A First Look at the SEC’s Proposed Soft Dollar Interpretative Release
Weíre told that the SECís new soft dollar interpretative release wonít see the light of day until later this week. Until then, hereís IM Insightís "shadow release," pieced together from statements made at the SECís September 21 open meeting as well as remarks delivered by OCIE associate director Gene Gohlke at the ICIís equity markets conference the following day. (Intriguingly, Gohlke appeared to have a draft copy of the SECís release up on the dais with him during his remarks.)
Much of the proposed interpretation appears to be a re-packaging and re-emphasis of existing SEC soft dollar guidance. However, there are a few changes of note, as well as some significant distinctions from the approach taken by the U.K. Financial Services Authority.
If adopted, the SECís interpretative release would set out a three-pronged test for advisers to use when determining whether a product or service is softable under Section 28(e):
Test #1: Is it "eligible" research and brokerage under Section 28(e)? First, a brokerage or research product or service must satisfy the eligibility criteria in Section 28(e).
According to a statement delivered by Division of Market Regulation deputy director Robert Colby during the SECís open meeting, eligible research would be limited to "advice, analyses, and reports that have informational and intellectual content." Eligible brokerage "would be those products and services that relate to the execution of the trade, beginning from the point at which the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution to the point at which funds and securities are delivered or credited to the advised account." The temporal limitation on eligible brokerage closely tracks the FSAís approach to defining permitted execution services, and is a new addition to the SECís soft dollar guidance. Interestingly, Commissioner Paul Atkins questioned whether the temporal standard would "invite gamesmanship."
So, whatís in and whatís out? Hereís a list of things specifically mentioned during the open meeting and during Gohlkeís comments as being outside the scope of 28(e): membership dues, professional licensing fees, office rent, carpeting, entertainment and travel expenses, computer hardware, salaries of research staff, and order management systems.
What about mixed-use products? They would not be prohibited, as some had feared. "The cost of mixed-use items must be reasonably allocated between eligible and ineligible uses, and the allocation must be documented," said Colby. Later in the meeting, Atkins indicated that analytical software would be included within the safe harbor as a mixed-use item.
. . . Data feeds? Although there was much debate on this point leading up to the proposal, data feeds made it in. Under the "informational and intellectual content" criteria for research, said Colby, "market, financial, economic, or similar data would be within the safe harbor." Thatís good news for those worried that the SEC would follow the approach of the FSA, which has classified "raw," non-manipulated data as non-permitted research (although it may be execution).
By the way, if youíve been wondering what, exactly, "market data" is, hereís an answer: "Market data would be such things as stock quotes, last sale prices, [and] volume statistics," said Gohlke. "Itís information on what is going on in a market or markets that the adviser is interested in following."
. . . Newspapers? Colby noted that some in the industry had suggested that mass-market periodicals be excluded from the definition of eligible research, since they are "essentially overhead, like magazines in a dentistís office." The thought was that such periodicals "donít add a lot to the decision-making process, they are sort of things that people just have to buy," he said.
The staff apparently agreed, and set to work on a standard to distinguish between materials targeted to a specialized audience and those targeted to a mass audience. However, said Colby, the staff wasnít able to come up with a standard that provided a clear line, since anything on the Internet is potentially directed at a mass audience. So they left it out.
But feel free to take a crack at it yourself. If, during the comment period, "somebody does craft a way of articulating this so that weíre comfortable with it," said Commissioner Cynthia Glassman, "weíll consider it."
SEC Chairman Christopher Cox said that the fact that there is "no explicit new guidance" on mass-marketed materials "doesnít suggest that we are changing any way our past guidance." The conventional wisdom, of course, is that newspapers should be treated as business overhead and not be softed.
. . . Post-trade analytics? Interestingly, not much was said about this. Atkins requested that the release ask for comment on whether post-trade analytics should be eligible. At one point during the open meeting, Colby indicated that post-trade analytics could be considered research.
Test #2: Does it provide lawful and appropriate assistance to the adviser? Back to the three-part test: Once a product or service is determined to be eligible under Section 28(e) as brokerage or research, it then needs to pass through a second hoop: the product or service must provide "lawful and appropriate assistance" to the money manager in carrying out its decision-making responsibilities. According to Gohlke, the release contains a statement that "the burden of proof in demonstrating" that a product or service provides lawful and appropriate assistance in an adviserís investment decision-making process "rests on the money manager."
While the "lawful and appropriate assistance" standard has been around since the SECís 1986 soft dollar release, "it is very much emphasized in this release," said Gohlke. "As I read it, product-by-product, the adviser needs to have a process to make this determination that [the] product will provide lawful and appropriate assistance in making investment decisions for clients."
Gohlkeís co-panelist, Mayer, Brown partner Stephanie Monaco, expressed concern that Gohlkeís use of the word "process" is, as she put it, "a code for procedures and monitoring and quarterly reviews and perhaps for disclosure of that process." She asked whether that might lead to SEC examiners second-guessing whether, for example, a particular data feed provides lawful and appropriate assistance to a particular adviser.
In a word, yes.
Gohlke replied that advisers should have a process in place so that when examiners ask, "I see you have this page, this list of stuff you get under your soft dollar arrangements . . . . I would like to see what considerations you had in determining that those things were one, eligible and two, that they provide this assistance, and [three,] that the commissions paid were reasonable."
Which brings us to . . .
Test #3: Is the amount of commissions paid reasonable? Last, but not least, an adviser must make a good faith determination that the amount of commissions paid to a broker-dealer are reasonable in relation to value of the products or services provided by the broker-dealer. That, of course, is simply a reiteration of the existing standard in Section 28(e).
How it all fits together. Say an adviser wants to soft some market data. To be eligible as research under 28(e), the data must reflect "informational and intellectual content." Helpfully, the SEC said flatly that based on those criteria, market data is, in fact, eligible research.
But the adviser canít stop there. It needs to then consider whether the data provides "lawful and appropriate assistance" in the adviserís investment decision-making process.
For some advisers, said Gohlke, "it might." For example, he said, "if you are quantitative shop . . . price movements in securities could be an important factor in your model."
For other advisers, it might not. If a shop doesnít use market data in its investment decision-making process, it canít soft it ó not because the data isnít eligible under 28(e), but rather, because it does not provide lawful and appropriate assistance to the adviser. "It depends on the facts and circumstances of the adviserís process," said Gohlke.
And, of course, the adviser has to determine that the amount of commissions paid to the broker-dealer providing the market data is reasonable.
Hereís another example of how the three-step test would work, using seminars: "If the content of the seminar fits within the statutory areas and a manager can also show that it provides assistance in making [investment] decisions and itís a good use of commission dollars, it could be within the safe harbor," said Market Reg senior associate director Larry Bergmann. Thatís a difference from FSA, which has said flatly that seminars are out. (Keep in mind, though, that any associated travel or hotel costs would not be softable, as Atkins noted.)
Other notable items in the release:
Commission-sharing arrangements. A discussion "towards the back" of the release "reiterates" that under Section 28(e), broker-dealers have to be financially responsible for the brokerage and research products and services that they provide to advisers, and they must be involved in effecting the trade. This discussion, said Gohlke, is applicable to introducing firm arrangements, step-out arrangements, so-called "commission savings accounts" offered by some broker-dealers, and other commission-sharing arrangements. Basically, he said, it applies any time a money manager executes a trade through Broker X, wants research from Broker Y, does not want to execute through Broker Y, and wants commissions to flow from Broker X to Broker Y to pay for the research. In those instances, he said, the release is proposing "some new requirements." Gohlkeís advice: "Firms ought to make sure that if they are in that space, to take a look at the back."
Quite helpfully, he then proceeded to read from the draft release:
"All parties to those arrangements" (Broker X, Broker Y, and the money manager, explained Gohlke) "need to consider whether the managerís fiduciary duty to its clients has been compromised through the involvement of multiple parties to the trade."
The release apparently goes beyond the old "provided by" standard to additionally emphasize that any broker receiving commissions for soft dollar products or services has to have had some role in the execution of the trades, either as an introducing broker carrying the adviserís account or by having some financial responsibility for the trade. And, of course, advisers may not contract directly with a research provider and send the providerís bill to their broker-dealer with a note that says, "Please pay out of my soft dollar account."
Gohlke also noted that the discussion of the commission-sharing arrangements was not intended to encompass client-directed commission recapture programs.
Parity of third-party and proprietary research. The release emphasizes the Commissionís view that independent, third-party research should be treated the same as proprietary research. As Gohlke put it, "the Commission is not at all interested in firms cutting back" on third-party research or treating it differently from proprietary research.
So whatís changed from past SEC interpretations? Colby noted that the proposed release would not affect the 1986 soft dollar releaseís discussion of best execution, third party brokerage, and mixed use allocations. However, with respect to the definition of research and brokerage, the proposed interpretative release would "supplement" the standard used in the 1986 release "with another, more specific, set of criteria," he said.
Atkins rightly anticipated the intense industry interest in identifying whatís changed. He noted that the draft release "obliquely" discussed the differences from past SEC interpretations, and asked for greater clarity. "I think we need to focus on the differences that we are taking" from the 1986 release, he said.
So look for the SEC to spell out the differences for us in black and white.
What about differences from the FSAís approach? Bergmann described the SECís approach as "actually quite similar" to the FSAís approach, both with respect to research and brokerage. The FSA, he noted, requires that research reflect represent "original thought and intellectual rigor," whereas the SEC uses an "intellectual content and informational content" standard. That, he said, "comes down to the same thing." Similarly, he noted that both the SEC and the FSA have adopted a temporal standard for determining eligible brokerage. "So there, I think we are pretty much on all fours," he said.
There are some differences. Notably, in the U.K., seminars and raw data feeds are not softable research. In the U.S., they may be softable, assuming the three-part test is met.
Perhaps the most notable break from the FSAís approach is the SECís view on commission-sharing arrangements. Speaking at the SIAís soft dollar conference early last week, Christina Sinclair, head of institutional business policy at the FSA, explained that in the U.K., commissions may be directed to all producers of research, whether they have execution capability or not, through the use of commission-sharing arrangements. "I understand that this is not the position under current U.S. legislation," said Sinclair, "and this may cause some difficulties for firms operating cross border."
Get out those pencils. The comment period on the interpretative release "is just a mere 30 days long," as Atkins put it. In contrast, he noted, the FSA engaged in "months of commentary and dialogue" on soft dollars. (Actually, it was years.) In any event, Atkins has set his own personal comment period, saying that he will welcome comments "right up until our next open meeting to consider this issue." Among other things, Atkins suggested that commenters discuss how much time the industry will need time to implement any new interpretations.
During his remarks, Gohlke emphasized that the interpretation was "only a proposal."