Special from Jay B. Gould,
White & Case LLP

On October 19, 2005, the Securities and Exchange Commission (the “SEC”) published for public comment an interpretive release (the “Release”) regarding the scope of brokerage and research services in light of “evolving technologies and industry practices.” This proposed SEC guidance has significant implications for hedge fund managers and other investment advisers, as well as broker-dealers. At the very least, hedge fund managers will need to review their offering materials and their Form ADV disclosures.

Fiduciary principles require money managers to seek the best execution for client trades, and limit money managers from using client assets for their own benefit. The SEC has long held the position that use of client commissions to pay for research and brokerage services presents money managers with significant conflicts of interest, and may give incentives for managers to disregard their best execution obligations when directing orders to obtain client commission services. The SEC is also concerned that this “soft-dollar” practice could provide an incentive to money managers to trade client securities inappropriately in order to earn credits for client commission services.

Recognizing the value of research in managing client accounts, however, Congress amended the Securities Exchange Act of 1934 (“Exchange Act”) in 1975 to add Section 28(e). The SEC promulgated rules shortly thereafter that ended fixed brokerage commissions. Section 28(e) provides a safe harbor that protects money managers from liability for a breach of fiduciary duty solely on the basis that they paid more than the lowest commission rate in order to receive “brokerage and research services” provided by a broker-dealer if the managers determined in good faith than the amount of the commission was reasonable in relation to the value of the brokerage and research services received.

Since 1975, the SEC has interpreted Section 28(e) several times and brought a number of enforcement actions alleging abuse of soft-dollar practices. Pursuant to the Release, the SEC would interpret the scope of the safe harbor as follows:

• Eligibility of brokerage and research services for safe harbor protection would be governed by the criteria in Section 28(e)(3), consistent with the Commission’s 1986 “lawful and appropriate assistance” standard.
• “Research Services” would be restricted to “advice,” “analyses,” and “reports” within the meaning of Section 28(e)(3).
• • Physical items, such as computer hardware, which do not reflect the expression of reasoning or knowledge relating to the subject matter identified in the statute, would be outside the safe harbor.
  • Market, financial, economic, and similar data would be eligible for the safe harbor.
• “Brokerage services” within the safe harbor would be those products and services that relate to the execution of the trade from the point at which the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution, through the point at which funds or securities are delivered or credited to the advised account.
• Mixed-use items would need to be reasonably allocated between eligible and ineligible uses, and allocation would need to be documented so as to enable the money manager to make the required good faith determination of the reasonableness of commissions in relation to the value of the brokerage and research services.

In the Release, the SEC reiterated the statutory requirement that money managers must make a good-faith determination that commissions paid are reasonable in relation to the value of the products and services provided by broker-dealers in connection with the managers’ responsibilities to the advisory accounts for which the managers exercise investment discretion.

Finally, the Release reiterated the SEC position that under Section 28(e), broker-dealers must be financially responsible for the brokerage and research products that they provide to money managers, and they must be involved in “effecting” the trade.

Note: White & Case LLP represents hedge fund and private equity fund sponsors and advisers, prime brokers, and administrators through its 38 offices in 25 countries around the world. For further information on the White & Case investment funds practice, contact:

Jay B. Gould, Esq.
White & Case LLP
Three Embarcadero Center, Suite 2210
San Francisco, California 94111
415-544-1112 (O)
310-800-6500 (C)
jgould@whitecase.com