Soft dollars won't be going as far as they used to in the new regulatory environment which means that investment advisors may have to change the way they run their businesses. Last July the SEC issued an interpretive release altering the boundaries for protected soft dollar transactions. The big news is that investment advisors can no longer use soft dollars to pay for certain office expenditures, says Brent Lipschultz, a CPA and attorney with Eisner LLP in New York. On the other hand, he says, advisors now have more clear-cut guidelines as to what they can and cannot purchase with them.
"Soft dollars" refers to the brokerage practice wherein advisors receive goods or services in exchange for directing client commissions to a broker/dealer. The practice dates back to the era of fixed B/D commissions, when competition was based on services provided. Using soft dollars obtained by trading client accounts to purchase research or services, however, is potentially a breach of the advisors' fiduciary duties. So to provide protection to advisors, section 28(e) of the Securities Exchange Act of 1934 provided a "safe harbor" for soft dollar transactions. Without the safe harbor, advisors could not use commissions earned on one account to obtain research that benefits all accounts, explains Gregory Nowak, a partner at Pepper Hamilton LLP in Philadelphia,.
If the safe harbor requirements are met, however, advisors have not breached their fiduciary duties under state or federal laws. The safe harbor protects investment advisors from SEC enforcement as well as from client actions, says Nowak, allowing them to run their businesses without fear of being accused of breaching their fiduciary duties.
To meet the safe harbor requirements, advisors must:
1. Determine if the product or service received is "eligible research" or "eligible brokerage."
2. Determine if the eligible product or service provides "lawful and appropriate assistance" to the advisor "in the performance of its investment decision-making responsibilities." Where a product or service has a mixed use, the advisor must reasonably allocate costs in accordance with that use.
3. Make a good-faith determination that the amount of client commissions paid is reasonable in light of the value of the products received or services rendered.
The bulk of the July 2006 Interpretive Release guidance deals with what is and what is not eligible research and brokerage. It helps advisors understand what they can use soft dollars to purchase and still remain within the boundaries of the safe harbor. Although the rules are now stricter than in the past, says Lipschultz, they are easier to follow because they provide objective--rather than subjective--guidance.
However, the SEC reversed or altered several of its previous positions--most notably, the reversal of its position on "mass marketed publications." Advisors can no longer use soft dollars to purchase widely circulated newspapers and magazines and be covered by the safe harbor. In the past, many investment advisors have subscribed to publications like The Wall Street Journal or Barron's, says Lipschultz. Under the new rules, subscriptions to these publications no longer qualify for the safe harbor, he says.
Publications that do qualify for the safe harbor must be marketed to a narrow audience, directed to readers with specialized interests in particular industries, products or issuers, and have a high cost. Whether the method of distribution is by mail or e-mail is not determinative. Furthermore, if a publication is marketed to a narrow audience, such as investment advisors, but can be accessed over the Internet by the general public, it is not disqualified as eligible research. An example of a publication that most likely qualifies as eligible research is a trade journal such as Wealth Manager, because it is targeted to a narrow audience--investment advisors--says Jackson Galloway, senior counsel at Goodwin Procter LLP in Boston.
In another change, the SEC now takes the position that soft-dollar purchases of computer hardware are outside the safe harbor. Many investment advisors have previously used soft dollars to purchase computer equipment, notes Lipschultz.
The SEC also altered its position on proxies. Research or advice on how to vote proxy ballots or handle the mechanical aspects of voting are now outside the scope of the safe harbor. However, to the extent that a product or service is used for both investment decision-making and in connection with voting, it could be treated as a mixed-use item.
There has been a change to the treatment of order management systems (OMS) as well. Previously OMS was not eligible brokerage. Now the SEC says that that OMS may be eligible brokerage if it provides: (1) dedicated lines between the broker/dealer and the advisor's OMS; (2) lines between the broker/dealer and OMS operated by third-party vendors; and (3) trading software used to route orders, provide algorithmic trading strategies or transmit orders to direct market access (DMA) systems or to provide connectivity to this software.
There is also new guidance on commission sharing arrangements--where more than one broker/dealer is involved in the transaction, and one provides eligible research. The interpretive release provides a new option for advisors to receive eligible research and services and still remain within the safe harbor for commission sharing.
Essentially, says Galloway, if a broker/dealer is not obligated to pay but does indeed pay, and the research provided is eligible, then the transaction is within the safe harbor. Previously, commission sharing arrangements only came under the safe harbor if the broker/dealer provided the service itself, or the research was provided under an arrangement with a third-party, and the broker/dealer was legally obligated to pay for the third-party service. "This provides advisors with a little bit more flexibility," says Galloway adding, however, that advisors will have to conduct due diligence to assure themselves that broker/dealers are meeting the requirements for this new option.
The bottom line? The SEC has taken a very firm stand on the use of soft dollars to pay for advisors' overhead. "Investment advisors will have to be responsible for their own overhead costs, and they can't pass them on to the end consumer," says Lipschultz.
Moreover, advisors had better have in place all necessary documentation to prove their soft-dollar purchases qualify when the SEC comes in for an audit, Nowak adds. Advisors who have been using soft dollars to pay for overhead have until January 24, 2007, to clean up their act. And, if in doubt as to whether or not something qualifies, an advisor can always ask for a no-action letter. "You can always ask the SEC if it's OK," Nowak says, "but the SEC has traditionally not issued a lot of guidance in this area. There have only been a few no-action letters issued on this topic in the last 20 years."
The Final Word on Research
The following research meets the SEC's safe harbor eligibility requirements:
o Traditional research reports analyzing the performance of a particular company or stock
o Discussions with research analysts
o Meetings with corporate executives to obtain oral performance reports
o Seminars or conferences that relate to research--i.e, that provide substantive content relating to the subject matter such as issuers, industries and securities
o Software that provides analyses of securities portfolios
o Corporate governance research, including corporate governance analytics and corporate governance rating services if, for example, they provide reports and analyses of issuers which may bear on the companies' performance outlook
o Consultants' services, if the consultant provides portfolio strategy advice
o Market research and data: Pre-trade and post-trade analytics, software and other products that depend on market information to generate market research, including research on optimal execution venues and trading strategies, or advice provided by broker/dealers or software regarding order execution, including advice on execution strategies, market color and the availability of buyers and sellers.
o Examples of eligible market and economic data include:
--Unemployment and inflation rates
--Gross domestic product figures
--Company financial data
The July 2006 Interpretive Release clarified the following as not eligible for the soft dollar safe harbor:
o Mass-marketed publications
o Research or advice on how to vote proxy ballots (although this could be a mixed-used item if it provides assistance with the investment decision-making process)
o Inherently tangible products and services, even if used in the delivery of eligible research, such as
-- Telephone lines
-- Office equipment
-- Business supplies
-- Office furniture
-- Computer hardware including terminals and peripherals
-- Telecommunications lines, transatlantic cables and computer cables
-- Travel, entertainment and meals associated with attending seminars and/or meeting with corporate executives and/or other individuals providing eligible oral research
-- Accounting fees and software
o Web site design, email software and Internet service
o Legal expenses, personnel management, marketing and utilities
o Membership dues, professional licensing fees
o Software that assists with administrative functions, such as back-office management, operating systems, word processing and related equipment maintenance and repair service
o Consultant services where advice relates to internal management or operations
Safe or Unsafe?
Brokerage services that meet the SEC's safe harbor eligibility requirements:
o Settlement and custody services
o The following post-trade services:
-- Post-trade matching of trade information
-- Other exchanges of messages among broker/dealers, custodians and institutions related to trade
-- Electronic communication of allocation instructions between institutions and broker/dealers
-- Routing settlement instructions to custodian banks and broker/dealers' clearing agents
-- Short-term custody related to clearance and settlement of particular transactions
-- Comparison services required by the SEC or self-regulatory organizations
o The following communications services:
-- Connectivity between the advisor and the broker/dealer and other relevant parties such as custodians
-- Lines between the broker/dealer and/or management systems operated by a third- party vendor
-- Message services used to transmit orders to broker/dealers for execution
o The following types of trading software:
-- Routing orders to market centers
-- Algorithmic trading strategies
-- Direct market access (DMA) systems
-- Order management systems (OMS) that provide connectivity to trading software used to effect the above
o Trade analytics may be treated as a mixed-use item when used both for research within the safe harbor, to assist in fulfilling contractual obligations to a client, or to assess whether an advisor has complied with its own regulatory or fiduciary obligations
o Short-term custody related to clearance and settlement of particular transactions
Not Safe Harbor
Brokerage services that fail to meet the SEC's safe harbor eligibility requirements:
o Hardware such as telephone or computer terminals, including those used in connection with OMS and trading software
o Software used for recordkeeping or administrative purposes such as managing portfolios
o Quantitative analytical software used to test "what if" scenarios related to adjusting portfolios, allocation, or portfolio modeling
o Items or services for meeting compliance responsibilities such as
-- Compliance tests that analyze information over time and as a means of forensic testing for quality of brokerage execution, excessive portfolio turnover or improper trade allocations
-- Creating trade parameters for compliance with regulatory requirements, prospectus disclosure or investment objectives
-- Stress testing of portfolios under a variety of market conditions or to monitor style drift
o Trade financing, such as stock-lending fees, capital introductions and margin services
o Error correction trades or related services provided to address advisor errors
o Long-term custody, custody that is provided post-settlement and that relates to long-term maintenance of securities positions
Elayne Robertson Demby, JD, has covered executive compensation, employee benefit and financial issues for more than 10 years.