FAQ’s about 28(e)

After commission rates were deregulated on May 1, 1975, the money management community raised concerns to Congress regarding their ability to make investment decisions based on price alone, no longer having access to research. Understanding the important role that research plays in the fiduciaries investment decision process, Congress passed the 28(e) safe harbor.

“Section 28(e) of the Exchange Act establishes a safe harbor that allows money managers to use client funds to purchase ‘‘brokerage and research services’’ for their managed accounts under certain circumstances without breaching their fiduciary duties to clients.”
Exchange Act Release 54165 (July 24, 2006) 71 Fed. Reg. 141; Pg 41978

Agency Transactions:
Fixed income trades have always been eligible since the law was created in 1975 on an ‘agency’ basis. An agency trade in fixed income is transacted where both legs of the trade are executed at the same price, and a commission is applied.

Certain Riskless Principal:
In 2001, the SEC modified its definition of the term “commission”, making it clear that certain riskless principal and agency transactions fall within the safe harbor. Certain riskless principal transactions for 28(e) are performed when there is a trade-reporting system in place, such as TRACE for corporates/agencies/mbs/abs or MSRB for municipals.

“In recognition of the transparency achieved in the Nasdaq market for certain riskless principal transactions, which allows a money manager to make the necessary determination under Section 28(e), we are modifying our interpretation of Section 28(e). Specifically, we now interpret the term “commission” in Section 28(e) of the Exchange Act to include a markup, markdown, commission equivalent or other fee paid by a managed account to a dealer for executing a transaction where the fee and transaction price are fully and separately disclosed on the confirmation and the transaction is reported under conditions that provide independent and objective verification of the transaction price subject to self-regulatory organization oversight.”
Exchange Act Release No. 45194 (December 27, 2001) 67 Fed. Reg. 6.

New Issues

“FINRA Rule 5141.02 states that nothing in the new rule prohibits a member or person
associated with a member that participates in a selling syndicate or selling group
from selling securities in the offering to a person or account to which it has provided or
will provide research, as long as the person or account pays the stated public offering
price for the securities and the research is provided pursuant to the requirements of
Section 28(e) of the Exchange Act.”
FINRA Regulatory Notice 10-47 (October 2010) Pg. 2

In 2003, the Global Settlement moved research from proprietary to third-party after an investigation discovered that proprietary research produced by Wall Street was inherently biased. Ten large investment banks were fined $875 million for allowing investment baking interests to have such a heavy influence on the proprietary research produced by brokerage firms.

“In addition to the monetary payments, the firms are also required to comply with significant requirements that dramatically reform their future practices, including separating the research and investment banking departments at the firms, how research is reviewed and supervised, and making independent research available to investors.”
Global Settlement pg 2

“The firms will be required to sever the links between research and investment banking, including prohibiting analysts from receiving compensation for investment banking activities, and prohibiting analysts’ involvement in investment banking ‘pitches’ and ‘roadshows.’”
Global Settlement pg 3

“If money managers were required to pay for all research out of management fees they would very likely be under-researched according to a recent study by Horan & Johnsen (2008). They find that from 1979 to 1997 every penny money managers paid in premium commissions to obtain research increased investment performance by 4.3 basis points per quarter, holding other factors constant.”
Bruce Johnsen, Using Bond Trades to Pay for Third-Party Research (July 19, 2010), p2.

“While some money managers have expressed concern about being sued for paying up for research even though protected by section 28(e) of the Exchange Act, it appears they should be more concerned about being sued for acting imprudently if they deliberately cut themselves off from street research or refuse to pay up for other needed brokerage services to the detriment of the accounts they manage.”
Thomas P. Lemke and Gerald T. Lins, Soft Dollars and other Brokerage Arrangements 2008-2009 Edition, Securities Law Handbook Series (Thomson Reuters/West/2009), p120.

“The fundamental obligation of the adviser to act in the best interest of his client also generally precludes the adviser from using client assets for the adviser’s own benefit or the benefit of other clients, at least without client consent.”
Exchange Act Release 54165 (July 24, 2006) 71 Fed. Reg. 141; Pg 41978 Footnote 3.

“…advisers may face conflicts of interest due to the potential for using one fund’s Commissions to pay for soft dollar research that benefits another fund. For example, under Section 28(e), a large-cap equity fund’s Commissions may pay for research that benefits a bond fund’s investors, despite the fact that the bond fund does not pay Commissions on its portfolio transactions. Due to these potential conflicts, the SEC requires managers to disclose soft dollar practices to their clients and, as noted above, has provided guidance to the industry as to the scope of the safe harbor afforded by Section 28(e).”
Report of the Mutual Fund Task Force: Soft Dollars and Portfolio Transaction Costs (November 11, 2004), p3.

“Based the Hoenig Letter, it is generally believed that only non-positioning brokers may provide money managers with research on agency trades in fixed income securities.”
Bruce Johnsen, Using Bond Trades to Pay for Third-Party Research (July 19, 2010), p22.
Note: Hoening Letter is written by Richard Ketchum, now the CEO of FINRA

“…in some cases a broker-dealer may execute transactions in fixed income securities…on an agency basis for a money manager, receiving a normal commission for its services. Because the broker-dealer actually acts as “agent,” these transaction can be contrasted with those described above in the Hoenig & Co. letter, where principal transactions were simply characterized as “agency” transactions. In connection wit these agency activities, the broker may provide research or other services to the money manager on a soft dollar basis, and the money manager may seek to rely on the Section 28(e) safe harbor…
…But where the broker-dealer is performing a legitimate agency function, this type of service may quality for the Section 28(e) safe harbor. For example, the broker-dealer could be keeping confidential the identity of a client seeking to effect a large transaction or series of transactions…, searching the broad market for an “all-in” price equal to or better than the price available on a principal basis, or making available other special expertise. As support of its claim to be acting in a legitimate agency function, a broker-dealer acting as an agent in fixed income or OTC securities often has a larger trading desk and more extensive market contacts than many money managers, resulting in better executions.”
Thomas P. Lemke and Gerald T. Lins, Soft Dollars and other Brokerage Arrangements 2008-2009 Edition, Securities Law Handbook Series (Thomson Reuters/West/2009), p104.

“…existing investment management relationships, including the size of the management fee, have been based, in part, on an environment which enables the manager to obtain research and other services from broker-dealers which services are paid out of portfolio brokerage and are not an expense of management.”
Senate Banking Report (1975), Payment for Research Services with Brokerage Commissions

“Research is the foundation of the money management industry. Providing research is one important, long-standing service of the brokerage business. Soft dollar arrangements have developed as a link between the brokerage industry’s supply of research and the money management industry’s demand for research.”
Securities and Exchange Commission Inspection Report on Soft Dollar Practices of Broker-Dealers, Investment Advisors and Mutual Funds (September 22, 1998)

“Third-party research arrangements can benefit advised accounts by providing greater breadth and depth of research. First, these arrangements can provide money managers with the ability to choose from a broad array of independent research products and services. Second, the manager can use third-party arrangements to obtain specialized research that is particularly beneficial to the advised accounts. We believe that the safe harbor encompasses third-party research and proprietary research on equal terms.”
Exchange Act Release 54165 (July 24, 2006) 71 Fed. Reg. 141; Pg 41992.

“The Task Force unanimously agreed that the safe harbor set forth in Section 28(e) of the Exchange Act should be preserved. The Task Force believes that investors will be best served if research of all types, including both proprietary and third-party research, continues to be widely available to all investment managers. The Task Force notes that soft dollar practices may be especially beneficial to the clients of smaller investment advisers. These smaller advisers can afford neither a large internal research staff nor extensive hard dollar payments for research. They can, however, supplement their internal research efforts through the use of soft dollar arrangements.”
Report of the Mutual Fund Task Force: Soft Dollars and Portfolio Transaction Costs (November 11, 2004); Pg 4.

Examples from Registered Investment Advisor Part II of the Form ADV:

“The best execution responsibility applies to the circumstances of each particular transaction and an investment adviser must consider the full range and quality of a broker-dealer’s services, including, among other things, execution capability, commission rates, the value of any research, financial responsibility and responsiveness. In seeking best execution, the determinative factor is not the lowest possible cost, but whether the transaction represents the best qualitative execution, taking into consideration the full range of a broker-dealer’s services including among others, the value of research provided, execution capability, commission rates, and responsiveness. Consistent with the foregoing, while HHG will seek competitive rates, it may not necessarily obtain the lowest possible commission rates for client transactions.”

“In determining what constitutes best execution, the determinative factor is not the lowest possible commission cost, but whether the transaction represents the best qualitative execution.”

“Best execution will be judged by many factors including the following: price, including commissions (if any), ability to execute and clear trades in an orderly and acceptable manner, and consistent quality of service regarding broad market coverage. In those instances where it is reasonably determined that more than one dealer or broker can offer the services needed to obtain most favorable execution, consideration may be given to those dealers or brokers who supply investment research, statistical information and other services related to investment research.”

SEC – Types of Soft Dollar Trades

Transaction type	% of Advisers Earning Soft Dollar Credits
Equities: Listed Agency	91.1%
Equities: OTC Principal	7.4%
Equities: OTC Agency	41.2%
Fixed-Income: Principal	3.6%
Fixed-Income: Agency	21.3%
New Issue Offerings	20.3%
International Equities	2.0%
Options	3.0%

Securities and Exchange Commission Inspection Report on Soft Dollar Practices of Broker-Dealers, Investment Advisors and Mutual Funds (September 22, 1998)