In August, the Securities and Exchange Commission (the “Commission”) issued proposed guidance to mutual fund boards of directors (“Boards”) regarding their duties and responsibilities in overseeing the brokerage trading practices of fund advisers (hereinafter the “Release”). The Commission indicated that this guidance was a follow up companion to a July 2006 interpretive release that provided guidance on the scope of the soft dollar safe harbor under Section 28(e) of the Securities Exchange Act of 1934 (the “Securities Act”). The proposed guidance focuses on a Board’s duty to ensure that advisers meet their best execution responsibilities, and reviews the types of information Boards should seek to evaluate whether an adviser is fulfilling Section 28(e) obligations with respect to mutual fund assets. While the Release provided only proposed guidance, we believe it provides insight into the Commission’s expectations for Board reviews of an advisor’s best execution obligations and soft dollar usage for the mutual funds they serve.
A Fiduciary Responsibility to Oversee and Monitor Fund Brokerage Trading Practices. The proposed guidance notes that Boards have a fiduciary duty to oversee and monitor their funds’ advisers’ brokerage trading practices. The Release states that the proposed guidance does not impose any new or additional requirements for Boards, but rather is intended to assist a Board in fulfilling its responsibilities of overseeing and monitoring an adviser’s satisfaction of its best execution obligations and the conflicts of interest that may exist when an adviser trades the securities of a mutual fund client.
Board Oversight of Advisers’ Best Execution Policies and Procedures. The Release indicates that a Board should evaluate an adviser’s best execution obligations as part of the Board’s approval of the adviser’s policies and procedures under Rule 38(a)-1 of the Investment Company Act of 1940, as amended (the “1940 Act”). According to the Release, a Board should request the following data for such a review: (i) the identification of broker-dealers to which the adviser has allocated fund trading and brokerage; (ii) the commission rates and spreads paid; (iii) the total brokerage commissions and value of the securities executed that are allocated to each broker-dealer during a particular period; and (iv) the mutual fund’s portfolio turnover rates. According to the proposed guidance, Boards should use this information in determining whether an adviser’s trading practices (including soft dollar usage) with respect to the mutual fund are consistent with the best interest of the fund and its shareholders.
Board Oversight of Advisers’ Use of Soft Dollars. The Release also discusses a Board’s role in overseeing an adviser’s use of soft dollars from fund trades, including, without limitation, the need for a Board to understand an adviser’s brokerage and conflicts of interest policies and procedures to ensure that soft dollars are not being used “inappropriately”. The proposed guidance suggests that Boards should pay particular attention to these policies and procedures in evaluating whether services the adviser obtains using fund brokerage commissions fall within the Section 28(e) safe harbor for “research” and “brokerage” services as required under Section 17(e)(1) of the 1940 Act.
Board Review of Soft Dollars during Adviser’s Contract Review Process. In the Release, the Commission also reminds Boards that brokerage review should be part of the Board’s annual review of an adviser’s contract under Section 15(c) of the 1940 Act. The guidance indicates that a Board should seek and review annual information regarding brokerage policies and practices, and soft dollar benefits received from fund trades, in addition to general information that advisers prepare for Boards for their annual contract review.
Comments to the Release. The deadline for submitting comments to the proposed guidance was October 1, 2008. The Commission has collected and published a number of comments on the proposed guidance that are currently under review. Several commenters have expressed their support for the proposed guidance, particularly to the extent it encourages further transparency with respect to brokerage costs and soft dollar usage for mutual funds. However, a number of commenters have raised significant questions about whether the proposed guidance would add new requirements for Boards, despite claims in the Release that it is not intended to set new standards. For example, several commenters have argued that statements indicating Boards should review whether soft dollars generated by fund trades are used in the best interest of the fund would set a new standard for fund commissions that is inconsistent with the soft dollar safe harbor permitting an adviser to consider benefits to all of its clients for purposes of meeting the adviser’s best execution obligation under Section 28(e). Some commenters also noted the Release’s generally negative tone toward soft dollars, and several urged the Commission to consider how the proposed guidance, if adopted, would impact the availability and use of soft dollars to purchase independent research.
Conclusion. We share concerns expressed by some commenters regarding whether the proposed guidance, if adopted, would usher in new standards of review for fund brokerage and soft dollars. At the same time, we recognize that an adviser’s direction of brokerage for funds is an important fiduciary responsibility, and should be carefully reviewed by Boards as part of their ongoing evaluation of fund advisers.
We encourage Boards to consider the Commission’s thoughts included in the proposed guidance as they continue to serve their funds as fiduciaries to shareholders since, whether the proposed guidance is adopted in a substantially similar final form or not, the Release provides insight into the Commission’s current thinking about Board responsibilities and duties with respect to brokerage and soft dollars.
If you have any questions regarding the Commission’s proposed guidance, or actions a Board might wish to begin taking in light of the proposed guidance, please feel free to contact us at the numbers below. In addition, we will be happy to provide you with a copy of the Release and public comments received by the Commission to the Release upon request.