[Federal Register Volume 67, Number 1 (Wednesday, January 2, 2002)]
[Rules and Regulations]
[Pages 6-8]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-32199]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 241

[Release No. 34-45194]


Commission Guidance on the Scope of Section 28(e) of the Exchange 
Act

AGENCY: Securities and Exchange Commission.

ACTION: Interpretation.

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SUMMARY: We are publishing interpretive guidance on the application of 
Section 28(e) of the Securities Exchange Act of 1934 (``Exchange 
Act''). This section provides a safe harbor to money managers who use 
the commission dollars of their advised accounts to obtain research and 
brokerage services. The guidance we are publishing today clarifies that 
the term ``commission'' for purposes of the Section 28(e) safe harbor 
encompasses, among other things, certain transaction costs, even if not 
denominated a ``commission.''

EFFECTIVE DATE: The guidance is effective on January 2, 2002.

FOR FURTHER INFORMATION CONTACT: Catherine McGuire, Chief Counsel; 
Joseph Corcoran, Special Counsel, (202) 942-0073, Office of the Chief 
Counsel, Division of Market Regulation, Securities and Exchange 
Commission, 450 Fifth Street, NW, Washington, DC 20549-1001.

SUPPLEMENTARY INFORMATION:

I. Background

    If money managers use commission dollars of their advised accounts 
to obtain research and brokerage services, Section 28(e) prevents them 
from being held to have breached a fiduciary duty, provided the 
conditions of the section are met.\1\ Previously, 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.\2\ That interpretation 
prevented money managers from relying 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.
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    \1\ 15 U.S.C. 78bb(e).
    \2\ Investment Advisers Act Release No. 1469 (February 14, 
1995), 60 FR 9750 (February 21, 1995). In this release, the 
Commission stated, ``[t]he safe harbor does not encompass soft 
dollar arrangements under which research services are acquired as a 
result of principal transactions,'' adopting a position originally 
outlined in a 1990 staff letter, authorized by the Commission, to 
the Department of Labor. See Letter re: Section 28(e) of the 
Securities Exchange Act of 1934 (July 25, 1990). See also Investment 
Company Act Release No. 20472 (August 11, 1994), 59 FR 42187 (August 
17, 1994).
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    The Nasdaq Stock Market, Inc. (``Nasdaq'') asked us to reconsider 
this interpretation of Section 28(e). In particular, Nasdaq urged us to 
interpret the Section 28(e) safe harbor to apply not just to research 
and brokerage services obtained in relation to commissions on agency 
transactions, but also to such 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 certain NASD trade reporting 
rules.\3\ In Nasdaq's view, the recent amendments to its trade 
reporting rules for certain riskless principal transactions support a 
modification of the Commission's interpretation of Section 28(e).\4\
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    \3\ See Letter from Hardwick Simmons, Chief Executive Officer, 
The Nasdaq Stock Market, Inc. to Harvey L. Pitt, Chairman, 
Commission, dated September 7, 2001.
    \4\ See Exchange Act Release Nos. 41208 (March 24, 1999), 64 FR 
15386 (March 31, 1999) (File No. SR-NASD-98-59); 41606 (July 8, 
1999), 64 FR 38226 (July 15, 1999) (File No. SR-NASD-98-08); 43303 
(September 19, 2000), 65 FR 57853 (September 26, 2000) (File No. SR-
NASD-00-52). These filing amended NASD Rules 4632 (the trade 
reporting rule for Nasdaq National Market securities), 4642 (the 
trade reporting rule for Nasdaq SmallCap Market securities), and 
6420 (the trade reporting rule for eligible securities).

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[[Page 7]]

II. Discussion

    Section 28(e) of the Exchange Act prevents a person who exercises 
investment discretion with respect to an account from being ``deemed to 
have acted unlawfully or to have breached a fiduciary duty * * * solely 
by reason of his having caused the account to pay a [broker-dealer] an 
amount of commission for effecting a securities transaction in excess 
of the amount of commission another [broker-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 [broker-
dealer]. * * *'' \5\
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    \5\ 15 U.S.C. 78bb(e). See also Exchange Act Release No. 23170 
(April 23, 1986), 51 FR 16004 (April 30, 1986).
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    This release clarifies the meaning of the term ``commission'' in 
the context of Section 28(e), and, therefore, the type of fees paid by 
a managed account to a broker-dealer for a securities transaction that 
may be used by the money manager to obtain research and brokerage 
services within the safe harbor. As noted above, the Commission to date 
has interpreted the term ``commission'' to include fees paid by a 
managed account to a broker-dealer for effecting a transaction in an 
agency capacity. This interpretation is based on the understanding that 
the term ``commission'' generally connotes an agency transaction.\6\ 
However, that interpretation is not mandated by the language of the 
statute. In fact, the reference to ``dealer'' in Section 28(e) might 
suggest that the term ``commission'' includes fees paid to a broker-
dealer acting in other than an agency capacity.
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    \6\ In adopting the position in 1995 that Section 28(e) does not 
encompass principal transactions, we noted a 1990 staff letter to 
the Department of Labor. In that letter, the Division of Market 
Regulation stated that, ``Section 28(e) refers to `commissions' 
only, which connote transactions effected on an agency basis, and 
does not refer to markups or markdowns, which would more clearly 
have suggested that Congress intended to extend the safe harbor to 
principal transactions.'' See supra note 2.
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    The meaning of the term ``commission'' in Section 28(e) is informed 
by the requirement that a money manager relying on the safe harbor must 
determine in good faith that the amount of ``commission'' is reasonable 
in relation to the value of research and brokerage services received. 
This requirement presupposes that a ``commission'' paid by the managed 
account is quantifiable in a verifiable way and is fully disclosed to 
the money manager. When we issued our guidance in 1995, an agency 
transaction had more cost transparency than a principal transaction 
because frequently embedded within the cost of a principal transaction 
was undisclosed compensation to the dealer. In other words, 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.
    Since that time, the NASD has modified its trade reporting rules 
for certain riskless principal transactions. Currently, NASD Rule 4632 
(applicable to Nasdaq National Market securities), NASD Rule 4642 
(applicable to Nasdaq SmallCap Market securities), and NASD Rule 6420 
(applicable to ``eligible securities'') require a riskless principal 
transaction in which both legs are executed at the same price 
(``Eligible Riskless Principal Transaction'') to be reported once, in 
the same manner as an agency transaction, exclusive of any markup, 
markdown, commission equivalent, or other fee.\7\ Coupled with Exchange 
Act Rule 10b-10, this form of trade reporting means that a money 
manager agreeing to an Eligible Riskless Principal Transaction receives 
the same price as received in the offsetting trade and that this price 
is disclosed on a confirmation that also fully discloses the 
remuneration to the NASD member for effecting this transaction.\8\ 
Thus, a money manager opting for an Eligible Riskless Principal 
Transaction would now be informed of the entire amount of a market 
maker's charge for effecting the trade.
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    \7\ See NASD Rules 4632(d)(3)(B) (for Nasdaq Market securities), 
4642(d)(3)(B) (for Nasdaq SmallCap Market securities), and 
6420(d)(3)(B) (for eligible securities). Each of these rules defines 
a riskless principal transaction as a ``transaction in which a 
member, after having received an order to buy a security, purchases 
the security as principal at the same price to satisfy the order to 
buy or, after having received an order to sell, sells the security 
as principal at the same price to satisfy the order to sell.''
    \8\ Exchange Act Rule 10b-10(a)(2)(ii), 17 CFR 240.10b-
10(a)(2)(ii). Nasdaq SmallCap Market securities are subject to 
Exchange Act Rule 10b-10. See Exchange Act Release No. 45081 
(November 19, 2001), 66 FR 59273 (November 27, 2001).
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    In recognition of the transparency achieved in the Nasdaq market 
for certain riskless principal transactions, which allows a money 
manager to make the necessary determination under Section 28(e), we are 
modifying our interpretation of Section 28(e). Specifically, we now 
interpret the term ``commission'' in Section 28(e) of the Exchange Act 
to include a markup, markdown, commission equivalent or other fee paid 
by a managed account to a dealer for executing a transaction where the 
fee and transaction price are fully and separately disclosed on the 
confirmation and the transaction is reported under conditions that 
provide independent and objective verification of the transaction price 
subject to self-regulatory organization oversight.
    Fees paid for Eligible Riskless Principal Transactions that are 
reported under NASD Rule 4632, 4642, or 6420 would fall within this 
interpretation.\9\ Fees paid to an NASD member for effecting an 
Eligible Riskless Principal Transaction are distinguishable from fees 
paid on traditional riskless principal transactions as well as 
traditional principal transactions involving a dealer's inventory. Fees 
on other riskless principal transactions can include an undisclosed fee 
(reflecting a dealer's profit on the difference in price between the 
first and second legs of the transaction). Fees on traditional 
principal transactions also can include an undisclosed fee based on 
some portion of the spread. In addition, the price of the trade, if 
reported, is to some degree within the control of the dealer. In 
contrast, fees on Eligible Riskless Principal Transactions that are 
reported under NASD Rule 4632, 4642, or 6420 must be fully and 
separately disclosed. Moreover, the price of the trade is validated by 
the offsetting leg of the transaction.
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    \9\ Riskless principal transactions in the debt market, however, 
are not currently subject to confirmation and reporting requirements 
that meet these conditions, under either NASD or Commission rules, 
and therefore would not be within the Section 28(e) safe harbor. 
Such transactions do not afford money managers the level of 
transparency necessary to determine if the remuneration paid is 
reasonable in relation to the value received, as required to rely on 
Section 28(e). The interpretation does not currently extend to other 
securities that may have similar reporting requirements, but that do 
not have the same confirmation requirements for market makers, e.g., 
OTC Bulletin Board stocks, Pink Sheet stocks, and convertible 
securities.
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    Required disclosure of fees under confirmation rules and reporting 
of the trade under self-regulatory organization rules at a single price 
for both offsetting transactions, which provides independent 
verification of this price, give money managers information about fees 
and trade prices sufficient to make the determination of reasonableness 
of these charges. It is therefore reasonable to treat such fees as a 
``commission'' for purposes of Section 28(e) only. As other markets 
develop equivalent regulations to ensure equivalent transparency, 
transaction charges in those markets that meet the requirements of this 
interpretation will be considered to fall within the interpretation.

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III. Conclusion

    For the foregoing reasons, we find that this interpretation is 
consistent with Section 28(e) of the Exchange Act and the requirements 
of that section.

List of Subjects in 17 CFR Part 241

    Securities.

Amendments to the Code of Federal Regulations

    For the reasons set forth above, 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

    1. Part 241 is amended by adding Release No. 34-45194 and the 
release date of December 27, 2001 to the list of interpretative 
releases.

    Dated: December 27, 2001.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-32199 Filed 12-31-01; 8:45 am]
BILLING CODE 8010-01-P