Before commission rates on the exchanges were unfixed by regulation and statute, broker-dealers routinely supplied institutional money managers with research reports alongside execution. Why did that practice grow up under fixed rates?

Exchange rules required members to furnish research to any institution sending them a minimum volume of orders

Unable to compete on the price of executing an order, firms competed on the services they offered alongside it

Managers were barred from paying cash for research, so commissions were the one lawful way to buy it at the time

Fixed rates were set below cost, so firms supplied research to support their requests to the Commission for increases

The Commission has identified an incentive that soft dollar arrangements create over how much a money manager trades its clients' accounts. What is that incentive?

To bunch the accounts' trades at quarter-ends, so that research credits fall in the period in which they are reported

To trade less often than the accounts need, so that the commissions spent on research stay below the disclosure level

To trade client securities more than their interests warrant, so as to earn credits for client commission services

To spread each order across several brokers, so that no single broker can see how much research the manager receives

A client's advisory agreement expressly forbids the manager to pay any broker more than the lowest commission available for a trade. The manager pays a higher commission to a research broker anyway, having determined in good faith that it was reasonable for the research. How does Section 28(e) bear on the client's claim under the agreement?

It does not shield the manager, the statute giving way where a contract expressly provides otherwise

It shields the manager, the statute overriding any contract term that limits the commissions paid

It shields the manager unless the client shows the research it bought was of no use to the account

It does not shield the manager, the safe harbor applying solely to accounts with no written agreement

A sub-adviser decides which securities a fund buys and sells, while the fund's named adviser keeps formal responsibility for those investment decisions. For Section 28(e) purposes, does the sub-adviser exercise investment discretion over the account?

No, since discretion rests only with the person carrying formal responsibility for the account's investment decisions

Yes, since a person who makes the decisions exercises discretion even though another has responsibility for them

No, unless the fund's board has delegated to the sub-adviser in writing the authority to sign the account's trade tickets

Yes, but only for those trades in which the sub-adviser has also chosen the broker-dealer that executes the order

Section 28(e) provides that a manager paying more than the lowest available commission is not deemed to have breached a fiduciary duty under State or Federal law. Which laws can still take that protection away?

A law of Congress enacted after June 4, 1975 that expressly provides to the contrary, but no State law

Any State law on fiduciary duty, whenever enacted, that sets a stricter standard for commissions paid

A law of Congress or of any State enacted after June 4, 1975 that expressly provides to the contrary

No law at all, the safe harbor preempting federal and State fiduciary law on the commissions it covers

Until 2001 the Commission read commission in Section 28(e) to exclude the charges of a market maker trading with a managed account as principal. What was its reason?

Discretionary accounts were barred from trading with dealers as principal, so no research could ever be tied to such a trade

Principal trades were outside the duty of best execution, so no dealer charge on them could ever be weighed against the research

Market makers were not then registered as broker-dealers, so the research they supplied could not count as provided by one

Principal fees were not quantified and fully disclosed in a way that let a manager judge whether they were reasonable

Which principal transactions did the Commission bring within the meaning of commission for Section 28(e) purposes in 2001?

Riskless principal trades whose two legs are executed at the same price and that are reported under trade reporting rules

Any principal trade in an exchange-listed security, provided that the dealer's full markup is shown on the customer's trade confirmation

Principal trades by a market maker that also supplies research, provided that the markup stays within its published commission schedule

Riskless principal trades in which the dealer holds the position overnight, provided that the second leg is reported on the next day

A consultant paid with client commissions advises a money manager on two things: the portfolio strategy for its equity accounts, and how to reorganise the manager's own staffing and operations. How does the safe harbor treat the two?

Both may be eligible research, since each is advice that reflects the consultant's reasoning and knowledge

The portfolio strategy advice may be eligible research; the advice on staffing and operations is not

Neither is eligible research, since advice qualifies only where a broker-dealer's own analysts produce it

The operations advice is eligible, as it improves how clients are served; the strategy advice is not eligible

A research firm's report analyses how a coming national election is likely to shift fiscal policy and, through it, the outlook for bank stocks. Section 28(e)(3) does not mention political factors. Can the report be eligible research?

It can, but solely the part of the report that names bank stocks, the rest being general commentary

It cannot, the statutory categories being an exhaustive list that political subjects fall outside of

It can, the statutory categories subsuming political factors that are interrelated with economic factors

It cannot, a forecast about an election being a prediction rather than advice, analysis or a report

A costly analytical journal is marketed only to institutional investment professionals, but anyone can read its articles on the publisher's website. Can a money manager pay for a subscription with client commissions as research?

No, because a publication can be research only where the broker-dealer paying for it wrote its content

No, because availability to the general public over the internet makes a publication mass-marketed

Yes, but for the printed edition alone, since electronic delivery to a manager counts as a data service

Yes, if it otherwise qualifies, because the focus of its marketing rather than its availability decides

A portfolio manager flies to another city to meet a company's chief executive and finance director and hear their account of the company's performance. The manager wants client commissions to cover the trip. What can the safe harbor reach?

The meeting's oral report on the company may be research, but the airfare, hotel and meals are not

The whole trip, since the travel was undertaken solely to obtain research on the company's current and expected performance

Nothing at all, since an issuer's own executives cannot furnish research about their own company to an outside investor

The airfare and hotel may be covered, but not the meeting, since an issuer's executives are not broker-dealers

A money manager proposes to use client commissions to pay part of the salaries of its own in-house research analysts, whose work drives its stock selection. How does the safe harbor treat those salaries?

As eligible research, since the analysts' output is advice and analysis on the statutory subject matter

As overhead outside the safe harbor, even though the analysts produce research that the manager uses

As a mixed-use item, eligible for the share of the analysts' working time spent on client portfolios

As eligible brokerage, provided the analysts also advise the trading desk on how to execute its orders

How does the Commission's 2006 guidance classify market data such as stock quotes, last sale prices and trading volumes under Section 28(e)?

As raw information outside the safe harbor until someone analyses it to reach conclusions

As brokerage under Section 28(e)(3)(C), since quotes are consulted when orders are executed

As reports concerning securities under Section 28(e)(3)(B), and so eligible as research

As eligible solely where a broker-dealer bundles it with its own written research reports

Under the temporal standard in the Commission's 2006 guidance, when do brokerage services begin and when do they end?

From the manager's first request for research on the security, to the settlement date of the trade that results from it

From the manager's decision to trade the security, to the close of the trading day on which the order is finally executed

From the broker-dealer's receipt of the order, to the moment of execution, with clearance and settlement left outside it

From the manager's communication with the broker to transmit an order, to delivery or credit of funds or securities to the account

A manager pays for two dedicated lines: one carries its orders from its order management system to a broker-dealer for execution, and the other only carries a research firm's reports into its office. How does the safe harbor treat the two lines?

The order line may be eligible brokerage; the research line is a delivery mechanism outside the research safe harbor

Both may be eligible, the order line as brokerage and the research line as part of the research that it delivers

Neither is eligible, every telecommunications line being hardware outside both the brokerage and research harbors

The research line may be eligible research; the order line is outside, connectivity being the manager's own overhead

A manager buys, with client commissions, a service that analyses the quality of its brokers' executions over time so that it can evaluate whether it is meeting its own best execution duty. How does the safe harbor treat the service?

As eligible brokerage, the analysis being about the execution of the account's own securities transactions

As outside it, the analysis serving the manager's own compliance responsibilities rather than its trading

As eligible research, the analysis being a report concerning securities and the market for those securities

As eligible only where the analysis comes from the same broker-dealer whose executions it is reviewing

A manager mistakenly buys the wrong security for a client and enters a second trade to correct it. Why can it not treat the correcting trade and its related services as brokerage under the safe harbor?

The correction is entered by compliance staff, not by the person exercising discretion over the account

The correction must be paid for by the broker-dealer that executed the first trade, not by the account

The correction is a separate transaction made to fix the manager's error, not to benefit the advised account

The correction is too small for any good faith determination of value to be made for its commission

A broker-dealer that executes a fund's trades offers its manager stock lending, margin financing and capital introduction, and suggests paying for them through the fund's commissions. How does the safe harbor treat these services?

As eligible brokerage for the margin, but outside it for the stock lending and capital introduction

As eligible brokerage, financing being a function incidental to effecting securities trades

As eligible research, the capital introduction being advice on the availability of purchasers

As outside it, trade financing not being sufficiently related to the execution of orders

A client's commissions are used to pay a custodian bank for holding the client's own securities for years after its trades settle. How does the Commission view this?

It does not engage the safe harbor at all, long-term custody being a service to the client for its own benefit

It is eligible brokerage, because the statute names custody, without any limit, among the functions incidental to effecting trades

It breaches the manager's fiduciary duty, custody being outside the safe harbor and yet paid for out of the client's commissions

It is eligible brokerage provided that the custodian bank also executes the client's trades, which makes the custody incidental to them

Two managers each buy the same eligible research product with client commissions. One uses it in deciding what to buy and sell; the other does not use it in making investment decisions at all. How does the safe harbor apply?

It protects both purchases, since eligibility is settled by the product's content and the use is irrelevant

It protects the first manager's purchase but not the second's, since protection turns on how the item is used

It protects neither purchase, since a product is research only where every buyer of it uses it in one way

It protects the second manager's purchase alone, provided the product is passed on to its clients to use

A manager splits the cost of an order management system between the part used for research and execution and the part used for its accounting, paying the first part with client commissions. Why must it keep adequate books and records of that split?

So that the broker-dealer can report the eligible part separately on the confirmation of each client trade

So that its clients can claim a tax deduction for the share of their commissions spent on the eligible part

So that it can make the required good faith showing that the commissions are reasonable for the eligible part

So that the Commission can approve the split before any commissions are used to pay for the system itself

When a manager decides what share of a mixed-use product's cost its clients' commissions will bear, what has the Commission said about that decision itself?

It must follow a fixed ratio that the Commission sets by rule, leaving no room for the manager's judgment

It is an ordinary business judgment for the manager, one needing no disclosure once the split is recorded

It belongs to the broker-dealer providing the product, which must then certify the split to the manager

It is a further conflict of interest for the manager, one that should be disclosed to the client

A broker supplies a manager with eligible research, and the manager pays it commissions set high enough also to reward it for referring new clients to the manager. Can the manager rely on Section 28(e) for those commissions?

No, the commissions include a payment for an ineligible service, so they cannot be judged reasonable for the research

Yes, provided the research by itself would have justified the commissions had no referrals been made by the broker

Yes, because the safe harbor protects any commission paid to a broker-dealer that also supplies eligible research

No, because a broker-dealer that refers clients to a manager is barred from supplying that manager with research

A broker-dealer that supplies research for commissions also sells the same research separately for a stated cash price. What role does that price play under Section 28(e)?

It caps the commissions the manager may pay for the research, any excess falling outside the safe harbor

It should inform the manager about the research's market value when it makes its good faith determination

It takes the research outside the safe harbor, since research sold for cash cannot be bought with commissions

It has no bearing, the good faith determination looking solely at the value of the brokerage services received

A broker-dealer is legally obligated to pay an independent firm for research that a manager receives through client commissions. The manager chose which research it wanted, and the independent firm sends it straight to the manager. Does either fact take the research outside the safe harbor?

The direct delivery does, research having to pass through the broker's hands to be provided by the broker

The manager's choice does, research not being provided by the broker where someone else has selected it

Neither does; the research stays eligible though the manager helped choose it and the firm sends it directly

Both do, an independent firm's research being eligible only where the broker-dealer commissioned its content

In a client commission arrangement, the broker-dealer effecting a manager's trades is not itself obligated to pay the research firm. What helps show that the broker-dealer is nonetheless providing the research?

It receives a copy of all research the manager buys, and pays whichever research firm the manager names without reviewing the services

It reimburses the manager for research invoices the manager has paid, and keeps a copy of each invoice for the Commission's review

It obtains the manager's written promise that the research is eligible, and lets the manager settle the research firm's bills itself

It pays the preparer directly, screens the services for red flags, agrees to fund nothing ineligible, and documents prompt payment

Section 28(e) requires the broker-dealer that provides research to be involved in effecting the trade. What practice was that requirement principally intended to stop?

Give-ups, in which part of a commission was passed to a broker with no role in the trade, rewarding services to the manager

Interpositioning, in which an order was routed through a second dealer with no role in pricing it, whose added markup the account paid

Front running, in which the executing broker traded ahead of a managed account's order, using its advance knowledge of that order for profit

Payment for order flow, in which a market maker paid a broker for routing that broker's customer orders to it for execution at its quotes

In a client commission arrangement, an introducing broker-dealer neither executes, clears nor settles a manager's trades. What must it do to count as effecting them for the safe harbor?

Perform all four minimum functions itself, from financial responsibility for customer trades to monitoring settlements, leaving the clearing firm only to execute

Perform at least one of four minimum functions, such as financial responsibility for trades until the clearing firm is paid, and see the rest reasonably allocated

Receive a share of each commission and show that share on each trade confirmation, which by itself makes it a party to every trade that it introduces

Accept the manager's orders by telephone and pass each of them on to the clearing firm, which by itself is enough to make it the broker effecting the trades

An adviser receives two kinds of soft dollar benefits: research that qualifies for the Section 28(e) safe harbor, and other products and services that fall outside it. What do Form ADV's disclosure requirements oblige it to disclose to clients?

Both kinds, with more detailed disclosure of the research that falls within the safe harbor

The services outside the safe harbor alone, since qualifying research needs no disclosure

Both kinds, with more detailed disclosure of the services that fall outside the safe harbor

Neither in detail, a single statement that the adviser uses soft dollars covering both kinds

Under Form ADV's disclosure requirements, what must an adviser explain to clients if it does not aggregate their trades when it has the opportunity to do so?

That its clients may not direct their own brokerage, since unaggregated trades go to the broker it chooses

That its clients may receive research of less value, since smaller orders earn fewer soft dollar credits

That it will allocate the trades it places among clients in proportion to the credits each one generates

That its clients may pay higher brokerage costs as a result of their trades not being aggregated

Soft Dollar Arrangements: The Section 28(e) Safe Harbor

What Are Soft Dollar Arrangements and How Does the Section 28(e) Safe Harbor Work?

A soft dollar arrangement is one in which a money manager uses the commissions generated by its clients' securities trades to obtain research or brokerage services from a broker-dealer, instead of paying for those services out of its own money. Because the commissions are client assets, the arrangement puts the manager on both sides of a decision: the clients pay for services that the manager would otherwise have had to buy itself.

Section 28(e) of the Securities Exchange Act of 1934, codified at 15 U.S.C. 78bb(e), creates a limited safe harbor for it. The Securities and Exchange Commission's 2006 interpretive release (Release No. 34-54165, 71 FR 41978) explains which products and services fall inside that safe harbor. And Item 12 of Form ADV Part 2A, the brochure that registered investment advisers deliver to clients, requires an adviser to disclose its soft dollar practices. The 2006 release calls these client commission arrangements.

Why Congress Created the Section 28(e) Safe Harbor

Commission rates on the national securities exchanges were long fixed by custom and regulation, until the Commission's Rule 19b-3 and the Securities Acts Amendments of 1975 ended fixed rates.

While rates were fixed, broker-dealers could not compete on price, so they competed on the services they offered alongside execution. They attracted institutional order flow by supplying research reports and brokerage functions.

As the fixed-rate era ended, money managers worried that in a world of competitive rates they would be forced to allocate brokerage on the lowest execution cost alone, and that paying more than the lowest available commission would be treated as a breach of fiduciary duty. Congress answered both concerns with the safe harbor it placed in the 1975 Amendments as Section 28(e).

The Conflict of Interest Behind Soft Dollars

A money manager is a fiduciary. It must act in the best interest of its clients, it must seek best execution of their trades, and it may not use client assets, including client commissions, for its own benefit without client consent. A manager that obtains research or brokerage services with client commissions does not have to buy those services with its own funds, and that saving is the source of the conflict.

The Commission has identified two incentives that the conflict creates. The first is to disregard best execution when choosing where to send orders, so as to obtain client commission services. The second is to trade client securities inappropriately in order to earn credits for client commission services.

What the Statute Protects and What It Leaves Alone

Section 28(e)(1) provides that a person exercising investment discretion with respect to an account shall not be deemed to have acted unlawfully or to have breached a fiduciary duty under State or Federal law solely by reason of having caused the account to pay a commission higher than another broker-dealer would have charged for the same transaction, if the person determined in good faith that the commission was reasonable in relation to the value of the brokerage and research services provided. The determination may be viewed in terms of either that transaction or the person's overall responsibilities to the accounts over which it exercises investment discretion. Under Exchange Act Section 3(a)(35), a person who makes an account's buy and sell decisions exercises investment discretion even if another person has responsibility for them.

The protection is narrow. It answers one charge only: that the manager paid more than the lowest available commission. Conduct that the safe harbor does not cover may still be a breach of fiduciary duty and a violation of the federal securities laws, and the enactment of Section 28(e) did not alter the manager's duty to seek best execution.

The statute also fixes its own limits. Its protection gives way where a law enacted by Congress or by any State after June 4, 1975 expressly provides to the contrary. It is exclusive and plenary for the conduct it covers unless a contract expressly provides otherwise, so a client and its manager can contract out of it. Under Section 28(e)(4) the safe harbor does not apply to securities that are security futures products.

Agency Commissions and Riskless Principal Trades

The statute speaks of a commission. Until 2001 the Commission read that word to cover only commissions paid to a broker-dealer acting in an agency capacity. A manager therefore could not rely on the safe harbor for research or brokerage obtained in relation to the charges of a market maker executing a trade as principal, because, in the Commission's view, fees on principal transactions were not quantifiable and fully disclosed in a way that would let the manager judge whether they were reasonable in relation to the value of the services received.

In 2001, at the request of the Nasdaq Stock Market, the Commission modified that interpretation. The word now also covers fees paid on riskless principal transactions in which both legs are executed at the same price and the transaction is reported under the trade reporting rules. Because the confirmation rules require such fees to be disclosed and the trade itself is reported, the Commission concluded that a manager can make the required determination of reasonableness for these charges.

Eligible Research: Advice, Analyses and Reports

Under Section 28(e)(3)(A) and (B), a person provides research services insofar as it furnishes advice, directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing or selling securities, and the availability of securities or of purchasers or sellers of securities; or furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts.

A product qualifies as research only if it is advice, analysis or a report and its subject matter falls within those categories. The common element of advice, analyses and reports is substantive content, the expression of reasoning or knowledge, and the form of the research, whether electronic, paper or oral, does not matter. The listed categories also subsume other topics related to securities and the financial markets, so a report on political factors that are interrelated with economic factors could fall within the safe harbor.

Traditional research reports on a company or stock are clearly eligible, and so are discussions with research analysts. Meetings with corporate executives to obtain oral reports on a company's performance are eligible because they are reports concerning issuers. Seminars and conferences may be eligible if they provide substantive content on such subjects as issuers, industries and securities. Software that analyses securities portfolios is eligible. The subject-matter test can cut both ways within one service: a consultant's advice on portfolio strategy may be eligible research, but the same consultant's advice on the manager's internal management or operations is not.

Mass-Marketed Publications

The research Congress meant to protect is the kind broker-dealers historically provided in the fixed-commission era, such as Wall Street research reports, rather than periodicals in general circulation to the retail public. The Commission therefore treats mass-marketed publications as outside the safe harbor and as overhead expenses of the manager. Their indicia include circulation to a wide audience, being intended for and marketed to the public rather than a small specialized readership, and low cost.

Publications with the opposite indicia, marketed to a narrow audience of readers with specialized interests in particular industries, products or issuers and carrying a high cost, may be eligible research. Trade magazines and technical journals about specific industries, marketed to a narrow audience, can qualify.

The method of distribution does not decide the question. Whether a publication arrives on paper or electronically is irrelevant, and it is the focus of the marketing, not the availability of the publication, that matters: a publication marketed to investment professionals keeps its eligibility even if the general population can reach it over the internet.

Hardware, Delivery Mechanisms and Overhead Expenses

Products without substantive content, including inherently tangible items, are not research. Computer hardware, including computer terminals and accessories, is outside the research safe harbor even though it may assist in the delivery of research, and so are the peripherals and delivery mechanisms associated with it or with the oral delivery of research, such as telecommunications lines and cables. The research delivered over a terminal or a data line may itself be eligible if it meets the criteria.

A manager's operational overhead is not research. Travel, entertainment and meals associated with attending seminars, and travel and related expenses for trips to meet corporate executives, analysts or others who may provide eligible research orally, are outside the safe harbor even where the meeting itself is eligible. So are office equipment and furniture, salaries (including those of research staff), rent, legal and accounting fees, marketing, utilities, membership dues and professional licensing fees.

Market Research and Market Data

Advice, analyses and reports about the market for securities, which the Commission calls market research, may be eligible research. Examples include pre-trade and post-trade analytics and advice from broker-dealers on execution strategies, market color and the availability of buyers and sellers.

Market data such as stock quotes, last sale prices and trading volumes contain aggregations of current information about securities, and the Commission treats them as reports concerning securities under Section 28(e)(3)(B), so they are eligible research.

The Commission gave two reasons for including data. Including it promotes innovation by managers who use raw data to build their own analytics, leveling the playing field with managers who buy finished research that already incorporates raw data. And excluding it could become meaningless, because vendors could add some minimal or inconsequential functionality to bring data within the safe harbor.

Brokerage Services and the Temporal Standard

Under Section 28(e)(3)(C), a person provides brokerage services insofar as it effects securities transactions and performs functions incidental to them, such as clearance, settlement and custody, or functions required in connection with them by rules of the Commission or of a self-regulatory organization. Eligible incidental services include post-trade matching, allocation instructions, settlement instructions and comparison services that the rules require.

The Commission uses a temporal standard to separate brokerage from overhead. Brokerage begins when the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution, and it ends when funds or securities are delivered or credited to the advised account or the account holder's agent. Research, by contrast, includes services provided before an order is communicated, so advice or trade analytics relating to the statutory subject matter delivered before an order is transmitted may fall within the research part of the safe harbor but not the brokerage part.

Within that window, connectivity is brokerage: dedicated lines between the broker-dealer and the manager's order management system, dedicated lines to the broker-dealer's trading desk, and message services used to transmit orders are eligible. Trading software used to route orders to market centers, software providing algorithmic trading strategies, and software used to send orders to direct market access systems are eligible brokerage too.

What Falls Outside Brokerage

Hardware such as telephones and computer terminals is not brokerage, even when used with an order management system or trading software, because it is not sufficiently related to order execution. Portfolio management, recordkeeping and what-if modeling software fall outside the temporal standard as well.

A manager may not use client commissions under the safe harbor to meet its own compliance responsibilities. Excluded examples include an analysis of the quality of brokerage executions made to evaluate the manager's own best execution performance, an analysis of portfolio turnover to see whether portfolio managers are overtrading, a comparison of similarly managed accounts to detect favoritism, and stress-testing a portfolio or monitoring style drift.

Trade financing, such as stock lending fees, capital introduction and margin services, is outside the safe harbor because it is not sufficiently related to order execution. Error correction trades, and services connected with them, are also excluded: they are separate transactions made to correct the manager's own error rather than to benefit the advised account, so they are not part of the client's original trade.

Custody Under the Safe Harbor

Section 28(e)(3)(C) names custody among the functions incidental to effecting transactions, and some commenters argued that the word covered custody of every kind. The Commission read the statute as limited to custody incidental to effecting securities transactions. Short-term custody related to effecting particular transactions and their clearance and settlement is eligible, because it is tied to processing the trade between the placing of the order and settlement.

Long-term custody is different. It is provided after settlement, relates to the long-term maintenance of securities positions, and is commonly supplied by firms, such as custodian banks, that execute no transactions for the client at all. The Commission therefore treats long-term custody and custodial recordkeeping as services provided to the client for the client's benefit, so that paying for a client's long-term custody with that client's own commissions does not implicate Section 28(e) at all.

Lawful and Appropriate Assistance in Investment Decision-Making

The 2006 release analyses a product in three steps: whether it is eligible research or brokerage under Section 28(e)(3); whether it provides lawful and appropriate assistance in investment decision-making; and whether the commissions are reasonable in good faith. An eligible product is not enough by itself. It must also provide the manager with lawful and appropriate assistance in making investment decisions, and that standard focuses on how the manager actually uses the item. Analyses of account performance, for example, are eligible research because they reflect reasoning or knowledge about the performance of accounts, but when a manager uses them for marketing they are not within the safe harbor, because marketing is not investment decision-making.

The same reasoning means one item can be protected for one manager and unprotected for another. A manager may buy an eligible piece of research with client commissions if it properly uses the information in formulating investment decisions, while another manager cannot rely on Section 28(e) to acquire the very same item if it does not use it for investment decisions. A manager relying on the safe harbor for brokerage must likewise be able to show that the brokerage product provides it with lawful and appropriate assistance in carrying out its responsibilities.

Allocating Mixed-Use Items

Many products serve both eligible and ineligible purposes. The Commission introduced the mixed-use concept in 1986 and reaffirmed it in 2006: where a product has a mixed use, the manager must make a reasonable allocation of its cost according to its use, paying the eligible portion with client commissions and the ineligible portion with its own funds. An allocable portion of a portfolio performance evaluation service may be paid for as research, while the portion used for marketing must be paid for by the manager.

The manager must keep adequate books and records concerning its allocations so that it can make the required good faith showing. Without that documentation, neither the manager nor its compliance staff can show the basis for the allocation.

The allocation decision is itself a further conflict of interest, because the manager decides how much of a product its clients will pay for. The Commission has said that this conflict should be disclosed to the client.

The Good Faith Determination of Reasonableness

Every use of the safe harbor rests on the manager's good faith determination that the commissions paid are reasonable in relation to the value of the brokerage and research services received, and the burden of proving that determination rests on the manager.

A manager may not obtain eligible products, such as market data, to camouflage the payment of higher commissions to a broker-dealer for ineligible services such as shelf space or client referrals; because the commission then includes a payment for services outside Section 28(e), the manager cannot determine in good faith that it is reasonable in relation to the eligible products. Where eligible research has simply been copied, repackaged or aggregated, the manager must make a good faith determination that any additional commissions paid for that copying, repackaging or aggregation are reasonable.

Where a broker-dealer also sells its research for an unbundled price, that price should inform the manager about the research's market value and help it make the determination.

Third-Party Research and the Provided By Requirement

The safe harbor covers third-party research on equal terms with a broker-dealer's proprietary research. Section 28(e) nevertheless requires that the research be provided by the broker-dealer. A broker-dealer is not providing research when it simply pays obligations that the manager has incurred to a third party, as the Commission found in its 1980 report on Investment Information, Inc.

A broker-dealer that is legally obligated to pay for research is providing it. Research supplied in a third-party arrangement remains eligible even if the manager participates in selecting the research the broker-dealer will provide, and the third party may send the research directly to the manager.

In 2006 the Commission widened the reading of provided by to cover a broker-dealer that is not directly obligated to pay for the research. The attributes that help show such a broker-dealer is providing the research are that it pays the research preparer directly; that it reviews the description of the services to be paid for with client commissions for red flags indicating they are outside Section 28(e), and agrees with the manager to use client commissions only for items that reasonably fall within the safe harbor; and that it maintains procedures so that research payments are documented and paid promptly.

Effecting the Trade, Give-Ups and Client Commission Arrangements

Section 28(e) also requires that the broker-dealer providing the research be involved in effecting the trade. That link between provided by and effecting was principally intended to stop give-ups. A give-up was a payment to another broker-dealer of part of the executing broker-dealer's commission, which managers used to reward broker-dealers for services that benefited the manager rather than its clients, such as steering clients to it.

Today managers often execute trades with one broker-dealer and obtain research through another. The Commission regards the functional separation of execution and research as beneficial to clients, and arrangements that promote that functional allocation are not give-ups.

For the manager to use the safe harbor, a broker-dealer in the arrangement that is effecting the trade must execute, clear or settle it, or perform at least one of four minimum functions and take steps to see that the others are reasonably allocated among the broker-dealers in the arrangement. The four are: taking financial responsibility for customer trades until the clearing broker-dealer has received payment or securities; making or maintaining the records of customer trades that Commission and self-regulatory organization rules require, such as blotters and memoranda of orders; monitoring and responding to customer comments about the trading process; and generally monitoring trades and settlements.

Disclosing Soft Dollar Benefits in Form ADV Part 2A

Section 28(e)(2) requires disclosure of commission policies and practices as the appropriate regulatory agency prescribes by rule. For registered investment advisers, Item 12 of Form ADV Part 2A, Brokerage Practices, requires the adviser to describe how it selects brokers for client transactions and determines the reasonableness of their compensation, and to disclose its practices if it receives soft dollar benefits in connection with client securities transactions.

Advisers must disclose their receipt of soft dollar benefits whether the benefits fall inside or outside the safe harbor. The description must be specific enough for clients and prospective clients to understand the types of products or services the adviser is acquiring and to evaluate the associated conflicts, and it must be more detailed for products or services that do not qualify for the Section 28(e) safe harbor, such as services that do not aid the adviser's investment decision-making.

The adviser must explain that it benefits because it does not have to produce or pay for the research or other products obtained with soft dollars, and that it therefore has an incentive to select brokers based on its interest in receiving those benefits rather than on the client's interest in the most favorable execution. It must explain whether it uses soft dollar benefits for all client accounts or only for those whose brokerage pays for them, whether it seeks to allocate benefits to accounts in proportion to the soft dollar credits the accounts generate, and whether it pays up, which means causing a client account to pay more than the lowest available commission rate in exchange for soft dollar products or services.

Directed Brokerage, Client Referrals and Trade Aggregation

If an adviser uses client brokerage to compensate or reward brokers for client referrals, it must disclose that practice, the conflicts of interest it creates, and the procedures it used during the last fiscal year to direct client brokerage to referring brokers.

An adviser that permits clients to direct brokerage must describe its practices and explain that it may be unable to obtain the most favorable execution of client transactions and that directing brokerage may cost clients more. An adviser that routinely recommends, requests or requires clients to direct brokerage must also disclose that not all advisers require directed brokerage and describe any relationship with the broker-dealer concerned that creates a material conflict of interest. The disclosure about being unable to obtain best execution may be omitted if the adviser conducts directed brokerage arrangements only subject to its ability to obtain best execution.

Item 12 also asks whether and under what conditions the adviser aggregates client trades. An adviser that does not aggregate trades when it has the opportunity to do so must explain that clients may pay higher brokerage costs as a result.

Common Errors and Exam Traps

Treating Section 28(e) as a licence for any soft dollar arrangement: it protects only against the charge of paying more than the lowest available commission, and only after the good faith determination.

Assuming that whatever delivers research is research: terminals and data lines are outside the research safe harbor even when the content is eligible.

Confusing the brokerage window with research: brokerage runs from transmission of the order to delivery or credit to the account.

Examination Relevance and Key Takeaways

The key points to retain are these. Section 28(e) shields a person exercising investment discretion from liability solely for paying more than the lowest commission, if it determines in good faith that the commission is reasonable in relation to the value of the brokerage and research services received. Research must be advice, analyses or reports on the statutory subjects; mass-marketed publications, hardware and overhead are excluded. Brokerage runs from transmission of an order to settlement. Mixed-use items must be allocated and documented. Form ADV Part 2A Item 12 requires disclosure of soft dollar benefits and the conflicts they create.