Richard A. Levan & Associates, PC

The SEC 's Long-Awaited Soft Dollar Report
By Richard A. Levan

April 1999

On September 22, 1998, the SEC's Office of Compliance Inspections and Examinations ("OCIE") issued its long-awaited Inspection Report on the Soft Dollar Practices of Investment Advisers, Broker-Dealers and Mutual Funds (the "Report").The Report is based upon a series of focused on -site inspections of the soft dollar practices of 75 broker-dealers and 280 investment advisers and investment companies between November 1996 and April 1997.

The SEC's 18-month "sweep" was motivated by ongoing concerns over abuses in the soft -dollar area. The inquiry focused on the types of products and services being paid for with soft dollars, the limits of Section 28(e)'s safe harbor, and the adequacy of the industry's soft dollar disclosure practices generally.

Findings of the Soft Dollar Report

The SEC made the following findings in its report:

Non-research products and services. The OCIE study revealed a significant number of soft dollar arrangements that failed to qualify for the safe harbor provided by Section 28(e) of the Securities Exchange Act of 1934 (the "Exchange Act"). Although receipt of non -research items (e.g., office equipment, accounting software) can be lawful outside the safe harbor if adequate disclosure is made, virtually all of the inspected advisers that obtained non-research products and/or services failed to provide meaningful disclosure of such practices to clients. As a result, there appears to be much confusion as to the "brokerage" and "research" qualifications for assessing Section 28(e)safe harbor treatment.

Computer equipment. Confusion was particularly apparent when the OCIE reviewed adviser assessments of high-tech computer equipment. Advisers evidenced considerable difficulty in determining whether computer hardware and peripherals, such as modems, monitors and fiber optic cables,qualify as "research" or "brokerage" within the meaning of Section 28(e).The prevailing rationale defines such items as products used to facilitate trade execution. Advisers considered this rationalization adequate to qualify the equipment for safe harbor treatment. The study, however, uncovered many inconsistencies in the application of this reasoning. Advisers were also generally found to be without clear interpretive guidance when making such assessments.

Mixed-use items. The study found shortcomings by advisers when assessing the safe harbor treatment of mixed-use items. Several of the advisers examined either failed to allocate the cost of such items between soft and hard dollars or were unable to adequately justify the allocation used. Instances of advisers ignoring the "provided by" concept were also uncovered. In fact, at least one fourth of all broker-dealers examined paid invoices submitted directly to them by advisers.

Disclosure practices. Perhaps most importantly, the study revealed widespread inadequacies in the disclosure practices of investment advisers. Disclosures often consisted of boilerplate language that was simply not meaningful to clients. Detailed information about the products and/or services received was not included in the disclosures and many of the disclosures lacked the clarity necessary for client assessments of soft dollar arrangements.

Recommendations Made to the Commission

Publish or reiterate guidance. Although the OCIE's study uncovered significant problems in the way investment advisers interpreted the Section 28(e) safe harbor and disclosed soft dollar arrangements, the Report stopped short of recommending a ban on any particular soft dollar practices. Instead, the Report recommended that the Commission reiterate and provide further guidance with respect to the scope of the Section 28(e) safe harbor. This would include reiterating guidance contained in the Soft Dollar Release on topics such as, what constitutes "brokerage" and "research"for the purposes of the safe harbor;mixed -use cost allocations;and third party "provided" research arrangements. In addition,the Commission was called upon to publish guidance on how to properly classify electronic equipment used to provide research and place trades.

Record keeping requirements. The Report also recommended the adoption of new record keeping requirements. The Report proposed the Commission adopt a rule whereby broker-dealers would be required to deliver to each investment adviser an annual statement of all products and services provided to the adviser in soft dollar arrangements. Advisers would then be required to reconcile all broker-dealer statements with their own records. Additionally, it was recommended that rules be adopted requiring advisers to maintain written evidence of the calculations used to allocate the cost of mixed-use products.

Modification of Form ADV. To encourage more detailed disclosures regarding products and services that do not qualify for the statutory safe harbor, modification of Form ADV was also recommended. Posing more specific inquires in the form and providing more detailed instructions for completing Items 12 and 13 on Form ADV Part II would guide advisers in providing their clients with meaningful disclosures.

The Report's Impact

As discussed above, the Report did not call for the elimination of any soft dollar practices nor were any major rule changes proposed. The impact of the Report, therefore, appears to be subtle. However, there are certain steps that can be taken by advisers to avoid problems in the future if the rule changes proposed are pursued by the SEC.

Improve record keeping. Detailed records should be kept by each adviser evidencing all products and services received via soft dollar arrangements. This will assist in reconciling the records of the adviser to any statements that may be received from broker-dealers.

Expand Form ADV disclosures. Advisers should include additional details in Form ADV describing any soft dollar arrangements falling outside the Section 28(e) safe harbor. Form ADV should disclose:

the products or services received;

the value of each item received in relation to its cost;

which clients generated the commissions that are being used to pay for the products or services;

which clients are receiving the benefit of such items; and

how the costs of mixed-use products are allocated.

It is important to remember that soft dollar arrangements outside of the safe harbor are not prohibited provided adequate disclosures of the arrangements have been made.

Review available guidance. Advisers should carefully review the Soft Dollar Release and any new guidance provided by the SEC. The OCIE acknowledged that one of the goals of recommending increased disclosure was to make advisers less likely to buy items outside of the safe harbor. Investment advisers, therefore, are advised to review their soft dollar practices now to prepare for additional SEC attention in the future.

Investment advisers are forewarned, although the Report appears to lack significant teeth, it could be a portender of things to come. Arthur Levitt, Jr., Chairman of the SEC, recently criticized the fine line between proper and improper soft dollar practices. To remedy the situation, he called for closer scrutiny by the law enforcement community as well as more stringent guidelines. In light of the fact that these issues are increasingly being brought to the forefront of public consciousness, their relevance will predictably continue to increase.