On September 22, 1988, the Securities and Exchange Commission’s Office of Compliance, Inspections and Examinations released its long awaited Inspection Report on the Soft Dollar Practices of Broker/Dealers, Investment Advisers, and Mutual Funds (the "Report").
"Soft dollar" arrangements are generally defined as the use of brokerage commission dollars to pay for products and services (typically investment research) beyond transaction execution costs. For example, an investment adviser, as a fiduciary, cannot use client assets to benefit itself, but it may use its client’s commissions to pay for research obtained from a broker-dealer. As a result, the adviser receives a benefit because it is relieved from the need to produce or pay for the research itself. To protect advisers from their clients’ claims that the advisers breached their fiduciary duty by causing the clients to pay more than the lowest available commission rates in exchange for research and execution, a soft dollar "safe harbor" under §28(e) of the Securities Exchange Act of 1934 ("Exchange Act") was developed. According to the Report, the estimated annual total value of third-party research purchased with soft dollars exceeds $1 billion.
From November 1996 through April 1997, the SEC undertook "limited scope on-site inspections" of the soft dollar activities of 75 broker-dealers and 280 investment advisers and investment companies. The results of this sweep are described in the Report, which also presents four general recommendations.
The first recommendation is based upon the SEC’s finding that broker-dealers and advisers are not consistently applying the standards set forth in a release issued by the SEC in 1986. The Report recommends that the Commission publish the findings of its on-site inspections in order to repeat its guidance concerning: (i) what constitutes research products and the services within the Section 28(e) safe harbor, (ii) advisers’ obligations to make a reasonable allocation of research and non-research uses of "mixed-use" items, maintain records to justify the allocation and to disclose the practice to clients; (iii) the obligation to clearly disclose soft dollar practices in plain English; (iv) the contractual liability of broker-dealers to pay for the product or service in order for the arrangement to fall within the safe harbor; (v) the liability of broker-dealers for aiding and abetting soft dollar transactions; (vi) the requirements of Exchange Act Rule 10b-10 with respect to disclosure; and (vii) the obligation of investment companies’ boards of directors to review all aspects of the advisers’ compensation, including benefits received in soft dollar arrangements, and their obligation to disclose the effect of using commissions to reduce fund expenses. The Report also recommends that the SEC provide further guidance on the scope of the safe harbor, particularly concerning the use and transmission of electronically-provided research and items that may facilitate trade execution.
Based on the SEC’s findings that large advisers did not properly monitor soft dollar transactions, the Report recommends that the SEC consider adopting recordkeeping requirements in order to fully document their soft dollar transactions. In particular, the Report suggests that the SEC adopt a rule requiring that all broker-dealers provide an annual statement to each investment adviser which would list all products, services and research provided to the adviser in exchange for soft dollars. Another recommended rule would require advisers to keep the statements of products and services provided by their broker-dealers, and to maintain their own detailed record of all products and services received, as well as the basis for allocating mixed-use products and services between their "hard" and "soft" dollar components.
Seeking more meaningful and effective disclosure, the Report recommends that the SEC revise the Form ADV (Uniform Application for Registration as an Investment Adviser) to clarify the information required about products and services purchased with soft dollars. The additional disclosure should be specific enough for clients to understand the types of products being purchased and to permit them to evaluate possible conflicts of interest. More detailed disclosure about products or services that are not used in carrying out the adviser’s investment decision-making responsibilities would also be required. If a particular client requested more detailed information, this information should be provided on a client-specific basis, including an itemized list of the research and products obtained with soft dollars during the previous period. For example, the availability to certain clients of commission recapture programs should be made known to all clients. Accordingly, the Report calls for the SEC to amend the Form ADV to require disclosure to an adviser’s clients of the availability of commission recapture if any client directly receives cash rebates, products, services, expense payments or expense reimbursements from one or more broker-dealers, on the basis of commissions generated by the client’s trades.
The final recommendation resulted from the wide diversity of internal control environments found at various broker-dealers and advisers. Some companies have comprehensive supervisory programs while others make no effort to monitor their soft dollar arrangements. It is recommended that the SEC publish the Report in order to encourage registrants to establish and implement internal controls relating to soft dollar practices. To facilitate compliance, a compilation of internal control procedures is attached to the Report.
See, Interpretive Release Concerning the Scope of §28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170 (April 23, 1986). This release reconfirmed the SEC’s policy that those products and services that provide administrative benefits or other non-research assistance to the adviser are not within the safe harbor. The SEC stated that the fact that a product or service is commercially available does not preclude a finding that the product or service is research. The controlling principle is whether the product or service provides lawful and appropriate assistance to the money manager in the carrying out of the investment decision-making responsibilities, which is a fact-based determination depending on the nature of the relationship between the various parties involved.