The five-member Securities and Exchange Commission yesterday unanimously adopted an interpretative release on “soft dollars” that is designed to ensure that money managers are not abusively using client commission dollars to pay for questionable brokerage and research services.
The meeting was the last one involving commissioner Cynthia Glassman, who is expected to leave the commission Friday, an SEC spokesman said. She is to be replaced Monday by Kathleen Casey, after Casey, former staff director and counsel to the Senate Banking Committee, is sworn in, he said.
Soft dollars refer to money managers using client commissions rather than direct payments to obtain research products and brokerage services from brokerage firms. A mutual fund, for example, may pay a broker-dealer for research that generates trades by executing those trades with that dealer. Soft dollars amount to billions of “dollars” each year for investment funds in the U.S., according to statistics cited by the SEC.
The interpretative release, which would update and clarify the commission’s 20-year-old interpretation of a 30-year-old law, would essentially take effect in six months. Technically, the guidance would become effective when published in the Federal Register, but the SEC will permit money managers to use the old guidance for the next six months, giving them a transition period in which to prepare to use the new guidance.
The SEC plans to follow up the interpretative release by developing another regulatory proposal that will require money managers to disclose more information about their use of soft dollars to mutual fund boards, commissioners and staff officials said during the meeting.
“This issue must be addressed … promptly,” said commissioner Annette Nazareth, who, when she served as director of the SEC’s market regulation division, was involved in the development of the proposed release, which the SEC issued last October, and was similar to the release adopted yesterday.
Explaining the need for the new guidance, SEC chairman Christopher Cox said in his opening statement at the meeting: “We have found that money managers are applying the commission’s 20-year old guidance in [the rapidly changing financial markets] in highly inconsistent ways — and at times overly aggressive ways. For example, we have seen soft dollars used to pay for membership dues, professional licensing fees, office rent, carpeting, and even entertainment and travel expenses.”
“The commission has brought enforcement actions in some of the most egregious cases,” he said. “But we have also recognized the need for greater clarity in our own guidance. Today’s interpretative release brings our guidance up to date and removes some of the uncertainties about how this 30-year law applies in the current environment.”
The release interprets a “safe harbor” in section 28(e) of the Securities Exchange Act of 1934 that states that a money manager will not be deemed to have acted unlawfully or breached a fiduciary duty under federal or state law by paying more than the lowest commission available if he or she determines in good faith that the amount of the commission is reasonable in relation to the value of the brokerage and research services received.
The release provides a three-part test for money managers who want to qualify for the safe harbor. They must acquire “eligible” research products and brokerage services, they must use those products and services lawfully and appropriately, and they must make a good-faith determination that the commissions they are paying are reasonable in light of the value of the products and services they are receiving.
Eligible research services are defined as advice, analyses, and reports that contain substantive intellectual or informational content, according to the release. Eligible brokerage products and services include those that relate to the execution of the trade from the time an order is placed, through the time it is executed, cleared, and settled.
Cox said that in more than 70 sets of comments received on the proposed rule, market participants agreed that, “The research services have to directly relate to and inform the money manager’s investment decision-making responsibilities. And the brokerage services rendered have to be for the purpose of facilitating the execution of the money manager’s orders.”
“There is no room in the safe harbor for overhead like carpeting, computer equipment, or lavish expenditures for interior decorators or beachfront villas,” Cox said.
Under the release, money managers can use soft dollars to obtain traditional company reports, as well as market research, market data, and trade analytics. They cannot use soft dollars for new computers, or to pay overhead costs such as the salaries of their research staff. Mass-marketed publications like newspapers and business magazines must be disclosed to investors as hard dollar expenses.
Money managers must make a reasonable allocation between eligible and ineligible uses with respect to mixed-use items, the SEC release states.
The release also clarifies the rules that apply to commission-sharing arrangements among money managers, brokers, and third-party research providers and departs from the earlier proposal by giving the industry more flexibility to structure a variety of arrangements that are consistent with the purposes of the law.
While all of the SEC commissioners supported the release, commissioner Roel Campos urged the SEC and Congress to continue to consider whether soft dollars should be banned.
