Alert August 05, 2008

SEC Votes to Propose Guidance for Fund Boards in Overseeing Best Execution and Adviser Soft Dollar Usage

At its open meeting last week, the SEC voted to propose guidance for registered fund directors regarding their oversight of fund portfolio transaction activity, including soft dollar use by fund advisers.   The soft dollar portion of the release appears designed to fulfill commitments made by the SEC at the time it issued interpretive guidance on the safe harbor under Section 28(e) of the Securities Exchange Act of 1934, as amended (the “1934 Act”), that it would also provide guidance to assist fund directors in overseeing adviser soft dollar use.   While the release proposing the guidance (the “Proposing Release”) states that it would not impose any new or additional requirements, the proposed guidance includes a number of prescriptions and suggestions for board and adviser action relating to best execution and soft dollar use that would likely have a noticeable impact in framing board and adviser conduct in these areas if the proposed guidance is issued in final form.  The Proposing Release provides a fairly extensive description of fund boards’ general fiduciary responsibilities before discussing their specific responsibilities with respect to fund portfolio transaction activity, which are presented as arising in three principal contexts – general ongoing oversight, approval/review of compliance programs and advisory contract approval.  Although not given the same degree of emphasis as ensuring best execution and appropriate soft dollar usage, the Proposing Release also addresses general control over transaction costs as a goal of board oversight of fund portfolio transaction activity, i.e., ensuring that the level of portfolio turnover is not excessive.

Best Execution.   The Proposing Release summarizes past SEC guidance defining a fund adviser’s duty of best execution.  It also discusses board consideration of an adviser’s use of alternative trading systems, noting that while use of these trading venues may offer potential benefits like lower costs they may not be appropriate for all funds or in all circumstances.  In evaluating an adviser’s efforts to achieve best execution, the proposed guidance recommends that a fund board request the following data: “(i) the identification of broker-dealers to which the adviser has allocated fund trading and brokerage, (ii) the commission rates or spreads paid, (iii) the total brokerage commissions and value of securities executed that are allocated to each broker-dealer during a particular period, and (iv) the fund’s portfolio turnover rates.” 

The Proposing Release also lists the following topics for fund boards to discuss with fund advisers, as applicable:

  • The process for making trading decisions and the factors involved in the selection of execution venues and the selection of broker-dealers;
  • The means by which the investment adviser determines best execution and evaluates execution quality as well as how best execution is affected by the use of alternative trading systems;
  • Who negotiates commission rates, how that negotiation is carried out, whether the amount of commissions agreed to depends on comparative data with respect to commission rates, and generally how transactions costs are measured;
  • How the quality of “execution-only” trades – trades that do not include payment for any additional research or services beyond execution – is evaluated compared to that of other trades (for example, whether trades that are executed through channels that include an additional soft dollar component are reviewed in comparison with execution-only trades to discern any discrepancies in the quality of execution);
  • How the performance of the adviser’s traders is evaluated, as well as the aggregate performance of the firm’s traders as a whole, how the performance of each broker-dealer the adviser uses for fund portfolio transactions is evaluated, and how problems or concerns that are identified with a trader or a broker-dealer are addressed;
  • If sub-advisers are used, how the adviser provides oversight and monitors each sub-adviser’s activities, including the trading intermediary selection process;
  • To what extent and under what conditions the adviser conducts portfolio  transactions with affiliates;
  • The process for trading fixed-income securities and determining the costs of fixed income transactions;
  • How the quality of trade execution is evaluated with respect to fixed-income and other instruments traded on a principal basis; and
  • If there are international trading activities, how these trades are conducted and monitored.

The proposed guidance also indicates that fund boards need to stay abreast of industry developments in trading and lists the following methods boards have to used to educate themselves in this area:

  1. establishing a committee of the board to specialize in portfolio trading practices;
  2. requiring that the adviser form special committees to consider best execution and the use of client commissions and to provide reports to the board on the adviser’s trading activities;
  3. requesting periodic summaries and analyses from officers of the adviser to explain the adviser’s portfolio trading practices;
  4. attending trade association events, seminars and/or other education events relating to brokerage practices;
  5. subscribing to third-party information providers or retaining experts to ensure that board members remain knowledgeable with respect to market developments; and
  6. periodically meeting with portfolio managers, business unit staff, trading personnel and other employees of the adviser.

Soft Dollars.  The Proposing Release frames a fund adviser’s use of soft dollars, i.e., the use of commissions paid on fund portfolio transactions to purchase research and brokerage in accordance with the safe harbor of Section 28(e) of the 1934 Act, in the broader context of using commissions on fund portfolio transactions for purposes other than for pure execution, including participation in commission recapture programs that provide rebates or pay fund service provider expenses.  Under the proposed guidance, a fund board should request information on the following:

  • How does the adviser determine the total amount of research to be obtained and how will the research actually be obtained? In particular:
    • How does the adviser determine the amount to be spent using hard versus soft dollars?
    • How does the adviser determine amounts to be spent on proprietary versus third-party research arrangements?
    • What types of research products and services will the adviser seek to obtain and how will this research be beneficial to the fund?
    • How does the adviser determine amounts to be used in commission recapture programs and expense reimbursement programs?
  • What is the process for establishing a soft dollar research budget and determining brokerage allocations in the soft dollar program? Is a broker vote process or some other mechanism used? [In a broker vote process, an adviser polls its portfolio managers and analysts regarding the quality of broker-dealer research and other services.]
  • Do any alternative trading venues that are used produce soft dollar credits? If so, how much?
    • How does the adviser determine that the use of soft dollars is within the Section 28(e) safe harbor? In particular:
    • Is the product or service obtained eligible brokerage or research, as defined under section 28(e)?
    • Does the product or service provide lawful and appropriate assistance to the adviser in carrying out its investment decision-making responsibilities?
    • Is the amount of commissions paid reasonable (based upon a good faith determination) in light of the value of brokerage and research services provided by the broker-dealer?
  • How does soft dollar usage compare to the adviser’s total commission budget?
  • How are soft dollar products and services allocated among the adviser’s clients? Are the commissions paid for certain trades in fund portfolio securities similar to commissions paid for transactions in similar securities, or of similar sizes, by the fund and the adviser’s other clients (including clients that are not funds)? Are other clients paying lower commissions that do not include a soft dollar component? If so, does the adviser adequately explain the discrepancy in commission rates and provide the board data sufficient to satisfy the board that the fund is not subsidizing the research needs of the adviser’s other client? To what extent are the products and services purchased through soft dollar arrangements used for the benefit of fixed-income or other funds that generally do not pay brokerage commissions?
  • What is the process for assessing the value of the products or services purchased with soft dollars?
  • What is the process used to evaluate the portion of a mixed use product or service that can be paid for under section 28(e)?
  • To what extent does the adviser use client commission arrangements? What effect do these arrangements have on how the adviser selects a broker-dealer to complete a particular transaction? How does the adviser explain that the use of client commission arrangements benefits the fund?

The proposed guidance would also have fund boards consider “(i) whether it is appropriate for the adviser to refrain from purchasing research services in connection with certain types of trades, depending on market conditions; (ii) whether it is appropriate for the adviser to use fund brokerage commissions to receive brokerage and research services on some or all trades; (iii) whether fund brokerage commissions should be used only in connection with a commission recapture or expense reimbursement program; and (iv) whether some combination of these alternatives may be in the best interest of the fund.”

Board Evaluation and Action.   Under the proposed guidance, a fund board would need to evaluate an adviser’s pursuit of best execution and use of soft dollars in terms of the best interest of the fund, and in each instance, would need to address with the adviser instances where it fell short of this standard.  The Proposing Release notes that where an adviser’s use of brokerage commissions is not in a fund’s best interest, “the board should prohibit or limit the use of fund brokerage commissions and direct the adviser accordingly.”  In this regard, the Proposing Release points out that Section 28(e) states that its safe harbor does not apply “where expressly provided by contract.”

Advisory Contract Approval.  The SEC proposes less extensive guidance in the context of the advisory contract renewal process where consideration of “fall out benefits” to an adviser such as soft dollar research and brokerage are one of the factors cited in the leading cases deciding  excessive advisory fee claims under the 1940 Act and in fund shareholder report disclosure requirements regarding advisory contract approvals.  Noting a wide range of practice in this area, the proposed guidance indicates that “fund directors should require investment advisers, at a minimum, to provide them with information regarding the adviser’s brokerage policies, and how a fund’s brokerage commissions, and, in particular, the adviser’s use of soft dollar commissions, were allocated, at least on an annual basis. . . .  Fund directors should, for example, consider whether the adviser properly accounts for use of fund brokerage commissions to purchase research that primarily or solely benefits another client of the adviser.”

Additional Soft Dollar Disclosure Requirements.  After noting changes in soft dollar disclosure it has already proposed for Form ADV Part 2 (as discussed in the April 22, 2008 Alert), the Proposing Release solicits comment on whether it should take further action on soft dollars disclosure with respect to fund investors to provide them with (i) the same kind of information the SEC proposes fund boards consider and (ii) specific disclosure to inform their investment decisions.  The Proposing Release also seeks comment on (a) whether the public dissemination of particular information regarding a fund adviser’s portfolio trading practices would have an adverse impact on the adviser’s relationships with the broker-dealers that execute fund portfolio transactions and (b) whether the SEC should again consider proposing that investment advisers provide their clients with customized information about how their individual brokerage is being used.

Public Comment.  Comments on the Proposing Release are due by October 1, 2008.