• More Light Shed on Soft-Dollar Research
  • August 30, 2006 | Authors: Gregory J. Nowak; Jennifer S. Meredith
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • On July 12, 2006, the Securities and Exchange Commission (SEC) published an Interpretative Release regarding the use of soft dollars under Section 28(e) of the Securities Exchange Act of 1934 (the 34 Act). The Interpretative Release had an effective date of July 24, 2006; however, reliance on the SEC’s prior analysis of soft dollar use may continue until January 24, 2007. The Interpretative Release aims to explain the limits of the Section 28(e) safe harbor, which allows investment managers to use commissions to purchase brokerage services and research. (For additional information and background on the Interpretative Release, see our prior alerts at http://www.pepperlaw.com/pepper/publications_article.cfm?rid=926.0 and http://www.pepperlaw.com/pepper/publications_update.cfm?rid=765.0.) The Interpretative Release addresses a significant increase in soft dollar use in the United States, as soft dollar use currently represents approximately 9 percent of total equity institutional commissions.

    During a July 31, 2006, speech, SEC Commissioner Roel Campos offered more clarification of the recently adopted Interpretative Release. Commissioner Campos noted that the original intent of the soft dollar safe harbor was to allow advisers to use broker-dealer commissions to purchase research if the research is bundled with execution costs. The advisers would benefit from the safe harbor with respect to their fiduciary duty to seek best execution. Commissioner Campos reiterated the three-part test used to determine whether certain research would fall with the Section 28(e) soft dollar safe harbor:

    • The service offered is eligible “research” or “brokerage;”
    • The service offered “provides lawful and appropriate assistance with investment decision-making” (especially with regard to mixed-use investment products); and
    • A good-faith determination is made that client commissions paid are reasonable as compared to the value of the products or services provided by the broker-dealer.

    Commissioner Campos offered additional general guidance and observations:

    • Eligibility under the three-part test does not alter or diminish the duty to seek best execution.
    • The SEC has not provided an exhaustive list of exempted research and services; use the examples issued so far as guidance.
    • Eligible research or services must reflect “an expression of reasoning or knowledge.” [Pepper Note – this is probably the most instructive observation.]
    • Still uncertain? Be cautious and pay for the research directly rather than through soft dollars.
    • Is unbundling necessary? Requiring brokers to unbundle their commissions to clarify the line between execution and research charges is a conservative approach, but is not required by the SEC at this time.
    • Third-party research falls within the safe harbor only if the broker is obligated to the third party to pay for the service.
    • Commission-sharing arrangements are permissible when certain conditions are met, especially with small broker-dealers or independent research providers who cannot provide all service independently. As such, broker-dealers may reasonably allocate functions among themselves, including the minimum requirements for complying with the Section 28(e) guidance.
    • Paying one broker-dealer for execution and another broker-dealer for research is not considered to be a violative “give-up,” and thus permissible under the safe harbor.