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News January 15, 2007 Issue

Complying with the SEC’s New Soft Dollar Regime

Seems like just yesterday the SEC issued its new soft dollar interpretive release. But time flies, and January 24, the mandatory compliance date for abiding by the new interpretation, is just around the corner.

Given that the SEC has emphasized the importance of its new three-step process for looking at soft dollars, it seems prudent for all advisers to spend some time confirming that they are in compliance with the SECís new parameters. Even shops that shun soft dollars or whose soft dollar practices are completely plain vanilla should review their practices. At a minimum, going through a reflective process will prepare you to handle SEC examinersí inevitable questions on how your firm has assured itself that it is in compliance with the new interpretation. It will also "count" toward your next annual review. And you never know: it may surface issues that you were not even aware of.

First, make sure you even care. Confirm that your firm has represented that it will abide by the 28(e) safe harbor. For mutual fund advisers and advisers with ERISA accounts, this should be a given. But for hedge fund advisers, it may not be.

If your firm has a stated policy of not softing anything, itís worth confirming that you are not, in fact, receiving any soft dollar products or services. For example, if your firm executes trades through a full-service broker that sends you unsolicited research, see what your favorite lawyer thinks about treating that research as a soft dollar product.

Read up. Assuming your firm is living in 28(e)-land, read (or re-read) pages 21 to 50 of the SECís release. If you are a history buff, you can read the pages before that. And if your firm participates in a commission-sharing arrangement, check out pages 50 to 60 of the release. But the bulk of what most firms will need to know lies on pages 21 to 50.

Of course, if you make a point of reading the whole release cover-to-cover, this will allow you to look SEC examiners in the eye and say, "I made a point of reading the whole release, cover-to-cover."

One way or another, you do need to go back and read. While the various law firm summaries of "whatís in" and "whatís out" are helpful, this is one area where you really should hear it from the horseís mouth. "The primary thing here is read this release," said Adviser Compliance Associates managing partner Rob Stype.

Find out what youíre currently doing vis a vis soft dollars. Make sure you have a handle on what, exactly, your firm is softing. You may think you already know. But itís still worth doing some investigative work. Stype said that when conducting mock audits, his firm "fairly often" runs into the situation where a firmís portfolio managers or research analysts will identify a soft dollar product or service that the firmís compliance department didnít even know about. "It is not that the research folks were trying to hide it," he explained. "They just didnít realize that they should have been talking to compliance about it because they didnít think of it as a soft dollar product."

To get a handle on whatís going on, review minutes of meetings of your firmís best execution committee. Look over any written soft dollar agreements. See if soft dollar products and benefits are tracked electronically on any of your firmís platforms.

At some point, however, youíll need to talk to your portfolio managers, analysts, and traders about what the firm is receiving from brokers. Make sure that you understand the nature of the products and services they describe, and donít be afraid to ask dumb questions. If they grouse, tell them that SEC examiners probably will be asking them the same questions down the line.

Stype emphasized the importance of talking to the firmís investment and research staff. "You can do all the great analyses you want on the products you know about, but if your firm is receiving products that you donít know about, you are going to be in trouble."

Make a matrix. To be clear: the SECís release doesnít say boo about a matrix or, for that matter, require any written document memorializing your soft dollar review. Still, a matrix is an idea worth considering, especially by larger firms. First, it will demonstrate that you have gone through the new three-step analysis set out in the soft dollar release. Without a doubt, examiners will be checking to see whether your firm has scrubbed the products and services it softs against the new interpretive guidance. And the SEC made no bones about the fact that it was laying out "the appropriate framework for analyzing whether a particular service falls within the Ďbrokerage and research servicesí safe harbor."

Not "an" appropriate framework, mind you. "The" appropriate framework.

Second, a matrix will allow you to document, in one place, the products and services that your firm is receiving. "In the Commissionís view," said the Commission, "the prudent way for a money manager to meet its burden of showing eligibility for the safe harbor is to document fully its client commission arrangements." At last fallís NSCP national conference, OCIE associate director Gene Gohlke indicated that examiners will look for documentation: "I think you can expect the examination staff to ask for things in writing from the adviser that [demonstrate] that they made those findings," he said.

What should your matrix look like? Going down the far lefthand side, have a column listing each product and service that your firm currently receives via soft dollars. Here, the question is whether you have to do an item-by-item analysis or whether you can group things into categories. Practically speaking, you probably will have to lump items into categories. Just make sure that the categories arenít too broad, and that the items in each category lend themselves to the same sort of analysis. For example, "research reports on the state of the economy" or "research reports received from Firm X" might work. But "software" probably wouldnít, as that category could include everything from compliance software (out) to order management systems (probably mixed use) to trade analytical software (in, or mixed use).

Examiners "generally understand that they canít just pull out every individual product and just say, ĎOkay, let me see the exact numbers on this product,í" explained Stype. Instead, they are typically more willing to look at soft dollars more broadly. "I think they understand that this analysis would be very difficult, if not impossible, to conduct on an item-by-item basis," he said.

Going across the top of the matrix, create the following four columns:

  • Eligible?
  • Provides lawful and appropriate assistance in the performance of our investment decision-making responsibilities? (putting down the whole thing keeps the relevant standard in front of you)
  • Mixed use? If so: Allocation? Who allocated? When?
  • Commissions paid reasonable in light of value?

You might want to consider throwing in additional columns, such as:

  • Brief description of the product or service.
  • How is the product or service used by the firm?
  • Does the product or service represent proprietary research?
  • Was the product or service obtained via a commission-sharing arrangement?
  • Has this information been confirmed with relevant business unit? Who confirmed it? When?

Before adding any of these bells and whistles, however, consider the work they will create and why you are adding them. Perfection should not be the enemy of the good. But youíll definitely want to have these four columns:

Column 1: Is it eligible? Youíve probably heard umpteen times that computers, long-term custody, and the Wall Street Journal are out. For more, consult one of the many lists or memos of "whatís in" and "whatís out" that are floating around. Or, better yet, just flip through the SECís release. "The release is actually pretty clear," said Stype. "Itís not difficult to understand what the SEC is saying." When in doubt about whether something is eligible, document the reasons behind your decision so youíll remember later and have something to show the examiners.

Column 2: While people tend to refer to this as the "lawful and appropriate" standard, prohibiting the softing of administrative and overhead costs, itís also worth thinking about it as the "investment decision-making" standard. At the end of the day, does the product or service help your firmís portfolio managers, analysts, or traders do their jobs better? The answer, of course, will depend on what kind of shop you are at. Keep in mind that things that might make it through the eligibility hoop may not make it through the lawful and appropriate assistance hoop.

Column 3: Is the item mixed use? Proxy voting services, order management services, performance measurement services, and trade analytics may all be mixed use. For each item that is mixed use, jot down the allocation and which individuals at the firm were responsible for the allocation and when the allocation was made. Heed the following guidance from the SEC: "In allocating costs for a particular product or service, a money manager should make a good faith, fact-based analysis of how it and its employees use the product or service. It may be reasonable for the money manager to infer relative costs from relative benefits to the firm or its clients. Relevant factors might include, for example, the amount of time the product or service is used for eligible purposes versus non-eligible purposes, the relative utility (measured by objective metrics) to the firm of the eligible versus non-eligible uses, and the extent to which the product is redundant with other products employed by the firm for the same purpose."

For some ó or all ó of your mixed used items, it may be worth creating a separate memorandum memorializing the reasons behind the allocation decision. At the NSCP conference, Gohlke cautioned that examiners still see "inadequate documentation of how that hard/soft dollar split was arrived at." Examiners, he said, do not want to find a "seat of the pants" analysis, "where the adviser says to itself, ĎA 90/10 split seems greatí but there is really no support for that allocation."

Column 4: Are commissions paid reasonable to the value of soft dollar products and services received? Stype described this step as "the hardest one," because the value of the softed item may not necessarily be tangible. Happily, the SEC asked advisers only to make a "good faith" determination, perhaps in recognition that advisers may not be able to pin down exact values.

If youíre not sure how much something is worth, see if you can find out the market value of the product or service, perhaps by asking the vendor directly.

And good luck trying to value proprietary research. Stype predicted that examiners "probably wonít push too hard on that issue," at least until the SEC requires unbundling (if, of course, they ever do). On that note, the SECís release did note that if a brokerage firm offers research at an unbundled price, "that price should inform the money manager as to its market value and help the manager make its good faith determination."

Once youíve gone through and jumped through the SECís three-step test (four steps, actually), let out a sigh of relief: If examiners walked in the door right that instant, youíd be in good shape.

But youíre still not done.

Make sure everyone is sharing nicely. If your firm receives soft dollar products or services via a commission-sharing arrangement, confirm that the brokers involved in that arrangement are complying with the SECís guidance for "effecting" and "providing" the product or service.

Review your disclosure. Since youíve just spent quite a bit of time familiarizing yourself with your firmís soft dollar practices, nowís an ideal time to review any and all disclosures your firm has made regarding its soft dollar activities. These may be found in the management agreements, ADV, fund prospectuses or SAI, or hedge fund offering documents. The disclosures donít have to be identical, noted Stype, as there may be different issues that are being addressed in different documents. "But certainly, there should not be inconsistencies," he said.

While youíre at it, do some tests. While youíre thinking about soft dollars, why not knock out part of your annual review obligation? Look at average commission rates paid by each client and average commission rates paid to each broker. Compare commissions paid to soft dollar brokers relative to commissions paid to non-soft dollar brokers. See if there are different commission rates charged for similar trades in the same security. Look for end of year (or end of period) excessive trading to meet soft dollar commitments. "Itís kind of a back-door way to find out if there are services that you werenít aware of as a compliance officer," explained Stype. A high volume of trades or high commission rates can indicate undisclosed soft dollar arrangements, or possibly referral arrangements.

Fix any problems that emerge. Obviously, if issues arise, youíll want to address them. Remember to review and revise your compliance policies and procedures, as necessary.

Also, consider whether your firm needs to make changes to its ADV disclosure. If the changes are significant, consider proactively sending the ADV to all clients/investors with a cover letter highlighting the changes. While that may not be ideal from an operational standpoint for firms that have a large number of clients, noted Stype, "itís a great protection."

Lastly, consider whether there are any other constituencies that need to be informed of the issues and/or changes, such as fund boards or service providers.