9750 Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules

1See Securities Exchange Act Rel. No. 23170

(Apr. 23, 1986) [51 FR 16004 (Apr. 30, 1986)]

(‘‘Release 23170’’) at § I; Robert J. Moran & Cathy

G. O’Kelly, Soft Dollars and Other Traps for the

Investment Adviser, 1 DePaul Bus. L.J. 45, 45 n.5

(1989).

2 Greenwich Associates, Soft-Dollars:

Opportunities and Challenges (special presentation

of May 10, 1994); Greenwich Associates,

Institutional Equity Investors 1994 (statistical

supp.) 3, 17.

3Securities Exchange Act Rel. No. 11203 (Jan. 23,

1975) (40 FR 7394 (Feb. 20, 1975)).

4Securities Acts Amendments of 1975, Pub. L.

No. 94–29, 89 Stat. 97, 107–08 (enacting Section

6(e)(1) of the 1934 Act (15 U.S.C. 78f(e)(1))).

5S. Rep. No. 75, 94th Cong., 1st Sess. 70 (1975).

6See SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. 180, 194 (1963).

7 Delaware Management Co., 43 S.E.C. 392, 396

(1967). An adviser is obligated to use reasonable

diligence to select a broker who will ‘‘execute

securities transactions for clients in such a manner

that the client’s total cost or proceeds in each

transaction is most favorable under the

circumstances.’’ Securities Exchange Act Rel. No.

23170 (Apr. 23, 1986) [51 FR 16004 (Apr. 30, 1994)]

(‘‘Release 23170’’) at § V (citing Kidder, Peabody &

Co., 43 S.E.C. 911, 915 (1968)). An adviser should

consider the full range and quality of the broker’s

services, including the value of research received,

in assessing whether a broker will provide best

execution. Id.

8Restatement (Second) of Trusts § 170 comment

a, § 216 (1959).

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Parts 275 and 279

[Release No. 34–35375; IA–1469; S7–5–95]

RIN 3235–AG36

Disclosure by Investment Advisers

Regarding Soft Dollar Practices

AGENCY: Securities and Exchange

Commission.

ACTION: Proposed rule and form.

SUMMARY: The Commission is proposing

for comment a new rule and form under

the Investment Advisers Act of 1940

that would require certain investment

advisers to provide clients with an

annual report regarding their use of

client brokerage. The proposed report

would include disclosure about an

adviser’s use of its clients’ brokerage

commissions during the previous year,

including information about research

and other services obtained by the

adviser with those commissions. The

proposed annual report is intended to

provide investment advisory clients

with important information about the

brokerage commissions they pay and

their advisers’ receipt of ‘‘soft dollar’’

benefits from those commissions.

DATES: Comments should be received on

or before May 19, 1995.

ADDRESSES: Comments should be

submitted in triplicate to Jonathan G.

Katz, Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W.,

Washington, D.C. 20549. All comment

letters should refer to File No. S7–5–95.

All comments received will be available

for public inspection and copying in the

Commission’s Public Reference Room,

450 Fifth Street, N.W., Washington, D.C.

20549.

FOR FURTHER INFORMATION CONTACT: Eric

C. Freed, Special Counsel, or Robert E.

Plaze, Assistant Director, (202) 942–

0721, Office of Disclosure and

Investment Adviser Regulation, Division

of Investment Management, Securities

and Exchange Commission, 450 Fifth

Street, N.W., Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION: The

Securities and Exchange Commission

today is proposing for comment:

(1) rule 204–4 (17 CFR 275.204–4)

under the Investment Advisers Act of

1940 (15 U.S.C. 80b–1 et seq.)

(‘‘Advisers Act’’), which would require

an investment adviser registered or

required to be registered under the

Advisers Act to deliver to its clients an

annual report on the adviser’s direction

of client brokerage transactions and its

receipt of research and other services in

connection with those transactions; and

(2) Form ADV–B under the Advisers

Act, which would set forth the

information required to be included in

the annual report.

Executive Summary

The Commission is proposing a new

rule and form under the Advisers Act to

require each investment adviser

(‘‘adviser’’), registered or required to be

registered under the Advisers Act, that

has the discretion to direct client

brokerage transactions and receives

services other than execution in

exchange for that brokerage, to provide

its clients with a report that would

contain information about its use of

client brokerage. The report would

disclose for the adviser’s most recently

completed fiscal year, (1) the twenty

brokers to which the adviser directed

the largest amounts of commissions and

certain other transaction-related

payments (collectively, ‘‘commissions’’),

(2) the three brokers substantially all of

whose services for the adviser were

execution services (‘‘execution-only

brokers’’) to which the adviser directed

the largest amounts of commissions, (3)

the aggregate amount of commissions

directed by the adviser to each broker

listed and the percentage of the

adviser’s total discretionary brokerage

this amount represents, (4) the average

commission rate paid to each broker

listed, and (5) for each broker other than

an execution-only broker, information

concerning products or services

obtained from the broker. The report

would also disclose the percentages of

the adviser’s total commissions that are

directed to execution-only brokers, to

other brokers, and at the request of

clients. The report would require only

information about an adviser’s use of

client brokerage on an aggregate basis; it

would not require separate information

about the brokerage of the adviser’s

various clients. The report would be

provided to existing advisory clients

annually and to prospective advisory

clients no later than the time that an

advisory agreement is entered into.

I. Background

Soft dollar practices are arrangements

under which products or services other

than execution of securities transactions

(‘‘soft dollar services’’) are obtained by

an adviser from or through a broker in

exchange for the direction by the

adviser of client brokerage transactions

to the broker.1 Soft dollar practices are

common in the institutional brokerage

market. According to an informal

annual survey of investment advisers

and other institutions, nearly ninety

percent of these institutions engage in

soft dollar arrangements, and more than

forty percent of commissions are

directed primarily for the purpose of

obtaining research services.2

Soft dollar practices originally

developed as a means by which brokers

provided discounts on brokerage

commissions that were fixed pursuant

to exchange and commission rules. In

1975, the Commission prohibited fixed

commission rates 3 and, later that year,

Congress codified the Commission’s

action.4 After the Commission abolished

fixed rates, concerns were raised

whether the soft dollar practices that

had developed in the context of fixed

rates would continue to be consistent

with various state and federal laws,

including the Advisers Act.5

Underlying these concerns is an

adviser’s fundamental obligation under

the Advisers Act (and state law) to act

in the best interest of its clients.6 This

duty requires the adviser to obtain best

execution of client transactions,7 and

precludes the adviser from using client

assets for its own benefit or the benefit

of other clients, at least without client

consent.8 Upon the Commission’s

eliminating fixed commission rates,

some argued that an adviser could be

deemed to have violated this duty if the

adviser caused a client’s account to pay

anything but the lowest commission

rates. If this view was upheld, soft

dollar arrangements could have been

effectively precluded by the decision to

eliminate fixed commission rates.
Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules 9751

9Securities Acts Amendments of 1975, Pub. L.

No. 94–29, 89 Stat. 97, 161–62.

10The Commission has stated that a product or

service may legitimately be considered a ‘‘brokerage

or research service’’ covered by the safe harbor if

it provides ‘‘lawful and appropriate assistance to

the [adviser’s] decision-making process.’’ Release

23170, supra note 1. The Commission’s Division of

Market Regulation has addressed the types of

transactions that are afforded the protection of the

safe harbor. See U.S. Department of Labor (pub.

avail. July 25, 1990) (safe harbor does not extend

to principal, riskless principal and futures

transactions); Hoenig & Co. (pub. avail. Oct. 15,

1990) (same); Instinet Corporation (pub. avail. Jan.

15, 1992) (safe harbor does apply to agency

transactions in equity securities on a computerbased real time market information and brokerage

system and after-hours order matching system).

11See Securities and Exchange Commission v.

Galleon Capital Management, Litigation Rel. No.

14315 (Nov. 1, 1994). The Commission’s complaint

in Galleon, in addition to alleging excessive trading

in order to generate soft dollar credits, alleged that

the adviser requested brokers to make soft dollar

payments to a consulting firm, and that these

payments eventually were rebated to the adviser.

See also Letter from Bradford P. Schaaf, Chairman,

and Victor J. Fontana, President and Chief

Executive Officer, Autranet, Inc. to Barry P.

Barbash, Director, Division of Investment

Management and Brandon Becker, Director,

Division of Market Regulation (Nov. 10, 1994)

(‘‘Autranet Letter’’) (proposing that the Commission

prohibit a broker from requiring an adviser, by

contract or understanding, to commit to direct any

specified amount of commissions to the broker in

order to receive soft dollar services).

12Section 28(e)(2) (15 U.S.C. 78bb(e)(2)).

13 In 1976, the Commission proposed rule 28e2–

1 under the 1934 Act, but the rule was never

adopted. See note 41 infra.

14Rule 204–3 under the Advisers Act (17 CFR

275.204–3) requires that a registered investment

adviser deliver the brochure to a prospective client

before entering into an advisory contract with the

client, and, annually thereafter, provide or offer to

provide the client with the brochure. The

Commission is not at this time proposing to amend

the Form ADV requirements regarding disclosure of

soft dollar arrangements. The Commission,

however, is considering whether changes to these

requirements would be appropriate, and may

propose changes in connection with future

revisions to Form ADV.

15 Item 12 of Part II of Form ADV. Registered

investment companies are required to include

similar disclosure in their Statements of Additional

Information. See, e.g., Item 17 of Form N–1A (17

CFR 239.15A, 274.11A).

16See Future of the Stock Market: Soft Dollars,

Hearing Before the Subcomm. on

Telecommunications and Finance of the House

Comm. on Energy and Commerce, 103d Cong., 1st

Sess. (1993) (‘‘1993 Hearings’’) (testimony of David

M. Silfen, Partner, Goldman, Sachs & Co. and

Anson M. Beard, Jr., Managing Director, Morgan

Stanley Group Inc.).

17The Commission has instituted a number of

enforcement actions against advisers based, at least

in part, on the failure to disclose soft dollar

arrangements adequately. See, e.g., Securities and

Exchange Commission v. Galleon Capital

Management, supra note 11; Kingsley, Jennison,

McNulty & Morse, Inc., Investment Advisers Act

Rel. No. 1396 (Dec. 23, 1993); DeMarche Associates,

Investment Advisers Act Rel. No. 1392 (Nov. 23,

1993); Jack Allen Pirrie, Investment Advisers Act

Rel. No. 1284 (July 29, 1991); Robert Michael Lee,

Investment Advisers Act Rel. No. 1249 (Sept. 17,

1990); Patterson Capital Corp., Investment Advisers

Act Rel. No. 1235 (June 25, 1990).

18The Goldman/Morgan Proposal will be placed

in the public comment file for the Commission’s

proposal.

19See Letter from The Alliance in Support of

Independent Research to Jonathan G. Katz,

Continued

Congress, in codifying the abolition of

fixed commission rates, responded to

these concerns by enacting Section 28(e)

of the Securities Exchange Act of 1934

(the ‘‘1934 Act’’) [15 U.S.C. 78bb(e)],

which provides a safe harbor for certain

soft dollar arrangements.9 Section 28(e)

provides, in pertinent part, that an

adviser with investment discretion over

an account will not be deemed to have

acted unlawfully or to have breached its

fiduciary duty by causing the account to

pay a higher commission to a broker

that provides research benefiting the

adviser’s accounts. To rely on the

Section 28(e) safe harbor, an adviser

must determine in good faith that the

commissions paid are reasonable in

relation to the value of the brokerage

and research services provided, either in

terms of the particular transaction or the

adviser’s overall responsibilities

towards its discretionary accounts.10

Section 28(e) modifies a fiduciary’s

strict duty to act in the best interest of

each client with respect to the

management of each client’s assets.

Thus, it permits an adviser to cause a

client to pay higher commissions than

otherwise are available to obtain

research that may not be used

exclusively for the benefit of the client

or used to benefit the client at all.

Section 28(e), however, does not afford

a safe harbor with respect to all conflicts

of interest between the adviser and its

clients that may arise from soft dollar

arrangements. For example, soft dollar

arrangements may cause an adviser, in

order to obtain soft dollar services, to

violate its best execution obligations by

directing client transactions to brokers

who could not adequately execute the

transactions. Soft dollar arrangements

also may give advisers incentives to

trade client securities inappropriately to

generate credits for soft dollar

services.11

Soft dollar practices also diminish the

ability of a client to evaluate the

expenses it incurs in obtaining portfolio

management services and may hinder

the ability of the client to negotiate fee

agreements, because the costs of soft

dollar services are ‘‘hidden’’ from

investors in brokerage commissions. By

permitting advisers to use their clients’

transactions to pay for research services

that they otherwise would have to

purchase with ‘‘hard dollars,’’ soft

dollar arrangements permit advisers to

charge fees that do not fully reflect the

cost of portfolio management. Advisers

that do not engage in soft dollar

arrangements may be put at a

competitive disadvantage if they pay for

services with hard dollars and attempt

to pass the cost of these services on to

clients through higher fees.

Congress recognized the conflicts that

soft dollar practices present and

provided in section 28(e) authority for

the Commission to require advisers to

disclose to their clients their policies

and practices with respect to the use of

client commissions.12 The Commission

has never adopted rules under section

28(e),13 but has instead required certain

disclosure in Part II of Form ADV,

which specifies the content of the

disclosure document or ‘‘brochure’’ that

an adviser is required to provide to

clients before entering into advisory

relationships.14 If soft dollar

arrangements are a factor in selecting

brokers to effect client transactions, the

brochure must disclose the nature of the

adviser’s soft dollar practices, including:

(i) the services that the adviser obtains

through soft dollar arrangements; (ii)

whether clients may pay higher

commissions (‘‘pay up’’) as a result of

the arrangements; (iii) whether soft

dollar services are used to benefit all

client accounts or only those accounts

the brokerage of which was used to

purchase the services; and (iv) any

procedures that the adviser uses to

allocate brokerage.15

Two broker-dealers, Goldman, Sachs

& Co. and Morgan Stanley Group Inc.,

themselves providers of research

services to advisers, have strongly

criticized the effectiveness of current

disclosure requirements.16 Current

disclosure primarily focuses on the

policies and practices that the adviser

intends to follow with respect to the use

of client brokerage.17 This disclosure

does not, Goldman, Sachs and Morgan

Stanley assert, adequately disclose to

clients the extent to which an adviser

has soft dollar commitments or the

specific benefits that accrue to the

adviser from the use of the client

brokerage. These brokers have proposed

that the Commission adopt a

requirement that advisers periodically

report to clients the soft dollar benefits

that they have received and the specific

value of those benefits, as well as

certain information about how the

brokerage of each client was directed

(the ‘‘Goldman/Morgan Proposal’’).18

Other participants in soft dollar

arrangements, organized by the Alliance

in Support of Independent Research,

have argued that current client

disclosure by advisers is adequate and

that the Goldman/Morgan Proposal is

anticompetitive and discriminatory.19
9752 Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules

Secretary, Securities and Exchange Commission

(Oct. 17, 1994), Commission File No. S7–22–94

(‘‘Alliance Letter’’); see also Autranet Letter, supra

note 11. The Alliance in Support of Independent

Research is ‘‘a group of broker-dealers, money

managers and research firms sharing a common

interest in fostering a favorable regulatory

environment in which independent research

services and products may be furnished to the

money management community.’’

20 In 1980, the Commission stated that research

provided through third-party arrangements falls

within Section 28(e) of the Exchange Act, even if

the money manager participates in selecting the

research services provided to it and the research is

delivered directly to the money manager by the

third party. Securities Exchange Act Rel. No. 17371

(Dec. 12, 1980) (45 FR 83707 (Dec. 19, 1980)). The

Section 28(e) safe harbor is not available to thirdparty soft dollar arrangements unless, among other

things, the broker is obligated to the third party to

pay for the services. Release 23170, supra note 1,

at § III; Kingsley, Jennison, McNulty & Morse, Inc.,

supra note 17.

21Some full service brokers also will enter into

third-party soft dollar arrangements with advisers.

22See Alliance Letter, supra note 19.

23See, e.g., 1993 Hearings, supra note 16

(statement of Holly A. Stark, Senior Vice President,

Dalton, Greiner, Hartman, Maher & Co.).

24Many pension plans require some form of soft

dollar reporting from their money managers,

primarily in response to a pronouncement of the

Department of Labor, the principal federal regulator

of employee benefit plans under the Employee

Retirement Income Security Act of 1974 (‘‘ERISA’’),

concerning the ongoing duty of plan fiduciaries to

monitor the use of soft dollars by managers. See

ERISA Technical Release No. 86–1.

Section 15(c) of the Investment Company Act of

1940 (15 U.S.C. 80a–15(c)) requires the directors of

a registered investment company to request and

review, and the company’s adviser to supply, such

information as may reasonably be necessary to

evaluate the terms of the advisory contract between

the adviser and the investment company. As

discussed above, soft dollar arrangements may bear

upon the reasonableness of advisory fees. See text

accompanying note 12 supra. Investment company

advisers that engage in soft dollar arrangements

therefore must provide their boards of directors

with information regarding soft dollar

arrangements. See Release 23170, supra note 1, at

§ IV.B.3.

Various institutional investors have expressed

their views on soft dollar arrangements. See 1993

Hearings (statement of Fred G. Weiss, Chairman,

Financial Executive Institute’s Committee on

Investment of Employee Benefit Assets (‘‘CIEBA’’)).

Mr. Weiss stated that CIEBA, which represents 150

corporate benefit plan sponsors with assets of

approximately $600 billion, was unable to develop

a clear consensus on whether soft dollar practices

were desirable or not. CIEBA did, however, call for

more comprehensive reporting of soft dollar

arrangements at a firm-wide level to supplement the

client-specific information that most of its members

currently receive. Other institutional investors

believe that current disclosure is adequate. See

1993 Hearings (written statement of State Board of

Administration of Florida). In addition, the

Institutional Investors Committee of the National

Association of Securities Dealers, Inc. (‘‘NASD

Committee’’), which includes representatives of

institutional investors, advisers, and brokerage

firms, submitted a recommendation to the

Commission’s staff for additional soft dollar

disclosure. The NASD Committee’s

recommendation was approved by the NASD’s

Board of Governors. The NASD Committee’s

recommendation will be placed in the public

comment file for the Commission’s proposal.

25See Letter from Louis R. Cohen and Marianne

K. Smythe, Wilmer, Cutler & Pickering to Jonathan

G. Katz, Secretary, Securities and Exchange

Commission (Oct. 17, 1994) (on behalf of Investors

Research Corp.) (‘‘Investors Research Letter’’),

Commission File No. S7–22–94.

26See U.S. Securities and Exchange Commission,

Division of Market Regulation, Market 2000: An

Examination of Current Equity Market

Developments (Jan. 1994).

27 Id. at V–15.

28The proposed amendments would not require

that advisers provide each client with information

about how that client’s transactions were directed.

See Section II.F infra.

The difference in the views of these

two groups may reflect the differences

in the ways the two groups provide

research services to advisers and the

effect that the Goldman/Morgan

Proposal would have on each group.

Goldman, Sachs and Morgan Stanley

operate as ‘‘full service brokers’’ and

provide a variety of execution, research

and related services to clients. An

adviser who executes client securities

transactions through these firms

typically receives research services

developed by the firms (‘‘proprietary’’

soft dollar services), much of which is

provided without being directly

requested by the adviser. The cost of

such services generally are bundled in

the overall commission charged by the

full service broker. In contrast, a ‘‘soft

dollar broker’’ typically provides

advisers with services prepared or

produced by parties other than the

broker (‘‘third-party’’ soft dollar

services) in exchange for the allocation

of specified amounts of commission

dollars.20 In these types of

arrangements, an explicit price

denominated in commission dollars,

rather than in hard dollars, is typically

attached to the research.21

The Goldman/Morgan Proposal would

affect the two groups of brokers

differently. Because proprietary soft

dollar services are not offered for a

specific price in commission dollars,

under the Goldman/Morgan Proposal,

disclosure would be required only about

the price and value of third-party soft

dollar services. Soft dollar brokers argue

that if the Commission required more

extensive disclosure of third-party soft

dollar services than proprietary soft

dollar services, advisory clients might

be led to believe that advisers derive

benefits from soft dollar brokers at the

clients’ expense that they do not derive

from full service brokers, when, in fact,

both types of firms confer benefits on

advisers.22 As a result, advisers might be

discouraged from using soft dollar

brokers.

Representatives of some investment

advisers have asserted that current

disclosure requirements are adequate.23

According to these advisers, clients

rarely request information about the soft

dollar benefits that the adviser receives,

and those that are interested currently

may obtain the information on

request.24 Other investment advisers,

however, argue that the nature of the

conflicts involved in soft dollar

arrangements warrant more extensive

client disclosure than is currently

required.25

The Commission staff considered

issues related to soft dollars in its

‘‘Market 2000’’ report on the equity

markets released in January 1994.26 In

that report, the staff recommended that

quantifiable information about soft

dollar services be required to be

provided to advisory clients.27 The

report also stated that ‘‘[m]ost

importantly * * * any new disclosure

requirements should apply equitably.

Thus, research and other services

obtained either from (full service) firms

or (soft dollar) firms should be subject

to disclosure.’’

II. Discussion

The Commission believes that, in

light of the conflicts of interest

presented by soft dollar arrangements,

additional disclosure about these

practices may be warranted. While

current disclosure may provide

sufficient notice to a client that the

adviser has these conflicts, it may not

provide the client with sufficient

information to permit it to assess the

extent to which the adviser obtains soft

dollar services or pays up for those

services, or the types of services that the

adviser obtains through soft dollar

arrangements. Enhanced disclosure may

provide existing clients with

information useful in negotiating limits

on the use of their brokerage, and enable

prospective clients to make better

informed choices of advisers.

The Commission is therefore

proposing that certain registered

advisers be required to provide clients

with annual reports setting forth certain

information about their use of client

brokerage and the soft dollar services

each adviser received during its most

recently completed fiscal year.28 The

proposal is intended to provide an

advisory client with information that

can be used to evaluate the extent to

which the client benefits from the

adviser’s brokerage practices, the extent

to which the adviser benefits, and

whether the client should attempt to

limit the adviser’s use of its brokerage.

Consistent with the recommendations of

the staff in the Market 2000 report, the

proposed disclosure requirements

would not impose different
Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules 9753

29The definition of ‘‘brokerage discretion’’ is

discussed at notes 58–59 and accompanying text

infra.

30For the purposes of the amendments,

‘‘commissions’’ would include amounts of markups and mark-downs on principal transactions if

those amounts are included on the confirmation of

the transaction required under rule 10b–10 under

the 1934 Act. See Section II.E infra. These mark-ups

and mark-downs, however, are not commissions for

purposes of Section 28(e). See note 10 supra.

31The definition of ‘‘execution-only broker’’ is

discussed at notes 36–38 and accompanying text

infra.

32 Items 2–3 of proposed Form ADV–B. For

purposes of determining the amount of

commissions and the corresponding percentage of

the adviser’s discretionary brokerage that this

amount represents, sales loads on transactions in

investment company shares would be considered

commissions. Because sales loads typically are not

calculated on a cents per share basis and could

potentially distort the average commission rate

data, sales loads would not be considered in

calculating average commission rates. Instruction 3

to Item 2 of proposed Form ADV–B.

33The Commission recognizes that the use of

execution-only brokers would not be appropriate or

possible in many circumstances. The proposed

disclosure about execution-only brokers is not

intended to imply that such brokers could have

been used in all circumstances. Furthermore, an

adviser would be permitted to explain its policies

regarding the use of execution-only brokers in a

narrative portion of the annual report. See General

Instruction 6 to Proposed Form ADV–B.

34 Item 4 of proposed Form ADV–B.

35For purposes of the annual report, a ‘‘broker’’

would include a bank that is not registered as a

broker-dealer under the 1934 Act. Instruction 1 to

Item 2 of proposed Form ADV–B.

36 Instruction to Item 3 of proposed Form ADV–

B. The definition of execution-only broker is

derived from Section 28(e)(3)(C) of the 1934 Act [15

U.S.C. 78bb(e)(3)(C)]. Under that section, custody of

securities is a function incidental to effecting a

transaction in the securities.

37A broker would be permitted to be considered

an execution-only broker if it provided a minimal

amount of soft dollar services to the adviser, such

as a single research report or a single contact with

a securities analyst.

38 Instruction to Item 3 of proposed Form ADV–

B. Typically, the sponsor of an automated trading

system will be required to be registered as a brokerdealer under the 1934 Act. An automated trading

system would be included in the definition of

broker in Form ADV–B if a fee is charged for using

the system, regardless of the basis for the fee (e.g.,

a flat usage fee or transaction-based fees).

39 Items 2 and 3 of proposed Form ADV–B.

requirements on third-party and

proprietary soft dollar arrangements.

A. The Annual Report in General

The Commission is proposing a new

rule under the Advisers Act, rule 204–

4, that would require any adviser,

registered or required to be registered

under the Advisers Act, that has

brokerage discretion 29 over any client

account and that receives soft dollar

services to deliver an annual report to

clients on its use of client brokerage.

The contents of the annual report would

be specified in new Form ADV–B.

The core of the annual report would

be a table disclosing information

regarding the adviser’s direction of

client brokerage. The table would list

the twenty brokers other than executiononly brokers (‘‘research brokers’’) to

which the adviser directed the greatest

amount of client commissions,30 and the

three execution-only brokers to which

the adviser directed the greatest amount

of client commissions during its most

recent fiscal year.31 For each broker

listed, the table would disclose: the

aggregate amount of commissions

directed by the adviser to the broker; the

percentage of the adviser’s discretionary

brokerage commissions that this

represents; the average commission rate

(in cents per share) paid to the broker;

and a description of the soft dollar

services provided by the broker.32

The table would provide an overview

of the brokers used by an adviser to

execute client transactions, the

commissions charged by the brokers,

and the soft dollar services received

from research brokers. This disclosure is

intended to assist an advisory client in

evaluating the adviser’s use of its

brokerage, including whether the client

could be paying lower commissions,

whether the adviser is obtaining soft

dollar services that can be used to

benefit the client, and whether the

advisory fee charged to the client is

appropriate in light of the services that

the adviser pays for with client

commissions. Institutional clients using

the services of more than one adviser

and prospective clients considering

different advisers will be able to use the

table to compare advisers’ use of

brokerage, including the commission

rates that they negotiate and the types

of services that they receive. The

disclosure regarding execution-only

brokers would assist clients in making

these determinations by providing

information about the availability of

brokerage alternatives, and, by

implication, the effect that soft dollar

services may have on commission

rates.33

The table would be followed by

certain data concerning the adviser’s

direction of brokerage: the percentages

of the adviser’s total brokerage that are

directed (1) by the adviser to research

brokers, (2) by the adviser to executiononly brokers, and (3) pursuant to

specific client instructions.34 This data

would provide clients with an overall

picture of how the adviser directs

brokerage.

B. Disclosure of Brokers

As noted above, the report would be

required to include information about

twenty research brokers and three

execution-only brokers.35 Limiting the

required disclosure to this number of

brokers is intended to result in reports

that provide useful information in a

relatively concise manner. Comment is

requested whether the proposed

numerical thresholds are appropriate.

Comment is also requested whether, as

an alternative, disclosure should be

required about brokers to which the

adviser directed more than a specified

percentage of its brokerage, such as one

percent.

For the purposes of the amendments,

a broker would be considered an

‘‘execution-only’’ broker if substantially

all of the services that the broker

provides to the adviser are execution

services, i.e., effecting securities

transactions and performing functions

incidental to or required in connection

with effecting those transactions.36

Consequently, a broker would not be

permitted to be considered an

execution-only broker if it provided any

significant amount of soft dollar services

to the adviser, even if the services were

not solicited or used by the adviser.37 If

a broker provided only execution

services to an adviser, however, the

adviser would include the broker as

execution-only even if the broker

provided additional services, such as

research, to its other customers. The

definition of execution-only broker

would include automated trading

systems (e.g., the Instinet and Lattice

systems) if the adviser received only

execution and execution-related

services as a result of using the system,

regardless of whether the system itself is

required to be registered as a brokerdealer under the 1934 Act.38

An adviser that did not utilize any

research brokers or that did not utilize

any execution-only brokers would be

required to so state under the

appropriate heading in the table.39 An

adviser that directed client commissions

to fewer than twenty research brokers

and/or fewer than three execution-only

brokers would be required to disclose

under the appropriate headings those

brokers to which it did direct client

commissions. As a result, an adviser’s

annual report would always include

some reference to the existence of

execution-only brokers. Comment is

requested whether there are better ways

to disclose to clients the availability and

cost of brokerage alternatives. For

instance, comment is requested whether

an adviser should be required to

disclose execution-only brokers that

offered to execute client transactions.

Similarly, comment is requested

whether the table should include
9754 Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules

40 In order to keep the report at a manageable

length, an adviser could be permitted merely to

indicate whether or not it received soft dollar

services, rather than to identify the services

received, from brokers that were not among those

it used most frequently (e.g., the top twenty).

41 In 1976, the Commission proposed rule 28e2–

1 under the 1934 Act, which would have required

advisers to make certain disclosures to clients

concerning soft dollar practices in a separate annual

report. Securities Exchange Act Rel. No. 13024

(Nov. 30, 1976) (41 FR 53356 (Dec. 6, 1976)). The

proposed rule, which was not adopted, would have

required, among other things, narrative disclosure

concerning research received ‘‘in return for’’

brokerage. Commenters stated that it was

impracticable to determine whether research was

obtained ‘‘in return for’’ specific services,

particularly when the research was not solicited.

See Securities Exchange Act Rel. No. 10569 (Jan. 30,

1979) (44 FR 7864 (Feb. 7, 1979)) (‘‘Release 10569’’).

42 Instruction 7 to Item 2 of proposed Form ADV–

B.

43 Id.

44 In connection with its annual survey of

institutions regarding their brokerage practices, see

note 2 and accompanying text supra, Greenwich

Associates uses the following nine categories of soft

dollar services: performance measurement, thirdparty research, corporate fundamental databases,

technical analysis software, portfolio modeling and

strategy software, on-line stock price quotations,

specialized political or economic analyses,

terminals and computers, and custody services.

Greenwich Associates, Institutional Equity

Investors 1994 (statistical supp.) 19.

45The Commission recently proposed that

estimates of the value of non-monetary payments

for order flow be disclosed to customers of brokers

receiving such payments. Securities Exchange Act

Rel. No. 34903 (Oct. 27, 1994) (59 FR 55014 (Nov.

2, 1994)). Payment for order flow is payment by a

broker, dealer, securities exchange, securities

association or exchange member to a broker or

dealer in return for the routing of customer orders

to the broker, dealer, securities exchange, securities

association, or exchange member.

46 In addition, it is unclear how a broker’s ‘‘cost’’

should be determined. An ‘‘average cost’’ could be

obtained by dividing the cost of producing the

services by the number of recipients. ‘‘Marginal

cost’’ would measure the actual cost of providing

the research to the last adviser. Full service brokers

frequently distribute to advisers and other

customers research services that were initially

produced for other purposes. The marginal cost of

such research might be only the cost of its

distribution.

disclosure regarding all brokers used by

the adviser.40

Comment is requested generally on

the definition of an execution-only

broker, and whether the proposal’s

classification of brokers into two types,

execution-only and all others, is

appropriate or practicable. Instead of

classifying brokers by type, the

Commission considered proposing that

advisers be required to classify brokers

or specific trades based upon the

purposes for which the trades were

directed to the broker (e.g., execution or

research). Under this approach, trades

directed to a broker that provided soft

dollar services could be considered to

be directed for the purposes of

execution if the services were a minimal

factor in directing the brokerage. The

Commission is not proposing this

approach because determining the

purposes for which brokers are used or

individual trades are directed may be

impracticable and burdensome.41 The

proposed approach, which would not

permit an adviser to treat a broker from

whom it receives significant soft dollar

services as an execution-only broker,

seeks to reduce the burden on advisers

by providing a more objective basis for

classifying brokers. Nevertheless,

comment is requested whether the

annual report should require advisers to

classify brokers or trades by the

purposes for which the adviser directed

the brokerage.

C. Disclosure of Products and Services

Received

The annual report would describe the

soft dollar services received by the

adviser from each research broker listed.

Except as discussed below, soft dollar

services would be required to be

identified specifically.42 The producer

of a third-party soft dollar service would

be identified unless its name was

evident from the name of the product.

This information is intended to permit

a client to assess whether it benefits

from the soft dollar services that the

adviser receives and, consequently,

whether it should attempt to limit the

adviser’s use of its brokerage.

In many cases, an adviser receives

research reports from a broker or is

given access to the broker’s securities

professionals in exchange for the

direction of brokerage. An adviser

would not be required to list separately

every report that it received or each

professional with whom it had contact.

Instead, an adviser would be permitted

to refer to these services generically

according to the following categories: (1)

Analyses and reports on specific

securities, issuers or industries, (2)

political or economic analyses or

reports, or (3) access to securities

analysts.43 All other services, including

computer hardware, software, databases,

and on-line services, financial or other

publications available by subscription,

and any products or services falling

outside the scope of Section 28(e) of the

1934 Act, would be required to be

identified specifically.

Comment is requested whether soft

dollar services should be identified in

this manner. Should the Commission

require more specific disclosure of

research reports or access to securities

analysts or other professionals, or

permit general descriptions of other

services? Comment is requested

whether, either in lieu of or in addition

to separate identification of the services

received, soft dollar services should be

required to be classified into specified

categories, and, if so, what those

categories should be.44

In addition to requiring a description

of the soft dollar services received, the

Goldman/Morgan Proposal would have

required that an adviser disclose the

price in commission dollars and fair

market value of each third-party soft

dollar service (which typically will be

provided at an explicit price). As noted

above, the Goldman/Morgan proposal

would not require this disclosure

regarding proprietary soft dollar

services, as these services are not

explicitly assigned a price. Price and

fair value information may be useful as

an expression of the value of the soft

dollar services obtained by the

adviser.45 The Commission is

concerned, however, that unless the

values of proprietary soft dollar services

are also included in the report, the

information provided to the client

would be incomplete and may distort

client understanding about the benefits

that advisers receive through client

brokerage. Clients, for example, may

incorrectly believe that soft dollar

services are not a consideration in an

adviser’s direction of client brokerage to

full service brokers or that third-party

soft dollar services are of greater value

(either to advisers or clients) than

proprietary soft dollar services.

Moreover, the Goldman/Morgan

Proposal may provide an investment

adviser an incentive to direct brokerage

to a full service broker rather than a soft

dollar broker for the same types of soft

dollar services, simply because of

differing client reporting requirements.

This consequence may not be in the best

interests of advisory clients and may be

unfair to soft dollar brokers. Thus,

consistent with the staff’s

recommendations in the Market 2000

report, the Commission is not proposing

that only third-party soft dollar services

be valued.

The Commission also considered

requiring advisers to report the fair

market value of all soft dollar services,

regardless of their source. Because there

often is no agreed upon price for

proprietary soft dollar services, their fair

market value may not readily be

ascertainable. One approach might be to

require advisers to disclose the cost to

the broker of producing proprietary soft

dollar services. The cost of producing

services, however, may not reflect their

fair market value, and an adviser may

not be able to verify cost information

provided by brokers.46 Alternatively, the

value of soft dollar services to the

adviser receiving them could be
Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules 9755

47An adviser could be required to report only

those proprietary soft dollar services for which it

specifically directed brokerage. Such a limitation,

however, would require highly subjective

determinations by advisers, and, as a practical

matter, might elicit disclosure about only thirdparty soft dollar services.

48This approach was suggested by one

commenter on the Commission’s recent proposal to

require that mutual fund expenses paid by brokers

should be included in fund expense and

performance data. See Investors Research Letter,

supra note 25. In that proposal, the Commission

requested comment whether the value of research

services received by a fund’s adviser should also be

included in fund expenses, and how the research

should be valued. See Investment Company Act

Rel. No. 20472 (Aug. 11, 1994) (59 FR 42187 (Aug.

17, 1994)), at § II.A.1. Most commenters on the

proposal, however, opposed the inclusion of

research services in fund expenses, and those

commenters that favored it generally provided little

guidance regarding how to value proprietary

services.

49 In proposing rule 28e2–1, the Commission

proposed that the fair value of non-research services

be disclosed, and requested comment on the

feasibility and desirability of requiring disclosure of

specific dollar amounts of brokerage commissions

paid to receive research services. Commenters

asserted that it would be impracticable to value soft

dollar services or to separate commissions into their

research and execution components. See Release

10569, supra note 41. 50 Item 4 of proposed Form ADV–B.

51Paragraph (a)(8) of rule 10b–10 [17 CFR 10b–

10(a)(8)].

52The safe harbor does not encompass soft dollar

arrangements under which research services are

acquired as a result of principal transactions. See

note 10 supra. Notwithstanding the lack of

availability of the safe harbor, the Commission

understands that full service brokers sometimes

provide research and other services based, at least

in part, on principal transactions. If an adviser were

required to list a broker in its annual report because

the broker is used frequently for agency

transactions, the adviser would be required to take

all of the soft dollar services obtained from the

broker into account in responding to the report’s

requirement to list the services obtained, even if

some of the services could be deemed to be received

as a result of principal transactions not within the

scope of the proposed amendments. Instruction 7 to

Item 2 of proposed Form ADV–B.

required to be disclosed, but it may be

inappropriate and misleading to reflect

services that the adviser did not solicit

or use as having no value.47

An adviser could be required to make

a good faith estimate of what the

proprietary soft dollar services would

have cost in an arms-length

transaction.48 This approach would

require advisers to report positive

values for unsolicited and unused

services, which could lead investors to

believe that the adviser (or the client)

substantially benefited from the

direction of the brokerage when, in fact,

receipt of the services was incidental to

brokerage direction decisions made

wholly on the basis of the broker’s

execution capabilities. In addition, good

faith estimates may be very difficult to

make if the services provided are unlike

those available for hard dollars. In this

regard, the Commission is concerned

with the burden that a good faith

estimate requirement would impose on

advisers and brokers and the accuracy of

the information that would be reported

to clients.49

The disclosure that the Commission is

proposing to require is designed to alert

a client that the adviser receives soft

dollar services from directing client

commissions, and provide some

indication of the extent to which the

client benefits from that direction. The

commission rate information, including

the commission rates of execution-only

brokers, may provide valuable

information on the costs of soft dollar

arrangements and may render valuation

estimates unnecessary. If additional

information is desired, the client can

request it from the adviser.

Comment is requested whether the

commission price and fair market value

of particular soft dollar services, or the

soft dollar services obtained from a

broker in the aggregate, should be

required in the annual report.

Commenters favoring inclusion of this

information should discuss how the

price and value of proprietary soft dollar

services should be determined.

D. Client-Directed Brokerage

Many clients of investment advisers

instruct their advisers to direct some or

all of their transactions to a particular

broker or brokers. A client may direct its

brokerage, among other reasons, to

obtain services for its own benefit or

because of a pre-existing relationship

with the broker.

In addition to disclosing the

percentages of an adviser’s total

commissions that are directed to

execution-only and research brokers, the

proposed annual report would be

required to disclose the percentage of

commissions that is directed by

clients.50 Client restrictions on an

adviser’s brokerage discretion may be of

interest to other clients of the adviser

because they may cause a larger

proportion of the brokerage of the other

clients to be used to obtain soft dollar

services for the adviser. Information on

client-directed brokerage, therefore, may

be useful to clients in determining the

amount of brokerage available to the

adviser to purchase soft dollar services.

Comment is requested whether the

proposed disclosure of the percentage of

client-directed brokerage would be

useful, and whether the Commission

should require that the data be

accompanied by disclosure explaining

its usefulness.

E. Principal Transactions

Proposed Form ADV–B would require

an adviser to include in the commission

and commission rate in the table markups and mark-downs paid in connection

with principal transactions if the

amounts of these mark-ups or markdowns are included in the

confirmations of the transactions

required under rule 10b–10 under the

1934 Act. Rule 10b–10 requires that a

dealer include transaction cost data in

confirmations of (1) riskless principal

transactions in equity securities if the

dealer is not a market maker in the

securities, and (2) transactions in a

listed equity securities and certain

Nasdaq securities.51

Proposed Form ADV–B would not

require disclosure of information about

other principal transactions or the markups, mark-downs or spreads paid on

these transactions. It may be difficult to

accurately determine transaction costs

associated with these principal

transactions. Furthermore, disclosure

about adviser direction of principal

transactions may not be necessary, as

soft dollar arrangements involving

principal transactions may be less

common than those involving agency

transactions because principal

transactions are not afforded the safe

harbor provided by Section 28(e).52

Comment is requested whether the

annual report should include

information on all principal

transactions, and, if so, how the

associated costs should be determined.

Comment is also requested whether

disclosure requirements that apply

primarily to agency transactions would

cause more transactions to be executed

on a principal basis.

The proposal would require

disclosure of the brokers to which the

greatest amounts of commissions had

been directed. Alternatively, the

obligation to disclose information about

a broker could be based on the dollar

amount of transactions, both principal

and agency, directed to the broker. The

resulting disclosure might be more

useful to clients in assessing any

relationship that may exist between the

adviser’s use of principal transactions

and its receipt of soft dollar services.

Comment is requested whether the basis

for requiring a broker to be listed in the

annual report should be the dollar

amount of transactions directed to the

broker, rather than the amount of

commissions.

F. Client-Specific Information

The proposed amendments would not

require that an adviser provide each

client with information about how that
9756 Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules

53To the extent differences between the manner

in which an adviser uses a particular client’s

brokerage and the brokerage of the adviser’s other

clients is caused by client-directed brokerage, the

requirement of the proposal to disclose the

percentage of client-directed brokerage might

render client-specific information unnecessary. See

Section II.D supra.

54See rule 10b–10 under the 1934 Act [17 CFR

240.10b–10] (requiring broker-dealers to send

immediate confirmations of transactions to their

customers). The confirmations, or quarterly

statements containing all of the information

required in the confirmations, must be sent to the

holder of the account, rather than any fiduciary

managing the account. See Securities Exchange Act

Rel. No. 34962 (Nov. 10, 1994) [59 FR 59612 (Nov.

17, 1994)] at § II.A.2.

55As noted above, an adviser to an investment

company is required to provide information about

its soft dollar arrangements to the company’s board

of directors. See note 24 supra. The information

provided by the adviser generally should include

specific information about the adviser’s use of the

investment company’s brokerage. The proposed

annual report would supplement this fund-specific

information.

56Paragraph (a) of proposed rule 204–4; General

Instructions 1 and 5 to proposed Form ADV–B. The

table in the annual report would be required to

disclose commissions paid during the adviser’s

most recently completed fiscal year even if soft

dollar services paid for with those commissions had

been or will be received during another fiscal year.

Conversely, disclosure of soft dollar services

received during a fiscal year would be required

even if commissions were or will be directed to pay

for those services during another fiscal year.

General Instruction 5 to proposed Form ADV–B.

57Paragraphs (a) and (b) of proposed rule 204–4;

General Instructions 3 and 4 to proposed Form

ADV–B. Rule 204–3 under the Advisers Act, which

generally requires advisers to furnish a disclosure

brochure to prospective clients no later than 48

hours prior to the time that the advisory contract

is entered into, permits the brochure to be delivered

at the time that the contract is entered into if the

contract can be terminated without penalty within

five business days. Paragraph (b)(1) of rule 204–3

[17 CFR 275.204–3(b)(1)]. Proposed rule 204–4

would not similarly differentiate between providing

the annual report before or at the time that the

contract is entered into. Generally, however, the

determination of when a contract is entered into

would be the same for the purposes of both rules.

58Paragraph (c)(1) of proposed rule 204–4;

General Instruction 2 to proposed Form ADV–B. An

adviser would not be deemed to have brokerage

discretion over an account if substantially all of the

client’s transactions were directed to a broker that

was compensated for executing the transactions

based upon a percentage of the assets managed by

the adviser, such as in a ‘‘wrap fee’’ program, even

if the adviser could in certain circumstances direct

the client’s transactions to other brokers.

59An adviser would be required to deliver the

annual report to a client if the adviser had

discretion over any of the client’s brokerage, even

if some or most of the client’s brokerage was

directed by the client. Delivery of the annual report

also would be required if the adviser had the

authority to select brokers for particular

transactions from a list previously approved by the

client.

60The Morgan/Goldman Proposal would have

required quarterly reporting.

61Autranet also has proposed that the

Commission prohibit understandings that commit

an adviser to a predetermined amount of

commissions in exchange for soft dollar services.

The Commission requests comment on the

feasibility of this proposal. In particular, the

Commission requests comment whether prohibiting

a stated commission ratio in exchange for soft dollar

services will deter the negotiation of commission

rates and cause advisers that are less sophisticated

or influential to pay higher commissions.

In addition, Autranet proposed that the

Commission ensure that an independent research

originator make its services available to a number

of brokers and not enter into exclusive agreements.

For instance, under ‘‘bump up’’ or bonus

arrangements a vendor will assign a cash value to

its product and offer it to the public at large for a

lower price than charged to a broker providing the

product pursuant to a soft dollar arrangement. In

other arrangements, a vendor will tie the

availability of its product to a single affiliated or

unaffiliated broker, thus causing all trades to go

through that broker in exchange for the service.

Autranet believes that by eliminating commission

commitments and exclusivity arrangements, a client

can be better assured that the adviser obtained the

best execution of the client’s order. The

Commission requests comment on the feasibility of

a prohibition on exclusivity and bonus

arrangements and whether such a proposal would

accomplish the objective of assuring best execution.

The Commission also has forwarded these

proposals to the NASD for its consideration under

its authority to promulgate just and equitable

principles of trade.

client’s brokerage was directed (‘‘clientspecific information’’). Client-specific

information could assist a client in

comparing the use of its brokerage with

that of the adviser’s other clients.53 The

benefits of a requirement to disclose

client-specific information, however,

may be outweighed by the time and cost

to advisers of preparing separate reports

for every client. This cost would likely

be passed on to advisory clients.

Furthermore, advisory clients currently

receive or have access to confirmations

of their transactions that disclose the

identities of the brokers used and the

amounts of commissions charged.54

Comment is requested whether clientspecific information should be required

in the annual report and, if so, what

information should be required.55

G. Delivery and Filing

Reports on Form ADV–B would be

prepared on an annual basis and would

report on brokerage directed during the

adviser’s most recently completed fiscal

year.56 The report would be required to

be filed with the Commission and

delivered to clients no later than sixty

days after the end of the fiscal year, and

delivered to prospective clients no later

than the time that an advisory contract

is entered into.57

Because the report would provide

information about brokerage over which

the adviser has discretion, the report

would be required to be delivered only

to those clients over whose accounts the

adviser has or will have brokerage

discretion. An adviser would be

considered to have brokerage discretion

over an account if it (1) had the

authority to determine, without

obtaining specific client consent, the

brokers to be used or the commissions

paid in connection with any

transactions for the account, or (2)

significantly influenced the selection of

brokers by a client and received soft

dollar services from a broker chosen by

the client.58 An adviser would not be

required to provide the report to a client

that, without the adviser’s influence,

directed that a single broker execute its

transactions, or prior to each transaction

approved the broker to be used for the

transaction.59 Comment is requested

whether this definition of brokerage

discretion is appropriate, and whether

the report should be required to be

delivered to clients over whose accounts

the adviser does not have brokerage

discretion.

The Commission is proposing that the

report be prepared on an annual basis.

More frequent reporting would be more

costly and may not be necessary for

clients to monitor an adviser’s brokerage

direction practices. Furthermore, an

annual report may provide a more

representative sample of an adviser’s

brokerage practices. Comment is

requested whether the report should be

required to be prepared more frequently

than annually, such as quarterly.60

H. Goldman/Morgan Proposal

The Goldman/Morgan Proposal differs

from the Commission’s proposal in a

number of respects. The Goldman/

Morgan Proposal would, among other

things, require quarterly rather than

annual reporting, require disclosure of

the commission price and value of

specific third-party soft dollar services,

and require disclosure of certain clientspecific information. The Commission

has requested comment on these

elements of the Goldman/Morgan

Proposal separately in this Release. The

Commission also requests comment

whether the Goldman/Morgan Proposal

generally would be preferable to the

Commission’s proposal.

III. Disclosure By Brokers Providing

Soft Dollar Services

The amendments being proposed in

this Release would require disclosure by

advisers that receive soft dollar services

from brokers. In a letter to the staff,

Autranet, Inc. (‘‘Autranet’’), a broker

providing third-party soft dollar services

to advisers, proposed an entirely

different approach that would impose

certain recordkeeping and disclosure

requirements on brokers providing

third-party soft dollar services to ensure

that the services were provided within

the safe harbor of Section 28(e) of the

Exchange Act.61 Under the Autranet
Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules 9757

proposal, these brokers would be

required to demonstrate that they

incurred a legal obligation to provide

soft dollar services to an adviser. This

obligation could be demonstrated either

by a contract that indicates the broker’s

financial obligation to purchase the soft

dollar services from an independent

research originator, or by an invoice

showing the broker’s payment for the

services for those soft dollar services not

typically the subject of a contract.

In addition, Autranet proposes that

third-party soft dollar brokers be

required to provide a description of the

soft dollar services provided in an

arrangement and specify how the

product assists an adviser in its

investment decisions. A broker would

be required to make this description

available to the managed account upon

request and provide the managed

account a quarterly report showing the

cost of the soft dollar service. For

products having a mixed-use, Autranet

proposes that the broker providing such

a product obtain from the adviser a

description of the adviser’s use of the

product and the adviser’s allocation

between the research and non-research

functions of the product.

Autranet proposes that these

descriptions be reflected in an annual

report that third-party soft dollar

brokers would file with the Commission

and provide to the advisers receiving

soft dollar services and to the clients of

those advisers whose commissions were

used to obtain the soft dollar services.

Autranet proposes that the report

include (1) a disclosure statement

describing the business of the third

party broker; (2) a financial summary,

quantifying on an aggregate basis the

value by category and, if necessary, subcategory, of the soft dollar services

provided; (3) a compliance report,

demonstrating that the soft dollar

services were in compliance with the

requirements set forth above and within

the safe harbor of Section 28(e); and (4)

an independent auditor’s report.

Autranet believes that such a reporting

requirement would not be costly to

third-party brokers because the

information required is readily available

and the reporting requirements should

reflect compliance procedures already

established by third-party brokers

providing soft dollar services.

The Commission requests comment

on whether some or all of the Autranet

proposals would be practical additions

to the disclosure currently required and

proposed of advisers. In particular, the

Commission requests comment on the

costs associated with this disclosure

approach and the ease with which this

information could be obtained by

brokers and provided to advisers and

their clients. In addition, the

Commission requests comment on the

extent to which full service brokers

providing proprietary soft dollar

services could or should be subject to

any of the reporting requirements

proposed by Autranet.

IV. General Request For Comments

Any interested persons wishing to

submit written comments on the

proposals that are the subject of this

Release, to suggest additional changes,

or to submit comments on other matters

that might have an effect on the

proposals that are contained in this

Release, are requested to do so.

V. Cost/Benefit Analysis

The rule and form proposed today are

intended to provide material

information to clients and prospective

clients of investment advisers that can

be used to evaluate an adviser’s

brokerage direction and soft dollar

practices. The proposals would enable

an advisory client to better assess

whether its adviser is directing its

brokerage in accordance with its best

interests, and whether the advisory fee

it pays is appropriate in light of the

services provided and costs incurred

directly by the adviser.

Adoption of the proposal would

impose some additional costs on

advisers required to prepare the report

and deliver it to clients. The

Commission believes, however, that the

proposals appropriately balance the

need for additional disclosure with the

costs of providing that disclosure. The

information that would be required by

the proposal should readily be

determinable by an adviser. A number

of alternatives that would make the

disclosure requirements more

burdensome, such as requiring advisers

to disclose the value of soft dollar

services received or report on the use of

each client’s brokerage, are not being

proposed. Furthermore, because the

report would need to be prepared and

delivered only annually, the costs of

preparing and delivering the report

should be minimized. In short, the

Commission believes that the costs of

the proposals would be outweighed by

the benefits to advisory clients in

receiving more useful information about

their advisers’ direction of client

brokerage.

VI. Summary Of Initial Regulatory

Flexibility Analysis

The Commission has prepared an

Initial Regulatory Flexibility Analysis in

accordance with 5 U.S.C. 603 regarding

the proposed amendments. The analysis

notes that the rule and form proposed in

this Release are intended to provide

investment advisory clients for whom

the adviser selects brokers to execute

client transactions with information

about the services the adviser receives

from those brokers and the commissions

charged by those brokers. Other

aggregate cost-benefit information

reflected in the ‘‘Cost/Benefit Analysis’’

section of this Release also is reflected

in the analysis. A copy of the Initial

Regulatory Flexibility Analysis may be

obtained by contacting Jana M. Cayne,

Securities and Exchange Commission,

450 Fifth Street, NW., Mail Stop 10–6,

Washington, DC 20549.

VII. Statutory Authority

The Commission is proposing rule

204–4 and Form ADV–B under the

authority set forth in Sections 204,

206(4) and 211(a) of the Advisers Act

[15 U.S.C. 80b–4, 80b–6(4) and 80b–

11(a)] and Section 28(e)(2) of the 1934

Act [15 U.S.C. 78bb(e)(2)].

Text Of Proposed Rule And Form

Amendments

List of Subjects in 17 CFR Parts 275 and

279

Investment advisers, Reporting and

recordkeeping requirements.

For the reasons set out in the

preamble, title 17, chapter II of the Code

of Federal Regulations is proposed to be

amended as follows.

PART 275—RULES AND

REGULATIONS, INVESTMENT

ADVISERS ACT OF 1940

1. The authority citation for Part 275

is amended by adding the following

citation:

Authority: 15 U.S.C. 80b–3, 80b–4, 80b–

6A, 80b–11, unless otherwise noted.

* * * * *

Section 275.204–4 is also issued

under 15 U.S.C. 78bb(e)(2).

2. By adding § 275.204–4 to read as

follows:

§ 275.204–4 Annual report on brokerage

practices.

(a) Each investment adviser,

registered or required to be registered

under Section 203 of the Act on the last

day of its most recently completed fiscal

year, that exercised brokerage discretion

over the account of any client during

that fiscal year and obtained services

other than execution services from a

broker to which it directed client

brokerage during that fiscal year shall

file a report on Form ADV–B with the

Commission no later than 60 days after

the end of that fiscal year, unless the

investment adviser’s registration was
9758 Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules

withdrawn, cancelled or revoked after

the end of the fiscal year.

(b) An investment adviser required to

file a report on Form ADV–B pursuant

to paragraph (a) of this section shall

furnish such report for its most recently

completed fiscal year:

(1) No later than 60 days after the end

of each fiscal year, to each advisory

client over whose account the

investment adviser exercises brokerage

discretion; and

(2) No later than the time that a

written or oral investment advisory

contract is entered into, to each new or

prospective advisory client over whose

account the investment adviser will or

proposes to exercise brokerage

discretion.

(c) For purposes of this section:

(1)(i) An investment adviser exercises

‘‘brokerage discretion’’ over a client’s

account if it:

(A) Has authority to determine,

without obtaining specific client

consent, the broker to be used or the

commission rates paid in connection

with any transaction of the client; or

(B) Significantly influences the

selection of brokers by the client and

receives services other than execution

services from a broker chosen by the

client.

(ii) An investment adviser does not

exercise brokerage discretion over a

client’s account if substantially all of the

client’s transactions were directed to a

broker that was compensated for

executing such transactions solely based

upon a specified percentage of the assets

managed by the investment adviser; and

(2) Execution services mean those

services set forth in paragraph (e)(3)(C)

of Section 28 of the Securities Exchange

Act of 1934 (15 U.S.C. 78bb(e)(3)(C)).

PART 279—FORMS PRESCRIBED

UNDER THE INVESTMENT ADVISERS

ACT OF 1940

3. The authority citation for Part 279

is amended by adding the following

citation:

Authority: The Investment Advisers Act of

1940, 15 U.S.C. 80b–1, et seq.

Section 275.204–4 is also issued

under 15 U.S.C. 78bb(e)(2).

4. By adding § 279.9 and Form ADV–

B to read as follows:

§ 279.9 Form ADV–B, annual report on

investment adviser’s brokerage direction

practices.

This form shall be filed annually by

an investment adviser, registered or

required to be registered under the

Investment Advisers Act of 1940, that

has the authority to select brokers to

execute the transactions of any client

and that obtains services other than

execution from a broker to which it

directs client brokerage.

Note: Form ADV–B is attached as

Appendix 1 to this document. The Form will

not appear in the Code of Federal

Regulations.

Dated: February 14, 1995.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

Appendix 1

OMB Approval

OMB Number:

Expires:

Estimated average burden hours per

response:

U.S. Securities and Exchange Commission,

Washington, DC 20549

Form ADV–B

Annual Report on Brokerage Practices for

Registered Investment Advisers Having

Discretion Over Client Brokerage

Applicant: lllllllllllllll

SEC File Number: 801– llllllllll

Date: llllllllllllllllll

MM/DD/YY

General Instructions for Preparing and

Filing Form ADV–B

1. Applicability of Form Requirement. A

report on Form ADV–B must be prepared and

filed by every investment adviser that (i) was

registered or required to be registered under

the Investment Advisers Act of 1940 on the

last day of its most recently completed fiscal

year (unless the adviser’s registration has

since been withdrawn, cancelled or revoked),

(ii) exercised ‘‘brokerage discretion’’ over the

account of any advisory client during that

fiscal year, and (iii) obtained services other

than ‘‘execution services’’ from a broker to

which it directed client brokerage during that

fiscal year.

2. Definitions.

Brokerage Discretion. An investment

adviser exercises brokerage discretion over a

client’s account if it (i) has the authority to

determine, without obtaining specific client

consent, the broker to be used or the

commission rates paid in connection with

any transaction of the client, or (ii)

significantly influences the selection of

brokers by the client and receives services

other than execution services from a broker

chosen by the client. An investment adviser

does not have discretion over a client’s

account, however, if substantially all of the

client’s transactions were directed to a broker

that was compensated for executing such

transactions solely based upon a specified

percentage of the assets managed by the

adviser, even if the adviser has the discretion

to direct certain of the client’s transactions to

other brokers.

Execution Services. Execution services

mean those services described in Section

28(e)(2)(C) of the Securities Exchange Act of

1934, i.e., effecting securities transactions

and performing functions incidental thereto

or required in connection therewith by rules

of the Securities and Exchange Commission

or a self-regulatory organization.

3. Format and Filing of Report. The report

required by this form should be prepared as

a separate document, not on copies of this

Form. The report shall be filed in triplicate

with the Securities and Exchange

Commission, 450 Fifth Street NW.,

Washington, DC 20549. Each copy of the

report filed with the Commission should be

attached to a completed copy of this page,

although only one such copy need be

manually executed. The report shall be filed

no later than 60 days after the end of the

adviser’s fiscal year.

Execution: The undersigned represents that

he or she has executed this form on behalf

of, and with the authority of, said investment

adviser. The undersigned and the investment

adviser represent that the information and

statements contained herein, including

exhibits attached hereto and other

information filed herewith, all of which are

made a part hereof, are current, true, and

complete.

Dated the llll day of

llllllllll, 19lll

lllllllllllllllllllll

(Name of registrant)

By: lllllllllllllllllll

(Signature and title)

4. Delivery.

Existing Clients. Rule 204–4 under the

Investment Advisers Act of 1940 requires

that the report be furnished no later than 60

days after the end of the investment adviser’s

most recently completed fiscal year to each

advisory client over whose account the

adviser exercises brokerage discretion (as

defined in Instruction 2 above).

Prospective Clients. Rule 204–4 also

requires that the report be furnished no later

than the time that a written or oral

investment advisory contract is entered into

to each new or prospective advisory client

over whose account the adviser will or

proposes to exercise brokerage discretion.

5. Period of Required Data. An investment

adviser must provide the requested

information for its most recently completed

fiscal year. Brokerage commissions directed

or services received during a fiscal year

should be included in the table, even if the

services corresponding to commissions

directed during the fiscal year were or will

be received during another fiscal year, or the

commissions corresponding to services

received during the fiscal year were or will

be directed during another fiscal year.

6. Additional Information. An investment

adviser may, in addition to providing the

required information, provide other

information, including additional data and

explanations of the required information,

about its brokerage practices in its response

to this Form.

Information Required in Annual Report

Item 1. General Description of Report

In an introduction to the report:

(a) explain that the report contains

information about the adviser’s practices in

selecting brokers to execute transactions for

its investment advisory clients that can be

used to evaluate whether the adviser directs
Federal Register / Vol. 60, No. 34 / Tuesday, February 21, 1995 / Proposed Rules 9759

client transactions consistent with the best

interests of its clients;

(b) explain that the information contained

in the report is provided on a firm-wide

basis, that the report does not include

specific information about the brokerage of

any particular client or the extent to which

services obtained are used for the benefit of

any particular client, and that clients should

refer to the confirmations or quarterly

account statements provided by their brokers

or contact the adviser for information about

the brokers used to execute their

transactions;

(c) explain, if applicable, that the report

does not include information about many

transactions executed on a ‘‘principal’’ basis,

that, in principal transactions, transaction

costs typically are included in the price of

the securities purchased or sold and are not

charged as separate commissions, and that

transactions in certain types of securities

typically are executed on a principal basis;

and

(d) provide an address or phone number at

which a client can contact the adviser to

request more information.

Item 2. Information Regarding the Twenty

Most Frequently Used Brokers

Using the captions and tabular format

illustrated below, provide the required

information for the twenty brokers (other

than ‘‘execution-only’’ brokers as defined in

Item 3) to which the investment adviser

directed the greatest amount of client

commissions. If no or fewer than twenty such

brokers were used, state either ‘‘no brokers

used that provided services other than

execution’’ after the title or ‘‘no additional

brokers used’’ after the last broker listed.

THE TWENTY BROKERS TO WHICH THE GREATEST AMOUNTS OF CLIENT COMMISSIONS WERE DIRECTED

Name of broker

Aggregate amount of

discretionary commissions

paid to broker

(in dollars)

Commissions paid to broker

(as a percentage of adviser’s discretionary commissions)Average commission rate

(in cents/share)

Description of services

obtained (other than

execution services)

Instructions

1. For the purposes of this Form, brokers

include broker-dealers registered under the

Securities Exchange Act of 1934, banks, and,

as set forth in Item 3, automated trading

systems.

2. ‘‘Discretionary commissions’’ are those

commissions, mark-ups and mark-downs that

are disclosed on the transaction

confirmations required under rule 10b-10

under the Securities Exchange Act of 1934

and that are paid in connection with

transactions for which the investment adviser

had the authority to determine, without

obtaining specific client consent, the broker

or dealer to be used or the commission rates

paid.

3. Commissions include sales loads paid in

connection with transactions in investment

company shares, although sales loads should

not be considered in calculating the average

commission rate. If the adviser directed

transactions in investment company shares to

a broker other than the principal underwriter

of the investment company, that broker,

rather than the principal underwriter, should

be considered to have executed the

transaction.

4. For purposes of this Form, commissions

do not include fees for brokerage services

that are based upon a specified percentage of

the assets managed (i.e., fees paid under

‘‘wrap fee’’ programs).

5. Calculate average commission rates on a

‘‘share-weighted’’ basis (i.e., by dividing the

total amount of client commissions that the

investment adviser directed to the broker by

the total number of shares, exclusive of

investment company shares, purchased or

sold by the broker for the adviser’s clients).

6. For the purposes of determining

commission amounts and average

commission rates, convert any commission

charged in foreign currency to dollars (and

cents per share). The investment adviser may

use any reasonable means and times for

determining the applicable exchange rate as

long as those means and times are used on

a consistent basis.

7. Under ‘‘Description of Services

Obtained,’’ products or services obtained by

the investment adviser from each broker,

including computer hardware, software,

databases, and on-line services, publications

available by subscription, and services falling

outside the scope of Section 28(e) of the

Securities Exchange Act of 1934, generally

should be identified separately and

specifically. Research reports and contacts

with securities analysts or professionals,

however, may be described generally by the

following terms: (i) analyses and reports on

specific securities, issuers, or industries, (ii)

general political or economic analyses or

reports, or (iii) contacts with securities

analysts. The party that produced a

specifically identified product or service

should also be identified unless the

producer’s name is evident from the name of

the product or service. An adviser should

report all products or services received from

a broker, even if some of the services could

be deemed to have been received as a result

of principal transactions the costs of which

are not required to be reported in the table.

Item 3. Information Regarding Three Most

Frequently Used Execution-Only Brokers

Using the captions specified under Item 2

(except ‘‘Description of Services Obtained’’),

provide a table titled ‘‘The Three Executiononly Brokers to which the Greatest Amounts

of Client Commissions were Directed’’ that

includes the required information for the

three execution-only brokers to which the

investment adviser directed the greatest

amount of client commissions. If no or fewer

than three execution-only brokers were used,

state either ‘‘no execution-only brokers used’’

after the title or ‘‘no additional executiononly brokers used’’ after the last broker listed.

Instruction

For the purposes of this Item, a broker

should be considered an execution-only

broker if substantially all of the services that

it provides to the adviser are execution

services (see the definition in Instruction 2 of

the General Instructions). An automated

trading system should be considered an

execution-only broker if substantially all of

the services received by the adviser in

connection with using the system are

execution services and if a fee is charged for

using the system, regardless of the basis for

the fee (e.g., a flat usage fee or transactionbased charges).

Item 4. Information Regarding Brokerage

Business Directed by Clients

Provide the following information under

the following captions:

Percentage of Total Commissions Directed

to Brokers Providing Research and Other

Services in Addition to Execution:

Percentage of Total Commissions Directed

to Execution-only Brokers:

Percentage of Total Commissions Directed

by Clients:

Instruction

For the purposes of this Item, commissions

directed by clients are those commissions

paid by accounts managed by the adviser that

were directed pursuant to client requests or

instructions. Total commissions equal the

sum of the adviser’s discretionary

commissions, as defined in Item 2, and the

commissions directed by clients.

[FR Doc. 95–4160 Filed 2–17–95; 8:45 am]

BILLING CODE 8010–01–P