[Federal Register Volume 60, Number 34 (Tuesday, February 21, 1995)]
[Proposed Rules]
[Pages 9750-9759]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-4160]
[[Page 9749]]
_______________________________________________________________________
Part IV
Securities and Exchange Commission
_______________________________________________________________________
17 CFR Parts 275 and 279
Disclosure By Investment Advisers Regarding Soft Dollar Practices;
Proposed Rule
Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 /
Proposed Rules
[[Page 9750]]
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 275 and 279
[Release No. 34-35375; IA-1469; S7-5-95]
RIN 3235-AG36
Disclosure by Investment Advisers Regarding Soft Dollar Practices
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule and form.
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SUMMARY: The Commission is proposing for comment a new rule and form
under the Investment Advisers Act of 1940 that would require certain
investment advisers to provide clients with an annual report regarding
their use of client brokerage. The proposed report would include
disclosure about an adviser's use of its clients' brokerage commissions
during the previous year, including information about research and
other services obtained by the adviser with those commissions. The
proposed annual report is intended to provide investment advisory
clients with important information about the brokerage commissions they
pay and their advisers' receipt of ``soft dollar'' benefits from those
commissions.
DATES: Comments should be received on or before May 19, 1995.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,
N.W., Washington, D.C. 20549. All comment letters should refer to File
No. S7-5-95. All comments received will be available for public
inspection and copying in the Commission's Public Reference Room, 450
Fifth Street, N.W., Washington, D.C. 20549.
FOR FURTHER INFORMATION CONTACT: Eric C. Freed, Special Counsel, or
Robert E. Plaze, Assistant Director, (202) 942-0721, Office of
Disclosure and Investment Adviser Regulation, Division of Investment
Management, Securities and Exchange Commission, 450 Fifth Street, N.W.,
Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission today
is proposing for comment:
(1) rule 204-4 (17 CFR 275.204-4) under the Investment Advisers Act
of 1940 (15 U.S.C. 80b-1 et seq.) (``Advisers Act''), which would
require an investment adviser registered or required to be registered
under the Advisers Act to deliver to its clients an annual report on
the adviser's direction of client brokerage transactions and its
receipt of research and other services in connection with those
transactions; and
(2) Form ADV-B under the Advisers Act, which would set forth the
information required to be included in the annual report.
Executive Summary
The Commission is proposing a new rule and form under the Advisers
Act to require each investment adviser (``adviser''), registered or
required to be registered under the Advisers Act, that has the
discretion to direct client brokerage transactions and receives
services other than execution in exchange for that brokerage, to
provide its clients with a report that would contain information about
its use of client brokerage. The report would disclose for the
adviser's most recently completed fiscal year, (1) the twenty brokers
to which the adviser directed the largest amounts of commissions and
certain other transaction-related payments (collectively,
``commissions''), (2) the three brokers substantially all of whose
services for the adviser were execution services (``execution-only
brokers'') to which the adviser directed the largest amounts of
commissions, (3) the aggregate amount of commissions directed by the
adviser to each broker listed and the percentage of the adviser's total
discretionary brokerage this amount represents, (4) the average
commission rate paid to each broker listed, and (5) for each broker
other than an execution-only broker, information concerning products or
services obtained from the broker. The report would also disclose the
percentages of the adviser's total commissions that are directed to
execution-only brokers, to other brokers, and at the request of
clients. The report would require only information about an adviser's
use of client brokerage on an aggregate basis; it would not require
separate information about the brokerage of the adviser's various
clients. The report would be provided to existing advisory clients
annually and to prospective advisory clients no later than the time
that an advisory agreement is entered into.
I. Background
Soft dollar practices are arrangements under which products or
services other than execution of securities transactions (``soft dollar
services'') are obtained by an adviser from or through a broker in
exchange for the direction by the adviser of client brokerage
transactions to the broker.\1\ Soft dollar practices are common in the
institutional brokerage market. According to an informal annual survey
of investment advisers and other institutions, nearly ninety percent of
these institutions engage in soft dollar arrangements, and more than
forty percent of commissions are directed primarily for the purpose of
obtaining research services.\2\
\1\See Securities Exchange Act Rel. No. 23170 (Apr. 23, 1986)
[51 FR 16004 (Apr. 30, 1986)] (``Release 23170'') at Sec. I; Robert
J. Moran & Cathy G. O'Kelly, Soft Dollars and Other Traps for the
Investment Adviser, 1 DePaul Bus. L.J. 45, 45 n.5 (1989).
\2\Greenwich Associates, Soft-Dollars: Opportunities and
Challenges (special presentation of May 10, 1994); Greenwich
Associates, Institutional Equity Investors 1994 (statistical supp.)
3, 17.
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Soft dollar practices originally developed as a means by which
brokers provided discounts on brokerage commissions that were fixed
pursuant to exchange and commission rules. In 1975, the Commission
prohibited fixed commission rates\3\ and, later that year, Congress
codified the Commission's action.\4\ After the Commission abolished
fixed rates, concerns were raised whether the soft dollar practices
that had developed in the context of fixed rates would continue to be
consistent with various state and federal laws, including the Advisers
Act.\5\
\3\Securities Exchange Act Rel. No. 11203 (Jan. 23, 1975) (40 FR
7394 (Feb. 20, 1975)).
\4\Securities Acts Amendments of 1975, Pub. L. No. 94-29, 89
Stat. 97, 107-08 (enacting Section 6(e)(1) of the 1934 Act (15
U.S.C. 78f(e)(1))).
\5\S. Rep. No. 75, 94th Cong., 1st Sess. 70 (1975).
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Underlying these concerns is an adviser's fundamental obligation
under the Advisers Act (and state law) to act in the best interest of
its clients.\6\ This duty requires the adviser to obtain best execution
of client transactions,\7\ and precludes the adviser from using client
assets for its own benefit or the benefit of other clients, at least
without client consent.\8\ Upon the Commission's eliminating fixed
commission rates, some argued that an adviser could be deemed to have
violated this duty if the adviser caused a client's account to pay
anything but the lowest commission rates. If this view was upheld, soft
dollar arrangements could have been effectively precluded by the
decision to eliminate fixed commission rates.
\6\See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180,
194 (1963).
\7\Delaware Management Co., 43 S.E.C. 392, 396 (1967). An
adviser is obligated to use reasonable diligence to select a broker
who will ``execute securities transactions for clients in such a
manner that the client's total cost or proceeds in each transaction
is most favorable under the circumstances.'' Securities Exchange Act
Rel. No. 23170 (Apr. 23, 1986) [51 FR 16004 (Apr. 30, 1994)]
(``Release 23170'') at Sec. V (citing Kidder, Peabody & Co., 43
S.E.C. 911, 915 (1968)). An adviser should consider the full range
and quality of the broker's services, including the value of
research received, in assessing whether a broker will provide best
execution. Id.
\8\Restatement (Second) of Trusts Sec. 170 comment a, Sec. 216
(1959). [[Page 9751]]
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Congress, in codifying the abolition of fixed commission rates,
responded to these concerns by enacting Section 28(e) of the Securities
Exchange Act of 1934 (the ``1934 Act'') [15 U.S.C. 78bb(e)], which
provides a safe harbor for certain soft dollar arrangements.\9\ Section
28(e) provides, in pertinent part, that an adviser with investment
discretion over an account will not be deemed to have acted unlawfully
or to have breached its fiduciary duty by causing the account to pay a
higher commission to a broker that provides research benefiting the
adviser's accounts. To rely on the Section 28(e) safe harbor, an
adviser must determine in good faith that the commissions paid are
reasonable in relation to the value of the brokerage and research
services provided, either in terms of the particular transaction or the
adviser's overall responsibilities towards its discretionary
accounts.\10\
\9\Securities Acts Amendments of 1975, Pub. L. No. 94-29, 89
Stat. 97, 161-62.
\10\The Commission has stated that a product or service may
legitimately be considered a ``brokerage or research service''
covered by the safe harbor if it provides ``lawful and appropriate
assistance to the [adviser's] decision-making process.'' Release
23170, supra note 1. The Commission's Division of Market Regulation
has addressed the types of transactions that are afforded the
protection of the safe harbor. See U.S. Department of Labor (pub.
avail. July 25, 1990) (safe harbor does not extend to principal,
riskless principal and futures transactions); Hoenig & Co. (pub.
avail. Oct. 15, 1990) (same); Instinet Corporation (pub. avail. Jan.
15, 1992) (safe harbor does apply to agency transactions in equity
securities on a computer-based real time market information and
brokerage system and after-hours order matching system).
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Section 28(e) modifies a fiduciary's strict duty to act in the best
interest of each client with respect to the management of each client's
assets. Thus, it permits an adviser to cause a client to pay higher
commissions than otherwise are available to obtain research that may
not be used exclusively for the benefit of the client or used to
benefit the client at all. Section 28(e), however, does not afford a
safe harbor with respect to all conflicts of interest between the
adviser and its clients that may arise from soft dollar arrangements.
For example, soft dollar arrangements may cause an adviser, in order to
obtain soft dollar services, to violate its best execution obligations
by directing client transactions to brokers who could not adequately
execute the transactions. Soft dollar arrangements also may give
advisers incentives to trade client securities inappropriately to
generate credits for soft dollar services.\11\
\11\See Securities and Exchange Commission v. Galleon Capital
Management, Litigation Rel. No. 14315 (Nov. 1, 1994). The
Commission's complaint in Galleon, in addition to alleging excessive
trading in order to generate soft dollar credits, alleged that the
adviser requested brokers to make soft dollar payments to a
consulting firm, and that these payments eventually were rebated to
the adviser. See also Letter from Bradford P. Schaaf, Chairman, and
Victor J. Fontana, President and Chief Executive Officer, Autranet,
Inc. to Barry P. Barbash, Director, Division of Investment
Management and Brandon Becker, Director, Division of Market
Regulation (Nov. 10, 1994) (``Autranet Letter'') (proposing that the
Commission prohibit a broker from requiring an adviser, by contract
or understanding, to commit to direct any specified amount of
commissions to the broker in order to receive soft dollar services).
Soft dollar practices also diminish the ability of a client to
evaluate the expenses it incurs in obtaining portfolio management
services and may hinder the ability of the client to negotiate fee
agreements, because the costs of soft dollar services are ``hidden''
from investors in brokerage commissions. By permitting advisers to use
their clients' transactions to pay for research services that they
otherwise would have to purchase with ``hard dollars,'' soft dollar
arrangements permit advisers to charge fees that do not fully reflect
the cost of portfolio management. Advisers that do not engage in soft
dollar arrangements may be put at a competitive disadvantage if they
pay for services with hard dollars and attempt to pass the cost of
these services on to clients through higher fees.
Congress recognized the conflicts that soft dollar practices
present and provided in section 28(e) authority for the Commission to
require advisers to disclose to their clients their policies and
practices with respect to the use of client commissions.\12\ The
Commission has never adopted rules under section 28(e),\13\ but has
instead required certain disclosure in Part II of Form ADV, which
specifies the content of the disclosure document or ``brochure'' that
an adviser is required to provide to clients before entering into
advisory relationships.\14\ If soft dollar arrangements are a factor in
selecting brokers to effect client transactions, the brochure must
disclose the nature of the adviser's soft dollar practices, including:
(i) the services that the adviser obtains through soft dollar
arrangements; (ii) whether clients may pay higher commissions (``pay
up'') as a result of the arrangements; (iii) whether soft dollar
services are used to benefit all client accounts or only those accounts
the brokerage of which was used to purchase the services; and (iv) any
procedures that the adviser uses to allocate brokerage.\15\
\12\Section 28(e)(2) (15 U.S.C. 78bb(e)(2)).
\13\In 1976, the Commission proposed rule 28e2-1 under the 1934
Act, but the rule was never adopted. See note 41 infra.
\14\Rule 204-3 under the Advisers Act (17 CFR 275.204-3)
requires that a registered investment adviser deliver the brochure
to a prospective client before entering into an advisory contract
with the client, and, annually thereafter, provide or offer to
provide the client with the brochure. The Commission is not at this
time proposing to amend the Form ADV requirements regarding
disclosure of soft dollar arrangements. The Commission, however, is
considering whether changes to these requirements would be
appropriate, and may propose changes in connection with future
revisions to Form ADV.
\15\Item 12 of Part II of Form ADV. Registered investment
companies are required to include similar disclosure in their
Statements of Additional Information. See, e.g., Item 17 of Form N-
1A (17 CFR 239.15A, 274.11A).
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Two broker-dealers, Goldman, Sachs & Co. and Morgan Stanley Group
Inc., themselves providers of research services to advisers, have
strongly criticized the effectiveness of current disclosure
requirements.\16\ Current disclosure primarily focuses on the policies
and practices that the adviser intends to follow with respect to the
use of client brokerage.\17\ This disclosure does not, Goldman, Sachs
and Morgan Stanley assert, adequately disclose to clients the extent to
which an adviser has soft dollar commitments or the specific benefits
that accrue to the adviser from the use of the client brokerage. These
brokers have proposed that the Commission adopt a requirement that
advisers periodically report to clients the soft dollar benefits that
they have received and the specific value of those benefits, as well as
certain information about how the brokerage of each client was directed
(the ``Goldman/Morgan Proposal'').\18\ Other participants in soft
dollar arrangements, organized by the Alliance in Support of
Independent Research, have argued that current client disclosure by
advisers is adequate and that the Goldman/Morgan Proposal is
anticompetitive and discriminatory.\19\
\16\See Future of the Stock Market: Soft Dollars, Hearing Before
the Subcomm. on Telecommunications and Finance of the House Comm. on
Energy and Commerce, 103d Cong., 1st Sess. (1993) (``1993
Hearings'') (testimony of David M. Silfen, Partner, Goldman, Sachs &
Co. and Anson M. Beard, Jr., Managing Director, Morgan Stanley Group
Inc.).
\17\The Commission has instituted a number of enforcement
actions against advisers based, at least in part, on the failure to
disclose soft dollar arrangements adequately. See, e.g., Securities
and Exchange Commission v. Galleon Capital Management, supra note
11; Kingsley, Jennison, McNulty & Morse, Inc., Investment Advisers
Act Rel. No. 1396 (Dec. 23, 1993); DeMarche Associates, Investment
Advisers Act Rel. No. 1392 (Nov. 23, 1993); Jack Allen Pirrie,
Investment Advisers Act Rel. No. 1284 (July 29, 1991); Robert
Michael Lee, Investment Advisers Act Rel. No. 1249 (Sept. 17, 1990);
Patterson Capital Corp., Investment Advisers Act Rel. No. 1235 (June
25, 1990).
\18\The Goldman/Morgan Proposal will be placed in the public
comment file for the Commission's proposal.
\19\See Letter from The Alliance in Support of Independent
Research to Jonathan G. Katz, Secretary, Securities and Exchange
Commission (Oct. 17, 1994), Commission File No. S7-22-94 (``Alliance
Letter''); see also Autranet Letter, supra note 11. The Alliance in
Support of Independent Research is ``a group of broker-dealers,
money managers and research firms sharing a common interest in
fostering a favorable regulatory environment in which independent
research services and products may be furnished to the money
management community.'' [[Page 9752]]
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The difference in the views of these two groups may reflect the
differences in the ways the two groups provide research services to
advisers and the effect that the Goldman/Morgan Proposal would have on
each group. Goldman, Sachs and Morgan Stanley operate as ``full service
brokers'' and provide a variety of execution, research and related
services to clients. An adviser who executes client securities
transactions through these firms typically receives research services
developed by the firms (``proprietary'' soft dollar services), much of
which is provided without being directly requested by the adviser. The
cost of such services generally are bundled in the overall commission
charged by the full service broker. In contrast, a ``soft dollar
broker'' typically provides advisers with services prepared or produced
by parties other than the broker (``third-party'' soft dollar services)
in exchange for the allocation of specified amounts of commission
dollars.\20\ In these types of arrangements, an explicit price
denominated in commission dollars, rather than in hard dollars, is
typically attached to the research.\21\
\20\In 1980, the Commission stated that research provided
through third-party arrangements falls within Section 28(e) of the
Exchange Act, even if the money manager participates in selecting
the research services provided to it and the research is delivered
directly to the money manager by the third party. Securities
Exchange Act Rel. No. 17371 (Dec. 12, 1980) (45 FR 83707 (Dec. 19,
1980)). The Section 28(e) safe harbor is not available to third-
party soft dollar arrangements unless, among other things, the
broker is obligated to the third party to pay for the services.
Release 23170, supra note 1, at Sec. III; Kingsley, Jennison,
McNulty & Morse, Inc., supra note 17.
\21\Some full service brokers also will enter into third-party
soft dollar arrangements with advisers.
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The Goldman/Morgan Proposal would affect the two groups of brokers
differently. Because proprietary soft dollar services are not offered
for a specific price in commission dollars, under the Goldman/Morgan
Proposal, disclosure would be required only about the price and value
of third-party soft dollar services. Soft dollar brokers argue that if
the Commission required more extensive disclosure of third-party soft
dollar services than proprietary soft dollar services, advisory clients
might be led to believe that advisers derive benefits from soft dollar
brokers at the clients' expense that they do not derive from full
service brokers, when, in fact, both types of firms confer benefits on
advisers.\22\ As a result, advisers might be discouraged from using
soft dollar brokers.
\22\See Alliance Letter, supra note 19.
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Representatives of some investment advisers have asserted that
current disclosure requirements are adequate.\23\ According to these
advisers, clients rarely request information about the soft dollar
benefits that the adviser receives, and those that are interested
currently may obtain the information on request.\24\ Other investment
advisers, however, argue that the nature of the conflicts involved in
soft dollar arrangements warrant more extensive client disclosure than
is currently required.\25\
\23\See, e.g., 1993 Hearings, supra note 16 (statement of Holly
A. Stark, Senior Vice President, Dalton, Greiner, Hartman, Maher &
Co.).
\24\Many pension plans require some form of soft dollar
reporting from their money managers, primarily in response to a
pronouncement of the Department of Labor, the principal federal
regulator of employee benefit plans under the Employee Retirement
Income Security Act of 1974 (``ERISA''), concerning the ongoing duty
of plan fiduciaries to monitor the use of soft dollars by managers.
See ERISA Technical Release No. 86-1.
Section 15(c) of the Investment Company Act of 1940 (15 U.S.C.
80a-15(c)) requires the directors of a registered investment company
to request and review, and the company's adviser to supply, such
information as may reasonably be necessary to evaluate the terms of
the advisory contract between the adviser and the investment
company. As discussed above, soft dollar arrangements may bear upon
the reasonableness of advisory fees. See text accompanying note 12
supra. Investment company advisers that engage in soft dollar
arrangements therefore must provide their boards of directors with
information regarding soft dollar arrangements. See Release 23170,
supra note 1, at Sec. IV.B.3.
Various institutional investors have expressed their views on
soft dollar arrangements. See 1993 Hearings (statement of Fred G.
Weiss, Chairman, Financial Executive Institute's Committee on
Investment of Employee Benefit Assets (``CIEBA'')). Mr. Weiss stated
that CIEBA, which represents 150 corporate benefit plan sponsors
with assets of approximately $600 billion, was unable to develop a
clear consensus on whether soft dollar practices were desirable or
not. CIEBA did, however, call for more comprehensive reporting of
soft dollar arrangements at a firm-wide level to supplement the
client-specific information that most of its members currently
receive. Other institutional investors believe that current
disclosure is adequate. See 1993 Hearings (written statement of
State Board of Administration of Florida). In addition, the
Institutional Investors Committee of the National Association of
Securities Dealers, Inc. (``NASD Committee''), which includes
representatives of institutional investors, advisers, and brokerage
firms, submitted a recommendation to the Commission's staff for
additional soft dollar disclosure. The NASD Committee's
recommendation was approved by the NASD's Board of Governors. The
NASD Committee's recommendation will be placed in the public comment
file for the Commission's proposal.
\25\See Letter from Louis R. Cohen and Marianne K. Smythe,
Wilmer, Cutler & Pickering to Jonathan G. Katz, Secretary,
Securities and Exchange Commission (Oct. 17, 1994) (on behalf of
Investors Research Corp.) (``Investors Research Letter''),
Commission File No. S7-22-94.
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The Commission staff considered issues related to soft dollars in
its ``Market 2000'' report on the equity markets released in January
1994.\26\ In that report, the staff recommended that quantifiable
information about soft dollar services be required to be provided to
advisory clients.\27\ The report also stated that ``[m]ost importantly
* * * any new disclosure requirements should apply equitably. Thus,
research and other services obtained either from (full service) firms
or (soft dollar) firms should be subject to disclosure.''
\26\See U.S. Securities and Exchange Commission, Division of
Market Regulation, Market 2000: An Examination of Current Equity
Market Developments (Jan. 1994).
\27\Id. at V-15.
II. Discussion
The Commission believes that, in light of the conflicts of interest
presented by soft dollar arrangements, additional disclosure about
these practices may be warranted. While current disclosure may provide
sufficient notice to a client that the adviser has these conflicts, it
may not provide the client with sufficient information to permit it to
assess the extent to which the adviser obtains soft dollar services or
pays up for those services, or the types of services that the adviser
obtains through soft dollar arrangements. Enhanced disclosure may
provide existing clients with information useful in negotiating limits
on the use of their brokerage, and enable prospective clients to make
better informed choices of advisers.
The Commission is therefore proposing that certain registered
advisers be required to provide clients with annual reports setting
forth certain information about their use of client brokerage and the
soft dollar services each adviser received during its most recently
completed fiscal year.28 The proposal is intended to provide an
advisory client with information that can be used to evaluate the
extent to which the client benefits from the adviser's brokerage
practices, the extent to which the adviser benefits, and whether the
client should attempt to limit the adviser's use of its brokerage.
Consistent with the recommendations of the staff in the Market 2000
report, the proposed disclosure requirements would not impose different
[[Page 9753]] requirements on third-party and proprietary soft dollar
arrangements.
\28\The proposed amendments would not require that advisers
provide each client with information about how that client's
transactions were directed. See Section II.F infra.
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A. The Annual Report in General
The Commission is proposing a new rule under the Advisers Act, rule
204-4, that would require any adviser, registered or required to be
registered under the Advisers Act, that has brokerage discretion29
over any client account and that receives soft dollar services to
deliver an annual report to clients on its use of client brokerage. The
contents of the annual report would be specified in new Form ADV-B.
\29\The definition of ``brokerage discretion'' is discussed at
notes 58-59 and accompanying text infra.
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The core of the annual report would be a table disclosing
information regarding the adviser's direction of client brokerage. The
table would list the twenty brokers other than execution-only brokers
(``research brokers'') to which the adviser directed the greatest
amount of client commissions,30 and the three execution-only
brokers to which the adviser directed the greatest amount of client
commissions during its most recent fiscal year.31 For each broker
listed, the table would disclose: the aggregate amount of commissions
directed by the adviser to the broker; the percentage of the adviser's
discretionary brokerage commissions that this represents; the average
commission rate (in cents per share) paid to the broker; and a
description of the soft dollar services provided by the broker.32
\30\For the purposes of the amendments, ``commissions'' would
include amounts of mark-ups and mark-downs on principal transactions
if those amounts are included on the confirmation of the transaction
required under rule 10b-10 under the 1934 Act. See Section II.E
infra. These mark-ups and mark-downs, however, are not commissions
for purposes of Section 28(e). See note 10 supra.
\31\The definition of ``execution-only broker'' is discussed at
notes 36-38 and accompanying text infra.
\32\Items 2-3 of proposed Form ADV-B. For purposes of
determining the amount of commissions and the corresponding
percentage of the adviser's discretionary brokerage that this amount
represents, sales loads on transactions in investment company shares
would be considered commissions. Because sales loads typically are
not calculated on a cents per share basis and could potentially
distort the average commission rate data, sales loads would not be
considered in calculating average commission rates. Instruction 3 to
Item 2 of proposed Form ADV-B.
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The table would provide an overview of the brokers used by an
adviser to execute client transactions, the commissions charged by the
brokers, and the soft dollar services received from research brokers.
This disclosure is intended to assist an advisory client in evaluating
the adviser's use of its brokerage, including whether the client could
be paying lower commissions, whether the adviser is obtaining soft
dollar services that can be used to benefit the client, and whether the
advisory fee charged to the client is appropriate in light of the
services that the adviser pays for with client commissions.
Institutional clients using the services of more than one adviser and
prospective clients considering different advisers will be able to use
the table to compare advisers' use of brokerage, including the
commission rates that they negotiate and the types of services that
they receive. The disclosure regarding execution-only brokers would
assist clients in making these determinations by providing information
about the availability of brokerage alternatives, and, by implication,
the effect that soft dollar services may have on commission
rates.33
\33\The Commission recognizes that the use of execution-only
brokers would not be appropriate or possible in many circumstances.
The proposed disclosure about execution-only brokers is not intended
to imply that such brokers could have been used in all
circumstances. Furthermore, an adviser would be permitted to explain
its policies regarding the use of execution-only brokers in a
narrative portion of the annual report. See General Instruction 6 to
Proposed Form ADV-B.
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The table would be followed by certain data concerning the
adviser's direction of brokerage: the percentages of the adviser's
total brokerage that are directed (1) by the adviser to research
brokers, (2) by the adviser to execution-only brokers, and (3) pursuant
to specific client instructions.34 This data would provide clients
with an overall picture of how the adviser directs brokerage.
\34\Item 4 of proposed Form ADV-B.
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B. Disclosure of Brokers
As noted above, the report would be required to include information
about twenty research brokers and three execution-only brokers.35
Limiting the required disclosure to this number of brokers is intended
to result in reports that provide useful information in a relatively
concise manner. Comment is requested whether the proposed numerical
thresholds are appropriate. Comment is also requested whether, as an
alternative, disclosure should be required about brokers to which the
adviser directed more than a specified percentage of its brokerage,
such as one percent.
\35\For purposes of the annual report, a ``broker'' would
include a bank that is not registered as a broker-dealer under the
1934 Act. Instruction 1 to Item 2 of proposed Form ADV-B.
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For the purposes of the amendments, a broker would be considered an
``execution-only'' broker if substantially all of the services that the
broker provides to the adviser are execution services, i.e., effecting
securities transactions and performing functions incidental to or
required in connection with effecting those transactions.36
Consequently, a broker would not be permitted to be considered an
execution-only broker if it provided any significant amount of soft
dollar services to the adviser, even if the services were not solicited
or used by the adviser.37 If a broker provided only execution
services to an adviser, however, the adviser would include the broker
as execution-only even if the broker provided additional services, such
as research, to its other customers. The definition of execution-only
broker would include automated trading systems (e.g., the Instinet and
Lattice systems) if the adviser received only execution and execution-
related services as a result of using the system, regardless of whether
the system itself is required to be registered as a broker-dealer under
the 1934 Act.38
\36\Instruction to Item 3 of proposed Form ADV-B. The definition
of execution-only broker is derived from Section 28(e)(3)(C) of the
1934 Act [15 U.S.C. 78bb(e)(3)(C)]. Under that section, custody of
securities is a function incidental to effecting a transaction in
the securities.
\37\A broker would be permitted to be considered an execution-
only broker if it provided a minimal amount of soft dollar services
to the adviser, such as a single research report or a single contact
with a securities analyst.
\38\Instruction to Item 3 of proposed Form ADV-B. Typically, the
sponsor of an automated trading system will be required to be
registered as a broker-dealer under the 1934 Act. An automated
trading system would be included in the definition of broker in Form
ADV-B if a fee is charged for using the system, regardless of the
basis for the fee (e.g., a flat usage fee or transaction-based
fees).
An adviser that did not utilize any research brokers or that did
not utilize any execution-only brokers would be required to so state
under the appropriate heading in the table.39 An adviser that
directed client commissions to fewer than twenty research brokers and/
or fewer than three execution-only brokers would be required to
disclose under the appropriate headings those brokers to which it did
direct client commissions. As a result, an adviser's annual report
would always include some reference to the existence of execution-only
brokers. Comment is requested whether there are better ways to disclose
to clients the availability and cost of brokerage alternatives. For
instance, comment is requested whether an adviser should be required to
disclose execution-only brokers that offered to execute client
transactions. Similarly, comment is requested whether the table should
include [[Page 9754]] disclosure regarding all brokers used by the
adviser.40
\39\Items 2 and 3 of proposed Form ADV-B.
\40\In order to keep the report at a manageable length, an
adviser could be permitted merely to indicate whether or not it
received soft dollar services, rather than to identify the services
received, from brokers that were not among those it used most
frequently (e.g., the top twenty).
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Comment is requested generally on the definition of an execution-
only broker, and whether the proposal's classification of brokers into
two types, execution-only and all others, is appropriate or
practicable. Instead of classifying brokers by type, the Commission
considered proposing that advisers be required to classify brokers or
specific trades based upon the purposes for which the trades were
directed to the broker (e.g., execution or research). Under this
approach, trades directed to a broker that provided soft dollar
services could be considered to be directed for the purposes of
execution if the services were a minimal factor in directing the
brokerage. The Commission is not proposing this approach because
determining the purposes for which brokers are used or individual
trades are directed may be impracticable and burdensome.41 The
proposed approach, which would not permit an adviser to treat a broker
from whom it receives significant soft dollar services as an execution-
only broker, seeks to reduce the burden on advisers by providing a more
objective basis for classifying brokers. Nevertheless, comment is
requested whether the annual report should require advisers to classify
brokers or trades by the purposes for which the adviser directed the
brokerage.
\41\In 1976, the Commission proposed rule 28e2-1 under the 1934
Act, which would have required advisers to make certain disclosures
to clients concerning soft dollar practices in a separate annual
report. Securities Exchange Act Rel. No. 13024 (Nov. 30, 1976) (41
FR 53356 (Dec. 6, 1976)). The proposed rule, which was not adopted,
would have required, among other things, narrative disclosure
concerning research received ``in return for'' brokerage. Commenters
stated that it was impracticable to determine whether research was
obtained ``in return for'' specific services, particularly when the
research was not solicited. See Securities Exchange Act Rel. No.
10569 (Jan. 30, 1979) (44 FR 7864 (Feb. 7, 1979)) (``Release
10569'').
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C. Disclosure of Products and Services Received
The annual report would describe the soft dollar services received
by the adviser from each research broker listed. Except as discussed
below, soft dollar services would be required to be identified
specifically.42 The producer of a third-party soft dollar service
would be identified unless its name was evident from the name of the
product. This information is intended to permit a client to assess
whether it benefits from the soft dollar services that the adviser
receives and, consequently, whether it should attempt to limit the
adviser's use of its brokerage.
\42\Instruction 7 to Item 2 of proposed Form ADV-B.
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In many cases, an adviser receives research reports from a broker
or is given access to the broker's securities professionals in exchange
for the direction of brokerage. An adviser would not be required to
list separately every report that it received or each professional with
whom it had contact. Instead, an adviser would be permitted to refer to
these services generically according to the following categories: (1)
Analyses and reports on specific securities, issuers or industries, (2)
political or economic analyses or reports, or (3) access to securities
analysts.43 All other services, including computer hardware,
software, databases, and on-line services, financial or other
publications available by subscription, and any products or services
falling outside the scope of Section 28(e) of the 1934 Act, would be
required to be identified specifically.
\43\Id.
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Comment is requested whether soft dollar services should be
identified in this manner. Should the Commission require more specific
disclosure of research reports or access to securities analysts or
other professionals, or permit general descriptions of other services?
Comment is requested whether, either in lieu of or in addition to
separate identification of the services received, soft dollar services
should be required to be classified into specified categories, and, if
so, what those categories should be.44
\44\In connection with its annual survey of institutions
regarding their brokerage practices, see note 2 and accompanying
text supra, Greenwich Associates uses the following nine categories
of soft dollar services: performance measurement, third-party
research, corporate fundamental databases, technical analysis
software, portfolio modeling and strategy software, on-line stock
price quotations, specialized political or economic analyses,
terminals and computers, and custody services. Greenwich Associates,
Institutional Equity Investors 1994 (statistical supp.) 19.
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In addition to requiring a description of the soft dollar services
received, the Goldman/Morgan Proposal would have required that an
adviser disclose the price in commission dollars and fair market value
of each third-party soft dollar service (which typically will be
provided at an explicit price). As noted above, the Goldman/Morgan
proposal would not require this disclosure regarding proprietary soft
dollar services, as these services are not explicitly assigned a price.
Price and fair value information may be useful as an expression of the
value of the soft dollar services obtained by the adviser.45 The
Commission is concerned, however, that unless the values of proprietary
soft dollar services are also included in the report, the information
provided to the client would be incomplete and may distort client
understanding about the benefits that advisers receive through client
brokerage. Clients, for example, may incorrectly believe that soft
dollar services are not a consideration in an adviser's direction of
client brokerage to full service brokers or that third-party soft
dollar services are of greater value (either to advisers or clients)
than proprietary soft dollar services. Moreover, the Goldman/Morgan
Proposal may provide an investment adviser an incentive to direct
brokerage to a full service broker rather than a soft dollar broker for
the same types of soft dollar services, simply because of differing
client reporting requirements. This consequence may not be in the best
interests of advisory clients and may be unfair to soft dollar brokers.
Thus, consistent with the staff's recommendations in the Market 2000
report, the Commission is not proposing that only third-party soft
dollar services be valued.
\45\The Commission recently proposed that estimates of the value
of non-monetary payments for order flow be disclosed to customers of
brokers receiving such payments. Securities Exchange Act Rel. No.
34903 (Oct. 27, 1994) (59 FR 55014 (Nov. 2, 1994)). Payment for
order flow is payment by a broker, dealer, securities exchange,
securities association or exchange member to a broker or dealer in
return for the routing of customer orders to the broker, dealer,
securities exchange, securities association, or exchange member.
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The Commission also considered requiring advisers to report the
fair market value of all soft dollar services, regardless of their
source. Because there often is no agreed upon price for proprietary
soft dollar services, their fair market value may not readily be
ascertainable. One approach might be to require advisers to disclose
the cost to the broker of producing proprietary soft dollar services.
The cost of producing services, however, may not reflect their fair
market value, and an adviser may not be able to verify cost information
provided by brokers.46 Alternatively, the value of soft dollar
services to the adviser receiving them could be [[Page 9755]] required
to be disclosed, but it may be inappropriate and misleading to reflect
services that the adviser did not solicit or use as having no
value.47
\46\In addition, it is unclear how a broker's ``cost'' should be
determined. An ``average cost'' could be obtained by dividing the
cost of producing the services by the number of recipients.
``Marginal cost'' would measure the actual cost of providing the
research to the last adviser. Full service brokers frequently
distribute to advisers and other customers research services that
were initially produced for other purposes. The marginal cost of
such research might be only the cost of its distribution.
\47\An adviser could be required to report only those
proprietary soft dollar services for which it specifically directed
brokerage. Such a limitation, however, would require highly
subjective determinations by advisers, and, as a practical matter,
might elicit disclosure about only third-party soft dollar services.
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An adviser could be required to make a good faith estimate of what
the proprietary soft dollar services would have cost in an arms-length
transaction.48 This approach would require advisers to report
positive values for unsolicited and unused services, which could lead
investors to believe that the adviser (or the client) substantially
benefited from the direction of the brokerage when, in fact, receipt of
the services was incidental to brokerage direction decisions made
wholly on the basis of the broker's execution capabilities. In
addition, good faith estimates may be very difficult to make if the
services provided are unlike those available for hard dollars. In this
regard, the Commission is concerned with the burden that a good faith
estimate requirement would impose on advisers and brokers and the
accuracy of the information that would be reported to clients.49
\48\This approach was suggested by one commenter on the
Commission's recent proposal to require that mutual fund expenses
paid by brokers should be included in fund expense and performance
data. See Investors Research Letter, supra note 25. In that
proposal, the Commission requested comment whether the value of
research services received by a fund's adviser should also be
included in fund expenses, and how the research should be valued.
See Investment Company Act Rel. No. 20472 (Aug. 11, 1994) (59 FR
42187 (Aug. 17, 1994)), at Sec. II.A.1. Most commenters on the
proposal, however, opposed the inclusion of research services in
fund expenses, and those commenters that favored it generally
provided little guidance regarding how to value proprietary
services.
\49\In proposing rule 28e2-1, the Commission proposed that the
fair value of non-research services be disclosed, and requested
comment on the feasibility and desirability of requiring disclosure
of specific dollar amounts of brokerage commissions paid to receive
research services. Commenters asserted that it would be
impracticable to value soft dollar services or to separate
commissions into their research and execution components. See
Release 10569, supra note 41.
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The disclosure that the Commission is proposing to require is
designed to alert a client that the adviser receives soft dollar
services from directing client commissions, and provide some indication
of the extent to which the client benefits from that direction. The
commission rate information, including the commission rates of
execution-only brokers, may provide valuable information on the costs
of soft dollar arrangements and may render valuation estimates
unnecessary. If additional information is desired, the client can
request it from the adviser.
Comment is requested whether the commission price and fair market
value of particular soft dollar services, or the soft dollar services
obtained from a broker in the aggregate, should be required in the
annual report. Commenters favoring inclusion of this information should
discuss how the price and value of proprietary soft dollar services
should be determined.
D. Client-Directed Brokerage
Many clients of investment advisers instruct their advisers to
direct some or all of their transactions to a particular broker or
brokers. A client may direct its brokerage, among other reasons, to
obtain services for its own benefit or because of a pre-existing
relationship with the broker.
In addition to disclosing the percentages of an adviser's total
commissions that are directed to execution-only and research brokers,
the proposed annual report would be required to disclose the percentage
of commissions that is directed by clients.50 Client restrictions
on an adviser's brokerage discretion may be of interest to other
clients of the adviser because they may cause a larger proportion of
the brokerage of the other clients to be used to obtain soft dollar
services for the adviser. Information on client-directed brokerage,
therefore, may be useful to clients in determining the amount of
brokerage available to the adviser to purchase soft dollar services.
Comment is requested whether the proposed disclosure of the percentage
of client-directed brokerage would be useful, and whether the
Commission should require that the data be accompanied by disclosure
explaining its usefulness.
\50\Item 4 of proposed Form ADV-B.
E. Principal Transactions
Proposed Form ADV-B would require an adviser to include in the
commission and commission rate in the table mark-ups and mark-downs
paid in connection with principal transactions if the amounts of these
mark-ups or mark-downs are included in the confirmations of the
transactions required under rule 10b-10 under the 1934 Act. Rule 10b-10
requires that a dealer include transaction cost data in confirmations
of (1) riskless principal transactions in equity securities if the
dealer is not a market maker in the securities, and (2) transactions in
a listed equity securities and certain Nasdaq securities.51
\51\Paragraph (a)(8) of rule 10b-10 [17 CFR 10b-10(a)(8)].
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Proposed Form ADV-B would not require disclosure of information
about other principal transactions or the mark-ups, mark-downs or
spreads paid on these transactions. It may be difficult to accurately
determine transaction costs associated with these principal
transactions. Furthermore, disclosure about adviser direction of
principal transactions may not be necessary, as soft dollar
arrangements involving principal transactions may be less common than
those involving agency transactions because principal transactions are
not afforded the safe harbor provided by Section 28(e).52
\52\The safe harbor does not encompass soft dollar arrangements
under which research services are acquired as a result of principal
transactions. See note 10 supra. Notwithstanding the lack of
availability of the safe harbor, the Commission understands that
full service brokers sometimes provide research and other services
based, at least in part, on principal transactions. If an adviser
were required to list a broker in its annual report because the
broker is used frequently for agency transactions, the adviser would
be required to take all of the soft dollar services obtained from
the broker into account in responding to the report's requirement to
list the services obtained, even if some of the services could be
deemed to be received as a result of principal transactions not
within the scope of the proposed amendments. Instruction 7 to Item 2
of proposed Form ADV-B.
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Comment is requested whether the annual report should include
information on all principal transactions, and, if so, how the
associated costs should be determined. Comment is also requested
whether disclosure requirements that apply primarily to agency
transactions would cause more transactions to be executed on a
principal basis.
The proposal would require disclosure of the brokers to which the
greatest amounts of commissions had been directed. Alternatively, the
obligation to disclose information about a broker could be based on the
dollar amount of transactions, both principal and agency, directed to
the broker. The resulting disclosure might be more useful to clients in
assessing any relationship that may exist between the adviser's use of
principal transactions and its receipt of soft dollar services. Comment
is requested whether the basis for requiring a broker to be listed in
the annual report should be the dollar amount of transactions directed
to the broker, rather than the amount of commissions.
F. Client-Specific Information
The proposed amendments would not require that an adviser provide
each client with information about how that [[Page 9756]] client's
brokerage was directed (``client-specific information''). Client-
specific information could assist a client in comparing the use of its
brokerage with that of the adviser's other clients.53 The benefits
of a requirement to disclose client-specific information, however, may
be outweighed by the time and cost to advisers of preparing separate
reports for every client. This cost would likely be passed on to
advisory clients. Furthermore, advisory clients currently receive or
have access to confirmations of their transactions that disclose the
identities of the brokers used and the amounts of commissions
charged.54 Comment is requested whether client-specific
information should be required in the annual report and, if so, what
information should be required.55
\53\To the extent differences between the manner in which an
adviser uses a particular client's brokerage and the brokerage of
the adviser's other clients is caused by client-directed brokerage,
the requirement of the proposal to disclose the percentage of
client-directed brokerage might render client-specific information
unnecessary. See Section II.D supra.
\54\See rule 10b-10 under the 1934 Act [17 CFR 240.10b-10]
(requiring broker-dealers to send immediate confirmations of
transactions to their customers). The confirmations, or quarterly
statements containing all of the information required in the
confirmations, must be sent to the holder of the account, rather
than any fiduciary managing the account. See Securities Exchange Act
Rel. No. 34962 (Nov. 10, 1994) [59 FR 59612 (Nov. 17, 1994)] at
Sec. II.A.2.
\55\As noted above, an adviser to an investment company is
required to provide information about its soft dollar arrangements
to the company's board of directors. See note 24 supra. The
information provided by the adviser generally should include
specific information about the adviser's use of the investment
company's brokerage. The proposed annual report would supplement
this fund-specific information.
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G. Delivery and Filing
Reports on Form ADV-B would be prepared on an annual basis and
would report on brokerage directed during the adviser's most recently
completed fiscal year.56 The report would be required to be filed
with the Commission and delivered to clients no later than sixty days
after the end of the fiscal year, and delivered to prospective clients
no later than the time that an advisory contract is entered
into.57
\56\Paragraph (a) of proposed rule 204-4; General Instructions 1
and 5 to proposed Form ADV-B. The table in the annual report would
be required to disclose commissions paid during the adviser's most
recently completed fiscal year even if soft dollar services paid for
with those commissions had been or will be received during another
fiscal year. Conversely, disclosure of soft dollar services received
during a fiscal year would be required even if commissions were or
will be directed to pay for those services during another fiscal
year. General Instruction 5 to proposed Form ADV-B.
\57\Paragraphs (a) and (b) of proposed rule 204-4; General
Instructions 3 and 4 to proposed Form ADV-B. Rule 204-3 under the
Advisers Act, which generally requires advisers to furnish a
disclosure brochure to prospective clients no later than 48 hours
prior to the time that the advisory contract is entered into,
permits the brochure to be delivered at the time that the contract
is entered into if the contract can be terminated without penalty
within five business days. Paragraph (b)(1) of rule 204-3 [17 CFR
275.204-3(b)(1)]. Proposed rule 204-4 would not similarly
differentiate between providing the annual report before or at the
time that the contract is entered into. Generally, however, the
determination of when a contract is entered into would be the same
for the purposes of both rules.
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Because the report would provide information about brokerage over
which the adviser has discretion, the report would be required to be
delivered only to those clients over whose accounts the adviser has or
will have brokerage discretion. An adviser would be considered to have
brokerage discretion over an account if it (1) had the authority to
determine, without obtaining specific client consent, the brokers to be
used or the commissions paid in connection with any transactions for
the account, or (2) significantly influenced the selection of brokers
by a client and received soft dollar services from a broker chosen by
the client.58 An adviser would not be required to provide the
report to a client that, without the adviser's influence, directed that
a single broker execute its transactions, or prior to each transaction
approved the broker to be used for the transaction.59 Comment is
requested whether this definition of brokerage discretion is
appropriate, and whether the report should be required to be delivered
to clients over whose accounts the adviser does not have brokerage
discretion.
\58\Paragraph (c)(1) of proposed rule 204-4; General Instruction
2 to proposed Form ADV-B. An adviser would not be deemed to have
brokerage discretion over an account if substantially all of the
client's transactions were directed to a broker that was compensated
for executing the transactions based upon a percentage of the assets
managed by the adviser, such as in a ``wrap fee'' program, even if
the adviser could in certain circumstances direct the client's
transactions to other brokers.
\59\An adviser would be required to deliver the annual report to
a client if the adviser had discretion over any of the client's
brokerage, even if some or most of the client's brokerage was
directed by the client. Delivery of the annual report also would be
required if the adviser had the authority to select brokers for
particular transactions from a list previously approved by the
client.
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The Commission is proposing that the report be prepared on an
annual basis. More frequent reporting would be more costly and may not
be necessary for clients to monitor an adviser's brokerage direction
practices. Furthermore, an annual report may provide a more
representative sample of an adviser's brokerage practices. Comment is
requested whether the report should be required to be prepared more
frequently than annually, such as quarterly.60
\60\The Morgan/Goldman Proposal would have required quarterly
reporting.
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H. Goldman/Morgan Proposal
The Goldman/Morgan Proposal differs from the Commission's proposal
in a number of respects. The Goldman/Morgan Proposal would, among other
things, require quarterly rather than annual reporting, require
disclosure of the commission price and value of specific third-party
soft dollar services, and require disclosure of certain client-specific
information. The Commission has requested comment on these elements of
the Goldman/Morgan Proposal separately in this Release. The Commission
also requests comment whether the Goldman/Morgan Proposal generally
would be preferable to the Commission's proposal.
III. Disclosure By Brokers Providing Soft Dollar Services
The amendments being proposed in this Release would require
disclosure by advisers that receive soft dollar services from brokers.
In a letter to the staff, Autranet, Inc. (``Autranet''), a broker
providing third-party soft dollar services to advisers, proposed an
entirely different approach that would impose certain recordkeeping and
disclosure requirements on brokers providing third-party soft dollar
services to ensure that the services were provided within the safe
harbor of Section 28(e) of the Exchange Act.61 Under the Autranet
[[Page 9757]] proposal, these brokers would be required to demonstrate
that they incurred a legal obligation to provide soft dollar services
to an adviser. This obligation could be demonstrated either by a
contract that indicates the broker's financial obligation to purchase
the soft dollar services from an independent research originator, or by
an invoice showing the broker's payment for the services for those soft
dollar services not typically the subject of a contract.
\61\Autranet also has proposed that the Commission prohibit
understandings that commit an adviser to a predetermined amount of
commissions in exchange for soft dollar services. The Commission
requests comment on the feasibility of this proposal. In particular,
the Commission requests comment whether prohibiting a stated
commission ratio in exchange for soft dollar services will deter the
negotiation of commission rates and cause advisers that are less
sophisticated or influential to pay higher commissions.
In addition, Autranet proposed that the Commission ensure that
an independent research originator make its services available to a
number of brokers and not enter into exclusive agreements. For
instance, under ``bump up'' or bonus arrangements a vendor will
assign a cash value to its product and offer it to the public at
large for a lower price than charged to a broker providing the
product pursuant to a soft dollar arrangement. In other
arrangements, a vendor will tie the availability of its product to a
single affiliated or unaffiliated broker, thus causing all trades to
go through that broker in exchange for the service. Autranet
believes that by eliminating commission commitments and exclusivity
arrangements, a client can be better assured that the adviser
obtained the best execution of the client's order. The Commission
requests comment on the feasibility of a prohibition on exclusivity
and bonus arrangements and whether such a proposal would accomplish
the objective of assuring best execution. The Commission also has
forwarded these proposals to the NASD for its consideration under
its authority to promulgate just and equitable principles of trade.
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In addition, Autranet proposes that third-party soft dollar brokers
be required to provide a description of the soft dollar services
provided in an arrangement and specify how the product assists an
adviser in its investment decisions. A broker would be required to make
this description available to the managed account upon request and
provide the managed account a quarterly report showing the cost of the
soft dollar service. For products having a mixed-use, Autranet proposes
that the broker providing such a product obtain from the adviser a
description of the adviser's use of the product and the adviser's
allocation between the research and non-research functions of the
product.
Autranet proposes that these descriptions be reflected in an annual
report that third-party soft dollar brokers would file with the
Commission and provide to the advisers receiving soft dollar services
and to the clients of those advisers whose commissions were used to
obtain the soft dollar services. Autranet proposes that the report
include (1) a disclosure statement describing the business of the third
party broker; (2) a financial summary, quantifying on an aggregate
basis the value by category and, if necessary, sub-category, of the
soft dollar services provided; (3) a compliance report, demonstrating
that the soft dollar services were in compliance with the requirements
set forth above and within the safe harbor of Section 28(e); and (4) an
independent auditor's report. Autranet believes that such a reporting
requirement would not be costly to third-party brokers because the
information required is readily available and the reporting
requirements should reflect compliance procedures already established
by third-party brokers providing soft dollar services.
The Commission requests comment on whether some or all of the
Autranet proposals would be practical additions to the disclosure
currently required and proposed of advisers. In particular, the
Commission requests comment on the costs associated with this
disclosure approach and the ease with which this information could be
obtained by brokers and provided to advisers and their clients. In
addition, the Commission requests comment on the extent to which full
service brokers providing proprietary soft dollar services could or
should be subject to any of the reporting requirements proposed by
Autranet.
IV. General Request For Comments
Any interested persons wishing to submit written comments on the
proposals that are the subject of this Release, to suggest additional
changes, or to submit comments on other matters that might have an
effect on the proposals that are contained in this Release, are
requested to do so.
V. Cost/Benefit Analysis
The rule and form proposed today are intended to provide material
information to clients and prospective clients of investment advisers
that can be used to evaluate an adviser's brokerage direction and soft
dollar practices. The proposals would enable an advisory client to
better assess whether its adviser is directing its brokerage in
accordance with its best interests, and whether the advisory fee it
pays is appropriate in light of the services provided and costs
incurred directly by the adviser.
Adoption of the proposal would impose some additional costs on
advisers required to prepare the report and deliver it to clients. The
Commission believes, however, that the proposals appropriately balance
the need for additional disclosure with the costs of providing that
disclosure. The information that would be required by the proposal
should readily be determinable by an adviser. A number of alternatives
that would make the disclosure requirements more burdensome, such as
requiring advisers to disclose the value of soft dollar services
received or report on the use of each client's brokerage, are not being
proposed. Furthermore, because the report would need to be prepared and
delivered only annually, the costs of preparing and delivering the
report should be minimized. In short, the Commission believes that the
costs of the proposals would be outweighed by the benefits to advisory
clients in receiving more useful information about their advisers'
direction of client brokerage.
VI. Summary Of Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis in accordance with 5 U.S.C. 603 regarding the proposed
amendments. The analysis notes that the rule and form proposed in this
Release are intended to provide investment advisory clients for whom
the adviser selects brokers to execute client transactions with
information about the services the adviser receives from those brokers
and the commissions charged by those brokers. Other aggregate cost-
benefit information reflected in the ``Cost/Benefit Analysis'' section
of this Release also is reflected in the analysis. A copy of the
Initial Regulatory Flexibility Analysis may be obtained by contacting
Jana M. Cayne, Securities and Exchange Commission, 450 Fifth Street,
NW., Mail Stop 10-6, Washington, DC 20549.
VII. Statutory Authority
The Commission is proposing rule 204-4 and Form ADV-B under the
authority set forth in Sections 204, 206(4) and 211(a) of the Advisers
Act [15 U.S.C. 80b-4, 80b-6(4) and 80b-11(a)] and Section 28(e)(2) of
the 1934 Act [15 U.S.C. 78bb(e)(2)].
Text Of Proposed Rule And Form Amendments
List of Subjects in 17 CFR Parts 275 and 279
Investment advisers, Reporting and recordkeeping requirements.
For the reasons set out in the preamble, title 17, chapter II of
the Code of Federal Regulations is proposed to be amended as follows.
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
1. The authority citation for Part 275 is amended by adding the
following citation:
Authority: 15 U.S.C. 80b-3, 80b-4, 80b-6A, 80b-11, unless
otherwise noted.
* * * * *
Section 275.204-4 is also issued under 15 U.S.C. 78bb(e)(2).
2. By adding Sec. 275.204-4 to read as follows:
Sec. 275.204-4 Annual report on brokerage practices.
(a) Each investment adviser, registered or required to be
registered under Section 203 of the Act on the last day of its most
recently completed fiscal year, that exercised brokerage discretion
over the account of any client during that fiscal year and obtained
services other than execution services from a broker to which it
directed client brokerage during that fiscal year shall file a report
on Form ADV-B with the Commission no later than 60 days after the end
of that fiscal year, unless the investment adviser's registration was
[[Page 9758]] withdrawn, cancelled or revoked after the end of the
fiscal year.
(b) An investment adviser required to file a report on Form ADV-B
pursuant to paragraph (a) of this section shall furnish such report for
its most recently completed fiscal year:
(1) No later than 60 days after the end of each fiscal year, to
each advisory client over whose account the investment adviser
exercises brokerage discretion; and
(2) No later than the time that a written or oral investment
advisory contract is entered into, to each new or prospective advisory
client over whose account the investment adviser will or proposes to
exercise brokerage discretion.
(c) For purposes of this section:
(1)(i) An investment adviser exercises ``brokerage discretion''
over a client's account if it:
(A) Has authority to determine, without obtaining specific client
consent, the broker to be used or the commission rates paid in
connection with any transaction of the client; or
(B) Significantly influences the selection of brokers by the client
and receives services other than execution services from a broker
chosen by the client.
(ii) An investment adviser does not exercise brokerage discretion
over a client's account if substantially all of the client's
transactions were directed to a broker that was compensated for
executing such transactions solely based upon a specified percentage of
the assets managed by the investment adviser; and
(2) Execution services mean those services set forth in paragraph
(e)(3)(C) of Section 28 of the Securities Exchange Act of 1934 (15
U.S.C. 78bb(e)(3)(C)).
PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF
1940
3. The authority citation for Part 279 is amended by adding the
following citation:
Authority: The Investment Advisers Act of 1940, 15 U.S.C. 80b-1,
et seq.
Section 275.204-4 is also issued under 15 U.S.C. 78bb(e)(2).
4. By adding Sec. 279.9 and Form ADV-B to read as follows:
Sec. 279.9 Form ADV-B, annual report on investment adviser's brokerage
direction practices.
This form shall be filed annually by an investment adviser,
registered or required to be registered under the Investment Advisers
Act of 1940, that has the authority to select brokers to execute the
transactions of any client and that obtains services other than
execution from a broker to which it directs client brokerage.
Note: Form ADV-B is attached as Appendix 1 to this document. The
Form will not appear in the Code of Federal Regulations.
Dated: February 14, 1995.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
Appendix 1
OMB Approval
OMB Number:
Expires:
Estimated average burden hours per response:
U.S. Securities and Exchange Commission, Washington, DC 20549
Form ADV-B
Annual Report on Brokerage Practices for Registered Investment Advisers
Having Discretion Over Client Brokerage
Applicant:-------------------------------------------------------------
SEC File Number: 801---------------------------------------------------
Date:------------------------------------------------------------------
MM/DD/YY
General Instructions for Preparing and Filing Form ADV-B
1. Applicability of Form Requirement. A report on Form ADV-B
must be prepared and filed by every investment adviser that (i) was
registered or required to be registered under the Investment
Advisers Act of 1940 on the last day of its most recently completed
fiscal year (unless the adviser's registration has since been
withdrawn, cancelled or revoked), (ii) exercised ``brokerage
discretion'' over the account of any advisory client during that
fiscal year, and (iii) obtained services other than ``execution
services'' from a broker to which it directed client brokerage
during that fiscal year.
2. Definitions.
Brokerage Discretion. An investment adviser exercises brokerage
discretion over a client's account if it (i) has the authority to
determine, without obtaining specific client consent, the broker to
be used or the commission rates paid in connection with any
transaction of the client, or (ii) significantly influences the
selection of brokers by the client and receives services other than
execution services from a broker chosen by the client. An investment
adviser does not have discretion over a client's account, however,
if substantially all of the client's transactions were directed to a
broker that was compensated for executing such transactions solely
based upon a specified percentage of the assets managed by the
adviser, even if the adviser has the discretion to direct certain of
the client's transactions to other brokers.
Execution Services. Execution services mean those services
described in Section 28(e)(2)(C) of the Securities Exchange Act of
1934, i.e., effecting securities transactions and performing
functions incidental thereto or required in connection therewith by
rules of the Securities and Exchange Commission or a self-regulatory
organization.
3. Format and Filing of Report. The report required by this form
should be prepared as a separate document, not on copies of this
Form. The report shall be filed in triplicate with the Securities
and Exchange Commission, 450 Fifth Street NW., Washington, DC 20549.
Each copy of the report filed with the Commission should be attached
to a completed copy of this page, although only one such copy need
be manually executed. The report shall be filed no later than 60
days after the end of the adviser's fiscal year.
Execution: The undersigned represents that he or she has
executed this form on behalf of, and with the authority of, said
investment adviser. The undersigned and the investment adviser
represent that the information and statements contained herein,
including exhibits attached hereto and other information filed
herewith, all of which are made a part hereof, are current, true,
and complete.
Dated the ________ day of ____________________, 19______
----------------------------------------------------------------------
(Name of registrant)
By:--------------------------------------------------------------------
(Signature and title)
4. Delivery.
Existing Clients. Rule 204-4 under the Investment Advisers Act
of 1940 requires that the report be furnished no later than 60 days
after the end of the investment adviser's most recently completed
fiscal year to each advisory client over whose account the adviser
exercises brokerage discretion (as defined in Instruction 2 above).
Prospective Clients. Rule 204-4 also requires that the report be
furnished no later than the time that a written or oral investment
advisory contract is entered into to each new or prospective
advisory client over whose account the adviser will or proposes to
exercise brokerage discretion.
5. Period of Required Data. An investment adviser must provide
the requested information for its most recently completed fiscal
year. Brokerage commissions directed or services received during a
fiscal year should be included in the table, even if the services
corresponding to commissions directed during the fiscal year were or
will be received during another fiscal year, or the commissions
corresponding to services received during the fiscal year were or
will be directed during another fiscal year.
6. Additional Information. An investment adviser may, in
addition to providing the required information, provide other
information, including additional data and explanations of the
required information, about its brokerage practices in its response
to this Form.
Information Required in Annual Report
Item 1. General Description of Report
In an introduction to the report:
(a) explain that the report contains information about the
adviser's practices in selecting brokers to execute transactions for
its investment advisory clients that can be used to evaluate whether
the adviser directs [[Page 9759]] client transactions consistent
with the best interests of its clients;
(b) explain that the information contained in the report is
provided on a firm-wide basis, that the report does not include
specific information about the brokerage of any particular client or
the extent to which services obtained are used for the benefit of
any particular client, and that clients should refer to the
confirmations or quarterly account statements provided by their
brokers or contact the adviser for information about the brokers
used to execute their transactions;
(c) explain, if applicable, that the report does not include
information about many transactions executed on a ``principal''
basis, that, in principal transactions, transaction costs typically
are included in the price of the securities purchased or sold and
are not charged as separate commissions, and that transactions in
certain types of securities typically are executed on a principal
basis; and
(d) provide an address or phone number at which a client can
contact the adviser to request more information.
Item 2. Information Regarding the Twenty Most Frequently Used
Brokers
Using the captions and tabular format illustrated below, provide
the required information for the twenty brokers (other than
``execution-only'' brokers as defined in Item 3) to which the
investment adviser directed the greatest amount of client
commissions. If no or fewer than twenty such brokers were used,
state either ``no brokers used that provided services other than
execution'' after the title or ``no additional brokers used'' after
the last broker listed.
The Twenty Brokers to Which the Greatest Amounts of Client Commissions Were Directed
----------------------------------------------------------------------------------------------------------------
Commissions paid to
Aggregate amount of broker (as a Description of
Name discretionary percentage of Average commission services obtained
of commissions paid to adviser's rate (in cents/ (other than
broker broker (in dollars) discretionary share) execution services)
commissions)
---------------------------------------------------------------------------------------------
Instructions
1. For the purposes of this Form, brokers include broker-dealers
registered under the Securities Exchange Act of 1934, banks, and, as
set forth in Item 3, automated trading systems.
2. ``Discretionary commissions'' are those commissions, mark-ups
and mark-downs that are disclosed on the transaction confirmations
required under rule 10b-10 under the Securities Exchange Act of 1934
and that are paid in connection with transactions for which the
investment adviser had the authority to determine, without obtaining
specific client consent, the broker or dealer to be used or the
commission rates paid.
3. Commissions include sales loads paid in connection with
transactions in investment company shares, although sales loads
should not be considered in calculating the average commission rate.
If the adviser directed transactions in investment company shares to
a broker other than the principal underwriter of the investment
company, that broker, rather than the principal underwriter, should
be considered to have executed the transaction.
4. For purposes of this Form, commissions do not include fees
for brokerage services that are based upon a specified percentage of
the assets managed (i.e., fees paid under ``wrap fee'' programs).
5. Calculate average commission rates on a ``share-weighted''
basis (i.e., by dividing the total amount of client commissions that
the investment adviser directed to the broker by the total number of
shares, exclusive of investment company shares, purchased or sold by
the broker for the adviser's clients).
6. For the purposes of determining commission amounts and
average commission rates, convert any commission charged in foreign
currency to dollars (and cents per share). The investment adviser
may use any reasonable means and times for determining the
applicable exchange rate as long as those means and times are used
on a consistent basis.
7. Under ``Description of Services Obtained,'' products or
services obtained by the investment adviser from each broker,
including computer hardware, software, databases, and on-line
services, publications available by subscription, and services
falling outside the scope of Section 28(e) of the Securities
Exchange Act of 1934, generally should be identified separately and
specifically. Research reports and contacts with securities analysts
or professionals, however, may be described generally by the
following terms: (i) analyses and reports on specific securities,
issuers, or industries, (ii) general political or economic analyses
or reports, or (iii) contacts with securities analysts. The party
that produced a specifically identified product or service should
also be identified unless the producer's name is evident from the
name of the product or service. An adviser should report all
products or services received from a broker, even if some of the
services could be deemed to have been received as a result of
principal transactions the costs of which are not required to be
reported in the table.
Item 3. Information Regarding Three Most Frequently Used Execution-
Only Brokers
Using the captions specified under Item 2 (except ``Description
of Services Obtained''), provide a table titled ``The Three
Execution-only Brokers to which the Greatest Amounts of Client
Commissions were Directed'' that includes the required information
for the three execution-only brokers to which the investment adviser
directed the greatest amount of client commissions. If no or fewer
than three execution-only brokers were used, state either ``no
execution-only brokers used'' after the title or ``no additional
execution-only brokers used'' after the last broker listed.
Instruction
For the purposes of this Item, a broker should be considered an
execution-only broker if substantially all of the services that it
provides to the adviser are execution services (see the definition
in Instruction 2 of the General Instructions). An automated trading
system should be considered an execution-only broker if
substantially all of the services received by the adviser in
connection with using the system are execution services and if a fee
is charged for using the system, regardless of the basis for the fee
(e.g., a flat usage fee or transaction-based charges).
Item 4. Information Regarding Brokerage Business Directed by
Clients
Provide the following information under the following captions:
Percentage of Total Commissions Directed to Brokers Providing
Research and Other Services in Addition to Execution:
Percentage of Total Commissions Directed to Execution-only
Brokers:
Percentage of Total Commissions Directed by Clients:
Instruction
For the purposes of this Item, commissions directed by clients
are those commissions paid by accounts managed by the adviser that
were directed pursuant to client requests or instructions. Total
commissions equal the sum of the adviser's discretionary
commissions, as defined in Item 2, and the commissions directed by
clients.
[FR Doc. 95-4160 Filed 2-17-95; 8:45 am]
BILLING CODE 8010-01-P