

[Federal Register: October 25, 2005 (Volume 70, Number 205)]
[Proposed Rules]               
[Page 61699-61712]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr25oc05-23]                         


[[Page 61699]]

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Part II





Securities and Exchange Commission





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17 CFR Part 241



Commission Guidance Regarding Client Commission Practices Under Section 
28(e) of the Securities Exchange Act of 1934; Proposed Rule


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 241

[Release No. 34-52635; File No. S7-09-05]

 
Commission Guidance Regarding Client Commission Practices Under 
Section 28(e) of the Securities Exchange Act of 1934

AGENCY: Securities and Exchange Commission.

ACTION: Proposed interpretation; request for comment.

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SUMMARY: The Securities and Exchange Commission is publishing for 
comment this interpretive release with respect to client commission 
practices under Section 28(e) of the Securities Exchange Act of 1934 
(``Exchange Act''). 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. In light of the Commission's experience with Section 28(e) and 
in recognition of changing market conditions, the Commission is 
proposing to provide further guidance on money managers' use of client 
assets to pay for research and brokerage services under Section 28(e) 
of the Exchange Act. This release also reiterates the statutory 
requirement that money managers must make a good faith determination 
that commissions paid are reasonable in relation to the value of the 
products and services provided by broker-dealers and that broker-
dealers must be financially responsible for the brokerage and research 
products that they provide to money managers and must be involved in 
``effecting'' the trade.

DATES: Comments should be received on or before November 25, 2005.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/interp.shtml.
); or     Send an e-mail to rule-comments@sec.gov. Please include 

File Number S7-09-05 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.


Paper Comments

 Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-9303.

All submissions should refer to File Number S7-09-05. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/interp.shtml). Comments are 

also available for public inspection and copying in the Commission's 
Public Reference Room, 100 F Street, NE., Washington, DC 20549. All 
comments received will be posted without change; we do not edit 
personal identifying information from submissions. You should submit 
only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Jo Anne Swindler, Assistant Director, 
at (202) 551-5750; Patrick M. Joyce, Special Counsel, at (202) 551-
5758; Stanley C. Macel, IV, Special Counsel, at (202) 551-5755; or 
Marlon Quintanilla Paz, Special Counsel, at (202) 551-5756, in the 
Office of Enforcement Liaison and Institutional Trading, Division of 
Market Regulation, United States Securities and Exchange Commission, 
100 F Street, NE., Washington, DC 20549-6628.

SUPPLEMENTARY INFORMATION:

I. Introduction and Summary

    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. In 
this release, the Commission is proposing to issue interpretive 
guidance with respect to the safe harbor, with the particular goal of 
clarifying the scope of ``brokerage and research services'' in the 
light of evolving technologies and industry practices. The Commission 
invites public comment on its proposed interpretive guidance.
    Fiduciary principles require money managers to seek the best 
execution for client trades, and limit money managers from using client 
assets for their own benefit.\1\ Use of client commissions to pay for 
research and brokerage services presents money managers with 
significant conflicts of interest, and may give incentives for managers 
to disregard their best execution obligations when directing orders to 
obtain client commission services as well as to trade client securities 
inappropriately in order to earn credits for client commission 
services.\2\ Recognizing the value of research in managing client 
accounts, however, Congress enacted Section 28(e) \3\ of the Securities 
Exchange Act of 1934 (``Exchange Act'') \4\ to provide a safe harbor 
that protects money managers from liability for a breach of fiduciary 
duty solely on the basis that they paid more than the lowest commission 
rate in order to receive ``brokerage and research services'' provided 
by a broker-dealer if the managers determined in good faith that the 
amount of the commission was reasonable in relation to the value of the 
brokerage and research services received.\5\
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    \1\ An adviser has a fundamental obligation under the Investment 
Advisers Act of 1940 (``Advisers Act'') [15 U.S.C. 80b-1] and state 
law, to act in the best interest of his client. See SEC v. Capital 
Gains Research Bureau, Inc., 375 U.S. 180, 189-191 (1963). ``As a 
fiduciary, a money manager has an obligation to obtain `best 
execution' of clients' transactions under the circumstances of the 
particular transaction.'' Exchange Act Release No. 23170 (Apr. 23, 
1986), 51 FR 16004, 16011 (Apr. 30, 1986) (``1986 Release''). See 
also Delaware Management Co., 43 SEC 392, 396 (1967). 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. See Restatement (Second) 
of Trusts Section 170 cmt. a, Section 216 (1959).
    \2\ Exchange Act Release No. 35375 (Feb. 14, 1995), 60 FR 9750, 
9751 (Feb. 21, 1995) (``1995 Rule Proposal'') (the Commission took 
no further action on this proposal). See also Sage Advisory Services 
LLC, Exchange Act Release No. 44600, 75 SEC Docket 1073 (July 27, 
2001) (Commission charged that adviser churned advised account to 
generate client commission credits to pay personal operating 
expenses and failed to seek to obtain best execution by causing 
account to pay commissions twice the rate the same broker charged 
other customers for comparable services).
    To avoid confusion that may arise over the usage of the phrase 
``soft dollars,'' in this release, the Commission uses the term 
``client commission'' practices or arrangements to refer to 
practices under Section 28(e).
    \3\ 15 U.S.C. 78bb(e).
    \4\ 15 U.S.C. 78a.
    \5\ See Securities Acts Amendments of 1975, Pub. L. 94-29, 89 
Stat. 97, 161-62 (1975).
    Congressional enactment of Section 28(e) did not alter the money 
manager's duty to seek best execution. See 1986 Release, 51 FR at 
16011. The directors of an investment company have a continuing 
fiduciary duty to oversee the company's brokerage practices. See 
Investment Company Act Release No. 11662 (Mar. 4, 1981), 46 FR 16012 
(Mar. 10, 1981). In addition, the directors have an obligation in 
connection with their review of the fund's investment advisory 
contract to review the adviser's compensation, including any ``soft 
dollar'' benefits the adviser may receive from fund brokerage. See 
1986 Release, 51 FR at 16010.
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    As discussed below in Part II, over the past thirty years, the 
Commission has issued several releases interpreting the Section 28(e) 
safe harbor. In 1998, the Commission published a report of its Office 
of Compliance Inspections and Examinations (``OCIE'') detailing a staff 
review of client commission practices at

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broker-dealers and investment advisers. The Commission also has brought 
enforcement actions involving client commission practices.\6\
    In light of the Commission's experience with Section 28(e) and in 
recognition of changing market conditions, the Commission is proposing 
to provide further guidance on money managers' use of client assets to 
pay for research and brokerage services under Section 28(e) of the 
Exchange Act.\7\ This release would interpret the scope of the safe 
harbor as follows:
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    \6\ See infra note 25.
    \7\ 15 U.S.C. 78bb(e). The Commission also is considering 
whether at a later time to propose requirements for disclosure and 
recordkeeping of client commission arrangements.
    In 2004, Chairman William H. Donaldson created an agency-wide 
Task Force on Soft Dollars, which conducted a thorough review of 
client commission practices.
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     Eligibility of brokerage and research services for safe 
harbor protection is governed by the criteria in Section 28(e)(3),\8\ 
consistent with the Commission's 1986 ``lawful and appropriate 
assistance'' standard.
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    \8\ 15 U.S.C. 78bb(e)(3).
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     ``Research services'' are restricted to ``advice,'' 
``analyses,'' and ``reports'' within the meaning of Section 28(e)(3).
     Physical items, such as computer hardware, which do not 
reflect the expression of reasoning or knowledge relating to the 
subject matter identified in the statute, are outside the safe harbor.
     Market, financial, economic, and similar data would be 
eligible for the safe harbor.
     ``Brokerage services'' within the safe harbor are those 
products and services that relate to the execution of the trade from 
the point at which the money manager communicates with the broker-
dealer for the purpose of transmitting an order for execution, through 
the point at which funds or securities are delivered or credited to the 
advised account.
     Mixed-use items must be reasonably allocated between 
eligible and ineligible uses, and the allocation must be documented so 
as to enable the money manager to make the required good faith 
determination of the reasonableness of commissions in relation to the 
value of brokerage and research services.
    This release reiterates the statutory requirement that money 
managers must make a good faith determination that commissions paid are 
reasonable in relation to the value of the products and services 
provided by broker-dealers in connection with the managers' 
responsibilities to the advisory accounts for which the managers 
exercise investment discretion.
    Finally, the release reiterates that under Section 28(e), broker-
dealers must be financially responsible for the brokerage and research 
products that they provide to money managers, and they must be involved 
in ``effecting'' the trade.

II. ``Brokerage and Research Services'' Under Section 28(e) of the 
Exchange Act

A. Origins of the Section 28(e) Safe Harbor

    In the early 1970s, the Commission studied whether to require 
unfixing commission rates on national exchanges, which had been fixed 
by custom and regulation since the founding of the New York Stock 
Exchange nearly two hundred years earlier.\9\ At the same time, the 
House and Senate began to consider whether to eliminate fixed 
commission rates legislatively.\10\ The Commission adopted Rule 19b-3 
under the Exchange Act,\11\ which ended fixed commission rates on 
national securities exchanges effective May 1, 1975.\12\ Just one month 
later, Congress passed legislation unfixing commission rates as part of 
the Securities Acts Amendments of 1975 (``1975 Amendments'').\13\
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    \9\ See U.S. Securities and Exchange Commission, Institutional 
Investor Study Report, H.R. Doc. No. 64, 92d Cong., 1st Sess., Vol. 
4, at 2206 (1971). See also U.S. Securities and Exchange Commission, 
Special Study of Securities Markets, H.R. Doc. No. 88-95, pt. 2, at 
323 (1963) (``Special Study'').
    \10\ See generally Senate Comm. on Banking, Housing and Urban 
Affairs, Securities Industry Study Report of the Subcommittee on 
Securities, S. Doc. No. 93-13 (1973).
    \11\ 17 CFR 240.19b-3. Rule 19b-3 was codified in certain 
respects by Section 6(e)(1) of the Exchange Act [15 U.S.C. 
78f(e)(1)], which was enacted as part of the Securities Acts 
Amendments of 1975, Pub. L. 94-29, 89 Stat. 97, 107-08 (1975). See 
also Exchange Act Release No. 26180 (Oct. 14, 1988), 53 FR 41205 
(Oct. 20, 1988) (rescinding Rule 19b-3).
    \12\ See Exchange Act Release No. 11203 (Jan. 23, 1975), 40 FR 
7394 (Feb. 20, 1975).
    \13\ See Securities Acts Amendments of 1975, Pub. L. 94-29, 89 
Stat. 97, 107-08 (1975) (enacting Section 6(e)(1) of the Exchange 
Act [15 U.S.C. 78f(e)(1)]). See generally Senate Comm. on Banking, 
Housing and Urban Affairs, Securities Acts Amendments of 1975, S. 
Rep. No. 94-75, at 69 (1975), reprinted in 1975 U.S.C.C.A.N. 179, 
247; House Comm. on Interstate and Foreign Commerce, Securities 
Reform Act of 1975, H.R. Rep. No. 94-123 (1975); Joint Explanatory 
Statement of the Comm. of Conference, Securities Acts Amendments of 
1975, H.R. Conf. Rep. No. 94-229, at 108 (1975), reprinted in 1975 
U.S.C.C.A.N. 321, 338.
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    In the era of fixed rates, when broker-dealers could not compete on 
the basis of the commissions that they could charge for executing 
orders, they competed on the basis of services including non-execution 
services that they could offer.\14\ Indeed, broker-dealers had long 
been accustomed to attracting order execution business from 
institutional money managers by offering them brokerage functions and 
research reports to distinguish their services from those of their 
competitors.\15\ As the end of the fixed-rate era drew near, however, 
money managers and broker-dealers alike questioned how competition over 
commission rates would disrupt these practices. Institutional money 
managers expressed concern that, in an environment of competitive 
commission rates, they would be forced to allocate brokerage solely on 
the basis of lowest execution costs, or that paying more than the 
lowest commission rate would be deemed a breach of fiduciary duty, and 
that useful research might become more difficult to obtain.\16\ Broker-
dealers, which were accustomed to producing proprietary ``Street'' 
research, expressed concern that they could no longer be compensated in 
commissions for their work product if orders were routed to broker-
dealers that provided execution-only service at lower rates.\17\
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    \14\ See Exchange Act Release No. 12251 (Mar. 24, 1976), 41 FR 
13678, 13679 (Mar. 31, 1976) (``1976 Release'').
    \15\ See Special Study, H.R. Doc. No. 88-95, pt. 2, at 321.
    \16\ See 1995 Rule Proposal, 60 FR at 9750; Report of 
Investigation in the Matter of Investment Information, Inc. Relating 
to the Activities of Certain Investment Advisers, Banks, and Broker-
Dealers, Exchange Act Release No. 16679, 19 SEC Docket 926, 931 
(Mar. 19, 1980) (``III Report''); 1976 Release, 41 FR at 13679.
    \17\ Securities Acts Amendments of 1975: Hearings on S. 249 
Before the Subcomm. on Securities of the Senate Comm. on Banking, 
Housing, and Urban Affairs, 94th Cong., 1st Sess. 329-31 (1975) 
(``S. 249 Hearings'') (Combined statement of Baker, Weeks & Co., 
Inc., Donaldson, Lufkin & Jenrette Sec. Corp., Mitchell, Hutchins 
Inc., and Oppenheimer & Co.).
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    In an effort to address the industry's uncertainties about 
competitive commission rates, Congress included a safe harbor in the 
1975 Amendments, codified as Section 28(e) of the Exchange Act.\18\ The 
safe harbor provides generally that a money manager does not breach his 
fiduciary duties under state or federal law solely on the basis that 
the money manager has paid brokerage commissions to a broker-dealer for 
effecting securities transactions in excess of the amount

[[Page 61702]]

another broker-dealer would have charged, if the money manager 
determines in good faith that the amount of the commissions paid is 
reasonable in relation to the value of the brokerage and research 
services provided by such broker-dealer.
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    \18\ See Securities Acts Amendments of 1975, Pub. L. 94-29, 89 
Stat. 97, 161-62 (1975). Section 28(e) [15 U.S.C. 78bb(e)] governs 
the conduct of all persons who exercise investment discretion with 
respect to an account, including investment advisers, mutual fund 
portfolio managers, fiduciaries of bank trust funds, and money 
managers of pension plans and hedge funds. The scope of Section 
28(e) therefore extends to entities that are within the jurisdiction 
of the Board of Governors of the Federal Reserve, the Office of the 
Comptroller of the Currency, the Department of Labor, and the Office 
of Thrift Supervision.
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    As fiduciaries, money managers are obligated to act in the best 
interest of their clients, and cannot use client assets (including 
client commissions) to benefit themselves, absent client consent.\19\ 
Money managers who obtain brokerage and research services with client 
commissions do not have to purchase those services with their own 
funds, which creates a conflict of interest for the money managers. 
Section 28(e) addresses these conflicts by permitting money managers to 
pay higher commissions on behalf of a client than otherwise are 
available to obtain brokerage and research services, if managers make 
their good faith determination regarding the reasonableness of 
commissions paid.\20\ Conduct not protected by Section 28(e) may 
constitute a breach of fiduciary duty as well as a violation of the 
federal securities laws, particularly the Investment Advisers Act of 
1940 \21\ and the Investment Company Act of 1940 (``Investment Company 
Act''),\22\ and the Employee Retirement Income Security Act of 1974 
(``ERISA'').\23\ In particular, money managers of registered investment 
companies and pension funds subject to ERISA may violate Section 
17(e)(1) of the Investment Company Act or ERISA, respectively, unless 
they satisfy the requirements of the Section 28(e) safe harbor.\24\
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    \19\ See supra note 1.
    \20\ The Commission has interpreted Section 28(e) as 
encompassing client commissions on agency transactions and fees on 
certain riskless principal transactions that are reported under NASD 
trade reporting rules. Exchange Act Release No. 45194 (Dec. 27, 
2001), 67 FR 6, 7 (Jan. 2, 2002) (``2001 Release''). Managers may 
not use client funds to obtain brokerage and research services under 
the safe harbor in connection with fixed income trades that are not 
executed on an agency basis, principal trades (except for certain 
riskless principal trades), or other instruments traded net with no 
explicit commissions.
    Further, directed brokerage transactions (whether to recapture a 
portion of the commission for the client or to pay client expenses 
such as sub-transfer agent fees, consultants' fees, or for 
administrative services) ``clearly do not fall within the safe 
harbor of Section 28(e)'' because ``[t]he safe harbor is available 
only to persons who are exercising investment discretion.'' 1986 
Release, 51 FR at 16011. ``A pension plan sponsor that has retained 
a money manager to make investment decisions, as is the case in 
directed brokerage arrangements, is not exercising investment 
discretion.'' Id. Similarly, a mutual fund that has retained a money 
manager to make investment decisions is not exercising investment 
discretion. Unlike client commission arrangements that raise 
conflict of interest concerns addressed by Section 28(e), directed 
brokerage arrangements do not raise these concerns because they 
typically involve use of a fund's commission dollars to obtain 
services that directly and exclusively benefit the fund. See Payment 
for Investment Company Services with Brokerage Commissions, 
Securities Act Release No. 7197 (July 21, 1995), 60 FR 38918 (July 
28, 1995). The Commission has recently prohibited funds from using 
brokerage to pay for distribution. See Investment Company Act 
Release No. 26591 (Sept. 2, 2004), 69 FR 54728 (Sept. 9, 2004).
    \21\ 15 U.S.C. 80b-1. See 1986 Release, 51 FR at 16008-09 
(discussing the principal provisions of the Advisers Act and rules 
and forms thereunder that impose disclosure and other obligations on 
investment advisers and related persons).
    \22\ 15 U.S.C. 80a-1. See 1986 Release, 51 FR at 16009 
(discussing the principal provisions of the Investment Company Act 
and rules and forms thereunder that impose disclosure and other 
obligations on investment advisers of registered investment 
companies and related persons).
    \23\ Employee Retirement Income Security Act of 1974, 29 U.S.C. 
1001. See also Statement of Policies Concerning Soft Dollar and 
Directed Commission Arrangements, ERISA Technical Release No. 86-1, 
[1986-87 Decisions] Fed. Sec. L. Rep. ] 84,009 (May 22, 1986).
    \24\ Section 17(e)(1) of the Investment Company Act [15 U.S.C. 
80a-17(e)(1)] generally makes it unlawful for any affiliated person 
of a registered investment company to receive any compensation for 
the purchase or sale of any property to or for the investment 
company when that person is acting as an agent for the company other 
than in the course of that person's business as a broker-dealer. 
Essentially, Section 17(e)(1) may be violated if an affiliated 
person of a registered investment company, such as an adviser, 
receives compensation for the purchase or sale of property to or 
from the investment company. Absent the protection of Section 28(e), 
an investment adviser's receipt of compensation under a client 
commission arrangement for the purchase or sale of any property, 
including securities, to or for the investment company may 
constitute a violation of Section 17(e)(1). See U.S. v. Deutsch, 451 
F.2d 98, 110-11 (2d Cir. 1971), cert. denied, 404 U.S. 1019 (1972). 
If a client commission arrangement is not consistent with Section 
28(e), disclosure of the arrangement would not cure any Section 
17(e)(1) violation. See 1986 Release, 51 FR at 16010 n.55.
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B. Previous Commission Guidance on the Scope of Section 28(e)

    The Commission has issued three interpretive releases under Section 
28(e) and a report pursuant to Section 21(a) of the Exchange Act that 
addresses issues associated with Section 28(e).\25\ We discuss these 
below.
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    \25\ See 2001 Release; 1986 Release; 1976 Release; III Report. 
In addition, the Commission has charged money managers and broker-
dealers with violations of the federal securities laws in 
circumstances in which they did not act within the safe harbor and 
defrauded investors. See, e.g., Portfolio Advisory Services, LLC, 
and Cedd L. Moses, Advisers Act Release No. 2038, 77 SEC Docket 
2759-31 (June 20, 2002); Dawson-Samberg Capital Management, Inc. and 
Judith A. Mack, Advisers Act Release No. 1889, 54 SEC 786 (Aug. 3, 
2000); Founders Asset Management LLC and Bjorn K. Borgen, Advisers 
Act Release No. 1879, 54 SEC 762 (June 15, 2000); Marvin & Palmer 
Associates, Inc., et al., Advisers Act Release No. 1841, 70 SEC 
Docket 1643 (Sept. 30, 1999); Fleet Investment Advisors, Inc., 
Advisers Act Release No. 1821, 70 SEC Docket 1217 (Sept. 9, 1999); 
Republic New York Sec. Corp. and James Edward Sweeney, Exchange Act 
Release No. 41036, 53 SEC 1283 (Feb. 10, 1999); SEC v. Sweeney 
Capital Management, Inc., Litig. Release No. 15664, 66 SEC Docket 
1613 (Mar. 10, 1998), 1999 U.S. Dist. LEXIS 22298 (1999) (order 
granting permanent injunction and other relief); Renaissance Capital 
Advisers, Inc., Advisers Act Release No. 1688, 66 SEC Docket 408 
(Dec. 22, 1997); Oakwood Counselors, Inc., Advisers Act Release No. 
1614, 63 SEC Docket 2034 (Feb. 11, 1997); S Squared Technology 
Corp., Advisers Act Release No. 1575, 62 SEC Docket 1446 (Aug. 7, 
1996); SEC v. Galleon Capital Mgmt., Litig. Release No. 14315, 57 
SEC Docket 2593 (Nov. 1, 1994).
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1. 1976 Release
    In 1976, the Commission issued an interpretive release stating that 
the safe harbor did not protect ``products and services which are 
readily and customarily available and offered to the general public on 
a commercial basis.'' \26\ The Commission identified these products and 
services as examples of excluded items: ``newspapers, magazines and 
periodicals, directories, computer facilities and software, government 
publications, electronic calculators, quotation equipment, office 
equipment, airline tickets, office furniture and business supplies.'' 
\27\
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    \26\ 1976 Release, 41 FR at 13678.
    \27\ Id.
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    In that release, the Commission also admonished money managers not 
to direct broker-dealers to make ``give-up'' payments, in which the 
money manager asked the broker-dealer, retained to effect a transaction 
for the account of a client, to ``give up'' part of the commission 
negotiated by the broker-dealer and the money manager to another 
broker-dealer designated by the money manager for whom the executing or 
clearing broker is not a normal and legitimate correspondent. The 
Commission stated that in order to be within the definition of 
``brokerage and research services'' under Section 28(e), ``it was 
intended * * * that a research service paid for in commissions by 
accounts under management be provided by the particular broker which 
executed the transactions for those accounts.'' \28\ At the same time, 
the Commission acknowledged the value of third-party research by 
stating that, ``under appropriate circumstances, [Section 28(e) might] 
be applicable to situations where a broker provides a money manager 
with research produced by third parties.'' \29\ The Commission 
emphasized that the money manager ``should be prepared to demonstrate 
the required good faith determination in connection with the 
transaction.'' \30\
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    \28\ Id. at 13679.
    \29\ Id.
    \30\ Id.
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2. Report in the Matter of Investment Information, Inc.
    In 1980, the Commission issued a report pursuant to Section 21(a) 
of the

[[Page 61703]]

Exchange Act following an investigation of Investment Information, 
Inc.''s (``III'') client commission arrangements (``III Report'').\31\ 
III managed the client commission programs of money managers. 
Typically, under these arrangements, the money manager directed 
brokerage transactions to broker-dealers that III designated. The 
broker-dealers, who provided execution services only, retained half of 
each commission and remitted the balance to III. III retained a fee 
(for ``services'' that III provided to money managers, ostensibly for 
managing the client commission accounts) and credited a portion of its 
commission to the money manager's account. The money manager could 
either recapture the credited amount (i.e., receive cash) for the 
benefit of his client or use the credit to purchase research 
services.\32\ The money managers made the arrangements for acquiring 
the research services directly with the service vendors, and III simply 
paid the bills for the services as the money managers requested. The 
executing broker-dealers were unaware of the specific services the 
money managers acquired from the vendors. III was not a registered 
broker-dealer, and it did not perform any kind of brokerage function in 
the securities transactions.
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    \31\ See III Report, 19 SEC Docket at 926.
    \32\ Applying the 1976 standard, the Commission found that 
certain services received by some participating money managers were 
not research services because these services were readily and 
customarily available and offered to the general public on a 
commercial basis. These included such items as periodicals, 
newspapers, quotation equipment, and general computer services. See 
III Report, 19 SEC Docket at 931 n.17.
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    The Commission found that these arrangements did not fall within 
Section 28(e) of the Exchange Act because the broker-dealers that were 
``effecting'' the transactions ``in no significant sense provided the 
money managers with research services.'' \33\ They only executed the 
transactions and paid a portion of the commissions to III. The broker-
dealers were not aware of the specific services that the managers 
acquired and did not pay the bills for these services. The Commission 
concluded that, although Section 28(e) does not require a broker-dealer 
to produce research services ``in-house,'' the services must 
nevertheless be ``provided by'' the broker-dealers. The Commission 
found that a broker-dealer is not providing research services when it 
pays obligations the money manager owes to a third party. The 
Commission indicated that, consistent with Section 28(e), broker-
dealers could arrange to have the third-party research provided 
directly to the money manager, with the payment obligation falling on 
the broker-dealer.\34\
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    \33\ Id. at 931-32.
    \34\ Id. at 932.
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3. 1986 Release
    Following a staff examination of client commission practices in 
1984-1985, the Commission concluded that the 1976 standard was 
``difficult to apply and unduly restrictive in some circumstances,'' 
particularly as the types of research products and their method of 
delivery had proliferated and become more complex.\35\ The Commission 
expressed concern that ``uncertainty about the standard may have 
impeded money managers from obtaining, for commission dollars, goods 
and services'' that they believed were important to making investment 
decisions.\36\
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    \35\ 1986 Release, 51 FR at 16005.
    \36\ Id. at 16005-06.
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    The Commission withdrew the 1976 standard and construed the safe 
harbor to be available to research services that satisfy the statute's 
definition of ``brokerage and research services'' in Section 28(e)(3) 
and provide ``lawful and appropriate assistance to the money manager in 
the performance of his investment decision-making responsibilities.'' 
\37\ We concluded that a product or service that was readily and 
customarily available and offered to the general public on a commercial 
basis nevertheless could constitute research. The 1986 Release also re-
affirmed that, under appropriate circumstances, money managers may use 
client commissions to obtain third-party research (i.e., research 
produced by someone other than the executing broker-dealer).\38\ The 
1986 Release also emphasized the importance of written disclosure of 
client commission arrangements to clients and reiterated a money 
manager's duty to seek best execution.
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    \37\ Id. at 16006.
    \38\ Id. at 16007.
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    The 1986 Release also introduced the concept of ``mixed use.'' In 
many cases, a product or service obtained using client commissions may 
serve functions that are not related to the investment decision-making 
process, such as accounting or marketing. Management information 
services, which may integrate trading, execution, accounting, 
recordkeeping, and other administrative matters such as measuring the 
performance of accounts, were noted as an example of a product that may 
have a mixed use. The Commission indicated that where a product has a 
mixed use, an investment manager should make a reasonable allocation of 
the cost of the product according to its use, and should keep adequate 
books and records concerning the allocations.\39\ The Commission also 
noted that the allocation decision itself poses a conflict of interest 
for the money manager that should be disclosed to the client. In the 
1986 Release, the Commission stated that a money manager may use client 
commissions pursuant to Section 28(e) to pay for the portion of a 
service or specific component that assists him in the investment 
decision-making process, but he cannot use client commissions to pay 
for that portion of a service that provides him administrative 
assistance.\40\
---------------------------------------------------------------------------

    \39\ Id. at 16006.
    \40\ Id.
---------------------------------------------------------------------------

    The 1986 Release also addressed third-party research. Citing to the 
III Report, the Commission reaffirmed its view that, ``while a broker 
may under appropriate circumstances arrange to have research materials 
or services produced by a third party, it is not `providing' such 
research services when it pays obligations incurred by the money 
manager to the third party.'' \41\ In the III Report, the Commission 
found that the money managers and the research vendors, rather than the 
broker-dealers, had made all of the arrangements for acquiring the 
services.\42\
---------------------------------------------------------------------------

    \41\ Id.
    \42\ Id. at 16007.
---------------------------------------------------------------------------

4. 2001 Release
    Until 2001, the Commission interpreted Section 28(e) to be 
available only for research and brokerage services obtained in relation 
to commissions paid to a broker-dealer acting in an ``agency'' 
capacity.\43\ That interpretation meant that money managers could not 
rely on the safe harbor for research and brokerage services obtained in 
relation to fees charged by market makers when they executed 
transactions in a ``principal'' capacity. The Commission interpreted 
the term ``commission'' in Section 28(e) in this fashion because, in 
the Commission's view, fees on principal transactions were not 
quantifiable and fully disclosed in a way that would permit a money 
manager to determine that the fees were reasonable in relation to the 
value of research and brokerage services received.\44\
---------------------------------------------------------------------------

    \43\ See 2001 Release, 67 FR at 6; 1995 Rule Proposal, 60 FR at 
9751 n.10; Investment Company Act Release No. 20472 (Aug. 11, 1994), 
59 FR 42187, 42188 n.3 (Aug. 17, 1994).
    \44\ 2001 Release, 67 FR at 7.
---------------------------------------------------------------------------

    In 2001, the Nasdaq Stock Market asked the Commission to reconsider 
this interpretation of Section 28(e) to apply

[[Page 61704]]

also to research and brokerage services obtained in relation to fully 
and separately disclosed fees on certain riskless principal 
transactions effected by National Association of Securities Dealers, 
Inc. (``NASD'') members and reported under NASD trade reporting 
rules.\45\ Based on required disclosure of fees under confirmation 
rules and reporting of the trade under NASD rules, the Commission 
determined that the money manager could make the necessary 
determination of the reasonableness of these charges under Section 
28(e). The Commission therefore modified its interpretation of 
``commission'' for purposes of the Section 28(e) safe harbor to 
encompass fees paid for riskless principal transactions in which both 
legs are executed at the same price and the transactions are reported 
under the NASD's trade reporting rules.\46\
---------------------------------------------------------------------------

    \45\ See Letter from Hardwick Simmons, Chief Executive Officer, 
The Nasdaq Stock Market, Inc. to Harvey L. Pitt, Chairman, U.S. 
Securities and Exchange Commission (Sept. 7, 2001) (on file with the 
Commission).
    \46\ 2001 Release, 67 FR at 7.
---------------------------------------------------------------------------

C. 1998 Office of Compliance Inspections and Examinations (``OCIE'') 
Report

    In 1998, after OCIE conducted examinations of approximately 355 
broker-dealers, advisers, and funds, the Commission published the 
staff's report, which described the range of products and services that 
advisers obtain under their client commission arrangements.\47\ The 
report raised concerns about the nature of products and services that 
were being treated as ``research,'' the purchase of ``mixed-use'' 
items, disclosure by advisers about their client commission 
arrangements, and recordkeeping.\48\ The 1998 OCIE Report made several 
recommendations for improving commission practices, including that the 
Commission provide further guidance on the scope of the safe harbor and 
require better recordkeeping and enhanced disclosure of client 
commission arrangements and transactions.\49\
---------------------------------------------------------------------------

    \47\ See Office of Compliance Inspections and Examination, U.S. 
Securities and Exchange Commission, Inspection Report on the Soft 
Dollar Practices of Broker-Dealers, Investment Advisers and Mutual 
Funds 3 (Sept. 22, 1998) (``1998 OCIE Report''), available at http://www.sec.gov/news/studies/softdolr.htm
.

    \48\ 1998 OCIE Report, at 4-5.
    \49\ Id. at 47-52.
---------------------------------------------------------------------------

D. Report of the NASD's Mutual Fund Task Force

    In 2004, the NASD Mutual Fund Task Force, composed of senior 
executives from mutual fund management companies and broker-dealers, as 
well as representatives from the academic and legal communities, 
published observations and recommendations to the Commission concerning 
client commission practices and portfolio transaction costs.\50\ In 
particular, the NASD Task Force Report recommended that the Section 
28(e) safe harbor be retained, but that the interpretation of the scope 
of research services be narrowed to better tailor it to the types of 
client commission services that principally benefit the adviser's 
clients rather than the adviser.\51\ The NASD Task Force Report 
recommended that the Commission interpret the safe harbor to protect 
only brokerage services as described in Section 28(e)(3) and the 
``intellectual content'' of research, but not the means by which such 
content is provided.\52\ The NASD Task Force Report suggested that this 
approach would exclude magazines, newspapers, and other such 
publications that are in general circulation to the retail public, and 
such items as computer hardware, phone lines, and data transmission 
lines.\53\ The NASD Task Force Report emphasized that the safe harbor 
should encompass third-party research and proprietary research on equal 
terms, and recommended improved disclosure.\54\
---------------------------------------------------------------------------

    \50\ See NASD, Report of the Mutual Fund Task Force, ``Soft 
Dollars and Portfolio Transaction Costs'' (Nov. 11, 2004) (``NASD 
Task Force Report''), available at http://www.nasd.com/web/groups/rules_regs/documents/rules_regs/nasdw_012356.pdf
.

    \51\ NASD Task Force Report, at 5.
    \52\ NASD Task Force Report, at 6-7. The Task Force proposed 
that ``intellectual content'' be defined as ``any investment 
formula, idea, analysis or strategy that is communicated in writing, 
orally or electronically and that has been developed, authored, 
provided or applied by the broker-dealer or third-party research 
provider (other than magazines, periodicals or other publications in 
general circulation).'' Id. at 7.
    \53\ Specifically, the NASD Task Force indicated that its 
proposed definition of research services would exclude the 
following: computer hardware and software, unrelated to any research 
content or analytical tool; phone lines and data transmission lines; 
terminals and similar facilities; magazines, newspapers, journals, 
and on-line news services; portfolio accounting services; proxy 
voting services unrelated to issuer research; and travel expenses 
incurred in company visits. NASD Task Force Report, at 7.
    \54\ Regarding disclosure, the NASD Task Force Report 
recommended, among other things: (a) Ensuring that fund boards 
obtain information about a fund adviser's brokerage allocation 
practices and client commission services received; (b) mandating 
enhanced disclosure in fund prospectuses to improve investor 
awareness; (c) applying disclosure requirements to all types of 
commissions; and (d) enhancing disclosure to investors about 
portfolio transaction costs. NASD Task Force Report, at 4. See infra 
note 7.
---------------------------------------------------------------------------

E. United Kingdom Financial Services Authority (``FSA'')

    On July 22, 2005, the FSA adopted final client commission rules in 
conjunction with issuing policy statement PS 05/9.\55\ The final rules 
describe ``execution'' and ``research'' services and products eligible 
to be paid for by commissions, and specify a number of ``non-
permitted'' services that must be paid for in hard dollars, such as 
custody not incidental to execution, computer hardware, telephone 
lines, and portfolio performance measurement and valuation 
services.\56\ The policy statement also acknowledges that some products 
and services may be permitted or non-permitted depending on how they 
are used by the money manager.\57\ The rules will become effective 
beginning in January 2006, with a transitional period until June 
2006.\58\
---------------------------------------------------------------------------

    \55\ U.K. Financial Services Authority, Policy Statement 05/9, 
Bundled Brokerage and Soft Commission Arrangements: Feedback on CP 
05/5 and Final Rules (July 2005) (``FSA Final Rules''), available at 
http://www.fsa.gov.uk/ pages/library/policy/ policy/2005/05--

09.shtml. The rules apply only to equity trades and not to fixed 
income trades. FSA Final Rules, at Annex, p. 6 (Conduct of Business 
Sourcebook Rule 7.18.1). The FSA proposed the rules in March 2005. 
See Consultation Paper 05/5, Bundled Brokerage and Soft Commission 
Arrangements: Proposed Rules (Mar. 2005) (``FSA Rule Proposal''), 
available at http://www.fsa.gov.uk/pubs/ cp/cp05--05.pdf.

    \56\ See FSA Final Rules, at Annex, pp. 8-9 (Conduct of Business 
Sourcebook Rules 7.18.4 to 7.18.8). See also FSA Rule Proposal, at 
63-64.
    \57\ FSA Final Rules, at 5. The rules also set forth the 
principle that investment managers should inform advisory clients 
how their commissions are being spent, and indicate that, in 
evaluating compliance with this principle, the FSA will have regard 
for the extent to which investment managers adopt the disclosure 
standards developed by industry associations such as the U.K. 
Investment Management Association (``IMA''). See FSA Final Rules, at 
Annex, p. 11 (Conduct of Business Sourcebook Rule 7.18.14). See also 
Investment Management Association, Pension Fund Disclosure Code, 
Second Edition (Mar. 2005), available at http://www.investmentuk.org/
 news/standards/pfdc2.pdf.

    \58\ FSA Final Rules, at 5. Firms may continue to comply with 
existing rules until the earlier of the expiration of existing 
agreements or June 30, 2006.
---------------------------------------------------------------------------

    With the globalization of the world's financial markets, many U.S. 
market participants have a significant presence abroad, and in 
particular in the U.K. To the extent that the Commission's approach to 
client commissions is compatible with that taken in the U.K., market 
participants' costs of compliance with multiple regulatory regimes 
would be reduced. Therefore, we have taken the FSA's work into account 
in developing our position in this release, while recognizing the 
significant differences in our governing law and rules, such as the 
fact that the U.K. does not have a statutory provision similar to

[[Page 61705]]

Section 28(e).\59\ This proposed interpretive guidance is generally 
consistent with the FSA's rules, with a few exceptions.\60\
---------------------------------------------------------------------------

    \59\ We have also taken note of the views of other regulators. 
See Ontario Securities Commission, Concept Paper 23-402, Best 
Execution and Soft Dollar Arrangements (Feb. 8, 2005), available at 
http://www.osc. gov.on.ca/Regulation/Rulemaking/Current/Part2/cp--

20050204--23-402 -- bestexecution.jsp; Australian Securities and 
Investments Commission, Press Release 04-181, Soft Dollar Benefits 
Need Clear Disclosure (June 10, 2004), available at http://www.asic.gov.au/asic/
 ASIC--PUB.NSF/byid/77D7FCEFB7653EC5CA 

256EAF0002F6C2?opendocument.
    \60\ The FSA has determined that market data that has not been 
analyzed or manipulated does not meet the requirements of a research 
service, but permits managers to justify using client commissions to 
pay for raw data feeds as execution services. The FSA also has 
identified seminars as ``non-permitted'' services. FSA Final Rules, 
at 2.15 and Annex, p. 9 (Conduct of Business Sourcebook Rules 7.18.7 
and 7.18.8(d)).
---------------------------------------------------------------------------

III. Commission's Interpretive Guidance

    In light of recent developments in client commission practices, 
evolving technologies, marketplace developments, and the observations 
of the staff in examinations of industry participants, we have 
revisited our previous guidance as to the meaning of the phrase 
``brokerage and research services'' in Section 28(e). After careful 
consideration, we are proposing a revised interpretation that would 
replace Sections II and III of the 1986 Release.\61\ Specifically, we 
are providing guidance with respect to: (i) The appropriate framework 
for analyzing whether a particular service falls within the ``brokerage 
and research services'' safe harbor; (ii) the eligibility criteria for 
``research''; (iii) the eligibility criteria for ``brokerage''; and 
(iv) the appropriate treatment of ``mixed-use'' items. We also discuss 
the money manager's statutory requirement to make a good faith 
determination that the commissions paid are reasonable in relation to 
the value of the brokerage and research services received. Finally, we 
provide guidance on third-party research and commission-sharing 
arrangements.
---------------------------------------------------------------------------

    \61\ Our proposed interpretation would not replace other 
sections of the 1986 Release.
---------------------------------------------------------------------------

    Section 28(e) applies equally to arrangements involving client 
commissions paid to full service broker-dealers that provide brokerage 
and research services directly to money managers, and to third-party 
research arrangements where the research services and products are 
developed by third parties and provided by a broker-dealer that 
participates in effecting the transaction. Today, it remains true that, 
if the conditions of the safe harbor of Section 28(e) are met, a money 
manager does not breach his fiduciary duties solely on the basis that 
he uses client commissions to pay a broker-dealer more than the lowest 
available commission rate for a bundle of products and services 
provided by the broker-dealer (i.e., anything more than ``pure 
execution'').

A. Present Environment

    In the 1986 Release, the Commission incorporated from the 
legislative history the phrase ``lawful and appropriate assistance'' to 
the money manager in carrying out his investment decision-making 
responsibilities in developing the Commission standard governing the 
range of brokerage and research products and services that may be 
obtained by a money manager within the safe harbor.\62\ Since that 
time, some have construed this standard broadly to apply to services 
and products that are only remotely connected to the investment 
decision-making process. In some cases, ``administrative'' or 
``overhead'' goods and services have been classified as research.\63\ 
In the 1998 OCIE Report, examiners reported that 28% of the money 
managers and 35% of the broker-dealers that were examined had entered 
into at least one client commission arrangement that, in the staff's 
view, was outside of the scope of Section 28(e) and the 1986 
Release.\64\ In particular, OCIE examiners identified numerous examples 
of advisers that it believed failed to separate overhead or 
administrative expenses from those items that provide benefits to 
clients as brokerage and research services.\65\ Examples of non-
research items included: certified financial analyst (CFA) exam review 
courses, membership dues and professional licensing fees, office rent, 
utilities, phone, carpeting, marketing, entertainment, meals, copiers, 
office supplies, fax machines, couriers, backup generators, electronic 
proxy voting services, salaries, and legal and travel expenses.\66\
---------------------------------------------------------------------------

    \62\ See Senate Comm. on Banking, Housing and Urban Affairs, 
Securities Acts Amendments of 1975, S. Rep. No. 94-75, at 71 (1975), 
reprinted in 1975 U.S.C.C.A.N. 179, 249. See also supra note 76.
    \63\ 1998 OCIE Report, at 31.
    \64\ Id. at 22, 31.
    \65\ Id. at 31.
    \66\ Id. at 31-32.
---------------------------------------------------------------------------

    Client commissions are also used extensively to pay for mechanisms 
related to the delivery of research or brokerage services. In the 1998 
OCIE Report, staff reported that some advisers used client commissions 
to pay for various peripheral items that support hardware and software, 
such as the power needed to run the computer and the dedicated 
telephone line used to receive information into the computer.\67\
---------------------------------------------------------------------------

    \67\ Id. at 34-35.
---------------------------------------------------------------------------

    The products and services available to money managers have grown 
more varied and complex. For example, a single software product may 
perform an array of functions, but only some of the functions are 
properly ``brokerage and research services'' under Section 28(e). In 
the 1998 OCIE Report, staff reported that ``the types of products 
available for purchase with client commissions have greatly expanded 
since 1986,'' leaving industry participants to grapple with decisions 
as to whether these products are ``research'' or ``brokerage'' within 
the safe harbor, or whether these products should be considered part of 
money managers' overhead expenses to be paid for by managers with their 
own funds.\68\
---------------------------------------------------------------------------

    \68\ Id. at 49.
---------------------------------------------------------------------------

    The Commission observes that developments in technology have led to 
difficulties in applying client commission standards that were 
developed over the past thirty years. In addition, OCIE staff reported 
that money managers have taken an overbroad view of the products and 
services that qualify as ``brokerage and research services'' under the 
safe harbor.\69\ The complexity of products and services creates 
uncertainty about whether client commissions may be used within the 
safe harbor to purchase all or a portion of particular products and 
services. This uncertainty may result in the use of client commission 
dollars to acquire products and services that are outside of the safe 
harbor, improper allocation of research and non-research mixed-use 
products and services (as contemplated by the 1986 Release), or 
inadequate documentation of allocations.\70\
---------------------------------------------------------------------------

    \69\ See id. at 3-4, 31-32.
    \70\ See id. at 4-6, 32-33.
---------------------------------------------------------------------------

    Questions regarding the use of client commissions have led 
legislators, regulators, fund industry participants, and investors to 
consider whether some uses of client commissions should be banned, the 
safe harbor withdrawn, or changes made to the regulatory landscape.\71\ 
As a first step to address

[[Page 61706]]

the present environment, the Commission has determined to provide 
further guidance on the scope of the safe harbor.\72\ Further guidance 
in this area may be particularly important because, under existing law 
and rules, money managers must disclose client commission arrangements 
as material information,\73\ and may provide more detailed disclosure 
when they receive products or services that fall outside the scope of 
the safe harbor. If a money manager incorrectly concludes that a 
product or service is within the safe harbor, the money manager may 
provide disclosure that is inadequate. In addition, guidance will 
assist money managers of registered investment companies and pension 
funds subject to ERISA in determining whether they are complying with 
the Investment Company Act and ERISA, respectively, because using 
client commissions to pay for products that are outside the safe harbor 
may violate these laws.
---------------------------------------------------------------------------

    \71\ See, e.g., Mutual Funds Integrity and Fee Transparency Act 
of 2003, H.R. 2420, 108th Cong. (2003) (This bill would have 
required, among other things, that the Commission do the following: 
issue rules requiring mutual funds to disclose their policies and 
practices regarding the use of client commissions to obtain 
research, advice, or brokerage activities; issue rules requiring 
managers to maintain copies of the written contracts with third-
party research providers; and conduct a study on the use of client 
commission arrangements by managers.); Mutual Fund Transparency Act 
of 2003, S. 1822, 108th Cong. (2003) (This bill would have required, 
among other things, that the Commission issue a rule to require 
mutual funds to disclose as fund fees and expenses brokerage 
commissions paid by the fund and borne by shareholders.). See also 
Letter from Matthew P. Fink, President, The Investment Company 
Institute, to William H. Donaldson, Chairman, U.S. Securities and 
Exchange Commission (Dec. 16, 2003) (urging the Commission to issue 
interpretative guidance excluding from the Section 28(e) safe 
harbor: (1) Computer hardware and software and other electronic 
communications facilities used in connection with trading investment 
decision-making; (2) publications, including books, newspapers, and 
electronic publications, that are available to the general public; 
and (3) third-party research services), available at http://www.sec.gov/
 rules/petitions/petn4-492.htm.

    \72\ In addition to concerns over the scope of the safe harbor 
under current market conditions, the Commission recognizes that 
improvements may be necessary in disclosure and documentation of 
client commission practices. For example, the ability to enforce 
client commission standards may be hampered by inadequate 
documentation. The Commission will evaluate whether further action 
is necessary.
    \73\ See Form ADV, Pt. II, Items 12.B and 13.A. See also Sage 
Advisory Services LLC, Exchange Act Release No. 44600, 75 SEC Docket 
1073 (July 27, 2001).
---------------------------------------------------------------------------

B. Framework for Analyzing the Scope of the ``Brokerage and Research 
Services'' Under Section 28(e)

    The Commission has recognized the need to interpret the scope of 
the terms ``brokerage and research services'' in Section 28(e) in light 
of Congress's intention to provide a limited safe harbor for conduct 
that otherwise may be a breach of fiduciary duty. The Senate Committee 
Report on the 1975 Amendments regarding Section 28(e) states: ``The 
definition of brokerage and research services is intended to comprehend 
the subject matter in the broadest terms, subject always to the good 
faith standard in Subsection (e)(1).'' \74\ However, as previously 
noted by the Commission, ``Since Section 28(e) involves a statutory 
exemption for conduct which might otherwise constitute a breach of 
fiduciary duty owed by a money manager to his client, the Commission 
believes that the section should be construed in light of its limited 
purposes.'' \75\
---------------------------------------------------------------------------

    \74\ Senate Comm. on Banking, Housing and Urban Affairs, 
Securities Acts Amendments of 1975, S. Rep. No. 94-75, at 71 (1975), 
reprinted in 1975 U.S.C.C.A.N. 179, 249.
    \75\ III Report, 19 SEC Docket at 931.
---------------------------------------------------------------------------

    In the 1986 Release, the Commission adopted the ``lawful and 
appropriate assistance'' standard for ``brokerage and research 
services,'' \76\ which was intended to supplement the statutory 
elements of the analysis of whether a money manager's payment for a 
product or service with client commissions is within the safe harbor. 
While the 1986 Release focused on the application of the ``lawful and 
appropriate assistance'' standard to research, we believe the standard 
also applies to brokerage services.
---------------------------------------------------------------------------

    \76\ See 1986 Release, 51 FR at 16006 n.9 (quoting from Senate 
Comm. on Banking, Housing and Urban Affairs, Securities Acts 
Amendments of 1975, S. Rep. No. 94-75, at 71 (1975), reprinted in 
1975 U.S.C.C.A.N. 179, 249) (The Report concludes, ``Thus, the 
touchstone for determining when a service is within or without the 
definition in Section 28(e)(3) is whether it provides lawful and 
appropriate assistance to the money manager in the carrying out of 
his responsibilities.''). In articulating the ``commercial 
availability'' standard for safe-harbor eligibility in the 1976 
Release, the Commission also expressly recognized ``lawful and 
appropriate assistance'' as the ``touchstone'' for whether a service 
is within or without the provision of Section 28(e)(3). 1976 
Release, 41 FR at 13679.
---------------------------------------------------------------------------

    Taking into account the legislative history of Section 28(e) and 
our prior guidance, the analysis of whether a particular product or 
service falls within the safe harbor should involve three steps. First, 
the money manager must determine whether the product or service falls 
within the specific statutory limits of Section 28(e)(3)(A), (B), or 
(C) (i.e., whether it is an eligible product or service under the safe 
harbor).\77\ Second, the manager must determine whether the eligible 
product or service actually provides lawful and appropriate assistance 
in the performance of his investment decision-making responsibilities. 
Finally, the manager must make a good faith determination that the 
amount of client commissions paid is reasonable in light of the value 
of products or services provided by the broker-dealer.\78\ We discuss 
these statutory elements in more detail below.
---------------------------------------------------------------------------

    \77\ See 1986 Release, 51 FR at 16006. See also 1976 Release, 41 
FR at 13679 (``The term `brokerage and research services', as used 
in Section 28(e), is defined in Section 28(e)(3).''). 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 the 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 Commission or a 
self-regulatory organization of which such person is a member or 
person associated with a member or in which such person is a 
participant. 15 U.S.C. 78bb(3)(A)-(C).
    \78\ 15 U.S.C.78bb(e). See 1986 Release, 51 FR at 16006-07. The 
Commission also emphasized the money manager's disclosure and other 
obligations under the federal securities laws, including the duty to 
seek best execution of his or her client's transactions. Id. at 
16007-11.
---------------------------------------------------------------------------

C. Eligibility Criteria for ``Research Services'' Under Section 
28(e)(3); Lawful and Appropriate Assistance

    The eligibility criteria that govern ``research services'' are set 
forth in Section 28(e)(3) of the Exchange Act:
    For purposes of the safe harbor, a person provides * * * 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 the 
performance of accounts; * * * \79\
---------------------------------------------------------------------------

    \79\ 15 U.S.C. 78bb(e)(3)(A)-(B) (emphasis added).
---------------------------------------------------------------------------

    In determining that a particular product or service falls within 
the safe harbor, the money manager must conclude that it constitutes 
``advice,'' ``analyses,'' or ``reports'' within the meaning of the 
statute and that its subject matter falls within the categories 
specified in Section 28(e)(3)(A) and (B). With respect to the subject 
matter of potential ``research services,'' we note that the categories 
expressly listed in Section 28(e)(3)(A) and (B) also ``subsume'' other 
topics related to securities and the financial markets.\80\

[[Page 61707]]

Thus, for example, a report concerning political factors that are 
interrelated with economic factors could fall within the scope of the 
safe harbor. The form (e.g., electronic or paper) of the research is 
irrelevant to the analysis of eligibility under the safe harbor.
---------------------------------------------------------------------------

    \80\ See Senate Comm. on Banking, Housing and Urban Affairs, 
Securities Acts Amendments of 1975, S. Rep. No. 94-75, at 71 (1975), 
reprinted in 1975 U.S.C.C.A.N. 179, 249 (``[T]he reference [in 
Section 28(e)] to economic factors and trends would subsume 
political factors which may have economic implications which may in 
turn have implications in terms of the securities markets as a whole 
or in terms of the past, present, or future values of individual 
securities or groups of securities.''). See also S. 249 Hearings, at 
329, 330 (Combined statement of Baker, Weeks & Co., Inc., Donaldson, 
Lufkin & Jenrette Sec. Corp., Mitchell, Hutchins Inc., and 
Oppenheimer & Co.) (Research under Section 28(e) should include 
``advice and information on industries, economics, world conditions, 
portfolio strategy and other areas.'').
---------------------------------------------------------------------------

    In evaluating the statutory language, the Commission notes that an 
important common element among ``advice,'' ``analyses,'' and 
``reports'' is that each reflects substantive content--that is, the 
expression of reasoning or knowledge.\81\ Thus, in determining whether 
a product or service is eligible as ``research'' under Section 28(e), 
the money manager must conclude that it reflects the expression of 
reasoning or knowledge and relates to the subject matter identified in 
Section 28(e)(3)(A) or (B). Traditional research reports analyzing the 
performance of a particular company or stock clearly would be eligible 
under Section 28(e). Certain financial newsletters and trade journals 
also could be eligible research services if they relate to the subject 
matter of the statute. Quantitative analytical software and software 
that provides analyses of securities portfolios would be eligible under 
the safe harbor if they reflect the expression of reasoning or 
knowledge relating to subject matter that is included in Section 
28(e)(3)(A) and (B).\82\ Seminars or conferences where the content 
satisfies the above criteria also would be eligible.\83\
---------------------------------------------------------------------------

    \81\ The content may be original research or a synthesis, 
analysis, or compilation of the research of others.
    \82\ See Senate Comm. on Banking, Housing and Urban Affairs, 
Securities Acts Amendments of 1975, S. Rep. No. 94-75, at 71 (1975), 
reprinted in 1975 U.S.C.C.A.N. 179, 249 (``computer analyses of 
securities portfolios would * * * be covered'').
    \83\ See 1986 Release, 51 FR at 16007. We note that the FSA has 
identified seminars as ``non-permitted'' services. See FSA Final 
Rules, at Annex, p. 9 (Conduct of Business Sourcebook Rule 
7.18.8(d)).
---------------------------------------------------------------------------

    In contrast, products or services that do not reflect the 
expression of reasoning or knowledge, including products with 
inherently tangible or physical attributes (such as telephone lines or 
office furniture), are not eligible as research under the safe harbor. 
We do not believe that these types of products and services could be 
said to constitute ``advice,'' ``analyses,'' or ``reports'' within the 
meaning of the statute. Applying this guidance, a money manager's 
operational overhead expenses would not constitute eligible ``research 
services.'' \84\ For example, travel expenses, entertainment, and meals 
associated with attending seminars would not be eligible under the safe 
harbor. Similarly, office equipment, office furniture and business 
supplies, telephone lines, salaries (including research staff), rent, 
accounting fees and software, website design, e-mail software, internet 
service, legal expenses, personnel management, marketing, utilities, 
membership dues, professional licensing fees, and software to assist 
with administrative functions such as managing back-office functions, 
operating systems, and word processing are examples of other overhead 
items that do not meet the statutory criteria for research (or 
brokerage) set forth in this release and are not eligible under the 
safe harbor.\85\
---------------------------------------------------------------------------

    \84\ See 1986 Release, 51 FR at 16006-07.
    \85\ According to the 1998 OCIE Report, advisers used client 
commissions to pay for many of these items. See notes 65-67 and 
accompanying text. See also Sage Advisory Services LLC, Exchange Act 
Release No. 44600, 75 SEC Docket 1073 (July 27, 2001) (adviser 
improperly used client commission credits to pay for undisclosed 
non-research business expenses such as legal, accounting, and back-
office record keeping services, payments of self-regulatory 
organization (``SRO'') fees, and rent).
---------------------------------------------------------------------------

    Computer hardware and computer accessories, while they may assist 
in the delivery of research, would not be eligible ``research 
services'' because they do not reflect substantive content related in 
any way to making decisions about investing.\86\ Similarly, the 
peripherals and delivery mechanisms associated with computer hardware, 
including telecommunications lines, transatlantic cables, and computer 
cables, are outside the ``research services'' safe harbor.
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    \86\ In 1986, the Commission suggested that advisers could use 
client commissions to pay for the portion of the cost of computers 
that relate to receiving research. See 1986 Release, 51 FR at 16006-
07. In light of developments in technology and broad application of 
the 1986 standard to products and services that are only remotely 
connected to investment decision-making, as discussed above, we now 
believe that it is important to clarify that computers fall outside 
the scope of the safe harbor.
---------------------------------------------------------------------------

    As noted above, even if the manager properly concludes that a 
particular product or service is an ``analysis,'' ``advice,'' or 
``report'' that reflects the expression of reasoning or knowledge, it 
would be eligible research only if the subject matter of the product or 
service falls within the categories specified in Section 28(e)(3)(A) 
and (B). Thus, for example, consultants' services may be eligible for 
the safe harbor if the consultant provides advice with respect to 
portfolio strategy, but such services would not be eligible if the 
advice relates to the managers' internal management or operations.
    With respect to data services--such as those that provide market 
data or economic data--we believe that such services could fall within 
the scope of the safe harbor as eligible ``reports'' provided that they 
satisfy the subject matter criteria. In the 1986 Release, we included 
market data services within the safe harbor, finding that they serve 
``a legitimate research function of pricing securities for investment 
and keeping a manager informed of market developments.'' \87\ Because 
market data contain aggregations of information on a current basis 
related to the subject matter identified in the statute, and in light 
of the history of Section 28(e), our interpretation would conclude that 
market data, such as stock quotes, last sale prices, and trading 
volumes, contain substantive content and constitute ``reports 
concerning * * * securities'' within the meaning of Section 
28(e)(3)(B),\88\ and thus would be eligible as ``research services'' 
under the safe harbor.\89\ Similarly, other data would be eligible 
under the safe harbor if they reflect substantive content--that is, the 
expression of reasoning or knowledge--related to the subject matter 
identified in the statute. For example, we believe that company 
financial data and economic data (such as unemployment and inflation 
rates or gross domestic product figures) would be eligible as research 
under Section 28(e).
---------------------------------------------------------------------------

    \87\ 1986 Release, 51 FR at 16006. We believe that, in the 1986 
Release, the Commission's indication that quotation equipment may be 
eligible under the safe harbor was intended to address market data.
    \88\ 15 U.S.C. 78bb(e)(3)(B).
    \89\ We note that the FSA has determined that, ``Examples of 
goods or services that relate to the provision of research that the 
FSA do not regard as meeting the requirements of [a research 
service] include price feeds or historical price data that have not 
been analyzed or manipulated to reach meaningful conclusions.'' FSA 
Final Rules, at Annex p. 9 (Conduct of Business Sourcebook Rule 
7.18.7).
---------------------------------------------------------------------------

    As discussed above, in order for a product or service to be within 
the safe harbor, it must not only satisfy the specific criteria of the 
statute, but it also must provide the money manager with lawful and 
appropriate assistance in making investment decisions. This standard 
focuses on how the manager uses the eligible research. For example, 
some money managers appear to be using client commissions to pay for 
analyses of account performance that are used for marketing 
purposes.\90\ Although analyses of the performance of accounts are 
eligible research items because they reflect the expression of 
reasoning or knowledge regarding subject matter included in Section 
28(e)(3)(B), these items when used for marketing purposes are not 
within the safe harbor because they are not providing lawful and 
appropriate

[[Page 61708]]

assistance to the money manager in performing his investment decision-
making responsibilities.\91\
---------------------------------------------------------------------------

    \90\ See 1998 OCIE Report, at 20.
    \91\ As discussed below in the mixed-use section, if the manager 
uses account performance analyses for both marketing purposes and 
investment decision-making, the manager may use client commissions 
only to pay for the allocable portion of the item attributable to 
use for investment decision-making under Section 28(e). See infra 
Section III.E.
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D. Eligibility Criteria for ``Brokerage'' Under Section 28(e)(3); 
Lawful and Appropriate Assistance

    Under Section 28(e)(3)(C) of the Act, a person provides ``brokerage 
* * * services'' insofar as he or she:

effects securities transactions and performs functions incidental 
thereto (such as clearance, settlement, and custody) or required in 
connection therewith by rules of the Commission or a self-regulatory 
organization of which such person is a member or in which such 
person is a participant.\92\
---------------------------------------------------------------------------

    \92\ 15 U.S.C. 78bb(e)(3)(C).

    Section 28(e)(3)(C) describes the brokerage products and services 
that are eligible under the safe harbor. In addition to activities 
required to effect securities transactions, Section 28(e)(3)(C) 
provides that functions ``incidental thereto'' are also eligible for 
the safe harbor, as are functions that are required by Commission or 
self-regulatory organization (``SRO'') rules. Clearance and settlement 
services in connection with trades effected by the broker are 
explicitly identified as eligible incidental brokerage services. 
Therefore, the following post-trade services relate to functions 
incidental to executing a transaction and are eligible under the safe 
harbor as ``brokerage services'': post-trade matching; exchange of 
messages among broker-dealers, custodians, and institutions; electronic 
communication of allocation instructions between institutions and 
broker-dealers; and routing settlement instructions to custodian banks 
and broker-dealers' clearing agents. Similarly, services that are 
required by the Commission or SRO rules are eligible under the safe 
harbor. For example, in certain circumstances, the use of electronic 
confirmation and affirmation of institutional trades is required in 
connection with settlement processing.\93\
---------------------------------------------------------------------------

    \93\ See NASD Rule 11860(a)(5); New York Stock Exchange 
(``NYSE'') Rule 387(a)(5); American Stock Exchange Rule 423(5); 
Chicago Stock Exchange Article XV, Rule 5; Pacific Exchange Rule 
9.12(a)(5); Philadelphia Stock Exchange Rule 274(b).
---------------------------------------------------------------------------

    In 1998, OCIE staff recommended that the Commission provide further 
guidance on the scope of the safe harbor concerning the use of items 
that may facilitate trade execution, based on examiners' reports that

[t]he technological explosion in the money management industry has 
been met with an increasing use of soft dollars to purchase state-
of-the-art computer and communications systems that may facilitate 
trade execution. * * * The use of soft dollars to purchase these 
products may present advisers with questions similar to those 
surrounding computers purchased for research and analysis, i.e., how 
should an adviser distinguish between `brokerage' services and 
`overhead' expenses.\94\
---------------------------------------------------------------------------

    \94\ 1998 OCIE Report, at 35-36, 50.

    In addition, we recognize that to the extent that this release 
would narrow the scope of eligible research under the safe harbor, 
there is a risk that, without further guidance on brokerage, some 
services and products that were previously classified as research could 
be inappropriately reclassified as brokerage.\95\ For these reasons, we 
are providing the guidance set forth below to assist money managers in 
determining whether items are eligible as ``brokerage services'' under 
the safe harbor.
---------------------------------------------------------------------------

    \95\ The NASD Task Force Report made a similar observation, and 
recommended that the Commission ``monitor the use of the safe harbor 
for brokerage services for such inappropriate attempts to maintain 
the status quo by expanding the brokerage services aspect of the 
safe harbor.'' NASD Task Force Report, at 7 n.20.
---------------------------------------------------------------------------

    Guided by the statute and legislative history, we believe that 
Congress intended ``brokerage'' services under the safe harbor to 
relate to the execution of securities transactions.\96\ In our view, 
brokerage under Section 28(e) should reflect historical and current 
industry practices that execution of transactions is a process, and 
that services related to execution of securities transactions begin 
when an order is transmitted to a broker-dealer and end at the 
conclusion of clearance and settlement of the transaction. We believe 
that this temporal standard is an appropriate way to distinguish 
between ``brokerage services'' that are eligible under Section 28(e) 
and those products and services, such as overhead, that are not 
eligible. Specifically, for purposes of the safe harbor, we believe 
that brokerage begins when the money manager communicates with the 
broker-dealer for the purpose of transmitting an order for execution 
and ends when funds or securities are delivered or credited to the 
advised account or the account holder's agent. Unlike brokerage, 
research services include services provided before the communication of 
an order. Thus, advice provided by a broker before an order is 
transmitted may fall within the research portion of the safe harbor, 
but not the brokerage portion of the safe harbor.
---------------------------------------------------------------------------

    \96\ See Securities Acts Amendments of 1974, H.R. 5050, 93d 
Cong. (1974) (House bill on safe harbor referred to ``brokerage 
services, including * * * research or execution services''); H.R. 
Rep. No. 93-1476 (1974) (House Committee Report on H.R. 5050 
referred to ``brokerage'' as ``research and other services related 
to the execution of securities transactions''); Joint Explanatory 
Statement of the Comm. of Conference, Securities Acts Amendments of 
1975, H.R. Conf. Rep. No. 94-229, at 108 (1975), reprinted in 1975 
U.S.C.C.A.N. 321, 338 (House Conference Report on final House bill 
on Section 28(e) describes the safe harbor as relating to paying 
more than the lowest available price for ``execution and research 
services'').
---------------------------------------------------------------------------

    Under this temporal standard, communications services related to 
the execution, clearing, and settlement of securities transactions and 
other incidental functions, i.e., connectivity service between the 
money manager and the broker-dealer and other relevant parties such as 
custodians (including dedicated lines between the broker-dealer and the 
money manager'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 money 
manager and the trading desk at the broker-dealer; and message services 
used to transmit orders to broker-dealers for execution) are eligible 
under Section 28(e)(3)(C). In addition, trading software operated by a 
broker-dealer to route orders to market centers and algorithmic trading 
software is ``brokerage.'' \97\
---------------------------------------------------------------------------

    \97\ Unlike research, brokerage services can include 
connectivity services and trading software where they are used to 
transmit orders to the broker, because this transmission of orders 
has traditionally been considered a core part of the brokerage 
service. We believe that mechanisms to deliver research, on the 
other hand, are separable from the research and the decision-making 
process.
---------------------------------------------------------------------------

    On the other hand, order management systems (``OMS'') used by money 
managers to manage their orders (including OMS developed in-house by 
the manager and those obtained from third-party vendors) and hardware, 
such as telephones or computer terminals, are not eligible for the safe 
harbor as ``brokerage'' because they are not sufficiently related to 
order execution and fall outside the temporal standard for 
``brokerage'' under the safe harbor. Products and services such as 
trade analytics, surveillance systems, or compliance mechanisms, do not 
qualify as ``brokerage'' in the safe harbor because they are not 
integral to the execution of orders by the broker-dealers, i.e., they 
fall outside the temporal standard described above.\98\

[[Page 61709]]

Moreover, error correction trades or related services in connection 
with errors made by money managers are not related to the initial trade 
for a client within the meaning of Section 28(e)(3)(C) because they are 
separate transactions to correct the manager's error, not to benefit 
the advised account, and thus error correction functions are not 
eligible ``brokerage services'' under the safe harbor.\99\ The products 
and services described in this paragraph are properly characterized as 
``overhead'' and are ineligible under Section 28(e).
---------------------------------------------------------------------------

    \98\ For example, to the extent that money managers use trade 
analytics both for research and to assist in fulfilling contractual 
obligations to the client or to assess whether they have complied 
with their own regulatory or fiduciary obligations such as the duty 
of best execution or for other internal compliance purposes, the 
trade analytical software is a mixed-use product, and managers must 
use their own funds to pay for the allocable portion of the cost of 
the software that is not within the safe harbor because it is 
attributable to internal compliance purposes. See supra note 1.
    \99\ We note that the staff has taken a similar position. See 
Charles Lerner, Department of Labor, No-Action Letter (Oct. 25, 
1988) (Dept. of Labor (``DOL'') sought Commission staff advice 
regarding applicability of Section 28(e) to commission practices 
discovered by DOL investigators involving ERISA plans).
---------------------------------------------------------------------------

    As with research, in order to obtain safe harbor protection for 
products and services that are eligible as brokerage, the money manager 
must be able to show that the eligible product or service provides him 
or her lawful and appropriate assistance in carrying out the manager's 
responsibilities, and the manager must make 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.

E. ``Mixed-Use'' Items

    As discussed above, the 1986 Release introduced the concept of 
``mixed use.'' \100\ Where a product obtained with client commissions 
has a mixed use, a money manager faces an additional conflict of 
interest in obtaining that product with client commissions.\101\ The 
1986 Release stated that where a product has a mixed use, a money 
manager should make a reasonable allocation of the cost of the product 
according to its use, and emphasized that the money manager must keep 
adequate books and records concerning allocations in order to make the 
required good faith determination.\102\ Moreover, the allocation 
determination itself poses a conflict of interest for the money manager 
that should be disclosed to the client.\103\ It appears that, in 
practice, some managers may have made questionable mixed-use 
allocations and failed to document the bases for their allocation 
decisions.\104\ Lack of documentation makes it difficult for the 
manager to make the required good faith showing of the reasonableness 
of the commissions paid in relation to the value of the portion of the 
item allocated as brokerage and research under Section 28(e), and also 
makes it difficult for compliance personnel to ascertain the basis for 
the allocation.\105\
---------------------------------------------------------------------------

    \100\ See 1986 Release, 51 FR at 16007.
    \101\ Id. at 16006-07.
    \102\ Id.
    \103\ Id. at 16006 n.13.
    \104\ 1998 OCIE Report, at 32-34.
    \105\ Id.
---------------------------------------------------------------------------

    We continue to believe that the ``mixed-use'' approach is 
appropriate. In that connection, we reiterate today the Commission's 
guidance provided in the 1986 Release regarding the mixed-use standard: 
\106\ ``The money manager must keep adequate books and records 
concerning allocations so as to be able to make the required good faith 
showing.'' \107\ As stated above, the mixed-use approach requires a 
money manager to make a reasonable allocation of the cost of the 
product according to its use. For example, an allocable portion of the 
cost of portfolio performance evaluation services or reports may be 
eligible as research, but money managers must use their own funds to 
pay for the allocable portion of such services or reports that is used 
for marketing purposes.\108\
---------------------------------------------------------------------------

    \106\ As noted above, this proposed interpretation would replace 
Sections II and III of the 1986 Release.
    \107\ 1986 Release, 51 FR at 16006. The Commission may further 
address the documentation of mixed-use items at a later time.
    \108\ Similarly, if the money manager seeks the protection of 
the safe harbor and receives both Section 28(e) eligible and 
ineligible products and services for a bundled commission rate, the 
manager must use his own funds to pay for the allocable portion of 
the cost of products and services that are not within the safe 
harbor.
---------------------------------------------------------------------------

F. The Money Manager's Good Faith Determination as to Reasonableness 
Under Section 28(e)

    Section 28(e) requires money managers who are seeking to avail 
themselves of the safe harbor to make a good faith determination that 
the commissions paid are reasonable in relation to the value of the 
brokerage and research services received.\109\ The Commission reaffirms 
the money manager's essential obligation under Section 28(e) to make 
this good faith determination. The burden of proof in demonstrating 
this determination rests on the money manager.\110\
---------------------------------------------------------------------------

    \109\ As we noted in 1986, ``[a] money manager should consider 
the full range and quality of a broker's services in placing 
brokerage including, among other things, the value of research 
provided as well as execution capability, commission rate, financial 
responsibility, and responsiveness to the money manager* * *. [T]he 
determinative factor is not the lowest possible commission cost but 
whether the transaction represents the best qualitative execution 
for the managed account.'' 1986 Release, 51 FR at 16011. See also 
supra note 5.
    \110\ See House Comm. on Interstate and Foreign Commerce, 
Securities Acts Amendments of 1975, H.R. No. 94-123, at 95 (1975). 
The report states that: ``It is, of course, expected that money 
managers paying brokers an amount [of commissions] which is based 
upon the quality and reliability of the broker's services including 
the availability and value of research, would stand ready and be 
required to demonstrate that such expenditures were bona fide.'' See 
also 1986 Release, 51 FR at 16006-16007.
---------------------------------------------------------------------------

    A money manager satisfies Section 28(e) if he or she can 
demonstrate that the item is eligible under the language of the 
statute, the manager has used the item in performing decision-making 
responsibilities for accounts over which he exercises investment 
discretion, and, in good faith, the manager believes that the amount of 
commissions paid is reasonable in relation to the value of the research 
or brokerage product or service received, either in terms of the 
particular transaction or the manager's overall responsibilities for 
discretionary accounts. Thus, for example, a money manager may purchase 
an eligible item of research with client commissions if he or she 
properly uses the information in formulating an investment decision, 
but another money manager cannot rely on Section 28(e) to acquire the 
very same item if the manager does not use the item for investment 
decisions or if the money manager determines that the commissions paid 
for the item are not reasonable with respect to the value of the 
research or brokerage received. Similarly, a money manager may not 
obtain eligible products, such as market data, to camouflage the 
payment of higher commissions to broker-dealers for ineligible 
services, such as shelf space.\111\ In this instance, the money manager 
could not make the determination, in good faith, that the commission 
rate was reasonable in relation to the value of the Section 28(e) 
eligible products because the commission would incorporate a payment to 
the broker-dealer for the non-Section 28(e) services. Further, if 
research products or services that are eligible under Section 28(e)(3) 
have

[[Page 61710]]

been simply copied, repackaged, or aggregated, the money manager must 
make a good faith determination that any additional commissions paid in 
respect of such copying, repackaging, or aggregation services are 
reasonable.
---------------------------------------------------------------------------

    \111\ In other situations, the Commission has imposed sanctions 
on money managers and broker-dealers for failing to disclose 
conflicts associated with the use of brokerage commissions to 
compensate broker-dealers for marketing particular funds (a practice 
known as payment for shelf-space). See, e.g., Edward D. Jones & Co., 
L.P., Securities Act Release No. 8520 (Dec. 22, 2004); Franklin 
Advisers, Inc. and Franklin/Templeton Distributors, Inc., Advisers 
Act Release No. 2337 (Dec. 13, 2004). Cf. Investment Company Act 
Release No. 26591 (Sept. 2, 2004), 69 FR 54728 (Sept. 9, 2004) 
(Commission adopted Rule 12b-1(h) under the Investment Company Act, 
which prohibits funds from using brokerage to pay for distribution).
---------------------------------------------------------------------------

G. Third-Party Research and Commission-Sharing Arrangements 
112
---------------------------------------------------------------------------

    \112\ Section 28(e)(1) states in relevant part:
    No person * * * shall be deemed to have acted unlawfully or to 
have breached a fiduciary duty * * * solely by reason of his having 
caused the account to pay a member of an exchange, broker, or dealer 
an amount of commission for effecting a securities transaction in 
excess of the amount of commission another member of an exchange, 
broker, or dealer would have charged for effecting that transaction, 
if such person determined in good faith that such amount of 
commission was reasonable in relation to the value of the brokerage 
and research services provided by such member, broker, or dealer, 
viewed in terms of either that particular transaction or his overall 
responsibilities with respect to the accounts as to which he 
exercises investment discretion. 15 U.S.C. 78bb(e)(1) (emphasis 
added).
---------------------------------------------------------------------------

    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 their advised accounts.
1. Research Services Must Be ``Provided by'' the Broker-Dealer
    Section 28(e) requires that the broker-dealer receiving commissions 
must ``provide'' brokerage or research services. The Commission has 
interpreted this to permit money managers to use client commissions to 
pay for research produced by someone other than the executing broker-
dealer, in certain circumstances (referred to as ``third-party 
research'').\113\ The essential feature of the ``provided by'' element 
is that the broker-dealer has the direct legal obligation to pay for 
the research.\114\ The Commission also has clarified that research 
provided in third-party arrangements is eligible under Section 28(e) 
even if the money manager participates in selecting the research 
services or products that the broker-dealer will provide.\115\ The 
third party may send the research directly to the broker's customer so 
long as the broker-dealer has the obligation to pay for the 
services.\116\ In contrast, a money manager may not rely upon Section 
28(e) if he uses the broker-dealer merely to pay an obligation that he 
has incurred with a third party.\117\ The 1998 OCIE Report discussed 
instances in which some money managers had entered into such 
arrangements whereby broker-dealers paid for research or brokerage 
services for which the money managers were obligated to pay.\118\ The 
Commission reminds money managers and broker-dealers that these 
arrangements are not eligible for the Section 28(e) safe harbor.
---------------------------------------------------------------------------

    \113\ See 1976 Release, 41 FR at 13679 (Section 28(e) ``might, 
under appropriate circumstances, be applicable to situations where a 
broker provides a money manager with research produced by third 
parties''). See also 1986 Release, 51 FR at 16007 (``Although the 
legislative history of Section 28(e) includes a strong statement 
that commission dollars may be paid only to the broker-dealer that 
``provides'' both the execution and research services and that the 
section does not authorize the resumption of ``give-ups,'' it seems 
unlikely that Congress intended to forbid certain common practices 
that were then considered permissible and whose elimination would be 
anti-competitive.''); III Report, 19 SEC Docket at 932 (broker need 
not produce research services ``in house'').
    \114\ See 1986 Release, 51 FR at 16007; III Report, 19 SEC 
Docket at 932.
    \115\ Exchange Act Release No. 17371 (Dec. 12, 1980), 45 FR 
83707, 83714 n.54 (Dec. 19, 1980) (``Papilsky Release''). See 1986 
Release, 51 FR at 16007. In the Papilsky Release, the Commission 
addressed Section 28(e) and third-party research in the context of 
defining ``bona-fide research'' for purposes of NASD rules that 
relate to obtaining research in a fixed-price offering.
    \116\ Papilsky Release, 45 FR at 83714 n.54. See 1986 Release, 
51 FR at 16007.
    \117\ Papilsky Release, 45 FR at 83714 n.54.
    \118\ OCIE reported that approximately 27% of the broker-dealers 
examined were paying invoices submitted directly by investment 
advisers for payment obligations of the investment advisers to the 
third parties. See 1998 OCIE Report, at 24-25.
---------------------------------------------------------------------------

2. ``Effecting'' Transactions
    Section 28(e) requires that the broker-dealer providing the 
research also be involved in ``effecting'' the trade.\119\ The 
inclusion of this element in Section 28(e) was principally intended to 
preclude the practice of paying ``give-ups.'' \120\ Specifically, when 
brokerage commissions were fixed before 1975, a ``give-up'' was a 
payment to another broker-dealer of a portion of the commission 
required to be charged by the executing broker-dealer.\121\ The broker-
dealer receiving the give-up may have had no role in the transaction 
generating the commission, and it may not even have known where or when 
the trade was executed. Because the portion of the commission ``given 
up'' is a charge above the cost of execution on client accounts and 
because the broker-dealer receiving the ``e-up'' did nothing in 
connection with the securities trade to benefit investors, the 
Commission found that these arrangements violated the securities 
laws.\122\ In enacting Section 28(e), Congress addressed the issue of 
give-ups by indicating that the provision did not apply when the money 
manager made payment to one broker-dealer for the services performed by 
another broker-dealer.\123\ In the 1986 Release, the Commission 
indicated that payment of a part of a commission to a broker-dealer who 
is a ``normal and legitimate correspondent'' of the executing or 
clearing broker-dealer would not necessarily be a ``give-up,'' outside 
the protection of Section 28(e).\124\
---------------------------------------------------------------------------

    \119\ 15 U.S.C. 78bb(e).
    \120\ In enacting Section 28(e), Congress described give-ups as 
a ``regrettable chapter in the history of the securities industry 
and the limited definition of fiduciary responsibility added to the 
law by this bill in no way permits its return.'' Joint Explanatory 
Statement Of The Comm. Of Conference, Securities Acts Amendments Of 
1975, H.R. Conf. Rep. No. 94-229, at 108 (1975), reprinted in 1975 
U.S.C.C.A.N. 321, 339.
    \121\ Give-ups took several forms, but typically occurred when a 
mutual fund (or its money manager or underwriter) directed an 
executing broker-dealer to pay a portion of a commission payment to 
another broker-dealer that was a member of the same exchange as the 
executing broker-dealer. The give-up often was payment for other 
services (that may have been unrelated to the trade) provided to the 
fund (or its adviser or underwriter) by the give-up recipient. See 
Division of Market Regulation, U.S. Securities and Exchange 
Commission, Market 2000: an Examination of Current Equity Market 
Developments (Jan. 1994), 1994 SEC LEXIS at 32-33 (citing Special 
Study, H.R. Doc. No. 88-95, pt. 2, at 316-317 and pt. 4, at 213-14). 
This type of give-up produced a conflict of interest for the adviser 
``between the interest of fund shareholders in lower commission 
charges and the interest of mutual fund advisers and underwriters in 
stimulating the sale of additional shares through directing a split 
of commission charges.'' Special Study, H.R. Doc. No. 88-95, pt. 2, 
at 318.
    \122\ See, e.g., Provident Management Corp., 44 SEC 442, 445-47 
(Dec. 1, 1970) (finding violations of the antifraud provisions of 
the federal securities laws where unaffiliated broker-dealers who 
participated with the fund's officers, adviser, and affiliated 
broker-dealer in a reciprocal arrangement in which fund transactions 
were placed with unaffiliated broker-dealer in exchange for payment 
to affiliated broker-dealer of ``clearance commissions'' on 
unrelated transactions for which affiliated broker-dealer performed 
no function). The Commission has found it a violation of the 
antifraud provisions of the securities laws to interpose an 
unnecessary party in a transaction, resulting in payment to the 
interposed party, and an additional cost to the fiduciary account. 
See Delaware Management Co., 43 SEC 392 (1967) (interpositioning 
broker between adviser and market maker caused adviser to pay 
unnecessary brokerage costs and violated the adviser's duty of best 
execution).
    \123\ Joint Explanatory Statement of the Comm. of Conference, 
Securities Acts Amendments of 1975, H.R. Conf. Rep. No. 94-229, at 
109 (1975), reprinted in 1975 U.S.C.C.A.N. 321, 339. See also 1986 
Release, 51 FR at 16007; 1976 Release, 41 FR at 13679.
    \124\ 1986 Release, 51 FR at 16007 (``Section 28(e) was not 
intended to exclude from its coverage the payment of commissions 
made in good faith to an introducing broker for execution and 
clearing services performed in whole or in part by the introducing 
broker's normal and legitimate correspondent.''); 1976 Release, 41 
FR at 13678 (Under Section 28(e), money managers may not direct 
brokers employed by them to ``give-up'' part of the commission 
negotiated by the broker and the money manager to another broker 
designated by the money manager for whom the executing or clearing 
broker is not a normal and legitimate correspondent.).

---------------------------------------------------------------------------

[[Page 61711]]

    Some investment managers today use ``commission-sharing'' 
arrangements to execute trades with one broker-dealer and obtain 
research or other services from a different broker-dealer. In some 
commission-sharing arrangements, the introducing broker-dealer accepts 
orders from its customers and then may execute the trade and provide 
research, while a second broker-dealer clears and settles the 
transaction. In other commission-sharing arrangements, an 
``introducing'' broker-dealer retains a portion of the commission, and 
has little, if any, role in accepting customer orders or in executing, 
clearing, or settling any portion of the trade. Rather, another broker-
dealer (often called the ``clearing broker'') executes, clears, and 
settles the trade, receiving a portion of the commission for its 
services. In some instances, the introducing broker is unaware of the 
daily trading activity of its customers because the orders are sent by 
the money manager directly (and only) to the clearing broker-
dealer.\125\
---------------------------------------------------------------------------

    \125\ The 1986 Release suggested that protection of Section 
28(e) would not be lost merely because the money manager by-passed 
the order desk of the introducing broker and called his orders 
directly into the clearing broker. 1986 Release, 51 FR at 16007.
    For purposes of this discussion, commission-sharing arrangements 
are different from ``step-outs.'' In a step-out, the investment 
manager directs the executing broker to allocate all or a certain 
number of shares of an executed trade, e.g., 100 shares of a 1000 
share trade, to another broker-dealer for clearance and settlement. 
In this example, the executing broker executes the entire trade, 
clears and settles 900 shares, and receives the commission for 900 
shares. The second or ``stepped-in'' broker clears and settles 100 
shares and negotiates the commission for 100 shares with the 
manager. The executing broker may not know what commission is paid 
to the stepped-out broker or what services (other than clearance and 
settlement) are provided by the stepped-out broker to the manager. 
Step-outs have been used, at the client's direction, where the 
client has a commission recapture arrangement with the ``stepped-
in'' broker. In the past, step-outs were used to reward the 
``stepped-in'' broker-dealer for fund distribution or to obtain 
``brokerage and research services.'' See Thomas P. Lemke and Gerald 
T. Lins, Soft Dollars and Other Brokerage Arrangements 4-16 to 4-17 
(2004). Provided that each broker in a step-out performs substantive 
functions in effecting trades, e.g., clearance and settlement, such 
arrangements may be eligible for the safe harbor.
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    Where more than one broker-dealer is involved in a commission-
sharing arrangement, the Commission takes the view that 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 money 
managers.'' \126\
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    \126\ 1986 Release, 51 FR at 16007, quoting Data Exchange 
Securities, No-Action Letter (Apr. 20, 1981).
    Where two broker-dealers are involved in a commission-sharing 
arrangement that otherwise satisfies Section 28(e), one of the 
broker-dealers must be financially responsible for providing the 
research. See 1986 Release, 51 FR at 16007; III Report, 19 SEC 
Docket at 932.
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    Commission-sharing arrangements typically involve clearing 
agreements pursuant to SRO rules.\127\ These SRO rules require that 
introducing and clearing firms contractually agree to allocate 
enumerated functions, but do not mandate how the functions should be 
divided (i.e., they do not specify the functions that must be done by 
the introducing broker-dealer or clearing broker-dealer).\128\ We note, 
however, that a clearing agreement that satisfies SRO rule requirements 
does not necessarily satisfy the criteria of Section 28(e). Each 
broker-dealer must play a role in effecting securities transactions 
that goes beyond the mere provision of research services to money 
managers.\129\ The nature of the activities actually performed by each 
broker-dealer determines whether the commission-sharing arrangement 
qualifies under Section 28(e).\130\
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    \127\ See, e.g., NYSE Rule 382, ``Carrying Agreements,'' 2 NYSE 
Guide ] 2382, Rule 382; NASD Rule 3230, ``Clearing Agreements'; NASD 
Rules of Fair Practice, Section 47, Article III; American Stock 
Exchange Rule 400 (mirrors the provisions of NYSE Rule 382(b)).
    \128\ For example, NYSE Rule 382 specifies that each fully-
disclosed clearing agreement between SRO members shall allocate to 
the respective member the following functions: (i) Opening, 
approving, and monitoring of accounts; (ii) extension of credit; 
(iii) maintenance of books and records; (iv) receipt and delivery of 
funds and securities; (v) safeguarding of funds and securities; (vi) 
confirmations and statements; (vii) acceptance of orders and 
execution of transactions. NYSE Rule 382(b). Further, the clearing 
broker must provide annually to the introducing broker-dealer a list 
of reports to assist the introducing broker to supervise and monitor 
its customer accounts and to fulfill its responsibilities under the 
agreement as well as deliver, and retain a copy of, those reports 
that the introducing broker requests. NYSE Rule 382(e)(1) and (2).
    \129\ Step-outs may not require clearing agreements but may be 
within Section 28(e) if each broker performs substantive functions 
in effecting the trade (e.g., clearance and settlement). See supra 
note 125.
    \130\ Introducing and clearing brokers still remain subject to 
all applicable securities laws and regulations and SRO rules. For 
instance, nothing in this release changes in any way the 
applicability of anti-money laundering (``AML'') laws and 
regulations applicable to an introducing broker or a clearing 
broker. See, e.g., Currency and Foreign Transactions Reporting Act 
of 1970 (``Bank Secrecy Act''), [31 U.S.C. 5311 et seq.] (as amended 
by the Uniting and Strengthening America by Providing Appropriate 
Tools Required to Intercept and Obstruct Terrorism Act of 2001 
(``USA Patriot Act''), Pub. L. 107-56, sec. 314, 326, 115 Stat. 
272); Treasury regulations adopted under the Bank Secrecy Act [31 
CFR Part 103]; Exchange Act Rule 17a-8 [17 CFR 240.17a-8]; NYSE Rule 
445; NASD Rule 3011. This interpretation also does not alter the 
introducing broker and the clearing broker's supervisory 
obligations. See, e.g., Securities Exchange Act Section 15(b)(4)(E) 
[15 U.S.C. 78o(b)(4)(E)]; NYSE Rules 342 and 405; NASD Rules 3010, 
3012, and 3013. This interpretation also does not alter a broker-
dealer's best execution obligation to its customers. See, e.g., NASD 
Rule 2320; NASD Notice to Members 01-22 (Apr. 2001).
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    In connection with commission-sharing arrangements, each party to 
the arrangement must determine if it is contributing to a violation of 
law, including whether the involvement of multiple parties to the trade 
is necessary to effecting the trade, beneficial to the client, and 
appropriate in light of all applicable duties.\131\ In particular, as 
discussed above, the broker-dealer involved in effecting the trade must 
also be legally obligated to pay for the third-party research or 
brokerage service (i.e., the ``provided by'' requirement).\132\
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    \131\ See 1976 Release, 41 FR at 13679 (``[N]or may money 
managers, under the authority of Section 28(e), direct brokers 
employed by them to make ``give up'' payments.''; ``[B]rokers should 
recognize that their compliance with any direction or suggestion by 
a fiduciary which would appear to involve a violation of the 
fiduciary's duty to its beneficiaries could implicate them in a 
course of conduct violating the anti-fraud provisions of the federal 
securities laws.''); III Report, 19 SEC Docket at 933 (Where brokers 
and money managers were aware that an intermediary was providing 
research to money managers in exchange for directing brokerage to 
the intermediary's designated brokers, but brokers had limited 
participation in providing the research, ``those involved should 
have realized that the arrangement was not permitted by Section 
28(e).''; ``[B]rokers should have been alerted to the possibility of 
conduct which contravened applicable fiduciary principles and the 
federal securities laws.'').
    \132\ See 1986 Release, 51 FR at 16007; III Report, 19 SEC 
Docket at 932.
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    The following elements are necessary for a commission-sharing 
arrangement under which research and brokerage services are provided 
under the safe harbor:
     The commission-sharing arrangement must be part of a 
normal and legitimate correspondent relationship in which each broker-
dealer is 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 money managers (i.e., 
``effecting securities transactions'' requirement).\133\ Based on the 
Commission's experience, we believe that, at a minimum, this means that 
the introducing broker-dealer must: (1) Be financially responsible to 
the clearing broker-dealer for all customer trades until the clearing 
broker-dealer has received payment (or securities), i.e., the 
introducing broker-dealer must be at risk to the clearing broker-dealer 
for its customers' failure to pay; (2) make and/or maintain records 
relating to its customer trades required by Commission and SRO rules, 
including blotters and memoranda of orders; (3) monitor and respond to 
customer comments concerning the trading

[[Page 61712]]

process; and (4) generally monitor trades and settlements;\134\ and
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    \133\ See supra notes 119-130 and accompanying text.
    \134\ See 1986 Release, 51 FR at 16007, citing SEI Financial 
Services Co., No-Action Letter (Dec. 15, 1983), which identified 
these minimum functions for an introducing broker in a correspondent 
relationship.
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     A broker-dealer effecting the trade (if not providing 
research and brokerage services directly) must be legally obligated to 
a third-party producer of research or brokerage services to pay for the 
service ultimately provided to a money manager (i.e., ``provided by'' 
requirement).\135\
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    \135\ See supra notes 113-118 and accompanying text.
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IV. Request for Comments

    The Commission seeks comment on its proposed interpretive guidance 
regarding client commission practices under Section 28(e) of the 
Exchange Act. The Commission asks commentators to address whether the 
proposed interpretation has accurately identified the industry 
practices for which guidance would be most useful, and to offer 
comments on any significant issues arising under Section 28(e) that 
this release has not addressed. The Commission also requests comment as 
to whether the proposed interpretive guidance would significantly 
affect the level and distribution of costs among industry participants 
and, if so, whether these effects would be beneficial to investors or 
otherwise serve the public interest.
    In addition, the Commission solicits comments on the following 
topics:
    Question 1. Does the Commission's interpretation offer sufficient 
guidance with respect to the types of ``advice,'' ``analyses,'' and 
``reports'' that are eligible as ``research services'' under Section 
28(e)?
    Question 2. How would investors, money managers, broker-dealers, 
and others be affected by the Commission's interpretive guidance that 
client commissions cannot be used to obtain computer equipment as 
``research'' under Section 28(e)?
    Question 3. Does the Commission's interpretation offer appropriate 
guidance as to the eligibility of market data and trade analytical 
software under Section 28(e)?
    Question 4. Does the Commission's interpretation offer sufficient 
guidance as to the eligibility of ``brokerage'' services, functions, 
and products under Section 28(e)? How would this guidance affect 
existing arrangements or practices? Is the Commission's temporal 
standard sufficiently clear? Are there types of services that should be 
excluded from the safe harbor, even though they might appear to satisfy 
the temporal standard? If so, explain why those services should be 
excluded--for example, is the service unrelated to execution of 
transactions?
    Question 5. Does the Commission's interpretation offer sufficient 
guidance about third-party research and commission-sharing 
arrangements?
    Question 6. How does the Commission's interpretive guidance differ 
from the approaches that other regulators, SROs, market participants, 
trade organizations, and investor advocacy groups have adopted or 
recommended with respect to client commission practices?
    Question 7. Are there types of products or services that are 
commonly paid for with client commissions for which additional guidance 
would be useful? If so, please provide facts about these products and 
services and their components, and how they are used. For example, are 
client commissions commonly used to pay for proxy voting services?
    Question 8. Should the Commission provide additional guidance on 
the allocation and documentation of mixed-use items?
    Question 9. Concerns have been expressed by some industry 
participants and others that mass-marketed publications (publications 
that are widely circulated to the general public and intended for a 
broad, public audience) are part of a firm's overhead and should not be 
paid for with client commissions. To what extent are these types of 
publications currently being paid for with client commissions? Are the 
purposes and uses of these types of publications distinguishable from 
those of traditional research products? Should the Commission provide 
further guidance in this area?
    Question 10. Should the Commission afford firms time to implement 
the interpretation? In commenting, please provide specific examples of 
any potential implementation issues.

    Dated: October 19, 2005.

    By the Commission.
Jonathan G. Katz,
Secretary.
[FR Doc. 05-21247 Filed 10-24-05; 8:45 am]

BILLING CODE 8010-01-P
