On October 19, 2005, the Securities and Exchange Commission (the “SEC” or “Commission”) published for comment a proposed interpretive release with respect to client commission practices under Section 28(e) of the Securities Exchange Act of 1934. The interpretive release, when finalized, would constitute the Commission’s fourth interpretive release under Section 28(e) over the past thirty years. In developing its position, the SEC took into account the views of other regulators, including the Ontario Securities Commission, the Australian Securities and Investments Commission, and in particular the United Kingdom Financial Services Authority (“FSA”), which adopted client commission rules that will be effective on January 1, 2006 followed by an additional 6-month transition period.
The SEC’s interpretive guidance, as proposed, is generally consistent with the FSA’s rules, with a few exceptions. The comment period will end 30 days after the proposed interpretive guidance is published in the Federal Register.
The release provides proposed guidance on six aspects of the safe harbor: (i) the appropriate framework for analyzing whether a service falls within the “brokerage and research services” safe harbor; (ii) the eligibility criteria for “research”; (iii) the eligibility criteria for “brokerage”; (iv) the appropriate treatment of “mixed-use” items; (v) the money manager’s duty to make a good faith determination as to reasonableness under Section 28(e); and (vi) third-party research and commissionsharing arrangements. The SEC is also considering whether to propose requirements for disclosure and recordkeeping of client commission practices and will evaluate whether further action is warranted.
Section 28(e) provides a safe harbor for money managers by shielding money managers from liability for statutory breaches and breaches of fiduciary duty claims on the basis that more than the lowest commission rate was paid in order to receive “brokerage and research services.” To be within the safe harbor, a broker-dealer must make a good faith determination that the amount of commission paid was reasonable in relation to the value of brokerage and research services received. The safe harbor is available to all persons exercising investment discretion with respect to an account, including fiduciaries of bank trust funds and investment advisers to separate accounts, mutual funds, hedge funds and pension plans. Although money managers cannot violate Section 28(e), conduct that is not under its protection may constitute a breach of the manager’s fiduciary duty under state law and the federal securities laws, including the Investment Advisers Act of 1940, the Investment Company Act of 1940, and the Employee Retirement Income Securities Act of 1974. One of the most significant aspects of the proposed interpretive release is that it suggests that the failure to fall within Section 28(e) necessarily creates a breach of fiduciary duty. The proposed interpretive release specifically replaces Sections II and III of its 1986 Release with revised interpretations, which give guidance as to third party research and the meaning of the phrase “brokerage and research services” in Section 28(e). These revised interpretations specifically change the definitions of "research" and "third-party research" arrangements, and establish a temporal standard for brokerage services.
FRAMEWORK FOR ANALYZING THE SCOPE OF “BROKERAGE AND RESEARCH SERVICES”
A money manager may avail itself of the Section 28(e) safe harbor so long as the manager: n determines that the product or service is eligible under the statute;
- uses the item in performing its decision-making responsibilities for accounts over which the manager exercises investment discretion; and
- makes a good faith determination that the amount of commissions paid is reasonable in relation to the value of research or brokerage product or service received.
Eligibility: Expression of Reasoning or Knowledge
In order for a product or service to constitute “research services” under the safe harbor, the product or service must constitute “advice,” “analyses” or “reports” within the meaning of the statute. The proposed interpretive release gives guidance that in order to constitute “advice,” “analyses” or “reports,” the money manager must make the determination that the product or service reflects the “expression of reasoning or knowledge.” Moreover, even if the product constitutes “advice,” “analysis,” or a “report,” the money manager must determine that the subject matter of the product or service falls within the categories specified in the statute. That is, advice 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 “analyses and reports” must relate to “issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts.”
Examples of potentially permissible research services described in the proposed interpretive release include: traditional research reports, financial newsletters and trade journals relating to the subject matter specified in the statute; software that both analyzes securities portfolios and reflects the expression of reasoning or knowledge; seminars or conferences on a subject matter specified in the statute, and market or economic data. Services deemed not to reflect the expression of reasoning and knowledge include products with inherently tangible or physical attributes, such as telephone lines, office furniture, and operational overhead expenses. Contrary to the 1986 Release, computer hardware and computer accessories are not eligible for research services since they are deemed not to reflect substantive content related to investment decisionmaking by the manager.
Lawful and Appropriate Assistance
In addition to meeting the statutory criteria, a product or service must also provide the money manager with “lawful and appropriate assistance” in making investment decisions. The proposed interpretive release states that whether a product provides “lawful and appropriate assistance” is determined largely on how the eligible product or service is used by the manager. For instance, account performance analyses used for marketing purposes do not fall within the safe harbor, but may fall within the safe harbor when used for investment decision-making purposes. Where eligible research is used for purposes within and outside of Section 28(e), the manager must treat the product or service as a mixeduse item and use client commissions to pay only the allocable portion of the item attributable to use for investment decision-making.
Eligibility: Temporal Standard
Section 28(e) explicitly states that brokerage products and services that are eligible under the safe harbor include activities required to effect securities transactions, functions incidental to securities transactions (e.g., clearance, settlement and custody), and services that are required by the SEC or SRO rules. The proposed interpretive release proposes a temporal standard for “brokerage services” under Section 28(e) whereby eligible “brokerage services” are those services provided between the time that an order is transmitted to a broker-dealer and the time that the transaction is cleared and settled (i.e., when funds or securities are delivered or credited to the advised account or the account holder’s agent). Services provided prior to an order transmission may fall within the research portion of the safe harbor, but are not eligible under the brokerage portion of the safe harbor.
Under the proposed temporal standard, communications services related to execution, clearance and settlement and other incidental functions are eligible brokerage services. Moreover, algorithmic trading software and trading software used to route orders to market centers constitute “brokerage” under the safe harbor. Although peripherals and delivery mechanisms associated with computer hardware (e.g., telecommunications lines, transatlantic cables, and computer cables) are deemed to fall outside of the “research services” safe harbor, they may be eligible under the “brokerage services” safe harbor since the transmission of orders is considered to be a “core part of the brokerage service.” However, products and services that are not integral to the execution of orders by broker-dealers and fall outside of the temporal standard do not qualify as “brokerage” in the safe harbor. Examples of ineligible products or services under the proposed temporal standard include: order management systems used by managers to manage their orders (whether developed in-house by the manager or by a third-party) and hardware (e.g., telephones or computer terminals); trade analytics, and surveillance systems. The proposed interpretive guidance also confirms that error correction trades or related services in connection with errors made by money managers are not eligible “brokerage services” under the safe harbor since they do not benefit the advised account and are separate transactions to correct the manager’s error.
Lawful and Appropriate Assistance
As with research products and services, eligible brokerage products and services must provide the money manager with lawful and appropriate assistance in carrying out its responsibilities and a good faith determination must be made by the money manager that the amount of commissions paid is reasonable in relation to the value of the brokerage product or service received.
The proposed interpretive release reiterates the SEC’s guidance in its 1986 Release regarding the mixed-use standard: if a money manager uses a research product or service for both research and non-research functions, the money manager must make a reasonable allocation of the cost of the product according to its use (i.e., the percentage of the product that provides assistance to the investment decision-making process may be paid for with soft dollars whereas the other non-research portion must be paid for by the manager with hard dollars). The manager must keep adequate records of these allocations to make a good faith determination that the amount paid for the mixed-use item in soft dollars was reasonable in relation to the value of the research product or service received.
GOOD-FAITH DETERMINATION AS TO REASONABLENESS
Each money manager seeking to avail itself of the safe harbor bears the burden of proof that it has made a good faith determination that the commissions paid are reasonable in relation to the value of brokerage and research services received, whether in terms of a particular transaction or the manager’s overall responsibilities for its discretionary accounts. The SEC also emphasized that managers must make a good faith determination that any additional commissions paid for “simply copied, repackaged, or aggregated” products or services are reasonable.
In third-party research arrangements, money managers may use client commissions to obtain research produced by someone other than the executing broker-dealer. The proposed interpretive release clarifies that research provided under these arrangements is eligible under Section 28(e) so long as the broker-dealer effecting the trade (e.g., clearance and settlement) is legally obligated to pay for any third party research provided to a money manager.
Commission sharing arrangements may be used by money managers as a means to acquire research via commissions. The proposed interpretive release addressed commission sharing arrangements. These arrangements allow managers to execute trades with one broker-dealer and obtain research or other services from another broker-dealer. Under the proposed interpretive release, the roles assumed by each broker-dealer will determine whether a commission-sharing arrangement is permissible under Section 28(e).
In order for a commissionsharing arrangement under which research and brokerage services are provided to fall within the safe harbor, the proposed interpretive release requires the following elements to be present:
- The commission-sharing arrangement must be part of a “normal and legitimate correspondent relationship” whereby each broker-dealer’s involvement is more significant than the mere receipt of commissions paid for research services provided to money managers. This means that the introducing broker-dealer must:
be financially responsible to the clearing broker-dealer for all customer trades until the clearing broker-dealer receives payment (or securities);
make and/or maintain records relating to its customer trades required by SEC and SRO rules (e.g., blotters and memoranda of orders);
monitor and respond to customer comments concerning the trading process; and generally monitor trades and settlements.
- The broker-dealer effecting the trade must be legally obligated to pay for any third party research or brokerage services or products provided to a money manager.
Comments on the proposed interpretive release must be submitted to the SEC on or before the thirtieth day after the release is published in the Federal Register. Specifically, the SEC is seeking comments on whether the proposed release is an accurate reflection of industry practices, whether there are any other significant issues under Section 28(e) that were not addressed, and whether the interpretive guidance would affect the level and distribution of costs and if so, whether these effects would be beneficial to investors or otherwise serve the public interest. The SEC specifically requested comments on the extent to which client commissions are paid for proxy voting services and massmarketed publications, and whether additional guidance from the SEC would be useful in these areas. The SEC has also requested comments on whether the final interpretive release should provide firms time to implement the interpretation.