SEC Approves New Interpretive Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934

At its Open Meeting held July 12, 2006, the Securities and Exchange Commission voted 5-0 to approve the issuance of an interpretive release (the ”2006 Interpretive Release”) regarding client commission practices under Section 28(e) of the Securities Exchange Act of 1934 (the ”Exchange Act”). Section 28(e) of the Exchange Act establishes a safe harbor that allows, under certain circumstances, money managers to use client funds (so-called ”soft dollars”) to purchase “brokerage and research services” for their managed accounts without breaching their fiduciary duties to clients to obtain “best execution.” Congress included the safe harbor in the 1975 amendments to the Exchange Act in light of the abolition of fixed commission rates.

The SEC has issued two prior interpretive releases related to the use of soft dollars. The first, issued concurrently with the 1975 amendments, stated that the Section 28(e) safe harbor did not apply to products and services that were readily and customarily available and offered to the general public on a commercial basis, such as newspapers, magazines and office supplies. The second, issued in 1986, afforded money managers greater flexibility to make judgments about how to treat such products and services. Noting that the 1986 guidance “opened the door to a potentially overbroad reading of the safe harbor,” Chairman Cox indicated that the 2006 Interpretive Release would better circumscribe the use of soft dollars and reflect changes in industry practices and technology that have evolved since 1986.

The key provisions of the 2006 Interpretive Release and certain comments made by the SEC commissioners and staff during the Open Meeting are summarized below. The text of the 2006 Interpretive Release has not yet been made publicly available.

The 2006 Interpretive Release explains that an analysis of brokerage and research services under Section 28(e) requires a three-step process consisting of:

Eligible research services will be limited to advice, analyses and reports that have substantive intellectual or informational content. The products and services must reflect the expression of reasoning or knowledge regarding the subject matters identified in the statute (such as the value of securities or portfolio strategy). The research services must directly relate to and inform the money manager’s investment decision-making responsibilities.

For example, the 2006 Interpretive Release will clarify that money managers may use soft dollars to obtain traditional company research reports, market research, advice on market color and execution strategies, market data and trade analytics. The 2006 Interpretive Release will also contain an explicit statement that these conditions apply equally to third party research and to in-house research. Money managers will not be permitted to use soft dollars for mass-marketed publications, computer equipment or overhead costs, including the salaries of research staff. Mixed-use items must be reasonably allocated between eligible and ineligible uses, and the allocation must 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 brokerage and research services.

Definition of Brokerage Services. The 2006 Interpretive Release will also clarify the scope of brokerage services. Eligible brokerage will include those products and services that related to the execution of the trade, from the point at which the money manager communicates with the broker-dealer for transmission of an order through the point at which funds or securities are delivered or credited to the advised account. Brokerage services rendered must be for the purpose of facilitating the execution of the money manager’s orders. For brokerage, the use of tangible objects is limited by this time standard. In response to a question from Commissioner Nazareth, Acting Division of Market Regulation Director Colby explained that the safe harbor would not cover hardware such as computers or telephones, but would cover the lines by which brokerage orders are transmitted.

Commission Sharing Arrangements. The 2006 Interpretive Release will also clarify so-called “commission sharing arrangements” in which money managers obtain brokerage services from one broker-dealer and research or other services from another. Under the 2006 Interpretive Release, in order for the safe harbor to be available in this situation, the “effecting” broker-dealer must execute, clear or settle the trade, or perform one of four other core functions and allocate the remaining functions. In addition, the effecting broker-dealer must (i) either be obligated to pay for the research or must pay the research preparer directly, (ii) review the description of the services to be paid for with client commissions and agree with the money manager to use the client commissions only to pay for those items within the safe harbor, and (iii) develop and maintain procedures so that research payments are documented and paid for promptly. The SEC is seeking additional public comment on commission sharing arrangements.

Proxy Services. Commissioner Glassman noted that one area that will be specifically addressed by the 2006 Interpretive Release is proxy services. Certain products or services provided by proxy services may be eligible for inclusion in the safe harbor if the money manager uses them to make investment decisions. However, proxy services that assist with the mechanics and administrative support of voting, and research and advice that assist a manager in deciding how to vote proxy ballots, will not be eligible for the safe harbor.

In response to a question posed by Commissioner Glassman regarding consistency with comparable rules of other regulators, the SEC staff noted that the UK Financial Services Authority (the ”FSA”) recently adopted final client commission rules that are stricter than those reflected in the 2006 Interpretive Release with respect to certain products and services. In particular, the SEC staff noted that seminars, subscription publications, market data, and portfolio valuation services are not permitted under the FSA’s soft dollar rules, whereas they could be within the Section 28(e) safe harbor if the money manager determines that they qualify as either research or brokerage and satisfy the lawful and appropriate use requirement under Section 28(e). In this regard, the SEC staff noted that the FSA was “writing on a clean slate,” while the SEC staff was trying to interpret an existing statutory safe harbor.

With respect to the disclosure aspects of soft dollar arrangements, Division of Investment Management Director Donohue indicated that the SEC staff would likely issue a proposal with respect to such matters before the end of the year.

The 2006 Interpretive Release will become effective six months after its publication in the Federal Register. In the interim, money managers may choose to follow either the existing guidance or the new guidance reflected in the 2006 Interpretive Release.

Please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed under Capital Markets in the “Our Practice” section of our website if you have any questions.

CLEARY GOTTLIEB STEEN & HAMILTON LLP