SEC Rethinks Commission-Sharing Arrangements in Final Soft Dollar Release
The SECís final soft dollar interpretative release contained two key changes: First, the Commission explicitly stated that mass market publications are not eligible research and therefore may not be obtained with soft dollars under Section 28(e). Second, the SEC significantly liberalized its views on commission-sharing arrangements.
The release also contained a number of subtle modifications. The Commission clarified that proxy services may be mixed-use, in that a proxy serviceís reports and analyses on issuers and securities may be research, but mechanical proxy voting services are overhead. The SEC provided additional guidance on what aspects of order management systems (OMSs) may and may not be softed: trade analytics provided through OMSs may be softable, but analyses of the quality of executions over time are not. Advisers "may not use client commissions under the safe harbor to meet their compliance responsibilities," said the SEC.
Also of note: Meetings with corporate executives to obtain oral reports on the companyís performance may be eligible research, but the travel costs of getting to those meetings are not.
The July 18 release recycles large swatches of text from the October 2005 proposal, and maintains the SECís original three-step test. Namely, to assure itself that a particular product or service is softable under 28(e), an adviser must:
determine whether the product or service falls within the definition of eligible research or brokerage;
determine if it actually provides lawful and appropriate assistance to the adviser in the performance of its own investment decision-making responsibilities; and
make a good faith determination that the amount of client commissions paid is reasonable in light of the value of the products or services provided.
The new guidance is effective as of July 24, 2006. To ease the transition, the SEC said that the industry may continue to rely on past interpretations of Section 28(e) for another six months, until January 24, 2007.
For an in-depth analysis of the release, including a handy set of charts of whatís in and whatís out, check out this quarterís Pickard Washington Report, released by BNY Securities Group.
The final release "is helpful in providing some needed clarifications" about what is and is not softable, said Michael Wolensky of Schiff Hardin. Wolenksy reported that when clients ask questions about the applicability of the guidance, their inquiry tends to focus on the permissibility of softing a particular type of product or service. The questions, he said, "are all so fact specific."
Mass market publications. In a change from the proposing release, the SEC explicitly stated that mass-marketed publications are not 28(e) "research," and therefore may not be softed. That new interpretation did not come as a complete surprise, reported Stradley Ronon partner Larry Stadulis. "A lot of people could see the writing on the wall" based on the Commissionís statements on the subject in the proposing release, he said.
To help advisers determine whether a particular publication is a "mass market publication," the SEC provided the following guidance: If a publication is circulated to a wide audience, intended for and marketed to the public, and carries a low cost, it would seem to be a mass-marketed publication and should be treated as overhead (i.e., not softed).
If, on the other hand, the publication is narrowly marketed, is directed to readers with specialized interests in particular industries, products, or issuers, and carries a high cost, it would appear to be softable research. The SEC stated that trade magazines and technical journals concerning specific industries or product lines, such as nano-technology or medical devices, are eligible as research if they are marketed to and intended to serve the interests of a narrow audience, such as physicians, rather than the general public.
The method of distribution (print, web, etc.) does not alter the analysis of whether an information source is a mass market publication. A publication that can be accessed on the web by the general population, but is marketed only to a narrow audience, can still be research.
Commission-sharing arrangements. By statute, brokers that participate in Section 28(e) arrangements must be involved in "effecting" the trade. In a change from the proposing release, the SEC has now taken the position that a broker may meet that requirement by executing, clearing, or settling the trade OR performing one of the following four functions and allocating the remaining three to another broker: 1) taking financial responsibility for customer trades; 2) maintaining records relating to customer trades; 3) monitoring and responding to customer comments concerning the trading process; or 4) monitoring trades and settlements.
Stadulis described this revised position as "one of the biggest changes" in the release. The initial release, he said, took the "fairly narrow" position that both brokers involved in a commission-sharing arrangement had to provide some level of execution services. However, he noted, the SEC received a significant number of comments on this point and consequently rethought its position. "They accommodated the industry to a large degree on this," he said. "As long as one of the brokers is effecting the transaction, both of them donít have to be." Stadulis noted that the new position more closely tracks the approach taken in the United Kingdom.
In his view, the SECís "big concern" with commission-sharing has been give-ups. Rather than getting bogged down in the terminology describing the different sorts of arrangements, he said, the SEC now seems to be asking whether, "at the end of the day," a particular arrangement involves a give-up. If a commission-sharing arrangement does not raise the policy concerns underlying give-ups, he said, it is fine. Stadulis praised this as a common-sense approach.
The SEC requested comment on its new commission-sharing guidance. Comments must be received by September 7, 2006.
BNY president John Meserve was pleased with the final interpretative release, saying that there had been a real effort within the Commission to "get consensus" while at the same time addressing market-place concerns. The SEC ended up with a "much more liberal approach to commission sharing than anyone had anticipated." Meserve noted that the mandatory four test approach, as originally set out in the proposing release, would have been difficult for many independent research providers to meet. Now, by saying that only one of the four tests must be met by the research provider, with the other elements met by the other broker, the SEC has established "a lower burden" that can be more realistically met by independent research providers. And, he noted, advisers can now "pool" their soft dollar credits so as to "build up a kitty" that can be used to purchase research, similar to the approach taken in the U.K.
Meserve also noted that the agency "reinforced and re-endorsed" the notion that commissions can be used to obtain research. "They were very, very strident" that independent research and proprietary research should be treated equally, he said. "The bottom line is that after three years, the Commission has done everything that we had hoped for."
Will there be a second soft dollar release? The SEC was vague about whether it would go on to issue a second disclosure-oriented release, saying only that it was considering "whether at a later time" to propose requirements for the disclosure and recordkeeping of client commission arrangements. Interestingly, the proposing release had described itself as "the first step" in addressing the current soft dollar environment. In contrast, the adopting release described itself only as "a step" towards doing so.
What about that footnote 108 brou-ha-ha? This time around, the SEC explained itself a bit better. Yes, an adviser must pay cash for the non-eligible portion of mixed used products, but that doesnít necessarily mean that advisers have to begin cutting checks to Schwab. See footnote 148 and accompanying text, describing how an adviser may "infer relative costs from relative benefits."