SEC Issues Soft Dollars Interpretive Release

Contents

1. SEC Issues Soft Dollars Interpretive Release

2. Federal Banking Agencies and FTC Issue Proposed Release Regarding Red Flags for Identity Theft

3. OTS Issues Outlines Regarding BSA/AML Compliance

The SEC approved an interpretive release (the "Release") that updates prior guidance regarding the safe harbor provided by Section 28(e) of the Securities Exchange Act of 1934, as amended. (In broad terms, Section 28(e) permits a money manager to use commissions paid on client brokerage transactions ("soft dollars") to purchase "brokerage and research services" that are used in fulfilling the money manager’s responsibilities with respect to its discretionary accounts (including accounts other than the one paying the commission) without breaching fiduciary duties the money manager owes its clients.) The Release includes a number of changes from the proposed interpretive release, but overall does not represent a significant departure from the status quo. The principal topic areas addressed in the Release are as follows:

• the analytic framework for determining whether a particular service is within the safe harbor
• eligibility criteria for "research"
• eligibility criteria for "brokerage"
• commission–sharing arrangements

As a technical matter, the Release replaces Sections II (Definition of Brokerage and Research Services) and III (Third-Party Research) of the SEC’s 1986 Soft Dollars Interpretive Release. As noted at the open meeting in remarks by Commissioners and by the new Director of the Division of Investment Management, the SEC staff is considering enhancements in disclosure and documentation requirements for soft dollar practices.

The Release indicates that analysis of whether a particular product or service falls within the Section 28(e) safe harbor should involve a three step analysis, as follows:

1. determination of whether the product or service is eligible research or brokerage under Section 28(e);

2. determination of whether the eligible product or service actually provides "lawful and appropriate assistance" in the performance of investment decision-making responsibilities (which means that when a money manager uses a product or service for multiple purposes, not all of which are within the safe harbor ("mixed-use"), the money manager must make a reasonable allocation of costs between safe harbor and non-safe harbor uses and may not pay for the non-safe harbor costs with soft dollars); and

3. a good faith determination that the amount of the commission paid is reasonable in light of the value of the product or service provided by the broker-dealer viewed in terms of the particular transaction or the money manager’s overall responsibilities with respect to accounts over which the money manager exercises investment discretion. The Release notes that "the prudent way for a money manager to meet its burden for showing eligibility for the safe harbor is to document fully its [soft dollar] arrangements."

In determining that a service or product constitutes "research" under Section 28(e), the Release indicates that a money manager must conclude that the product or service reflects substantive content (the expression of reasoning or knowledge) and relates to the specific subject matter cited in Section 28(e), as follow s:

• advice, either 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 purchasers or sellers of securities

• analyses, and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy and the performance of accounts

The Release notes that the express categories in Section 28(e) subsume other topics related to securities and the financial markets, such as (a) political factors and trends, which may have economic implications and (b) advice and information on industries, economics, world conditions and portfolio strategy. The form in which the research is delivered, be it electronic, paper or oral, is irrelevant to the analysis of eligibility under the safe harbor (except that delivery mechanisms for research are not within the safe harbor as discussed below).

The Release emphasizes that the categories of research identified in the statute reflect "substantive content," which is "the expression of reasoning or knowledge," and that in order for a product or service to be eligible as research under the safe harbor, a money manager must conclude that the product or service (1) reflects the expression of reasoning or knowledge and (2) relates to the permitted subject matter. The Release provides a number of examples of eligible research, as follows:

• traditional research reports analyzing performance of a particular company or stock

• discussions with research analysts

• meetings with corporate executives to obtain oral reports on company performance

• seminars or conferences that provide substantive content relating to the subject matter cited in Section 28(e), such as issuers, industries and securities (but not including travel and related expenses, e.g., meals, lodging and entertainment)

• software that provides analyses of securities portfolios

• corporate governance research (including corporate governance analytics) and corporate governance rating services to the extent they constitute "analyses," "advice" or "reports" that are used in the investment decision-making process (see "Eligible Proxy Services" below)

(i) Mass-Marketed Publications – Not Eligible. Reversing the SEC’s prior position, the Release indicates that mass-marketed publications are not eligible for the safe harbor of Section 28(e). The Release defines mass-marketed publications as those that are intended for and marketed to a broad, public audience. According to the Release, indicia of mass-marketed publications include, among other things, that they (1) are circulated to a wide audience, (2) are intended for and marketed to the public, rather than intended to serve the specialized interests of a small readership, and (3) have low costs; conversely, indicia of publications that are not mass-marketed (and could be eligible research) include, among other things, that they (A) are marketed to a narrow audience, (B) are directed to readers with specialized interests in particular industries, products, or issuers, and (C) have high costs. The Release cites trade magazines and technical journals concerning specific industries (e.g., nano-technology), or product lines (e.g., medical devices), as eligible research if the publications are marketed to, and intended to serve the interest of a narrow audience (e.g., physicians), rather than the general public. The Release emphasizes the importance of the manner in which a publication is marketed, as opposed to its availability, as a criterion for determining the availability of the safe harbor. The fact that a publication marketed to a narrow audience, such as investment professionals, is available over the Internet to the general population, does not alter the eligibility of the publication as research under Section 28(e).

(ii) Inherently Tangible Products and Services-Not Eligible. Products with inherently tangible or physical attributes are not eligible for the Section 28(e) safe harbor under the Release. The Release provides the following examples of these types of products and services:

• travel, entertainment and meals associated with (a) attending seminars and (b) meeting with corporate executives, analysts or other individuals who may provide eligible research orally
• office equipment, office furniture and business supplies
• salaries (including research staff and rent)
• accounting fees and software
• website design, e-mail software and Internet service
• legal expenses, personnel management, marketing and utilities
• membership dues, professional licensing fees
• software that assists with administrative functions, such as managing back-office functions, operating systems, word processing and related equipment maintenance and repair service

Computer hardware, including computer terminals and computer accessories along with peripherals and delivery mechanisms associated with computer hardware or associated with the oral delivery of research, including telecommunications, lines, transatlantic cables and computer cables are outside the safe harbor. In the Release, the SEC responds specifically to comments seeking clarification about whether computer terminals dedicated to the transmission of particular research products are eligible for the safe harbor; the Release indicates that the SEC does not believe that any computer terminals are eligible "research" under Section 28(e).

(iii) Eligible Market Research and Data. The Release clarifies that advice, analyses and reports regarding the market for securities ("market research") may be eligible research under the sale harbor, as follows:

• 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
• advice provided by broker-dealers or software regarding order execution, including advice on execution strategies, market color and the availability of buyers and sellers

The Release states that data services, such as those that provide market or economic data, are within the Section 28(e) safe harbor as eligible "reports." Examples of eligible market and economic data provided in the Release include the following:

• stock quotes
• last sale prices
• trading volumes
• economic data (such as unemployment and inflation rates or gross domestic product figures)
• company financial data

(iv) Eligible Proxy Services. The Release acknowledges that a money manager could determine that certain proxy products and services provide it with assistance in the investment decision-making process and are therefore eligible for the safe harbor. For example, corporate governance research and corporate governance rating services provided as part of proxy services may be eligible research to the extent they are used for investment decision-making (but not in connection with deciding how to vote proxies). To the extent a proxy product also assists a money manager in deciding how to vote proxy ballots or handles mechanical aspects of voting, such as casting, counting, recording and reporting votes, the proxy product would have to be treated as a mixed-use item.

Noting that clearance, settlement and custody services are explicitly identified in Section 28(e) as eligible incidental brokerage services, the Release indicates that the following post-trade services are eligible under the safe-harbor as "brokerage services":

• post-trade matching of trade information
• other exchanges of messages among broker-dealers, custodians and institutions related to the 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 effecting particular transactions in relation to clearance and settlement of the trade
• comparison services required by SEC or self regulatory organization rules (e.g., electronic confirmation and affirmation of certain institutional trades)

The Release reaffirms the temporal standard for determining the eligibility of services for the safe harbor as brokerage set forth in the proposing release – services related to execution of securities transactions are eligible for the safe harbor if their use falls within the time period beginning when an order is transmitted to a broker-dealer and ending at the conclusion of clearance and settlement of the transaction, i.e., when funds or securities are delivered or credited to the advised account or the account holder’s agent.

(i) Communication Services. The Release gives the following examples of communications services that would be eligible brokerage services:

• connectivity service between the money manager and the broker-dealer and other relevant parties such as custodians (including dedicated lines between the broker-dealer and the money manager’s order of management system)
• lines between the broker-dealer and/or management systems operated by a third-party vendor
• dedicated lines providing direct dial-up service between the money manager and the trading desk at the broker-dealer
• message services used to transmit orders to broker-dealers for execution

The Release highlights an important distinction between research and brokerage under the safe harbor – mechanisms such as dedicated lines may qualify for the safe harbor as brokerage, but delivery mechanisms do not qualify for the safe harbor as research.

(ii) Trading Software. The Release gives the following examples of trading software that would be eligible brokerage services:

• software used to route orders to market centers
• software that provides algorithmic trading strategies
• software used to transmit orders to direct market access ("DMA") systems

The Release notes that order management systems ("OMS") may include trading software used to route orders, provide algorithmic trading strategies or transmit orders to DMA systems or to provide connectivity to the software, in which case these aspects of OMS may be eligible brokerage.

(iii) Ineligible Overhead. In contrast to communication services as discussed above, hardware, such as telephone or computer terminals, including those used in connection with OMS and trading software, are not eligible for the safe harbor. In addition, (a) software functionality used for recordkeeping or administrative purposes, such as managing portfolios, and (b) quantitative analytical software used to test "what if" scenarios related to adjusting portfolios or asset allocation, or for portfolio modeling, do not qualify as brokerage. The Release notes particularly that money managers may not use soft dollars under the safe harbor to meet compliance responsibilities such as:

• performing compliance tests that analyze information over time and as a means of forensic testing, e.g., 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 portfolio under a variety of market conditions or to monitor style drift

The Release does acknowledge, however, that a money manager may treat trade analytics as a mixed-use product when used both (1) for research within the safe harbor and (2) to assist in fulfilling contractual obligations to a client or to assess whether a money manager has complied with its own regulatory or fiduciary obligations, such as the duty of best execution. The Release indicates that trade financing, such as stock lending fees and capital introduction and margin services are not within the safe harbor, nor are error correction trades or related services provided to address errors made by a money manager. In the Release, the SEC also clarifies that long-term custody, custody that is provided post-settlement and that relates to long-term maintenance of securities positions, is not eligible brokerage, while short-term custody, custody related to effecting a particular transaction in relation to clearance and settlement of that trade, is eligible to be treated as brokerage.

In addressing commission sharing arrangements (where more than one broker-dealer is involved in the transaction and one of the broker-dealers provides brokerage or research services), the Release focuses on the statutory requirement that the broker-dealer providing the research must also be involved in effecting the trade. The Release states that a broker-dealer is effecting a securities transaction if it is executing, clearing or settling the trade. The Release also indicates that a broker-dealer may effect a transaction by performing at least one of four minimum functions and taking steps to see that the other functions have been reasonably allocated to one or another of the broker-dealers participating in the transaction in a manner that is fully consistent with applicable self regulatory organization and SEC rules. The four minimum functions are as follows:

• taking financial responsibility for all customer trades until the clearing broker-dealer has received payment (or securities), i.e., one of the broker-dealers in the arrangement must be at risk for the customer’s failure to pay
• making and/or maintaining records relating to customer trades required by SEC and SRO rules, including blotters and memoranda or orders
• monitoring and responding to customer comments concerning the trading process
• generally monitoring trades and settlements (the Release notes that in particular, one of the broker-dealers participating in the soft dollar arrangement must be aware of and monitor daily trading activity of customers even where the money manager sends orders directly to (and only to) the clearing broker)

The Release reiterates the prior standard for providing brokerage or research services – that the broker-dealer provides the service itself or where the research is provided under an arrangement with a third-party (which may be selected by the money manager), the broker-dealer is legally obligated to pay for the service provided by the third-party. The Release also adds a third set of circumstances (not discussed in the proposing release) under which a broker-dealer "provides" brokerage or research services within the meaning of the safe harbor. Under the third set of circumstances, the broker-dealer is not directly obligated to pay for eligible third-party services, but the broker-dealer pays the third-party directly and takes steps to assure itself that such services are solely eligible brokerage or research services. In terms of specific measures that should be taken under this type of arrangement, the Release suggests the following:

• the broker-dealer reviews a description of the third-party services to be provided for red flags that indicate they are not within the safe harbor and agrees with the money manager that soft dollars may be used only for items that reasonably fall within the safe harbor; and
• the broker-dealer develops and maintains procedures designed to ensure that payments for third-party services are made promptly and documented.

The guidance in the Release was effective July 24, 2006, but market participants may continue to rely on the SEC’s prior interpretations until January 24, 2007.

Noting the potential benefits to investors of flexibility in commission sharing arrangements, the Release indicates that the SEC will consider further comment on evolving industry practices with respect to commission sharing arrangements. Comments should be received by the SEC no later than September 7, 2006.

The FRB, FDIC, OCC, OTS, NCUA and FTC jointly released a proposed rule (the "Red Flag Rule") implementing sections of the Fair and Accurate Credit Transactions Act ("FACT Act") and establishing guidelines for banks and other regulated financial institutions in noting instances of identity theft. The Red Flags Rule would require financial institutions to establish reasonable policies and procedures to implement the broad guidelines contained in the Red Flags Rule.

The Red Flags Rule applies to entities meeting the Fair Credit Reporting Act definitions of "financial institution" or "creditor" as amended by the FACT Act. Financial institutions and creditors must develop a written program ("Program") that assesses identity theft risks and outlines controls to address those risks. The Red Flags Rule gives financial institutions and creditors flexibility in crafting the Program, but the Program must be appropriate to the size and complexity of the applicable organization and adaptable to address new identity theft risks. Specifically, the Program must:

• Identify those Red Flags that are relevant to detecting a possible risk of identity theft to a customer or to the safety and soundness of the financial institution or creditor;
• Verify the identity of persons opening accounts;
• Detect the Red Flags that the financial institution or creditor identifies as relevant in connection with the opening of an account or any existing account;
• Assess whether the Red Flags detected evidence a risk of identity theft;
• Mitigate the risk of identity theft, in a manner commensurate with the degree of risk posed;
• Train staff to implement the Program; and
• Oversee service provider arrangements.

Although the Red Flags Rule provides flexibility to financial institutions and creditors in designing the Program, an appendix to the Red Flags Rule lists 31 specific red flags that should alert the institution to the possibility of identity theft. The appendix includes red flags in the areas of account opening and existing accounts, documentary information, personal information, address changes, anomalous use of the account, notice from customers or others regarding customer accounts, and other red flags. Some of the requirements of the Red Flags Rule may well already be met by banks as part of them compliance programs related to other laws, such as programs that address anti-money laundering compliance requirements.

The Red Flags Rule requires oversight of the Program by the financial institution or creditor’s board of directors and senior management. The Program must be approved by the board of directors or by an appropriate committee of the board. Implementation of the Program must be overseen by the board, a board committee or senior management and staff implementing the Program must report at least annually to the group overseeing implementation.

Comments on the proposed Red Flags Rule are due no later than September 18, 2006.

The OTS, in preparation for a July 31, 2006 conference call regarding Bank Secrecy Act/Anti-Money Laundering ("BSA/AML") compliance, made two outlines publicly available on the OTS website. The first presentation covers "How to Build a Successful BSA/AML Compliance Program & Common Violations" and the second outline concerns "OTS Formal and Informal Enforcement Actions." Among other things, the OTS: (1) noted examiners’ expectations regarding BSA/AML risk analyses; (2) emphasized the importance of documentation; (3) stressed the need to have an effective program that entails more than a "canned" policy; and (4) stated that a revised and updated version of the bank regulators’ BSA/AML Examination Manual is expected to be released on July 28, 2006.

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