

[Federal Register: July 24, 2006 (Volume 71, Number 141)]
[Rules and Regulations]               
[Page 41977-41996]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr24jy06-11]                         


[[Page 41977]]

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Part IV





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; Final Rule


[[Page 41978]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 241

[Release No. 34-54165; File No. S7-13-06]

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

AGENCY: Securities and Exchange Commission.

ACTION: Interpretation; solicitation of comment.

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SUMMARY: The Securities and Exchange Commission is publishing this 
interpretive release with respect to the scope of ``brokerage and 
research services'' and client commission arrangements under Section 
28(e) of the Securities Exchange Act of 1934 (``Exchange Act''). The 
Commission is soliciting further comment on client commission 
arrangements under Section 28(e).

DATES: Effective Date: July 24, 2006.
    Comment Due Date: Comments should be received on or before 
September 7, 2006.
    Other Date: Market participants may continue to rely on the 
Commission's prior interpretations of Section 28(e) until January 24, 
2007.

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 S7-13-06 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 Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-13-06. 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) \1\ of the Exchange Act \2\ 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 issuing 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.
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    \1\ 15 U.S.C. 78bb(e).
    \2\ 15 U.S.C. 78a.
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    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.\3\ 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.\4\ Recognizing the value of research in managing client 
accounts, however, Congress enacted Section 28(e) \5\ of the Exchange 
Act 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.\6\
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    \3\ Money managers include investment advisers, who have 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 their clients, SEC v. Capital Gains Research 
Bureau, Inc., 375 U.S. 180, 189-191 (1963). This includes the 
obligation to seek ``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 Sec.  170 cmt. a, Sec.  216 (1959).
    \4\ For a discussion of managers' conflicts in connection with 
the safe harbor, see generally 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). Similarly, to minimize confusion with 
the phrase ``commission-sharing arrangements'' as used in the United 
Kingdom to refer to unique arrangements in that market place, we 
refer to arrangements under Section 28(e) as ``client commission 
arrangements'' or ``Section 28(e) arrangements.''
    \5\ 15 U.S.C. 78bb(e).
    \6\ 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 Section 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 broker-dealers and investment 
advisers.\7\ The Commission also has

[[Page 41979]]

brought enforcement actions involving purported client commission 
practices.\8\
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    \7\ 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
.

    \8\ See, e.g., Dawson-Samberg Capital Management, Inc. and 
Judith A. Mack, Advisers Act Release No. 1889, 54 SEC 786 (Aug. 3, 
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., Litigation 
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., Litigation Release No. 14315, 57 SEC Docket 2593 (Nov. 1, 
1994).
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    On October 19, 2005, the Commission issued a proposed interpretive 
release regarding client commission practices under Section 28(e) 
(``Proposing Release'').\9\ We received letters from seventy-one 
commenters in response to the Proposing Release.\10\ More than half of 
the commenters supported the Commission's efforts in the Proposing 
Release to clarify the scope of Section 28(e).\11\ Overall, the 
comments provided useful information regarding industry practices in 
this area.\12\
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    \9\ Exchange Act Release No. 52635 (Oct. 19, 2005), 70 FR 61700 
(Oct. 25, 2005).
    \10\ Seventy-one different commenters submitted seventy-six 
comment letters. The comment letters are available for inspection in 
the Commission's Public Reference Room in File No. S7-09-05, or may 
be viewed at http://www.sec.gov/rules/interp/s70905.shtml. The 

commenters were: Committee on Federal Regulation of Securities, 
Business Law Section, American Bar Association (``ABA''); Adams 
Harkness (``Adams Harkness''); American Bankers Association 
(``AmBankers''); The Alliance in Support of Independent Research, 
Nov. 23, 2005 (``ASIR 1''); The Alliance in Support of Independent 
Research , June 2, 2006 (``ASIR 2''); Axia Advisory Corporation 
(``Axia''); Bingham McCutcheon LLP, on behalf of Frank Russell 
Securities, Inc. (``Bingham McCutcheon''); Bloomberg L.P. 
(``Bloomberg''); BNY Securities Group on behalf of the Bank of New 
York Company, Inc., Nov. 25, 2005 (``BNY 1''); BNY Securities Group 
on behalf of the Bank of New York Company, Inc., May 2, 2006 (``BNY 
2''); California Public Employees' Retirement System (``CalPERS''); 
Capital Institutional Services, Inc. (``CAPIS''); Carolina Capital 
Markets, Inc., Nov. 23, 2005 (``CCM 1''); Carolina Capital Markets, 
Inc., Nov. 25, 2005 (``CCM 2''); CFA Centre for Financial Market 
Integrity, CFA Institute (``CFA Institute''); Consumer Federation of 
America/Fund Democracy (joint letter) (``CFA/FD''); Charles River 
Brokerage (``Charles River''); C.L. King & Associates, Inc. (``CL 
King''); Commission Direct, Inc. (``Commission Direct''); Credit 
Suisse Securities (USA) LLC (``Credit Suisse''); Neal J. Dean 
(``Dean''); U.S. Department of Labor, Employee Benefits Security 
Administration (``DOL''); Michael Donovan (``Donovan''); Dow Jones & 
Company, Inc. (``Dow Jones''); E*Trade Financial Corporation 
(``E*Trade''); European Association of Independent Research 
Providers (``EuroIRP''); Eze Castle Software (``Eze Castle''); 
Fidelity Management and Research Company (``Fidelity''); FinTech 
Securities (``FinTech''); Tamar Frankel (``Frankel''); William T. 
George, Oct. 20, 2005 (``George 1''); William T. George, Oct. 28, 
2005 (``George 2''); William T. George, Apr. 4, 2006 (``George 3''); 
GovernanceMetrics International (``GMI''); Independent Directors 
Council (``IDC''); Instinet, LLC (``Instinet''); International 
Securities Association for Institutional Trade Communications 
(``ISITC''); The Interstate Group (``Interstate Group''); Investment 
Adviser Association (``IAA''); Investment Company Institute 
(``ICI''); Investment Management Association (``IMA''); Investorside 
Research Association (``Investorside''); International Shareholder 
Services Inc. (``ISS''); ITG Inc. (``ITG''); J.P. Morgan Securities 
Inc., Nov. 28, 2005 (``JP Morgan 1''); J.P. Morgan Securities Inc., 
Mar. 28, 2006 (``JP Morgan 2''); Thomas F. Lamprecht 
(``Lamprecht''); Mellon Financial Corporation (``Mellon''); Merrill 
Lynch & Co., Inc. (``Merrill''); Managed Funds Association 
(``MFA''); Mutual Fund Directors Forum (``MFDF''); Morgan Stanley & 
Co., Inc. (``Morgan Stanley''); Missouri State Employees'' 
Retirement System (``MOSERS''); Emmett Murphy (``Murphy''); National 
Compliance Services, Inc. (``NCS''); Bernard Notas (``Notas''); 
National Society of Compliance Professionals Inc. (``NSCP''); Junius 
W. Peake, Oct. 21, 2005 (``Peake 1''); Junius W. Peake, Oct. 26, 
2005 (``Peake 2''); Rainier Investment Management, Inc. 
(``Rainier''); The Reserve Funds (``Reserve''); Reuters America LLC 
(``Reuters''); Riedel Research Group (``Riedel''); Charlotte 
Roederer (``Roederer''); Sanderson & Stocker, Inc. (``Sanderson & 
Stocker''); U.S. Senator Charles C. Schumer and U.S. Senator John E. 
Sununu (joint letter) (``Senators Schumer and Sununu''); Charles 
Schwab & Co., Inc. (``Schwab''); Seward & Kissel LLP (``Seward & 
Kissel''); Securities Industry Association (``SIA''); Security 
Traders Association (``STA''); T. Rowe Price Associates, Inc. (``T. 
Rowe Price''); UBS Securities LLC (``UBS''); Vandham Securities 
Corp. (``Vandham''); The Vanguard Group, Inc. (``Vanguard''); Ward & 
Smith, P.A. on behalf of First Citizens Bank & Trust Company (``Ward 
& Smith''); West Virginia Investment Management Board (``WVIMB'').
    \11\ ABA; ASIR 1; AmBankers; BNY; Bloomberg; CalPERS; CAPIS; CFA 
Institute; Charles River; Commission Direct; DOL; Dow Jones; 
E*Trade; EuroIRP; Eze Castle; Fidelity; FinTech; IDC; ISS; 
Interstate Group; IAA; ICI; IMA; Investorside; ITG; JP Morgan 1; 
MFA; Mellon; Merrill; Morgan Stanley; NCS; NSCP; Reuters; Riedel; 
Roederer; Schwab; SIA; STA; T. Rowe Price; UBS; Vandham; Vanguard.
    \12\ Ten commenters expressed the view that money managers 
should refrain from using client commissions to obtain brokerage and 
research or that Congress should repeal Section 28(e). See Axia; 
CFA/FD (joint letter); Dean; Frankel; MOSERS; MFDF; Peake 2; 
Reserve; WVIMB.
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    After considering the comments received and the Commission's 
experience with Section 28(e), and upon further examination of changing 
market conditions, current industry practices, and the purposes 
underlying Section 28(e), we are issuing this interpretive release on 
money managers' use of client assets to pay for research and brokerage 
services under Section 28(e) of the Exchange Act.\13\ This release 
interprets the scope of the safe harbor as follows:
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    \13\ 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.
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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.
     Research related to the market for securities, such as 
trade analytics (including analytics available through order management 
systems) and advice on market color and execution strategies, are 
eligible for the safe harbor.
     Market, financial, economic, and similar data could be 
eligible for the safe harbor.
     Mass-marketed publications are not eligible as research 
under 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.
     Eligibility of both brokerage and research services for 
safe harbor protection is governed by the criteria in Section 
28(e)(3),\14\ consistent with the Commission's 1986 ``lawful and 
appropriate assistance'' standard.
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    \14\ 15 U.S.C. 78bb(e)(3).
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     Mixed-use items must be reasonably allocated between 
eligible and ineligible uses, and the manager must keep adequate books 
and records concerning allocations so as to enable the manager to make 
the required good faith determination of the reasonableness of 
commissions in relation to the value of brokerage and research 
services.
     In order for the safe harbor to be available to the money 
manager, the following principles apply:
     Broker-dealers that are parties to arrangements under 
Section 28(e) are involved in ``effecting'' the trade if they execute, 
clear, or settle the trade, or perform one of four specified functions 
\15\ and allocate the other functions to another broker-dealer.
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    \15\ The four functions are: (1) Taking financial responsibility 
for customer trades; (2) maintaining records relating to customer 
trades; (3) monitoring and responding to customer comments 
concerning the trading process; and (4) monitoring trades and 
settlements. See discussion infra note 176 and accompanying text.
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     Broker-dealers ``provide'' the research if they (i) 
prepare the research, (ii) are financially obligated to pay for the 
research, or (iii) are not financially obligated to pay but their 
arrangements have certain attributes.

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    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.
    The guidance in this Release shall be effective immediately upon 
its publication in the Federal Register. Market participants may 
continue to rely on the Commission's prior interpretations for six 
months following the publication of this Release in the Federal 
Register. Nonetheless, the Commission will receive and consider 
additional comment regarding Section III.I of this Release with respect 
to client commission arrangements given evolving developments in the 
industry. Based on any comments received, the Commission may, but need 
not, supplement the guidance in this Release in the future.

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 1970's, 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.\16\ At the same time, the 
House and Senate began to consider whether to eliminate fixed 
commission rates legislatively.\17\ The Commission adopted Rule 19b-3 
under the Exchange Act,\18\ which ended fixed commission rates on 
national securities exchanges effective May 1, 1975.\19\ Just one month 
later, Congress passed legislation unfixing commission rates as part of 
the Securities Acts Amendments of 1975 (``1975 Amendments'').\20\
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    \16\ 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'').
    \17\ 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).
    \18\ 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).
    \19\ See Exchange Act Release No. 11203 (Jan. 23, 1975), 40 FR 
7394 (Feb. 20, 1975).
    \20\ 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.\21\ 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.\22\ 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.\23\ 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.\24\
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    \21\ See Exchange Act Release No. 12251 (Mar. 24, 1976), 41 FR 
13678, 13679 (Mar. 31, 1976) (``1976 Release'').
    \22\ See Special Study, H.R. Doc. No. 88-95, pt. 2, at 321.
    \23\ 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.
    \24\ 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.\25\ 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 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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    \25\ 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.\26\ 
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 this conflict 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.\27\

[[Page 41981]]

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 Advisers Act \28\ and the Investment Company Act of 
1940 (``Investment Company Act''),\29\ and the Employee Retirement 
Income Security Act of 1974 (``ERISA'').\30\ 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 and 
ERISA, respectively, unless they satisfy the requirements of the 
Section 28(e) safe harbor.\31\
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    \26\ See supra note 3.
    \27\ 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, transactions for which the client has directed the 
money manager to a particular broker in order to recapture a portion 
of the commission for that client or to pay expenses of that client 
such as sub-transfer agent fees, consultants' fees, or 
administrative services fees generally do not raise the types of 
conflicts for the money manager that the safe harbor of Section 
28(e) was designed to address. See, e.g., 1986 Release, 51 FR at 
16011. These types of directed brokerage arrangements typically 
involve use of a client's commission dollars to obtain services that 
directly and exclusively benefit the client. See Payment for 
Investment Company Services with Brokerage Commissions, Securities 
Act Release No. 7197 (July 21, 1995), 60 FR 38918 (July 28, 1995).
    \28\ 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).
    \29\ 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).
    \30\ 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).
    \31\ 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 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, for or to 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).\32\ We discuss these 
below.
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    \32\ 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., Litigation 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., Litigation 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.'' \33\ 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.'' 
\34\
---------------------------------------------------------------------------

    \33\ 1976 Release, 41 FR at 13678.
    \34\ Id.
---------------------------------------------------------------------------

    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.'' \35\ 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.'' \36\ The Commission 
emphasized that the money manager ``should be prepared to demonstrate 
the required good faith determination in connection with the 
transaction.'' \37\
---------------------------------------------------------------------------

    \35\ Id. at 13679.
    \36\ Id.
    \37\ Id.
---------------------------------------------------------------------------

2. Report in the Matter of Investment Information, Inc.
    In 1980, the Commission issued a report pursuant to Section 21(a) 
of the Exchange Act following an investigation of Investment 
Information, Inc.'s (``III'') purported client commission arrangements 
(``III Report''). \38\ 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.\39\ 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.
---------------------------------------------------------------------------

    \38\ See III Report, 19 SEC Docket at 926.
    \39\ 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.
---------------------------------------------------------------------------

    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.'' \40\ 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

[[Page 41982]]

``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.\41\
---------------------------------------------------------------------------

    \40\ Id. at 931-32.
    \41\ Id. at 932.
---------------------------------------------------------------------------

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.\42\ 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.\43\
---------------------------------------------------------------------------

    \42\ 1986 Release, 51 FR at 16005.
    \43\ Id. at 16005-06.
---------------------------------------------------------------------------

    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.'' 
\44\ 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).\45\ 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.
---------------------------------------------------------------------------

    \44\ Id. at 16006.
    \45\ Id. at 16007.
---------------------------------------------------------------------------

    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.\46\ 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.\47\
---------------------------------------------------------------------------

    \46\ Id. at 16006.
    \47\ 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.'' \48\ 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.\49\
---------------------------------------------------------------------------

    \48\ Id.
    \49\ 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.\50\ 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.\51\
---------------------------------------------------------------------------

    \50\ 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).
    \51\ 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 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.\52\ 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.\53\
---------------------------------------------------------------------------

    \52\ 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).
    \53\ 2001 Release, 67 FR at 7.
---------------------------------------------------------------------------

C. 1998 Office of Compliance Inspections and Examinations 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.\54\ 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.\55\ 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.\56\
---------------------------------------------------------------------------

    \54\ See 1998 OCIE Report, at 3.
    \55\ 1998 OCIE Report, at 4-5.
    \56\ Id. at 47-52.

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[[Page 41983]]

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.\57\ 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.\58\ 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.\59\ 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.\60\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.\61\
---------------------------------------------------------------------------

    \57\ 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.
    \58\ NASD Task Force Report, at 5.
    \59\ 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.
    \60\ 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.
    \61\ 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 supra 
note 13.
---------------------------------------------------------------------------

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.\62\ 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.\63\ 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.\64\ The rules became effective beginning 
in January 2006, with a transitional period until June 2006.\65\
---------------------------------------------------------------------------

    \62\ 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.

    \63\ 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.
    \64\ 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.

    \65\ FSA Final Rules, at 5. Firms were permitted to 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 United Kingdom. To the extent that the Commission's 
approach to client commissions is compatible with that taken in the 
United Kingdom., market participants' costs of compliance with multiple 
regulatory regimes are 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 United Kingdom. does not have a statutory 
provision similar to Section 28(e).\66\ This interpretive guidance is 
generally consistent with the FSA's rules, with a few exceptions.\67\
---------------------------------------------------------------------------

    \66\ 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/77D7FCEFB7653EC5 

CA256EAF0002F6C2? opendocument.
    \67\ 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 subscriptions for publications and seminar fees as ``non-
permitted'' services. FSA Final Rules, at 2.15 and Annex, p. 9 
(Conduct of Business Sourcebook Rules 7.18.7, 7.18.8(d), and 
7.18.8(e)).
---------------------------------------------------------------------------

III. Commission's Interpretive Guidance

    In light of developments in client commission practices, evolving 
technologies, marketplace developments, the observations of the staff 
in examinations of industry participants, and comments received on the 
Proposing Release, 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 providing a revised 
interpretation that replaces Sections II and III of the 1986 
Release.\68\ 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 are issuing 
guidance on third-party research and client commission arrangements and 
are seeking further comment relating to client commission arrangements 
(Section III.I of this Release).
---------------------------------------------------------------------------

    \68\ Our interpretation does not replace other sections of the 
1986 Release.
---------------------------------------------------------------------------

    Section 28(e) applies equally to arrangements involving client 
commissions paid to full service broker-

[[Page 41984]]

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.\69\ 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.\70\ 
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 arrangement that, in the staff's view, was outside of 
the scope of Section 28(e) and the 1986 Release.\71\ 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.\72\ Examples of non-research items included: Chartered 
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.\73\
---------------------------------------------------------------------------

    \69\ 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 infra note 82.
    \70\ 1998 OCIE Report, at 31.
    \71\ Id. at 22, 31.
    \72\ Id. at 31.
    \73\ 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.\74\
---------------------------------------------------------------------------

    \74\ 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.\75\
---------------------------------------------------------------------------

    \75\ 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.\76\ 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.\77\
---------------------------------------------------------------------------

    \76\ See id. at 3-4, 31-32.
    \77\ 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.\78\ 
As a step to address the present environment and comments received in 
response to the Proposing Release, the Commission has determined to 
provide further guidance on the scope of the safe harbor.\79\ 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,\80\ 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 because using client commissions 
to pay for products that are outside the safe harbor may violate these 
laws.
---------------------------------------------------------------------------

    \78\ 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
.

    \79\ 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.
    \80\ 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

[[Page 41985]]

``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.\81\ In the 1986 Release, 
the Commission adopted the ``lawful and appropriate assistance'' 
standard for ``brokerage and research services,'' \82\ 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.
---------------------------------------------------------------------------

    \81\ Senate Comm. on Banking, Housing and Urban Affairs, 
Securities Acts Amendments of 1975, S. Rep. No. 94-75, at 74 (1975), 
reprinted in 1975 U.S.C.C.A.N. 179, 249.
    \82\ 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.\83\ 
First, the money manager must determine whether the product or service 
falls within the specific statutory limits of Section 28(e)(3) (i.e., 
whether it is eligible ``research'' under Section 28(e)(3)(A) or (B) or 
eligible ``brokerage'' under Section 28(e)(3)(C)).\84\ 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. Where a product or service 
has a mixed use, a money manager must make a reasonable allocation of 
the costs of the product according to its use. 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. \85\ We discuss these statutory 
elements in more detail below.
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    \83\ In the Commission's view, the prudent way for a money 
manager to meet its burden of showing eligibility for the safe 
harbor is to document fully its client commission arrangements.
    \84\ 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).
    \85\ 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.
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C. Eligibility Criteria for ``Research Services'' Under Section 
28(e)(3)

    In response to the Proposing Release, nine comment letters 
supported the Commission's proposed narrowing of the scope of research 
under Section 28(e).\86\ Three commenter stated that the Commission's 
approach did not sufficiently narrow the scope of ``research,'' \87\ 
while another commenter recommended that the Commission improve clarity 
by providing extensive lists of research items that are eligible and 
ineligible for the Section 28(e) safe harbor.\88\ Based on the language 
of the statute and our analysis of the legislative history, and taking 
into consideration the comments to the Proposing Release regarding the 
types of products and services paid for and their uses, we believe that 
the eligibility criteria for ``research'' under the safe harbor 
discussed in the Proposing Release and set forth below represents the 
appropriate interpretation of Section 28(e).
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    \86\ ASIR 1; BNY 1; CFA Institute; FinTech; IMA; MFDF; NCS; T. 
Rowe Price; Vanguard.
    \87\ CFA/FD (joint letter); IDC.
    \88\ Notas.
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    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; * * *. \89\
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    \89\ 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.\90\ 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, paper, or oral discussions) of the research 
is irrelevant to the analysis of eligibility under the safe harbor.
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    \90\ 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.'').
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    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.\91\ 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 are eligible under 
Section 28(e). Discussions with research analysts also fall squarely 
within the statute because they involve ``furnish[ing] advice * * * 
directly * * * as to the * * * advisability of investing in 
securities.'' Thus, they reflect the expression of reasoning or 
knowledge (i.e., furnishing advice) relating to the statutory subject 
matter (i.e., the advisability of investing in securities). Meetings 
with corporate

[[Page 41986]]

executives to obtain oral reports on the performance of a company are 
eligible because reasoning or knowledge will be imparted at the meeting 
(i.e., reports) about the subject matter of Section 28(e) (i.e., 
concerning issuers). Seminars or conferences may also be eligible under 
the safe harbor if they truly relate to research, that is, they provide 
substantive content relating to the subject matter in the statute, such 
as issuers, industries, and securities.\92\ Software that provides 
analyses of securities portfolios is eligible under the safe harbor 
because it reflects the expression of reasoning or knowledge relating 
to subject matter that is included in Section 28(e)(3)(A) and (B).\93\ 
Corporate governance research (including corporate governance 
analytics) and corporate governance rating services could be eligible 
if they reflect the expression of reasoning or knowledge relating to 
the subject matter of the statute (for example, if they provide reports 
and analyses about issuers, which can have a bearing on the companies' 
performance outlook).\94\
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    \91\ The content may be original research or a synthesis, 
analysis, or compilation of the research of others.
    \92\ As discussed below, travel and related expenses (e.g., 
meals and entertainment) associated with arranging trips to meet 
corporate executives or to attend seminars or conferences are not 
eligible under the safe harbor. 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)).
    \93\ 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'').
    \94\ This paragraph incorporates responses to commenters' 
requests to clarify the eligibility of the following: discussions 
with analysts (T. Rowe Price); meetings with corporate executives 
(Murphy; T. Rowe Price); and corporate governance research, 
corporate governance research analytics, and corporate governance 
rating services (GMI; ISS).
---------------------------------------------------------------------------

    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 
is 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 are not eligible if the advice 
relates to the managers' internal management or operations.
1. Mass-Marketed Publications
    The Proposing Release sought comment on whether the Commission 
should provide further guidance regarding mass-marketed publications. 
More than half of the commenters who discussed this issue indicated 
that mass-marketed publications were readily distinguishable from 
traditional research products and should be excluded from the safe 
harbor on that basis.\95\ Other commenters believed that mass-marketed 
publications should be subjected to the same eligibility criteria as 
other forms of research.\96\
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    \95\ Bloomberg; CFA/FD; George 2; ICI; IDC; Merrill Lynch; SIA; 
T. Rowe Price. Two other commenters seemed to believe that certain 
mass-marketed publications should be included and others excluded. 
Charles River; ISITC.
    \96\ ABA; CFA Institute; Commission Direct; Dow Jones; Reuters; 
Seward & Kissel. Commission Direct questioned whether, as a 
practical matter, managers will pay for mass-marketed publications 
under Section 28(e), noting that money managers that provide to 
clients a list of services paid for with commissions ``will be very 
reluctant to identify ubiquitous newspapers or journals.''
---------------------------------------------------------------------------

    The congressional hearings on the 1975 Amendments and 
contemporaneous statements support the view that ``research services'' 
intended to be covered by the safe harbor are the types that broker-
dealers had historically provided to money managers during the era of 
fixed commissions--exemplified by research reports produced by Wall 
Street brokerage firms--rather than newspapers, magazines, and other 
periodical publications that are in general circulation to the retail 
public.\97\ Accordingly, we believe that Section 28(e) should not 
protect the money manager's purchase of publications that are mass-
marketed. Mass-marketed publications are those publications that are 
intended for and marketed to a broad, public audience. Indicia of these 
mass-marketed publications include, among other things, that they are 
circulated to a wide audience, intended for and marketed to the public, 
rather than intended to serve the specialized interests of a small 
readership, and have low cost. These mass-marketed publications are 
more appropriately considered as overhead expenses of money 
managers.\98\
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    \97\ S. 249 Hearings, at 201-205 (Statement of Ray Garrett, Jr., 
Chairman, U.S. Securities and Exchange Commission). See also S. 249 
Hearings, at 330-31 (Combined statement of Baker, Weeks & Co., Inc., 
Donaldson, Lufkin & Jenrette Sec. Corp., Mitchell, Hutchins Inc., 
and Oppenheimer & Co.) (legislation is necessary to protect 
professional fiduciary's access to broker-generated research.); 
Harvey E. Bines, The Law of Investment Management 9-56 (1978); 
Richard L. Teberg and Mary B. Cane, Paying Up for Research, 115 
Trusts & Estates 62 (January 1976) (``[T]he Wall Street Journal or 
Fortune * * * [and other] services, of course, are clearly not 
within the congressional purposes of Section 28(e) since they do not 
relate to the research or execution function.''); A.A. Sommer, Jr., 
A Glance at the Past, a Probe of the Future, Address at the Mid-
Continental District of the Securities Industry Association (Mar. 
18, 1976) (``There continues to be the problem of how the good 
research capacity of Wall Street can be compensated and preserved * 
* * .''); James F. Jorden, Paying Up for Research: A Regulatory and 
Legislative Analysis, 1975 Duke L.J. 1103, 1123-24 (1975) (``[A] 
prudent adviser * * * cannot use brokerage to purchase * * * a 
subscription to the Wall Street Journal.''). Speaking just weeks 
before the safe harbor legislation was signed into law, Commissioner 
Sommer stated: ``Already we are being asked questions about what can 
properly be deemed research for which business may be allocated or 
commissions paid * * * .[F]rankly I don't think a conscientious, 
scrupulous professional needs us to tell him that a subscription to 
The Wall Street Journal or Fortune, or legal or accounting services, 
or office furniture, is not the ``research'' which he can lawfully 
buy with his beneficiary's dollars.'' A.A. Sommer, Jr., Have We 
Learned Anything? Address at the Investment Company Institute (May 
14, 1975), in Securities Week, 14 (May 19, 1975).
    \98\ The Commission recognizes that mass-marketed publications 
can play a role in keeping money managers informed about matters 
relevant to the performance of their responsibilities. It is the 
Commission's expectation that money managers may market their 
services and receive advisory fees based on a fundamental level of 
knowledge about the industry, which could include review of these 
mass-marketed publications. Nonetheless, money managers should 
obtain these mass-marketed publications with their own funds, rather 
than have clients pay for them through commissions.
---------------------------------------------------------------------------

    Our conclusion that the safe harbor of Section 28(e) should not 
include mass-marketed publications does not affect the eligibility of 
certain other publications that qualify as ``research'' under the 
guidance above. Indicia of publications that are not mass-marketed and 
could be eligible research under the safe harbor include, among other 
things, that they are marketed to a narrow audience, directed to 
readers with specialized interests in particular industries, products, 
or issuers, and have high cost. For example, financial newsletters and 
other financial and economic publications that are not targeted to a 
wide, public audience may be eligible research under the safe harbor. 
Trade magazines and technical journals concerning specific industries 
(e.g., nano-technology) or product lines (e.g., medical devices) are 
eligible as research under Section 28(e) if they are marketed to, and 
intended to serve the interests of a narrow audience (e.g., 
physicians), rather than the general public.
    The method of distribution of a publication does not determine 
whether it is mass-marketed. Thus, whether a publication is distributed 
in paper or electronically does not determine the availability of the 
safe harbor. Moreover, it is the focus of the marketing and not the 
availability of the publication that is an important criterion for 
determining the applicability of the safe harbor. Even if a publication 
that is marketed to a narrow audience, such as investment 
professionals, can be accessed over the internet by the general 
population, this does not alter its eligibility as research

[[Page 41987]]

under Section 28(e). The purpose of such publications is to reach a 
small audience and to serve the specialized interests of a narrow 
group. Accordingly, if these publications otherwise meet the 
eligibility criteria for research (that is, they contain the expression 
of reasoning or knowledge related to the statutory subject matter), 
money managers can use client commissions to pay for them under Section 
28(e).
2. Inherently Tangible Products and Services
    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 do not constitute eligible ``research services.'' \99\ For 
example, expenses for travel, entertainment, and meals associated with 
attending seminars, and travel and related expenses associated with 
arranging trips to meet corporate executives, analysts, or other 
individuals who may provide eligible research orally are not eligible 
under the safe harbor. Similarly, office equipment, office furniture 
and business supplies, salaries (including research staff), rent, 
accounting fees and software, Web site design, e-mail software, 
Internet service, legal expenses, personnel management, marketing, 
utilities, membership dues (including initial and maintenance fees paid 
on behalf of the money manager or any of its employees to any 
organization or representative or lobbying group or firm), professional 
licensing fees, and software to assist with administrative functions 
such as managing back-office functions, operating systems, word 
processing, and equipment maintenance and repair services are examples 
of other overhead items that do not meet the statutory criteria for 
research set forth in this release and are not eligible under the safe 
harbor.\100\
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    \99\ See 1986 Release, 51 FR at 16006-07.
    \100\ According to the 1998 OCIE Report, advisers used client 
commissions to pay for many of these items. See notes 70-74 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, including computer terminals,\101\ and computer 
accessories, while they may assist in the delivery of research, are not 
eligible ``research services'' because they do not reflect substantive 
content related in any way to making decisions about investing.\102\ 
Similarly, the peripherals and delivery mechanisms associated with 
computer hardware or associated with the oral delivery of research, 
including telecommunications lines, transatlantic cables, and computer 
cables, are outside the ``research services'' safe harbor.\103\
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    \101\ The Proposing Release asked how investors, money managers, 
broker-dealers, and others would be affected by the Commission's 
interpretive guidance that client commissions cannot be used to 
obtain computer equipment as research under Section 28(e). See 
Proposing Release, Question 2. Commenters either expressly supported 
the proposal to exclude computer equipment from the safe harbor 
(Bloomberg; Commission Direct; E*Trade; IMA; Merrill; Reuters) or 
indicated that this position would have minimal impact to industry 
participants (Charles River; George 2). Four commenters sought 
clarification about whether computer terminals dedicated to the 
transmission of particular research products are eligible. IMA; 
Mellon; NCS; STA. For the reasons explained in this Release, we do 
not believe that any computer terminals are eligible ``research'' 
under Section 28(e).
    \102\ 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.
    \103\ As indicated above, the products or services delivered 
over computer terminals and T-1 lines may be eligible if they 
satisfy the criteria set forth in this Release.
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3. Market Research
    Based on the comments we received in response to the Proposing 
Release, we believe that technology now permits managers to obtain 
research related to the market for securities from many sources and 
products, and through many delivery mechanisms, including order 
management systems (``OMS'') and trade analytical software.\104\ In 
many instances, this ``market research'' is the type of research report 
and advice historically provided directly by broker-dealers, such as 
advice on market color and execution strategies. Therefore, we believe 
that it is appropriate to clarify that ``advice,'' ``analyses,'' and 
``reports'' regarding the market for securities--or ``market 
research''--may be eligible under the safe harbor if they otherwise 
satisfy the standards for ``research.'' For example, market research 
that may be eligible under Section 28(e) can include pre-trade and 
post-trade analytics, software, and other products that depend on 
market information to generate market research, including research on 
optimal execution venues and trading strategies.\105\ In addition, 
advice from broker-dealers on order execution, including advice on 
execution strategies, market color, and the availability of buyers and 
sellers (and software that provides these types of market research) may 
be eligible ``research'' under the safe harbor.
---------------------------------------------------------------------------

    \104\ Twenty-one commenters to the Proposing Release indicated 
that OMS should be eligible under the safe harbor as brokerage or 
research. AmBankers; ASIR 1; BNY; CAPIS; Charles River; Eze Castle; 
IAA; ICI; IMA; Interstate; ISITC; ITG; Mellon; Merrill; Morgan 
Stanley; NSCP; Rainier; SIA; STA; UBS; Ward & Smith. Of these, 
fourteen commenters proposed that OMS should be eligible either as 
research services (if the Commission determined that they could not 
be appropriately analyzed as eligible brokerage) (CAPIS; Eze Castle; 
IAA; ICI; Interstate; ISITC; ITG; NSCP; Rainier) or as 
undifferentiated ``brokerage and research services'' (ASIR 1; BNY 1; 
Mellon; SIA; Ward & Smith).
    \105\ If these products and services also contain functionality 
that is not eligible brokerage or research under the safe harbor, or 
if the products and services are eligible brokerage or research but 
the money manager does not use them in a way that provides lawful 
and appropriate assistance in investment decision-making, they may 
be mixed-use items. See infra note 125.
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4. Data
    The Proposing Release proposed that data services, including market 
data, would be eligible under the safe harbor if the data reflected 
substantive content related to the subject matter categories identified 
in Section 28(e). Based on the comments received on this issue 
regarding the content and use of these products, we believe that the 
analysis regarding data set forth in the Proposing Release is 
appropriate.\106\ In our view, this approach will promote innovation by 
money managers who use raw data to create their own research analytics, 
thereby leveling the playing field with those money managers who buy 
finished research, which incorporates raw data, from others. 
Additionally, we believe that excluding market data from the safe 
harbor could become meaningless if it encouraged purveyors of this 
information to simply add some minimal or inconsequential

[[Page 41988]]

functionality to the data to bring it within the safe harbor.
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    \106\ Eight commenters expressed views about market data. ASIR 
1; CFA/FD; CFA Institute; IDC; IMA; Reuters; T. Rowe Price. Of 
these, four commenters advocated that data should be excluded from 
the safe harbor as overhead. CFA/FD; IDC; T. Rowe Price. An equal 
number supported the proposal to include market data in the safe 
harbor as research or as brokerage. ASIR 1; CFA Institute; IMA; 
Reuters. A ninth commenter, the SIA, implicitly endorsed the 
inclusion of market data in the safe harbor by describing market 
data as part of order management systems that should be eligible 
under Section 28(e).
---------------------------------------------------------------------------

    Accordingly, 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 and provide 
lawful and appropriate assistance in the investment decision-making 
process. 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.'' \107\ 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), we 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),\108\ and thus are eligible as ``research 
services'' under the safe harbor.\109\ Other data are 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) are eligible as research under 
Section 28(e).
---------------------------------------------------------------------------

    \107\ 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.
    \108\ 15 U.S.C. 78bb(e)(3)(B).
    \109\ 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).
---------------------------------------------------------------------------

5. Proxy Services
    The Proposing Release requested information regarding industry 
practice with respect to proxy services (which include research and 
voting products and services provided by ``proxy service'' providers). 
The commenters that responded to this issue expressed the view that 
proxy services should qualify under the safe harbor depending on how 
they are used, and should be subject to the mixed-use criteria.\110\ 
These commenters believe that certain proxy services should qualify as 
eligible research because they provide information and analysis that 
money managers consider when they determine the advisability of 
investing in, or retaining a position in, a security. Some of these 
commenters went further by suggesting that proxy research services used 
by managers in deciding how to vote proxies should also be eligible 
research under the safe harbor.\111\ All the commenters on this issue 
recognize that proxy services may serve administrative or other non-
research purposes as well. For example, these services may assist in 
receiving ballots, voting, returning ballots, and reporting on the 
votes cast.
---------------------------------------------------------------------------

    \110\ ASIR 1; BNY 1; IAA; ICI; ISS; Mellon; Seward & Kissel.
    \111\ BNY 1; ICI; ISS; Mellon; Seward & Kissel.
---------------------------------------------------------------------------

    As discussed above, in order for an eligible research product or 
service to be within Section 28(e), it must provide the money manager 
with lawful and appropriate assistance in making investment decisions. 
This standard focuses on how the manager uses eligible research. It is 
possible that managers could determine after a careful analysis that 
certain proxy products that contain reports and analyses on issuers, 
securities, and the advisability of investing in securities may be 
eligible research that may provide managers with lawful and appropriate 
assistance in investment decision-making. In contrast, we do not 
believe that eligible research that assists a manager in deciding how 
to vote proxy ballots provides the manager lawful and appropriate 
assistance in making decisions about investments for his clients.
    In view of these comments, we believe that proxy services may be 
treated as mixed-use items, as appropriate.\112\ Proxy service 
providers offer a range of products, some of which may satisfy the 
standards set forth in this Release for eligible ``research'' under the 
safe harbor. For example, reports and analyses on issuers, securities, 
and the advisability of investing in securities that are transmitted 
through a proxy service may be within Section 28(e).\113\ In contrast, 
we believe that products or services offered by a proxy service 
provider that handle the mechanical aspects of voting, such as casting, 
counting, recording, and reporting votes, are administrative overhead 
expenses of the manager and are not eligible under Section 28(e).
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    \112\ See Section III.F below for a discussion of mixed-use 
items.
    \113\ Proxy services may also provide corporate governance 
research and corporate governance rating services. As discussed 
above, these products and services may be eligible research under 
Section 28(e) to the extent that they are used for investment 
decision-making but not in connection with voting.
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D. Eligibility Criteria for ``Brokerage'' Under Section 28(e)(3)

    We recognize that to the extent that this interpretive release 
narrows 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.\114\ 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
---------------------------------------------------------------------------

    \114\ 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.

[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.\115\
---------------------------------------------------------------------------

    \115\ 1998 OCIE Report, at 35-36, 50.

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.
    The Proposing Release discussed a ``temporal'' standard to 
distinguish between brokerage services that are related to the 
execution of securities transactions, which are eligible as brokerage 
under the safe harbor, and those that are overhead expenses, which are 
not. Twenty-seven commenters believe that the safe harbor should 
include certain products and services as eligible ``brokerage.'' \116\ 
Many of these commenters advocated expanding the temporal standard on 
the front end to include pre-trade analytics \117\ and

[[Page 41989]]

OMS,\118\ and others suggested expanding it on the back end to include 
long-term custody.\119\ We considered these comments and for the 
reasons discussed below, we do not believe that all of the products and 
services identified by commenters fit within the proposed temporal 
standard, which we believe reflects an appropriate interpretation of 
the scope of ``brokerage'' services under Section 28(e). As clarified 
above, we have determined that market research (which includes pre- and 
post-trade analytics, including trade analytics transmitted through 
OMS) may be eligible research under the safe harbor. In addition, as 
explained below, we believe that Section 28(e) covers short-term 
custody, but not long-term custody. Also as explained, certain 
functionality provided through OMS may be eligible brokerage or 
research.
---------------------------------------------------------------------------

    \116\ ABA; ASIR 1; Bloomberg; BNY 1; Charles River; E*Trade; Eze 
Castle; Fidelity; George 2; ICI; IMA; ISITC; Interstate Group; ITG; 
Mellon; Merrill; MFA; Morgan Stanley; NSCP; Rainier; Reuters; Seward 
& Kissel; SIA; STA; T. Rowe Price; UBS; Ward & Smith. Only two 
commenters stated that the proposed brokerage standard was 
overbroad. CFA/FD.
    \117\ Bloomberg; E*Trade; George 2; IMA; Interstate Group; ITG; 
Mellon; MFA; Morgan Stanley; NSCP; Reuters; SIA; STA; UBS. In 
addition, Fidelity questioned whether the Commission should exclude 
all pre-trade services.
    \118\ ASIR 1; BNY 1; Charles River; Eze Castle; ICI; IMA; 
Interstate Group; ISITC; ITG; Mellon; Morgan Stanley; NSCP; Rainier; 
STA; T. Rowe Price; UBS; Ward & Smith.
    \119\ ASIR 1; Merrill; Morgan Stanley; NSCP; SIA; STA. 
Commenters also suggested that the safe harbor should include the 
following products and services as eligible brokerage: advice on 
market color (ABA; BNY 1; ITG; Merrill; Seward & Kissel; SIA; UBS) 
and indications of interest (ABA; Merrill; SIA; UBS); capital 
commitment (BNY 1; SIA; UBS); and prime brokerage services 
(including extending stock loans and margin) (UBS).
---------------------------------------------------------------------------

    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.\120\
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    \120\ 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 
SRO rules. Clearance, settlement, and custody 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 of trade information; other exchanges 
of messages among broker-dealers, custodians, and institutions related 
to the trade; electronic communication of allocation instructions 
between institutions and broker-dealers; routing settlement 
instructions to custodian banks and broker-dealers' clearing agents; 
and short-term custody related to effecting particular transactions in 
relation to clearance and settlement of the trade. Similarly, 
comparison 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.\121\
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    \121\ 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).
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1. Temporal Standard
    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.\122\ 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 or trade analytical 
software that relates to the subject matter of the statute before an 
order is transmitted may fall within the research portion of the safe 
harbor, but not the brokerage portion of the safe harbor.\123\
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    \122\ 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'').
    \123\ See supra text accompanying notes 104-105 for discussion 
of market research that may be eligible under Section 28(e).
---------------------------------------------------------------------------

    Under this temporal standard, communications services related to 
the execution, clearing, and settlement of securities transactions and 
other functions incidental to effecting securities transactions, 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 used to route orders to market centers, 
software that provides algorithmic trading strategies, and software 
used to transmit orders to direct market access (``DMA'') systems are 
within the temporal standard and thus are eligible ``brokerage'' under 
the safe harbor.\124\
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    \124\ 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.
    We understand that OMS may include trading software used to 
route orders, provide algorithmic trading strategies, or transmit 
orders to DMA systems or provide connectivity to this software. 
Accordingly, these aspects of the OMS may be eligible brokerage.
---------------------------------------------------------------------------

2. Ineligible Overhead
    On the other hand, hardware, such as telephones or computer 
terminals, including those used in connection with OMS and trading 
software, 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. In 
addition, software functionality used for recordkeeping or 
administrative purposes, such as managing portfolios, and quantitative 
analytical software used to test ``what if'' scenarios related to 
adjusting portfolios, asset allocation, or for portfolio modeling 
(whether or not provided through OMS) do not qualify as ``brokerage'' 
under the safe harbor because they are not integral to the execution of 
orders by the broker-

[[Page 41990]]

dealers, i.e., they fall outside the temporal standard described above. 
Further, managers may not use client commissions under the safe harbor 
to meet their compliance responsibilities,\125\ such as: (i) Performing 
compliance tests that analyze information over time in order to 
identify unusual patterns, including for example, an analysis of the 
quality of brokerage executions (for the purpose of evaluating the 
manager's fulfillment of its duty of best execution), an analysis of 
the portfolio turnover rate (to determine whether portfolio managers 
are overtrading securities), or an analysis of the comparative 
performance of similarly managed accounts (to detect favoritism, 
misallocation of investment opportunities, or other breaches of 
fiduciary responsibilities); (ii) creating trade parameters for 
compliance with regulatory requirements, prospectus disclosure, or 
investment objectives; or (iii) stress-testing a portfolio under a 
variety of market conditions or to monitor style drift. Additionally, 
trade financing, such as stock lending fees, and capital introduction 
and margin services are not within the safe harbor because these 
services are not sufficiently related to order execution.\126\ 
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.\127\ The 
products and services described in this paragraph are properly 
characterized as ``overhead,'' i.e., part of the manager's cost of 
doing business, and are ineligible under Section 28(e).
---------------------------------------------------------------------------

    \125\ For example, to the extent that money managers use trade 
analytics, including trade analytical software to test ``what if'' 
scenarios related to adjusting portfolios, asset allocations, or 
portfolio modeling, or OMS 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 or OMS is a 
mixed-use product, and managers must use their own funds to pay for 
the allocable portion of the cost of the software or OMS that is not 
within the safe harbor because it is attributable to purposes 
outside Section 28(e) such as for internal compliance.
    \126\ Often, advisory clients pay their own trade financing 
costs, which provides transparency that is beneficial to investors 
and does not necessarily implicate Section 28(e).
    \127\ 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).
---------------------------------------------------------------------------

3. Custody
    Several commenters asked the Commission to clarify that custody is 
within the safe harbor,\128\ and several of these commenters advocated 
broadly including long-term custody in Section 28(e), arguing that the 
statute explicitly references custody without limitation.\129\ On its 
face, the plain language of the statute limits the scope of the safe 
harbor to custody that is incidental to effecting securities 
transactions. We believe that short-term custody related to effecting 
particular transactions and clearance and settlement of those trades 
fits squarely within the statute because it is tied to processing the 
trade between the time the order is placed and settlement of the trade. 
In contrast, long-term custody is provided post-settlement and relates 
to long-term maintenance of securities positions. Further, we 
understand that many money managers and their clients consider long-
term custody to be a direct benefit to the advisory client and custody 
fees to be client expenses. In fact, advisory clients, rather than 
money managers, typically enter into contractual arrangements directly 
with custodians for their services, and many advisory clients pay for 
their own long-term custody.\130\ We believe this is a healthy approach 
that provides transparency. Common industry practice is that financial 
firms that do not execute transactions for the client at all (e.g., 
custodian banks) provide this service, which has no relationship to, 
and cannot be considered incidental to, effecting securities 
transactions. Therefore, we believe that custodial services, such as 
long-term custody and custodial recordkeeping, provided in connection 
with accounts after clearance and settlement of transactions, are not 
incidental to effecting securities transactions and are services 
provided to the adviser's client, for the benefit of the client. As 
such, payment for a client's long-term custody and custodial 
recordkeeping with that client's commissions does not implicate Section 
28(e).\131\
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    \128\ ASIR 1; Merrill; Morgan Stanley; NSCP; Schwab; SIA; STA; 
UBS.
    \129\ Merrill; Schwab; SIA. In addition, UBS argued that the 
temporal standard is too narrow because the standard would exclude 
some important services, such as custody, that take place after 
settlement.
    \130\ See, e.g., Phyllis Feinberg, ``Takeaway Game'': Some 
Custody Banks Create 2-Tiered Bidding System For Old, New Clients, 
Pensions and Investments, Dec. 8, 2003, at 1 (discussing services 
and fees custodial banks charge their clients, such as Indiana State 
Teachers' Retirement System or the New Mexico Board of Finance). In 
addition, registered investment companies must disclose the amount 
of fees and expenses paid in connection with custody of investments. 
See Form N-1A, Item 23(g)( Registered investment companies must 
attach custodian agreements and depository contracts concerning the 
fund's securities and similar investments, including the schedule of 
remuneration, as an exhibit to the registration statement.); 
Regulation S-X 210.6-07 (requiring that registered investment 
companies describe in the statement of operations the total amount 
of fees and expenses in connection with custody of investments).
    \131\ In some cases, we understand that advisory clients may pay 
for long-term custodial services through directed brokerage. See 
discussion of directed brokerage, supra note 27.
---------------------------------------------------------------------------

E. Lawful and Appropriate Assistance

    In order for a product or service to be within the safe harbor, 
eligible research 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.\132\ 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 assistance to the money manager in performing his 
investment decision-making responsibilities.\133\
---------------------------------------------------------------------------

    \132\ See 1998 OCIE Report, at 20.
    \133\ 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.F.
---------------------------------------------------------------------------

    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.

F. ``Mixed-Use'' Items

    As discussed above, the 1986 Release introduced the concept of 
``mixed use.'' \134\ Where a product or service obtained with client 
commissions has a mixed use, a money manager faces an additional 
conflict of interest in obtaining that product with client 
commissions.\135\ The 1986 Release

[[Page 41991]]

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 so as to be able to make the 
required good faith determination.\136\ Moreover, the allocation 
determination itself poses a conflict of interest for the money manager 
that should be disclosed to the client.\137\ It appears that, in 
practice, some managers may have made questionable mixed-use 
allocations and failed to document the bases for their allocation 
decisions.\138\ 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.\139\ The Proposing Release asked whether the Commission 
should provide additional guidance on the allocation and documentation 
of mixed-use items.\140\
---------------------------------------------------------------------------

    \134\ See 1986 Release, 51 FR at 16007.
    \135\ Id. at 16006-07.
    \136\ Id.
    \137\ Id. at 16006 n.13.
    \138\ 1998 OCIE Report, at 32-34.
    \139\ Id.
    \140\ See Proposing Release, Question 8.
---------------------------------------------------------------------------

    Twenty-seven commenters submitted comments that touched upon the 
concept of mixed use.\141\ Most of those commenters endorsed the mixed-
use concept by recommending that the Commission consider particular 
products as mixed-use items.\142\ For example, commenters indicated 
that the following products and services may be mixed-use products: 
trade analytical software (which may sometimes be put to administrative 
use); \143\ proxy voting services; \144\ and OMS.\145\
---------------------------------------------------------------------------

    \141\ AmBankers; Bloomberg; BNY 1; CAPIS; CFA Institute; DOL; 
E*Trade; IAA; ICI; IMA; Interstate Group; ISITC; ISS; ITG; Mellon; 
Merrill; MFA; Morgan Stanley; NSCP; Rainier; Schwab; Seward & 
Kissel; SIA; STA; T. Rowe Price; UBS; Ward & Smith.
    \142\ Bloomberg; BNY 1; CAPIS; CFA Institute; DOL; E*Trade; IAA; 
ICI; IMA; Interstate Group; ISITC; ISS; ITG; Mellon; Merrill; 
Rainier; Seward & Kissel; SIA; T. Rowe Price. The remaining eight 
commenters endorsed the concept of mixed use with little discussion. 
AmBankers; MFA; Morgan Stanley; NSCP; Schwab; STA; UBS; Ward & 
Smith.
    \143\ Bloomberg; E*Trade; IAA; Merrill; SIA.
    \144\ ASIR 1; BNY 1; IAA; ICI; ISS; Mellon; Seward & Kissel.
    \145\ BNY 1; CAPIS; IAA; ICI; IMA; Interstate Group; ISITC; ITG; 
Mellon; Merrill; Morgan Stanley; Rainier; SIA; T. Rowe Price.
---------------------------------------------------------------------------

    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: 
\146\ ``The money manager must keep adequate books and records 
concerning allocations so as to be able to make the required good faith 
showing.'' \147\ 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.\148\
---------------------------------------------------------------------------

    \146\ As noted above, this interpretation replaces Sections II 
and III of the 1986 Release.
    \147\ 1986 Release, 51 FR at 16006. The Commission may further 
address the documentation of mixed-use items at a later time.
    \148\ In allocating costs for a particular product or service, a 
money manager should make a good faith, fact-based analysis of how 
it and its employees use the product or service. It may be 
reasonable for the money manager to infer relative costs from 
relative benefits to the firm or its clients. Relevant factors might 
include, for example, the amount of time the product or service is 
used for eligible purposes versus non-eligible purposes, the 
relative utility (measured by objective metrics) to the firm of the 
eligible versus non-eligible uses, and the extent to which the 
product is redundant with other products employed by the firm for 
the same purpose.
---------------------------------------------------------------------------

G. 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.\149\ None of the commenters 
questioned the good faith determination requirement under the safe 
harbor. 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.\150\
---------------------------------------------------------------------------

    \149\ 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 6.
    \150\ 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 investment 
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.\151\ 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 or client referrals.\152\ 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 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. Finally, where a 
broker-dealer also offers its research for an unbundled price, that 
price should inform the money manager as to its market value

[[Page 41992]]

and help the manager make its good faith determination.
---------------------------------------------------------------------------

    \151\ If the money manager seeks the protection of the safe 
harbor, he or she should take care to analyze whether products and 
services provided by a broker-dealer and used in connection with 
advised accounts satisfy the eligibility and use standards for the 
safe harbor.
    \152\ Rule 12b-1(h) under the Investment Company Act prohibits 
funds from using brokerage to pay for distribution. See Investment 
Company Act Release No. 26591 (Sept. 2, 2004), 69 FR 54728 (Sept. 9, 
2004).
---------------------------------------------------------------------------

H. Third-Party Research

    The Proposing Release asked whether the Commission's discussion of 
third-party research offered sufficient guidance in this area.\153\ 
Regarding third-party research, several commenters expressly endorsed 
the Commission's view that independent research providers should be 
accorded equal treatment with proprietary research providers.\154\ None 
of the commenters disputed this point. Accordingly, we reiterate our 
views on this issue below.
---------------------------------------------------------------------------

    \153\ See Proposing Release, Question 5.
    \154\ AmBankers; Bloomberg; BNY 1; Investorside.
---------------------------------------------------------------------------

    Third-party research arrangements can benefit advised accounts by 
providing greater breadth and depth of research. First, these 
arrangements can provide money managers with the ability to choose from 
a broad array of independent research products and services. Second, 
the manager can use third-party arrangements to obtain specialized 
research that is particularly beneficial to the advised accounts. We 
believe that the safe harbor encompasses third-party research and 
proprietary research on equal terms.

I. Client Commission Arrangements Under Section 28(e)

    The Proposing Release asked whether the Commission's discussion of 
arrangements under Section 28(e) offered sufficient guidance in this 
area.\155\ We received a substantial number of comments on industry 
practices related to client commission arrangements under Section 
28(e).\156\ Based on these comments and for the reasons discussed 
below, we are modifying our interpretation of ``provided by'' and 
``effecting'' under Section 28(e).\157\ In order to determine whether 
our guidance requires further clarification, we are soliciting 
additional comment on our revised interpretation of the safe harbor 
with respect to client commission arrangements under Section 28(e).
---------------------------------------------------------------------------

    \155\ See Proposing Release, Question 5.
    \156\ BNY 1; Bloomberg; CL King; Commission Direct; CAPIS; 
E*Trade; EuroIRP; Instinet; Interstate Group; IAA; ICI; IMA; JP 
Morgan 1 and JP Morgan 2; Mellon; Merrill; Morgan Stanley; NSCP; 
Reuters; Riedel; SIA; STA; T. Rowe Price; UBS; George 1, George 2, 
and George 3.
    \157\ 157 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).
---------------------------------------------------------------------------

    Twenty-four commenters addressed arrangements under Section 
28(e).\158\ Although some commenters supported the Commission's 
guidance with respect to Section 28(e) arrangements,\159\ others 
expressed concern that the proposal (and, in particular, the 
requirement that introducing broker-dealers must perform certain 
minimum functions in order to ``provide'' research under the safe 
harbor) could have unwarranted and harmful policy consequences, such as 
reducing independent research and increasing the costs that the clients 
of money managers pay for brokerage and research.\160\ Some of the 
commenters that objected to the proposed approach on this issue stated 
that some introducing broker-dealers that facilitate access to valuable 
research may not satisfy the minimum requirements that the Release 
would impose, and may have to discontinue operations. They recommended 
that the Commission eliminate the minimum requirements or modify them 
so that introducing broker-dealers can more easily satisfy them. In 
addition, several commenters asked the Commission to consider a broader 
interpretation of the ``provided by'' concept under Section 28(e).\161\ 
These commenters argued that Section 28(e) arrangements have become 
more complex and less transparent than if broker-dealers were permitted 
to engage in these arrangements unencumbered by the requirement that 
the broker ``effecting'' the transaction also must be ``providing'' the 
research. Both groups of commenters recommended that the Commission 
interpret Section 28(e) to allow money managers the maximum flexibility 
to seek best execution and, separately, obtain good research, by 
permitting a broker to be responsible for execution and another party 
to be responsible for providing eligible research.
---------------------------------------------------------------------------

    \158\ BNY 1; Bloomberg; CL King; Commission Direct; CAPIS; 
E*Trade; EuroIRP; Instinet; Interstate Group; IAA; ICI; IMA; JP 
Morgan 1 and JP Morgan 2; Mellon; Merrill; Morgan Stanley; NSCP; 
Reuters; Riedel; SIA; STA; T. Rowe Price; UBS; George 1, George 2, 
and George 3.
    \159\ BNY 1; George 2; Interstate; Reuters.
    \160\ Bloomberg; CAPIS; E*Trade; EuroIRP; ICI; Instinet; IMA; 
NSCP; JP Morgan 1; Riedel; STA; SIA; Merrill; Morgan Stanley. These 
commenters noted that investors' costs could increase if introducing 
broker-dealers must add staff and/or trading desks to fulfill the 
minimum requirements and raise their fees accordingly. Implicit 
transaction costs could also increase if these broker-dealers build 
trade execution capabilities so that they satisfy the four minimum 
criteria but are inexpert at execution.
    \161\ Commission Direct; EuroIRP; IMA; T. Rowe Price.
---------------------------------------------------------------------------

    In addition, several commenters noted that the United Kingdom's 
regulatory efforts in this area allow money managers to use client 
commissions to pay separately for trade execution by the broker-dealer 
that can provide the best execution and ask the executing broker-dealer 
to allocate a portion of the commission directly to an independent 
research provider or allocate a portion of the commission to a pool of 
``credits'' maintained by the broker-dealer and from which the broker-
dealer, at the direction of the money manager, may pay independent 
research providers, without requiring that the executing broker-dealer 
be legally responsible for the research.\162\ As noted above, some 
commenters believed that Section 28(e) arrangements in the United 
States reflect a market inefficiency if the manager seeks to use client 
commissions to pay for research under Section 28(e) and uses this 
middle-man to access independent research providers.
---------------------------------------------------------------------------

    \162\ Commission Direct; EroIRP; IMA; JP Morgan 1. In addition 
the SIA expressed concern over cross-border harmonization, noting 
that the Commission's four minimum functions for introducing broker-
dealers may impose stricter requirements than those in place in the 
U.K. with respect to client commission arrangements.
---------------------------------------------------------------------------

    These comments highlight the considerable variety of arrangements 
under Section 28(e) that the industry has developed to seek to obtain 
the benefits that inure to investors from best execution on orders for 
advised accounts and providing money managers with both third-party and 
proprietary brokerage and research products and services of value to 
the advised accounts. Based on the additional information regarding 
current industry practices provided by these comments and consideration 
of congressional intent behind Section 28(e), we are revising our 
interpretation of the safe harbor to address the industry's innovative 
Section 28(e) arrangements and permit the industry to flexibly 
structure arrangements that are consistent with the statute and best 
serve investors. We are soliciting additional comment on client 
commission arrangements under the safe harbor because of the many 
variations and complexity of these arrangements. In particular, we 
solicit comment on whether this guidance is sufficient to address this 
area.

[[Page 41993]]

1. Statutory Linkage Between ``Provided by'' and ``Effecting''
    Section 28(e) requires that the broker-dealer providing the 
research also be involved in effecting the trade.\163\ The statutory 
linkage of the ``provided by'' and ``effecting'' elements in Section 
28(e) was principally intended to preclude the practice of paying 
``give-ups.'' \164\ 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.\165\ A principal concern regarding ``give-ups'' was that 
managers used them to direct client commissions to broker-dealers in 
exchange for providing services that benefited the money manager but 
had no benefit for his clients--such as to reward broker-dealers for 
distribution or for steering clients to the manager. 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 on client accounts and because the broker-dealer 
receiving the ``give-up'' did nothing in connection with the securities 
trade to benefit investors, the Commission found that these 
arrangements violated the securities laws.\166\ 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.\167\ 
In the 1986 Release, the Commission departed from a strict 
interpretation of the ``provided by'' provision when it concluded 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).\168\ We believe that both the legislative history and 
the Commission's prior interpretations in this area reflect an effort 
to safeguard against money managers and broker-dealers using Section 
28(e) arrangements as mechanisms for the manager to use client 
commissions to make concealed payments to a broker-dealer that did not 
provide any services to benefit the advised accounts.
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    \163\ 15 U.S.C. 78bb(e).
    \164\ 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 Act Amendments of 
1975, H.R. Conf. Rep. No. 94-229, at 108 (1975), reprinted in 1975 
U.S.C.C.A.N. 321, 339.
    \165\ 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.
    \166\ 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).
    \167\ 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. See also 1986 
Release, 51 FR at 16007; 1976 Release, 41 FR at 13679.
    \168\ 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 13678-79 (Where ``fudiciaries * * * [ask] the broker, retained 
to effect a transaction for the account of a beneficiary, to ``give 
up'' part of the commission negotiated by the broker and the 
fiduciary to another broker designated by the fiduciary for whom the 
executing or clearing broker is not a normal and legitimate 
correspondent[,] * * * [t]he Commission does not believe that 
Section 28(e) would apply.''
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    As noted above, the industry has developed many types of Section 
28(e) arrangements. Some investment managers today use these 
arrangements to execute trades with one broker-dealer and obtain 
research and other services from a different broker-dealer. In some 
Section 28(e) 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 arrangements, an introducing broker-dealer 
facilitates access to research 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 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.\169\ In addition, several commenters 
endorsed arrangements similar to those that have developed in the 
United Kingdom, in which money managers direct broker-dealers to 
collect and pool client commissions that may have been generated from 
orders executed at that broker-dealer, and periodically direct the 
broker-dealer to pay for research that the money manager has determined 
is valuable.\170\
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    \169\ 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.
    \170\ Commission Direct; EuroIRP; IMA; JP Morgan 1; T. Rowe 
Price.
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    As discussed above, the legislative history behind the linkage 
created between the ``provided by'' and ``effecting'' statutory 
language in Section 28(e) indicates that Congress was concerned that 
the safe harbor ``would be asserted as a shield behind which the give-
ups and reciprocal practices which were so notorious during the late 
1960's could be reinstituted.'' \171\ Since passage of the safe harbor 
in the 1970's, specialization and innovation in the financial industry 
have resulted in the functional separation of execution and research. 
Thus, efficient execution venues provide good, low-cost execution while 
research providers offer valuable research ideas that can benefit 
managed accounts. We believe that this separation of functions is 
beneficial to the money managers' clients, and Section 28(e) 
arrangements that promote functional allocation of these services are 
not the same as ``give-ups.''
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    \171\ Joint Explanatory Statement of the Committee of 
Conference, Securities Acts Amendments of 1975, H.R. Conf. Rep. 94-
229, at 108 (1975), reprinted in 1975 U.S.C.C.A.N. 321, 339.
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2. ``Effecting'' Transactions
    Section 28(e) arrangements typically involve clearing agreements 
pursuant to

[[Page 41994]]

SRO rules.\172\ 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).\173\ The Commission has stated that, under 
Section 28(e), it contemplates that in correspondent relationships, an 
``introducing broker-dealer would be engaged in securities activities 
of a more extensive nature than merely the receipt of commissions paid 
to [them] by other broker-dealers for `research services' provided to 
money managers.'' \174\ The Proposing Release identified four minimum 
criteria that an introducing broker-dealer must satisfy in order to be 
``effecting'' transactions.
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    \172\ 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)).
    \173\ 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).
    \174\ 1986 Release, 51 FR at 16007, quoting Data Exchange 
Securities, No-Action Letter (Apr. 20, 1981).
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    Based on the comments received, which are discussed above, we 
recognize the benefit to investors of money managers being able to 
functionally separate trade execution from access to valuable research. 
At the same time, we believe that the statutory term ``effecting'' 
requires that, in order for the money manager to use the safe harbor, a 
broker-dealer that is ``effecting'' the trade must perform at least one 
of four minimum functions and take steps to see that the other 
functions have been reasonably allocated to one or another of the 
broker-dealers in the arrangement in a manner that is fully consistent 
with their obligations under SRO and Commission rules.\175\ The four 
functions are: (1) Taking financial responsibility for all customer 
trades until the clearing broker-dealer has received payment (or 
securities), i.e., one of the broker-dealers in the arrangement must be 
at risk for the customer's failure to pay; (2) making and/or 
maintaining records relating to customer trades required by Commission 
and SRO rules, including blotters and memoranda of orders; (3) 
monitoring and responding to customer comments concerning the trading 
process; and (4) generally monitoring trades and settlements.\176\ In 
addition, of course, a broker-dealer is effecting securities 
transactions if it is executing, clearing, or settling the trade.
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    \175\ 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 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. No. 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., 
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).
    \176\ See 1986 Release, 51 FR at 16007, citing SEI Financial 
Services Co., No-Action Letter (Dec. 15, 1983), in which the 
introducing broker in a correspondent relationship performed these 
functions.
    In particular, one of the broker-dealers to the Section 28(e) 
arrangement must be aware of and monitor daily trading activity of 
customers even where the money manager sends orders directly to (and 
only to) the clearing broker.
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3. Research Services Must Be ``Provided by'' the Broker-Dealer
    Section 28(e) requires that the broker-dealer receiving commissions 
for ``effecting'' transactions must ``provide'' the 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'').\177\ 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.\178\ In addition, the Commission has stated 
that the third party also may send the research directly to the broker-
dealer's customer.\179\ In the Proposing Release, the Commission 
restated its previous view that the broker-dealer must have the legal 
obligation to pay for the research in order to be considered 
``providing'' the brokerage and research services under Section 
28(e).\180\ We continue to believe that a broker-dealer that is legally 
obligated to pay for research is ``providing'' research under the safe 
harbor. In addition, as stated above, based on the legislative history 
of Section 28(e), the comments received in response to the Proposing 
Release, and the benefits to investors of flexibility in these 
arrangements, we are modifying our interpretation of ``provided by.'' 
\181\
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    \177\ 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'').
    \178\ 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.
    \179\ Papilsky Release, 45 FR at 83714 n.54. See 1986 Release, 
51 FR at 16007.
    \180\ See 1986 Release, 51 FR at 16007; III Report, 19 SEC 
Docket at 932.
    \181\ As noted above, this Release replaces Sections II and III 
of the 1986 Release, which include the ``provided by'' 
interpretation. See text accompanying note 68.
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    We believe that the safe harbor was not meant to allow money 
managers to use Section 28(e) arrangements to conceal the payment of 
client commissions to intermediaries (including broker-dealers) that 
provide benefits only to the money manager. In particular, we interpret 
Section 28(e) to be available as a safe harbor for the money manager in 
situations where broker-dealers use a money manager's client 
commissions to pay for eligible research and brokerage for which such 
broker-dealer is not directly obligated to pay if such broker-dealer 
pays the research preparer directly and takes steps to assure itself 
that the client commissions that the manager directs it to use to pay 
for such services are used only for eligible brokerage and research. 
Accordingly, for purposes of Section 28(e), we believe that the 
following attributes will help determine whether the broker-dealer that 
is effecting transactions for the advised accounts has satisfied the 
``provided by'' element, and the Section 28(e) safe harbor is

[[Page 41995]]

available to a money manager: \182\ (i) the broker-dealer pays the 
research preparer directly; (ii) the broker-dealer reviews the 
description of the services to be paid for with client commissions 
under the safe harbor for red flags that indicate the services are not 
within Section 28(e) and agrees with the money manager to use client 
commissions only to pay for those items that reasonably fall within the 
safe harbor; \183\ and (iii) the broker-dealer develops and maintains 
procedures so that research payments are documented and paid for 
promptly.\184\
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    \182\ In Section 28(e) arrangements involving multiple broker-
dealers, at least one of the broker-dealers (but not necessarily 
all) must satisfy the requirements for ``effecting'' transactions 
and ``providing'' research.
    \183\ In all Section 28(e) arrangements, including those in 
which the broker-dealer is legally obligated to pay for the 
research, the broker-dealer may be subject to liability for aiding 
and abetting violations by money managers where the broker-dealer 
pays for services that are not within Section 28(e). 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); 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., Litigation 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); SEC v. Galleon Capital 
Mgmt., Litigation Release No. 14315, 57 SEC Docket 2593 (Nov. 1, 
1994).
    \184\ A broker-dealer would need to satisfy the ``effecting'' 
and ``provided by'' elements of Section 28(e) only where the money 
manager seeks to operate within the safe harbor. If the money 
manager is operating in part outside of the safe harbor, the broker-
dealer would need to satisfy the ``effecting'' and ``provided by'' 
elements only with respect to the portion of the money manager's 
business for which the manager seeks to operate within the safe 
harbor.
    Prompt payment is relevant to the determination of whether the 
broker-dealer has ``provided'' research because it assures that the 
research and the payment are linked, thereby preserving the 
statutory language requiring that the broker-dealer that ``effects'' 
the transactions for the advised accounts ``provides'' the research.
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4. Legal Obligations of Parties to Section 28(e) Arrangements
    The Proposing Release stated that parties to arrangements under 
Section 28(e) must determine whether they are contributing to a 
violation of law, including whether the involvement of other parties is 
appropriate.\185\ Commenters expressed concern that this statement 
imposed heightened responsibility on money managers and broker-
dealers.\186\ To clarify, the Commission intends only to remind parties 
to Section 28(e) arrangements that, under existing law, money managers 
may be subject to liability under federal securities laws, ERISA, and 
state law, and broker-dealers may be subject to liability if they aid 
and abet another person's violation of a provision of the securities 
laws.\187\ For example, if a broker-dealer knows that a money manager 
has represented to its clients that he will operate solely within 
Section 28(e),\188\ and the adviser asks the broker-dealer to pay for 
office furniture and computer terminals, which under this release are 
not eligible under the safe harbor, the broker-dealer may risk aiding 
and abetting liability.
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    \185\ Exchange Act Release No. 52635 (Oct. 19, 2005), 70 FR 
61700 (Oct. 25, 2005).
    \186\ BNY 1; IAA; ICI; Mellon; NSCP; T.Rowe Price.
    \187\ See, e.g., supra, notes 28-31 and accompanying text; 
Exchange Act Sec.  15(b)(4)(iv)(E) and Advisers Act Sec.  203(e)(6); 
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.''). See also Exchange Act Release No. 11629 (Sept. 
3, 1975), (``A broker which causes or assists an institution to 
violate a duty to the investor may be aiding and abetting a 
fraudulent or deceptive act or practice.''); 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.'').
    \188\ Advisers that are not required to operate within the safe 
harbor may voluntarily choose to do so, and may represent to their 
clients that they do so. However, if an adviser that represents to 
its clients that he will operate within Section 28(e) and fails to 
do so, the representation is false and the conduct may be a 
violation of Section 206 of the Advisers Act and Section 10(b) of 
the Exchange Act and Rule 10b-5. Advisers to mutual funds and ERISA 
plans must operate within the safe harbor with respect to those 
clients because of Section 17(e) of the Investment Company Act or 
ERISA. See supra notes 30-31 and accompanying text.
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IV. Request for Comments

    The Commission will consider further comment on evolving 
developments in connection with industry practices with respect to 
client commission arrangements under the safe harbor identified in 
Section III.I of this Release to evaluate whether additional guidance 
might be appropriate in the future. Based on any comments received, the 
Commission may, but need not, supplement the guidance in this Release 
in the future.

V. Implementation

    The Proposing Release asked whether the Commission should allow 
market participants some period of time to implement the 
interpretation, and requested examples of potential implementation 
issues.\189\ Fifteen commenters requested that the Commission establish 
a grace period for industry participants to implement the Commission's 
interpretative guidance of between three months \190\ to at least one 
year.\191\ Several commenters urged the Commission to issue the 
interpretation without any phase-in period.\192\ Several of these 
commenters suggested that the Commission should delay the effectiveness 
of its final interpretive guidance in order to allow existing annual 
contracts among money managers and broker-dealers to expire \193\ or to 
review their arrangements in light of the Commission's final 
interpretation \194\; others indicated that an implementation period is 
important to accommodate significant operational changes in the 
industry, including any changes necessitated in the agreements among 
money managers and broker dealers.\195\
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    \189\ Proposing Release, Question 10.
    \190\ T. Rowe Price.
    \191\ CAPIS; IAA; IMA; Mellon; Merrill; NSCP; Seward & Kissel; 
SIA; UBS. Three commenters recommended six months. BNY 1; George 2; 
ITG. Two commenters suggested that the Commission provide the 
industry an unspecified ``reasonable'' period of time within which 
to comply with the Commission's interpretation. Charles River; 
E*Trade.
    \192\ Investorside; Reuters.
    \193\ CAPIS; IAA; Mellon; Merrill; NSCP; Seward & Kissel.
    \194\ BNY 1; ITG.
    \195\ SIA; UBS.
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    Since participants have relied on the Commission's prior 
interpretations, the Commission believes that they should be entitled 
to continue to rely on them for a period of time. We believe that, 
considering the views expressed in the comment letters, an appropriate 
period for market participants to continue to rely on the Commission's 
prior interpretations is six months. The interpretation set forth in 
this Release is effective immediately upon its publication in the 
Federal Register, on July 24, 2006. Market participants may continue to 
rely on the Commission's prior interpretations for six months following 
the publication of this Release in the Federal Register, that is, until 
January 24, 2007.

List of Subjects in 17 CFR Part 241

    Securities.

[[Page 41996]]

Amendments to the Code of Federal Regulations

0
For the reasons set out in the preamble, the Commission is amending 
Title 17, chapter II of the Code of Federal Regulations as set forth 
below:

PART 241--INTERPRETATIVE RELEASES RELATING TO THE SECURITIES 
EXCHANGE ACT OF 1934 AND GENERAL RULES AND REGULATIONS THEREUNDER

    Part 241 is amended by adding Release No. 34-54165 and the release 
date of July 18, 2006 to the list of interpretive releases.

    Dated: July 18, 2006.

    By the Commission.
Nancy M. Morris,
Secretary.
[FR Doc. 06-6410 Filed 7-21-06; 8:45 am]

BILLING CODE 8010-01-P
