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News June 28, 2004 Issue

A First Look at Where the SEC Soft Dollar Task Force Is Coming Out

If soft dollars are a key component of your business, you can let out that deep breath you’ve been holding in. Based on the early signs, it looks as if the worst the SEC’s soft dollar task force will do is recommend a rule prohibiting softing of things like Bloomberg terminals (of course, depending on your business, that can be a big deal). You may have to specifically document how you’ve addressed soft dollar conflicts of interest, and you may have to rethink any step-out arrangements you’ve set up. But you won’t have to abandon your beloved third-party independent research providers or, for that matter, abandon soft dollars altogether.

Until now, the inner workings of the SEC’s soft dollar task force, convened last spring by SEC Chairman William Donaldson, have largely remained secret. Late last week, however, SEC Division of Market Regulation senior associate director Larry Bergmann, speaking at the Securities Industry Association soft dollar conference in New York, shed a surprising amount of light on where the task force may be coming out on a number of issues.

Bergmann also announced that the SEC and the NASD have launched a soft dollar sweep. He said that “it’s still in the early stages” and that he had “no idea” what the sweep would reveal. But don’t be surprised if the sweep turns up something. Several times during his remarks, Bergmann noted that the SEC has seen instances of people “pushing the envelope” by engaging in soft dollar practices that have “gotten away from what the statute says.”

Bergmann portrayed the task force as taking a careful, methodical approach to studying the soft dollar issue. “We want to fully understand how the businesses are operating out there, what are the issues, what are all the moving parts, and whether or not the Commission should be doing anything about it,” he said. He agreed with the viewpoint, expressed by others at the conference, that the SEC should not take “rash action” that could have unintended consequences. Bergmann said that the task force, which is jointly chaired by the Divisions of Market Regulation and Investment Management and includes staff members from other divisions and offices, has been conducting a series of “very informative” meetings with industry representatives.

Some good news: if you were at all worried that the SEC would recommend a repeal of Section 28(e), you can relax. Throughout his remarks, Bergmann made clear that the task force is focusing its efforts on whether, and how, to tailor the scope of the Section 28(e) safe harbor. The task force, he said, is looking at “what was [Section 28(e)] really meant to cover” and “what should it be covering today.” He made no reference to any possible move by the SEC to ask for legislation to repeal the safe harbor or otherwise amend the statutory language.

More good news: while Bergmann confirmed that the SEC is paying close attention to the U.K. Financial Services Authority’s soft dollar initiative, he said that the FSA’s decisions and outcome would not drive the SEC. Unlike the SEC, which is guided by Section 28(e), “they don’t have a statute,” explained Bergmann. “They’re writing on a clean slate.” While he said the SEC staff, recognizing that soft dollars involves a global business, “wants to coordinate as much as possible” with the FSA, he promised that “we will make our own decisions about where to go on these things.”

Based on Bergmann’s remarks, it looks like we can expect the task force to come up with a rule proposal for consideration by the Commission that would recommend a new definition of “research.”

What would that definition look like? Bergmann referenced the idea, espoused by the Investment Company Institute and others, that research is “something that has intellectual content.” While he said that he thought that the intellectual content approach “conceptually” was “the right answer,” he went on to note that “that’s a really tough rule to write . . . . we’re thinking about it but I don’t know if that’s the terminology that we’re going to be using.”

The betting money is that any new definition of research will closely track the language in Section 28(e). Several times during his presentation, in discussing how the task force might approach the definition of research, Bergmann harkened back to the literal language of Section 28(e). “We are going back to the words of the statute,” he said. The task force is considering whether to “give more guidance” or simply “reiterating what the statute is focused on.”

During his remarks, Bergmann read portions of Section 28(e)(3), which says that for purposes of the soft dollar safe harbor, a person provides brokerage and research services by:

  • furnishing advice about the value of securities, the advisability of investing in, purchasing, or selling securities, or the availability of securities or purchasers or sellers of securities;
  • furnishing analyses and reports about issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts
  • ; or
  • effecting securities transactions and performing incidental functions such as clearance, settlement, and custody or related functions required by SEC or SRO rules.

“It doesn’t say anything about carpeting. It doesn’t say anything about airline tickets,” he added.

Whether or not the staff is going to “narrow” the safe harbor depends on how you look at it. “We’re just looking at getting the safe harbor back,” said Bergmann, by “reemphasizing what the safe harbor terms we think were designed to do when the statute was enacted.” It would only be narrowing in the sense that “some people may have pushed the envelope beyond where it really belongs.”

A literal reading of the statute, however, can cut against some current practices. The betting money is that Bloomberg terminals and computer hardware and software would fall out. And what about step-out arrangements? Section 28(e) contemplates that all of the broker-dealers providing the research are involved in effecting the securities transactions generating the soft dollar credits. Bergmann noted there have been questions about whether the broker-dealer receiving the stepped-out portion has been involved in the transaction. “We wonder whether or not in some contexts the broker-dealers really have no involvement in effecting the securities transaction and yet are being paid with commission dollars for research and claiming the safe harbor,” he said.

Later during the presentation, Pickard & Djinis LLP partner Lee Pickard asked whether “there was anything inherently wrong” in a situation where a broker contracts out the execution piece to a clearing broker and contracts out the research piece to an independent third party broker. Bergmann wasn’t optimistic: “Maybe this wasn’t the line that we would draw today,” he responded, “but it is the line within the statute so we have to go with that.”

Turning to some other issues:

Cost Disclosure. Bergmann said the task force was looking at “whether the costs of research should be quantified” and other ways the cost of research can be made more transparent.

Documentation. Bergmann noted that under Section 28(e), a money manager “has the clear responsibility” make a good faith determination that what it is paying out in its clients’ commission dollars is reasonably related to the value of what the adviser is receiving. Bergmann noted that although the SEC’s 1998 soft dollar sweep did not reveal many problems related to soft dollars, “one of the big problems that it did identify” was a lack of documentation “of what exactly was going on in terms of what was being received, what was being paid out.” One of the areas that the task force is looking at is “documenting this good faith determination” that soft dollars benefit clients, Bergmann said.

Later, he returned to the same theme: “There’s been a lot of focus on managing conflicts,” said Bergmann. “That’s another big piece of this. Are there conflicts that are presented especially in this context with the money manager being adequately addressed? Is there a way to tell that they are not being adequately addressed? . . . . Is there a need for more documentation about the elements that the manager is considering when making these decisions and how he is making those decisions?”

Mixed Use Products. Bergmann said that there has been “uneven attention being paid by the industry” to the use of mixed use products. He said the task force is looking at how the allocation of mixed-used products is documented.

Delivery Mechanisms. The task force is looking at whether soft dollars are being used to pay for “very expensive items” that “might be delivering research in a certain sense,” but whose wider use “may shift into mixed use,” said Bergmann. He suggested that the delivery mechanism for research should be de minimis, “like postage which would have been the classic example of what Congress may have had in mind in 1975.”

Third-party Research. The task force is not following the recommendation of the ICI to ban the softing of third party research. He said that the “operating assumption of the task force” is that “there should not be a distinction between third party and proprietary research.”

A la Carte Products. It looks as if the task force will take the view that just because a product or service is offered a la carte, it doesn’t mean it can’t be softed. “We generally think that whether it’s available for hard dollars” is not “a serious distinction” in considering whether it’s research or not, said Bergmann.

Paper vs. Electronic. Bergmann said that the task force would not distinguish between research in paper or electronic form.

So, what’s next?

Bergmann said that he hoped that the task force would submit a report to Chairman Donaldson “by the end of the year.” And then, he added, “where it goes from there is up to the Commission.” Also of note: The NASD-led mutual fund task force, which was charged by the SEC with considering soft dollars and other issues related to mutual fund portfolio transaction costs and providing “input” to the SEC’s rulemaking process, held its first meeting last week.

Meanwhile, here’s some practical advice from Bergmann’s co-panelist, ING Furman Selz general counsel Gerald Lins. While prefacing his remarks with “when in doubt, err on the safer side,” he suggested that the industry wait “until the SEC comes out with something,” before revising their soft dollar practices. Despite all the discussion surrounding soft dollars, said Lins, “not a lot has changed” and won’t “until they actually say something.”