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SEC Proposes Curbs on Soft Dollars: Restricts Usage to Advice, Analysis, Reports

Questions having to do with compromising best execution of trades and paying above-average trading commissions in exchange for the receipt of soft dollars - be it research, equipment, software or other goods and services - have prompted the Securities and Exchange Commission to propose new guidelines with respect to the safe harbor on soft-dollar practices.

The SEC's vote on the new guidelines last month was unanimous, and the Commission is accepting comment letters on its proposed new rules through Nov. 25.

The interpretive guidelines redefine the phrase "brokerage and research services." As fiduciaries, the SEC notes, investment managers are obligated to seek best execution of trades and may not use client assets for their own benefit. Use of client commissions to pay for research and brokerage services leaves managers with a conflict of interest and may tempt them to disregard their best-trade obligations.

According to the SEC's proposed new rules, when determining whether a particular soft-dollar product or service falls within safe harbor, a money manager must determine whether it constitutes advice, analysis or a report, and that the subject matter is related to the securities and financial markets.

In order for a service or product to be considered safe harbor, it must provide the money manager with lawful and appropriate assistance in making investment decisions. For example, a traditional research report that deals with analyzing the performance of a particular company or stock would obviously be within safe harbor.

Independent and third-party research, market data, some financial newsletters, trade journals, portfolio analysis software and conferences and seminars are all items that affect an advisor's investment decisions and, therefore, qualify for safe harbor.

Consulting services for investment strategies may be eligible. However, consulting on issues not related to investing would not qualify.

Also, products or services that do not mirror reasoning or knowledge, like tangible products such as telephone lines or office furniture, are not considered to be research under the SEC's proposed new safe harbor. Travel, entertainment, meals, computers and other office equipment, supplies, rent, telephones and other utilities, administrative software and salaries, including for research staff, do not qualify as safe harbor under the new SEC proposed guidance.

The SEC is also allowing some brokerage services, as they relate to clearance and settlement, to qualify for safe harbor. This includes: "post-trade matching; exchange of messages among broker/dealers, custodians and institutions; electronic communication of allocation instructions between institutions and broker/dealers; and routing settlement instructions to custodian banks and broker/dealers' clearing agents."

How money managers use the products and services they get through soft-dollar arrangements affects their eligibility, as well. Money managers may use soft dollars for performance analysis or investing, but not for marketing, shelf space or other distribution efforts.

The new guidelines continue to allow mixed-use goods and services - such as those that combine trading, execution, accounting and marketing - but explicitly require money managers to "keep adequate books and records concerning allocations so as to be able to make the required good faith showing" that they are only expensing the portion of their trading commissions that affects their investment decision-making.

"For example, an allocable portion of the cost of portfolio performance evaluation services or reports may be eligible as research, but money managers must use their own funds to pay for the allocable portion of such services or reports that is used for marketing purposes," according to the SEC.

The SEC also addressed commission-sharing arrangements between brokers, determining that "each party to the arrangement must determine if it is contributing to a violation of the law, including whether the involvement of multiple parties to the trade is necessary to effecting the trade, beneficial to the client and appropriate in light of all applicable duties."

Still, some don't believe the SEC's new guidance goes far enough. Many groups are contesting soft-dollar deals between mutual fund companies and brokerage firms altogether, and are now calling on fund directors and/or the SEC to ban them outright. "Soft dollars should be completely done away with," said Keith L. Shadrick, president of Indianapolis-based financial consultancy Axia Advisory Corp., in a comment letter to the SEC.

Recently, Fidelity Investments of Boston struck a deal with Lehman Brothers of New York to pay separately for research, and a number of other large fund managers are expected to follow suit.

On the other hand, The Bank of New York issued a release applauding the SEC's decision to continue to allow research to be bundled into trading commissions, while requiring more transparency.