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News January 19, 2015 Issue

Soft Dollars: Use Them, But Use Them Wisely

Research and brokerage services may be charged to clients through the use of soft dollars. But advisers doing so need to ensure they use them properly.

Section 28(e) of the Securities Exchange Act provides a safe harbor for advisers who receive research with soft dollars, more formally known as "client commissions," without being viewed as breaching their fiduciary duty to clients. The safe harbor allows a money manager to cause an account to "pay a broker-dealer a higher commission for effecting a trade than another broker-dealer might charge," said Morgan Lewis partner Steven Stone. But those soft dollars must be used in strict compliance with the requirements of that safe harbor, as well as SEC guidance.

The statute allowing soft dollars is a "preemptive provision." As such, it "slices through all other laws, including state law, the Investment Company Act and ERISA," Stone said. The most recent interpretive guidance from the SEC came in 2006, and that guidance provides specific criteria for eligible research and brokerage services.

Money managers seeking to use soft dollars should first determine whether the desired use falls within the list of eligible research or brokerage product or services listed in Section 28(e), and then, assuming those products or services are legal and appropriate, determine "in good faith that such amount of commission was reasonable," according to the statute.

Advisers would be wise to periodically review and conduct staff re-education on soft-dollar use, said Rogers & Hardin partner Stephen Councill. They should make a point of periodically evaluating the value of their research and brokerage services to make sure they are appropriate.

Eligible research services

The SEC, according to the 2006†agency interpretation, stated that research products or services will be considered eligible for the soft-dollar safe harbor if they:

  • Constitute advice, analyses or reports;
  • Provide advice, either directly or through publications or writings, regarding the value of securities and the advisability of investing, purchasing or selling them, as well as the availability of securities or purchasers or sellers of them;
  • Provide analyses and reports in regards to the securities, issuers, industries, economic factors and trends, portfolio strategy, and/or performance; and
  • Reflect an "expression of reasoning or knowledge," the SEC said.

Types of research that might qualify include:

  • Publications narrowly marketed to readers with specialized interests in particular fields, and which have "high cost";
  • Market research, such as pre-trade and post-trade analytics, software and products that depend on market information to generate market research; and
  • Proxy services, if they contain reports and analyses on issuers, securities and the advisability of investing in them.

"Not everything that one might think of as research is research," Stone said. For instance, subscriptions to mass-market publications, such as the Wall Street Journal, would not qualify.

Eligible brokerage services

Brokerage services, like research services, "also are more limited that one might think," Stone said, noting that they cover only services provided "from when an order is placed to when it is settled," and that they do not include long-term custody services.

Those services that do qualify, according to the 2006 interpretive guidance, include:

  • Order management systems, but only those parts that provide brokerage or research value, such as pre-trade and post-trade analytics, order routing services, and algorithmic trading services;
  • Post-trade matching of trade information;
  • Electronic communication of allocation instructions between institutions and broker-dealers;
  • Routing settlement instructions to custodian banks and broker-dealersí clearing agents; and
  • Short-term custody related to effecting particular transactions in relation to clearance and settlement of the trade.

Best practices

Aside from meeting the requirements of the statute and the 2006 SEC interpretive guidance, Stone suggested that advisers interested in using soft dollars consider the following best practices:

Disclose soft dollars to clients to address potential conflicts of interest. This can usually be taken care of by providing the information on the adviserís Form ADV, Part 2A ("Brochure"), Stone said. At other times, however, such as when using soft dollars in conjunction with pooled investment vehicles, disclosure is also required in private placement memorandums.

  • Be wary of saying that you donít "pay up" for research. Saying that you donít "pay up," or pay a higher commission, for the receipt of soft dollar products or services can land you in a trap of your own making. For instance, a money manager might think that it does not pay for soft dollars at the time of disclosure, but may regret that lack of flexibility later on, particularly if it needs to negotiate over commissions, something that "could leave you subject to scrutiny by the SEC," Stone said. Councill noted that new firms, for instance, may not use research vendors in their early years and therefore not list them on the disclosure form. Some time later those firms will start using research vendors, but because they never revisited the 28(e) requirements, they never went back and changed the form, leaving them open to a disclosure violation.
  • Be careful with mixed-use services. These are services where only part of their use falls within the eligible criteria of research or brokerage services. For instance, said Stone, if a money manager uses research for purposes other than investment decisions or managing client accounts or by employees that are not involved in providing these services, they would be considered outside the safe harbor. In such cases, the portion of the service that falls outside the safe harbor would have to be paid for by the money manager. Advisers that use mixed-use services would be wise to come up with a methodology detailing how they would determine what portion of the services should be paid with their own money, he said, as the SEC does not provide one. That methodology should be reviewed at least annually, he said.