On July 12, 2006, the Securities and Exchange Commission (the "SEC") voted to publish an Interpretive Release (the "Release") that provides guidance on money managers' use of client commissions to pay for brokerage and research services under the "soft dollars" safe harbor in Section 28(e) of the Securities Exchange Act of 1934.

Section 28(e) provides that a person who exercises 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 an account to pay more than the lowest available commission if the money manager 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 SEC has provided guidance on a number of occasions since Section 28(e) was enacted in 1975 in an attempt to respond to changes in the industry and indicate whether the types of products and services that brokers make available to money managers fall within the Section 28(e) safe harbor.

As a result of the Release, the SEC now interprets the safe harbor as follows:

  • "Research services" are restricted to "advice", "analyses", and "reports" with respect to the value of securities, the advisability of investing in, purchasing or selling securities and the availability of securities or purchasers or sellers of securities, including information concerning issuers, industries, securities, economic factors or trends, portfolio strategy or the performance of accounts.
  • Physical items which do not reflect the expression of reasoning or knowledge relating to the list of items above, are outside the safe harbor.
  • Research related to the market for securities, such as trade analytics (including analytics available through order management systems) and advice on market color and execution strategies, are eligible for the safe harbor.
  • Market, financial, economic, and similar data could be eligible for the safe harbor.
  • Mass-marketed publications are not eligible as research under the safe harbor.
  • "Brokerage services" within the safe harbor are those products and services that relate to the execution of the trade from the point at which the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution, through the point at which funds or securities are delivered or credited to the advised account.
  • Eligibility of both brokerage and research services for safe harbor protection is subject to the SEC’s previous "lawful and appropriate assistance" standard.
  • Mixed-use items must be reasonably allocated between eligible and ineligible use, and the money manager must keep adequate books and records concerning allocations so as to enable the money manager to make the required good faith determination of the reasonableness of commissions in relation to the value of brokerage and research services.

The SEC has indicated that for the safe harbor to be available to a money manager, the following principles will apply:

  • Broker-dealers that are parties to soft dollar arrangements are involved in "effecting" the trade if they execute, clear, or settle the trade, or perform one of four specified functions and allocate the other functions to another broker-dealer. The four functions are: (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; and (4) monitoring trades and settlements.
  • Broker-dealers "provide" the research if they (i) prepare the research, (ii) are financially obligated to pay for the research, or (iii) are not financially obligated to pay but their arrangements have certain attributes.

The SEC will receive and consider additional comment on these client commission arrangements and may supplement the guidance in the Release if the SEC determines that it is appropriate to do so. The Release is effective immediately, but market participants will be able to rely on prior SEC guidance for the next six months.

Accordingly, money managers and broker dealers should review their soft dollar arrangements and make any necessary adjustments. Money managers must also review how such arrangements are disclosed in their Form ADV, hedge fund offering and subscription documents, and marketing materials, and make any necessary revisions.

Pillsbury Winthrop Shaw Pittman LLP represents hedge fund sponsors and advisers, prime brokers, and administrators through its 16 offices, located in global centers for capital markets, finance, energy, and technology.

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