Blog Article

An Overview of RIA Compliance Rules Regarding Soft Dollar Benefits

Jul 09, 2015

The proper use and disclosure of soft dollar benefits by RIA firms remains a regulatory focus area.

The topic of soft dollar benefits continues to be an area of confusion among registered investment adviser (RIA) firms and a topic of discussion among the Securities and Exchange Commission (SEC) and state regulators. As access to soft dollar benefits continues to develop and grow, many advisory firms are utilizing products and services provided by broker-dealers. However, regulators continue to uncover disclosure and compliance issues with regard to investment advisers utilizing soft dollar benefits.

The SEC has defined soft dollar benefits as “arrangements under which products or services other than execution of securities transactions are obtained by an adviser from or through a broker-dealer in exchange for the direction by the adviser of client brokerage transactions to the broker-dealer.” When an advisory firm exercises “investment discretion” over a client account and obtains research by use of client commissions within Section 28(e) of the Securities Exchange Act of 1934 (Section 28(e)), the adviser is protected under certain circumstances without breaching their fiduciary duty

Section 28(e) was enacted by congress in 1975 to provide a safe harbor that protects money managers from liability for a breach of fiduciary duty so long as the adviser could meet a three prong test to determine if the products or services received from a broker-dealer falls within Section 28(e) safe harbor.

  1. The adviser must determine whether the product or service falls within the criteria deemed eligible “research” or eligible “brokerage”.
  2. The adviser must determine whether the product or services provide lawful appropriate assistance in the performance of the adviser’s investment decision-making responsibilities; and
  3. The adviser must make a good faith determination that the cost of the client commissions in relation to the value of the brokerage and research products and services received by the broker-dealer is reasonable.

Conduct outside of the safe harbor of Section 28(e) may constitute a breach of fiduciary duty.

The SEC released an interpretative guidance of soft dollars in 2006.  The SEC release interpreted the purview of the safe harbor as follows:

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

RIA firms should protect themselves and their clients by obtaining the knowledge necessary to successfully operate in compliance with the soft dollar benefit rules. As RIA compliance consultants, we strongly recommend that the Chief Compliance Officer (CCO) of every advisory firm, whether state or federally regulated, do the following:

  1. Determine whether any benefits received from a broker dealer and/or custodian are within the safe harbor of Section 28(e)
  2. Ensure that all proper disclosures are made and any potential conflicts of interest are addressed in the Form ADV Part 1 and 2

Failing to properly disclose soft dollar benefits can raise issue as to whether advisers are defrauding clients if specific conflicts of interest are not fully disclosed and consented to by the client. Full and fair disclosure of conflicts of interest is fundamental to adviser’s fiduciary duty. It’s also important to note that proper disclosure of soft dollar benefits does not relieve an RIA firm of its best execution obligations to its clients.