In our last post, Craig began our discussion of trading practices by examining an adviser’s duty to obtain best execution. This post continues our trading practice discussion with a focus on soft dollar arrangements.
Soft dollar arrangements generally arise when an adviser receives research or brokerage products or services from a broker-dealer in exchange for placing securities transactions with that broker-dealer. Soft dollars arrangements can potentially provide significant benefits to your firm’s clients by generating access to a greater variety of investment research or services than would otherwise be available without them.
So, what’s the potential issue? In order to receive the research or services, your firm may pay more than the lowest possible commission rate to a broker-dealer. If it does so, because the research and brokerage services are provided in exchange for client commission dollars (i.e., soft dollars), which are client assets, your firm could be viewed as breaching its fiduciary duty to its clients by using client assets to pay for products or services that should be paid for by your firm directly.
While the potential for conflict is inherent in utilizing soft dollar arrangements, your firm does not have to avoid them as a general prohibition. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for advisers that enter into soft dollar arrangements, provided certain conditions of the safe harbor are satisfied. In other words, by adhering to the conditions contained in Section 28(e), your firm will not have breached its fiduciary duties under state or federal law solely because it paid a brokerage commission to a broker-dealer for effecting securities transactions in excess of the amount another broker-dealer would have charged.
Generally, a particular product or service falls within the safe harbor if an adviser can demonstrate that the research or brokerage service obtained with soft dollars: (i) is an eligible research or brokerage service within the specific limits of the safe harbor, (ii) provides lawful and appropriate assistance in the performance of an adviser’s investment decision-making responsibilities, including the appropriate treatment of “mixed-use” items (i.e., certain products and services may have mixed use and could be allocated between hard and soft dollars depending on the way in which the adviser uses the products or services), and (iii) the amount of client commissions paid is reasonable in light of the value of the products or services provided by the broker-dealer.
It’s important to note that while the three prongs listed above comprise the conditions of the safe harbor in its entirety, each prong requires additional individual analysis and application to the particular arrangement proposed. As stated above, soft dollar arrangements have the potential to provide significant benefits to your clients. However, you should enter them with care, consulting with a compliance professional as necessary, so that you can be sure that any proposed arrangement is not likely to violate your firm’s fiduciary obligations. If you have any questions about your firm’s soft dollar arrangements, please don’t hesitate to reach out to us.
Check back in next post, when our colleague Marc Minor debuts on the blog with his discussion of a firm’s duties with respect to the personal trading activities of its supervised persons. Thank you for your continued support!