Securities And Exchange Commission Proposed Guidance On The Scope Of Section 28(e)

Sunday, January 1, 2006 - 00:00

Investment advisers are fiduciaries with respect to their clients, and as such are obligated to act in their clients' best interests in entering into brokerage transactions. Specifically, investment advisers have a duty to obtain "best execution" in connection with client transactions. Best execution requires an adviser to "execute securities transactions for clients in such a manner that the client's total cost or proceeds in each transaction are the most favorable under the circumstances."1

Section 28(e) of the Securities Exchange Act of 1934 (the "Exchange Act") provides a safe harbor from liability for a breach of fiduciary duty, and permits advisers in certain circumstances to pay more than the lowest available commission rates for securities transactions if the adviser obtains "brokerage and research services" in the transactions.

On October 19, 2005, the Securities and Exchange Commission (the "Commission") issued a proposed interpretive release (the "Release") providing additional guidance and requesting comments on the scope of the brokerage-allocation safe harbor in Section 28(e).2

Section 28(e)(3) states that a person provides "brokerage and research services" insofar as he:

(A) furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities;

(B) furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy and performance of accounts; or

(C) effects securities transactions and performs functions incidental thereto (such as clearance, settlement and custody) or required in connection therewith by rules of the SEC or self-regulatory organization of which such person is a member or "person associated with a member" or in which such person is a participant.

The key elements of the Release are:


  • Research must be "an expression of reasoning and knowledge" to qualify as "eligible research" under Section 28(e)'s safe harbor;

  • "Eligible Brokerage" begins when an order is transmitted to the broker-dealer, and ends at the conclusion of clearance and settlement of the transaction (the "temporal" standard); and

  • Prior positions on mixed-use items, third-party research and commission-sharing arrangements are reaffirmed by the Commission.
  • The Scope Of Section 28(e)'s Safe Harbor

    I. Consideration of Products or Services

    The Release sets forth a three-step analysis that an investment adviser should employ when determining whether a product or service falls within the statutory scope of Section 28(e)'s safe harbor. In making a determination, the investment adviser should:

    1. determine whether the product or service falls within the specific statutory limits of Section 28(e)(3) ( i.e., whether it involves an eligible product or service);

    2. determine whether the product or service provides lawful and appropriate assistance in the performance of the investment adviser's investment decision-making responsibilities; and

    3. make a good-faith determination that the amount of client commissions paid is reasonable in light of the value of the products or services provided by the broker-dealer.

    II. Eligible Research

    In determining whether a product or service qualifies as "eligible research" under Section 28(e), the Release provides that an investment adviser must conclude that the product or service reflects an expression of reasoning or knowledge and relates to the subject matter enumerated in Section 28(e)(3)(A) or (B). Section 28 (e)(3)(C) is the basis of "eligible brokerage."

    In evaluating the statutory language, the Commission noted that the common nexus of eligible advice, analyses and reports is that each is an expression of reasoning and knowledge, and that the delivery mechanism (e.g., paper or electronic) of the research is not a factor when determining whether a product or service qualifies as "eligible research."

    The Release provides some examples of "eligible research" under the safe harbor of Section 28(e), including:


  • consultants advising on portfolio strategy (not the adviser's operations),

  • market or economic data services satisfying the subject matter in Section 28(e)(3)(A) or (B),

  • quantitative analytical software and software that provides analyses of securities portfolios, and

  • seminars or conferences where the content satisfies Section 28(e)(3)(A) or (B).
  • Specifically, the Commission stated that a data service could fall within the scope of the safe harbor provided it satisfies the subject matter criteria set forth in Section 28(e).3

    In the Release, the Commission emphasized that when an investment adviser makes a determination, the adviser must differentiate between the computer hardware that receives the delivery of the research and the software application that is an expression of reasoning and knowledge. The Commission explicitly stated that computer hardware and computer accessories, while assisting in the delivery of research, would not be eligible "research services" because they do not reflect substantive content related to making investment decisions.4

    In addition, the Commission takes the position that the following products and services are not "eligible research" within the scope of 28(e):


  • telecommunications lines,

  • office equipment and other operational overhead, and

  • travel expenses, entertainment and meals associated with attending an eligible seminar.
  • The final criterion for determining if a product or service falls within the safe harbor of Section 28(e) is whether the product or service provides the investment adviser with lawful and appropriate assistance in making investment decisions. The Commission stated that although a product or service might satisfy the criteria set forth in Section 28(e), that product or service would not fall within the safe harbor of Section 28(e) if it were used for marketing purposes.

    III. Eligible Brokerage

    In addition to eligible research, certain brokerage products and services are also eligible for safe harbor protection under Section 28(e). In implementing a "temporal" standard for what constitutes eligible brokerage, the Commission stated that execution of transactions is a process, and that services related to the execution of securities transactions begin when an order is transmitted to the broker-dealer and end at the conclusion of clearance and settlement of the transaction.

    The Release provides the following examples of "eligible brokerage" under the safe harbor of Section 28(e):


  • dedicated lines between the broker-dealer and the investment adviser's order management system,

  • lines between the broker-dealer and order management systems operated by a third-party vendor,

  • dedicated lines providing direct dial-up service between the investment adviser and the trading desk of the broker-dealer, and the message services used to transmit orders to broker-dealers for execution,

  • software operated by a broker-dealer that routes orders to market centers, and

  • algorithmic trading software.
  • The Release also provides the following list of ineligible brokerage services under Section 28(e)'s safe harbor:


  • order management systems and hardware,

  • telephones or computer terminals,

  • trade analytics,

  • surveillance systems,

  • compliance programs, and

  • error correction trades and related services in connection with errors by investment advisers.5
  • As with research products and services, brokerage services will be eligible for Section 28(e)'s safe harbor only if the services provide the investment adviser with lawful and appropriate assistance in carrying out the adviser's responsibility, and the adviser makes a good-faith determination that the amount of commissions paid is reasonable in relation to the value of the research and brokerage product or service received.

    IV. Mixed-Use Items

    The Release reaffirms the Commission's position taken in its 1986 Release regarding mixed-use items. The 1986 Release stated that where a product has a mixed use, the investment adviser should make a reasonable allocation of the cost in accordance with its uses, and the allocation determination itself poses a conflict of interest for the adviser that should be disclosed to the client. In addition, the investment adviser should maintain adequate books and records to make and justify its good-faith determination. Finally, the Commission restated its 1986 position that an investment adviser relying on the Section 28(e) safe harbor must pay its own hard dollars for the ineligible portion when the adviser receives both eligible and ineligible products or services for a bundled commission rate.

    V. Good-Faith Determination That Commissions Are Reasonable

    The Commission reaffirmed that an investment adviser has an obligation under Section 28(e) to make (and the burden of proof to show it made), a good faith determination that the commissions paid are reasonable in relation to the value of the brokerage and research services received. In the Release, the Commission cited its 1986 position that "the determinative factor [in selecting a broker-dealer] is not the lowest possible cost but whether the transaction represents the best qualitative execution for the managed accounts."

    The Commission also stated that an investment adviser satisfies its good faith obligation under Section 28(e) if the adviser can demonstrate that:


  • the item is eligible under the language of the statute,

  • the adviser used the item in performing decision-making responsibilities over accounts as to which the adviser exercises investment discretion, and

  • in good faith, the adviser believes that the amount of commissions paid is reasonable in relation to the value of the research or brokerage product or service received.
  • VI. Third-Party Research and Commission-Sharing Arrangements

    The Release reaffirmed the Commission's position that Section 28(e)'s safe harbor applies equally to in-house research obtained by a full-service broker-dealer as well as to third-party research provided by an executing broker-dealer. Section 28(e) requires that the broker-dealer receiving commissions must "provide" the brokerage or research services. The Commission continues to permit investment advisers to use client commissions to pay for research produced by someone else other than the executing broker-dealer, even if the investment adviser participates in selecting the research services or products that the broker-dealer will provide, but only if the broker-dealer has the direct legal obligation to pay and thus provide for the research.

    When relying on Section 28(e)'s safe harbor, an adviser must use the same method of analysis in determining whether a product or service is eligible under the safe harbor for third-party research as in-house research. The Commission's rationale in continuing to permit reliance on Section 28(e) for third-party research is to provide an investment adviser with (1) a broader universe of available research, and (2) access to specialized research that may not be available from the executing broker.

    The Commission reaffirmed its 1986 view of more than one broker-dealer being involved in a commission sharing arrangement: the "introducing broker [must be] engaged in securities activities of a more extensive nature than merely the receipt of commissions paid to it by other broker-dealers for research services provided to investment managers."

    Additional Action To Be Considered

    The Commission also recognized that improvements may be necessary regarding disclosure and documentation of client commission practices, but stated that it will evaluate whether further action might be necessary.6

    Request For Comments

    A number of letters were submitted in response to the Commission's request for comments regarding the Release.7 The Commision asked if the Release accurately identified the industry practices for which guidance would be most useful, and whether there were other significant issues arising under Section 28(e) that the Release did not address. It will be interesting to see the extent to which these comments are reflected in the final guidance issued by the Commission.

    1 Securities Exchange Act Release No. 23170 (April 23, 1986), (the "1986 Release") 51 FR 16011 (April 30, 1986).
    2 SEC Release No. 34-52635 (Oct. 19, 2005), available at: http://www.sec.gov/rules/interp/34-52635.pdf (the "Release") 70 FR at 61700 (October 25, 2005).
    3 The Commission believes that this would include a company's financial data and economic data (such as unemployment and inflation rates or GDP figures). This position reaffirms the Commission's position set forth in the 1986 Release, where the Commission stated that this type of service serves "a legitimate research function of pricing securities for investment and keeping a manager informed of market developments."
    4 The Release 70 FR 61707. The Commission at note 86 indicated that the 1986 Release 51 FR at 16006-07 suggested that advisers could use client commissions to pay for a portion of the cost of computers that relate to receiving research, but now wish to clarify they fall outside the safe harbor.
    5 Id. 70 FR at 61708-61709. The Release states that such services are "not integral to the execution of orders by the broker-dealers."
    6 The Release, 70 FR 61706 at note 72.
    7 Comments are available at http://www.sec.gov/rules/interp/s70905.shtml.

    Martin R. Miller is Special Counsel and Paul F. Schlichting is an Associate in the Corporate and Financial Services Department of Willkie Farr &Gallagher LLP in New York City and Washington DC respectively.

    Please email the authors at mmiller@willkie.com and pschlichting@willkie.com with questions about this article.