The following excerpt comes from a speech made to the Teachers’ Retirement System of the State of Illinois Opportunity Forum by SEC Commissioner Campos: I will move on to soft dollars. As I noted at the Commission open meeting approving the guidance, the magnitude of soft dollar use in the US is significant. According to a recently published report by Greenwich Associates, soft dollar use in the United States has remained steady at just under $1.0 billion in 2006 — approximately 9% of total equity institutional commissions for the period. As originally conceived in 1975, the soft dollar safe harbor was designed to permit funds to use commissions to purchase primarily research that was bundled with execution, without being held to have violated their fiduciary obligations solely for not having paid the lowest possible commission costs. The use of soft dollars has spread to services far beyond research to those that closely resemble the type of overhead items for which use of soft dollars was specifically prohibited. The Commission’s recent guidance was issued in an attempt to reign in the abusive practices, and to address the growth and development of the technology, products and services currently available to money managers. In short, the guidance outlines a three-part test for evaluating whether a service falls within the safe harbor of Section 28(e). First, the money manager must determine whether the service falls within the statutory limitations and consequently that it is eligible “research” or “brokerage.” Second, the manager must determine whether the eligible service provides lawful and appropriate assistance in the performance of his investment decision-making responsibilities. This step in the analysis is particularly important in relation to mixed-use products. Finally, the manager must make a good faith determination that the amount of client commissions paid is reasonable in light of the value of products or services provided by the broker-dealer. This test does not modify a manager’s obligation to seek best execution. To provide greater clarity within the broad categories of eligible research and brokerage products and services, the guidance details certain items that are in and certain items that are out of the safe harbor. Importantly, the lists are illustrative and should not be considered exclusive. When in doubt, managers should revert to the text of the interpretation in which the Commission explains, for example, that eligible research must reflect an expression of reasoning or knowledge. If uncertainty continues to linger, I recommend managers err on the side of caution and pay for the service out of their own pocket. Remember, the context in which we are analyzing services is a safe harbor from a fiduciary duty — not an entitlement. Some managers, such as Fidelity, have taken matters into their own hands, encouraging brokers to unbundle the commissions they charge, exposing the cost of the actual execution and the cost of the ancillary research services. Others, including the 2004 Mutual Fund Task Force and the SIA, support a more moderate approach of instilling transparency and disclosure to the soft dollar regime, thereby preserving the safe harbor but arming shareholders and fund directors with information on how their money is spent, without demanding unbundling. I too have urged this position for the near term but continue to believe we must look at all alternatives. That is why, at this time, the Commission has not only attempted to provide current and meaningful guidance for interpreting the safe harbor, but it has also reaffirmed its position on third-party research. Such research falls within the safe harbor so long as, among other things, the broker is obligated to the third party to pay for the services. Despite our earlier decree, we had heard that a number of third-party research providers have faced difficulty stemming from supposed uncertainty on behalf of brokers and money managers as to whether the third-party research remained within the safe harbor. These reports were disturbing not only for the third-party research provider, who might be a small, up and coming company trying to compete against the conflicted, in-house research provider, but also for small firms. The small firm, which accounts for over 80% of the NASD’s members, often does not have an in-house research staff. It relies on third-party research providers. Moreover, as I just mentioned, the small firm often relies on soft dollars to pay for that research. Lastly, the Commission’s interpretation modified the proposed guidance with respect to commission-sharing arrangements. In the interest of recognizing the realities of the marketplace, the new guidance expands the scope of the “provided by” language when certain conditions are met and states that broker-dealers may reasonably allocate functions among themselves, including the minimum requirements for complying with the guidance. Thus, small introducing broker-dealers or independent research providers are not cut out of the soft dollar equation because they do not themselves perform all of the functions of “providing” a service and “effecting” a transaction. It is important to note that the guidance does not alter the Commission’s position with respect to “give ups.” A manager still cannot use soft dollars to make payments to a broker-dealer that did not provide any services to benefit the advised accounts. Instead, the Commission guidance provides that arrangements that allow for a portion of the commissions to go to one broker-dealer for execution and another for research are not “give ups” in contravention of the “provided by” and “effecting” language of the statute. I believe this approach is the appropriate approach that retains Congressional intent but moves us into the year 2006. I would be interested to hear your comments on the matter. Please Click here for more information.
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