What is a mixed use item?

In many cases, an otherwise eligible product or service obtained using client commissions may also serve functions that are not related to the investment decision-making process. In such situations it is said that the product or service has a mixed use.

Can you provide an example of a situation where an otherwise eligible product or service may also have a mixed use?

If an adviser uses account performance analysis for both marketing purposes and investment decision-making, under Section 28(e) the investment adviser may use soft dollars only to pay for the applicable portion of the item attributable to use for investment decision-making.

What are the requirements for mixed use items?

The SEC has indicated that where a product or service has a mixed use, an investment adviser is required to make a reasonable allocation of the cost of the product according to its use. The adviser is also required to keep adequate books and records concerning the allocations.

 

Determining Reasonableness

How does an investment adviser make a good faith determination that the commissions paid are reasonable in relation to the value of the brokerage and research services received?

In making such a determination, an investment adviser should not only consider the commission rate, but also consider the range and quality of a broker’s services, including the value of the research provided, execution capability, financial responsibility and responsiveness.

Is there any guidance to help investment advisers make a good faith determination?

The SEC has offered the following examples:

  • An investment adviser who obtains an eligible product, such as market data, to camouflage the payment of higher commissions to broker-dealers for ineligible services, such as shelf space or client referrals, could not make a good faith determination that the commission rate was reasonable in relation to the value of the Section 28(e) eligible products because the commission would incorporate a payment to the broker-dealer for the non-Section 28(e) eligible services.
  • If research products or services that are eligible under Section 28(e)(3) have been simply copied, repackaged, or aggregated, the investment adviser must make a good faith determination that any additional commissions paid in respect of such copying, repackaging, or aggregation services are reasonable.
  • Where a broker-dealer also offers its research for an unbundled price, that price should inform the money manager as to its market value and help the manager make its good faith determination.

 

Disclosure Requirements

What are the disclosure requirements when an investment adviser enters into a soft dollar arrangement?

The investment adviser must disclose the use of soft dollars in both Item 8.G(1) of Form ADV Part 1 and Item 12 of Form ADV Part 2A.

What types of disclosures must the investment adviser make in Form ADV Part 2A?

If an investment adviser receives research or other products or services other than execution from a broker-dealer or a third-party in connection with client securities transactions, the adviser must disclose their practices and discuss the conflicts of interest they create. The adviser’s disclosure and discussion must include all soft dollar benefits they receive, including, in the case of research, both proprietary research (created or developed by the broker-dealer) and research created or developed by a third party.

Are there any additional disclosures that an investment adviser must make in Item 12 of Form ADV Part 2A?

The adviser must:

  • Explain when they use client brokerage commissions (or markups or markdowns) to obtain research of other products or services, the adviser receives a benefit because they do not have to produce or pay for the research, products or services.
  • Disclose that they may have an incentive to select or recommend a broker-dealer based on their interest in receiving the research or other products or services, rather than on their clients’ interest in receiving most favorable execution.
  • Disclose if they may cause clients to pay commissions (or markups or markdowns) higher than those charged by other broker-dealers in return for soft dollar benefits (known as paying-up).
  • Disclose whether they use soft dollar benefits to service all of their clients’ accounts or only those that paid for the benefits.
  • Describe the types of products and services they or any of their related persons acquired with client brokerage commission (or markups or markdowns) within their last fiscal year. This description must be specific enough for the adviser’s clients to understand the types of products or services that the adviser is acquiring and to permit them to evaluate possible conflicts of interest. The description must be more detailed for products or services that do not qualify for the Section 28(e) safe harbor. Merely disclosing that the advisory firm obtains various research reports and products is not specific enough.
  • Explain the procedures they used during their last fiscal year to direct client transactions to a particular broker-dealer in return for soft dollar benefits they received.

 

Important Information

The information contained in this Frequently Asked Questions is only a summary and is not intended to be a comprehensive analysis of the rules and regulations applicable to registered investment advisers. It is not intended to constitute legal or compliance consulting advice or apply to any one investment adviser’s particular situation. For more information, please see our Terms of Use.

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