Tag Archives: Section 28(e)

Hedge Fund Soft Dollar Disclosure Practices

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 Disclosure Under Greater Scrutiny

Both registered investment advisers and unregistered managers are generally required to make complete and accurate disclosures with respect to their investment programs.  The obvious purpose of this requirement is to provide potential investors and clients with accurate information so the investors can make informed decision about the merits of a particular investment or investment program.  Disclosures regarding a manager’s soft dollar practices are especially important.  In general managers will need to provide accurate disclosure of their soft dollar practices in Form ADV, the hedge fund offering documents, the investment advisory contracts, and marketing materials.

Note: The Hedge Fund Law Blog discussed the Section 28(e) safe harbor for research and brokerage services in a previous post.

ADV Part 2 Required Soft Dollar Disclosures

The SEC’s most recent guidance regarding required soft dollar disclosures is provided by the instructions for Item 12 (“Brokerage Practices”) of the new Form ADV Part 2. The “Research and Other Soft Dollar Benefits” section of Item 12, requires disclosure of “all soft dollar benefits you receive, including, in the case of research, both proprietary research (created or developed by the broker-dealer) and research created or developed by a third party.”

The following specific items from the instructions provide additional guidance as to the details that must be included in the disclosures:

a. Explain that when you use client brokerage commissions (or markups or markdowns) to obtain research or other products or services, you receive a benefit because you do not have to produce or pay for the research, products or services.

b. Disclose that you may have an incentive to select or recommend a broker-dealer based on your interest in receiving the research or other products or services, rather than on your clients’ interest in receiving most favorable execution.

c.  If you may cause clients to pay commissions (or markups or markdowns) higher than those charged by other broker-dealers in return for soft dollar benefits (known as paying-up), disclose this fact.

d. Disclose whether you use soft dollar benefits to service all of your clients’ accounts or only those that paid for the benefits. Disclose whether you seek to allocate soft dollar benefits to client accounts proportionately to the soft dollar credits the accounts generate.

e. Describe the types of products and services you or any of your related persons acquired with client brokerage commissions (or markups or markdowns) within your last fiscal year.

Note: This description must be specific enough for your clients to understand the types of products or services that you are acquiring and to permit them to evaluate possible conflicts of interest. Your description must be more detailed for products or services that do not qualify for the safe harbor in section 28(e) of the Securities Exchange Act of 1934, such as those services that do not aid in investment decision-making or trade execution. Merely disclosing that you obtain various research reports and products is not specific enough.

f. Explain the procedures you used during your last fiscal year to direct client transactions to a particular broker-dealer in return for soft dollar benefits you received.

Hedge fund managers should note that the disclosures must be detailed and specific and include a description of the procedures used to direct trades in exchange for soft dollar benefits. Hedge fund offering documents should contain similar soft dollar disclosures. The only case where disclosure is not required is when an investment adviser is not using any soft dollars at all.

Importance of Complete and Accurate Soft Dollar Disclosures

Under general fiduciary principles, an investment adviser has a duty to seek best execution for discretionary client trades. The receipt of soft-dollar benefits in exchange for trade execution represents a conflict of interest with the fiduciary duty of best execution because the client is generally paying for more than mere execution. Accurate and complete disclosure of the adviser’s conflicts of interest is fundamental to an adviser’s fiduciary duty and typically deemed necessary in order to avoid violating the anti-fraud provisions of the Investment Advisers Act of 1940 (see Sections 206(1), (2) and (4)). Additionally, Section 207 of the Advisers Act provides that it is unlawful for any person willfully to make any untrue statement of material fact in any registration application filed with the SEC or willfully to omit to state in any such application any material fact required to be stated therein. Accordingly, many of the SEC enforcement actions involving soft dollars contain allegations of violations of Section 206 and/or Section 207 of the Advisers Act.

Examples of Improper Disclosure

The SEC takes disclosure practices seriously.  Below are two cases involving deficiencies in soft dollar disclosure practices:

In Schultze Asset Management LLC, et al., Investment Advisers Act Release No. 2633 (Aug. 15, 2007), the SEC sanctioned Schultze Asset Management (“SAM”) for violations of Section 206(1) and 206(2) because SAM’s disclosures to an advisory client indicated that SAM was using “client commissions generated by the account only for expenses covered by the safe harbor provided by Section 28(e),” when, in fact, SAM used the soft-dollars generated by the client trades to pay for expenses outside the 28(e) safe harbor, including the salary of the principal. In resolution of the action, SAM returned approximately $350,000 to its clients, representing all soft dollar payments SAM received. Additionally, the SEC censured SAM, its principal, and fined SAM and the principal $100,000 and $50,000 respectively.

In In re Dawson-Samberg Capital Mgmt, Inc. Investment Adviser Act Release No. 1889 (Aug. 3, 2000), the SEC sanctioned Dawson-Samberg for violations of Section 206(2) and Section 207 of the Advisers Act because of its failure to appropriately disclose soft dollar practices that included use of soft dollars to pay for “research-related travel expenses.” Dawson-Samberg and one of its principals were censured and fined $100,000 and $20,000 respectively.

Conclusion

Manager need to take soft dollar disclosure seriously.  If you have questions about whether current disclosure is sufficient, you should discuss with your legal counsel.

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Cole-Frieman & Mallon LLP provides legal advice to hedge fund managers.  The firm also has a focus on investment adviser registration and compliance matters.  Bart Mallon can be reached directly at 415-868-5345.  Karl Cole-Frieman can be reached at 415-352-2300.

Hedge Fund Soft Dollars – Permitted Soft Dollar Practices

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This memorandum contains information regarding eligible and ineligible uses of soft dollars within the safe harbor found under Section 28(e) of the Securities Exchange Act of 1934.  This memo is structured in three parts: (i) discusses, generally, the eligibility of research services; (ii) discusses, generally, the eligibility of brokerage activities; and (iii) discusses, generally, mixed-use items. Continue reading →

Section 28(e) of the Securities Exchange Act of 1934

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Section 28(e) – Exchange, broker, and dealer commissions; brokerage and research services

(1) No person using the mails, or any means or instrumentality of interstate commerce, in the exercise of investment discretion with respect to an account shall be deemed to have acted unlawfully or to have breached a fiduciary duty under State or Federal law unless expressly provided to the contrary by a law enacted by the Congress or any State subsequent to June 4, 1975, solely by reason of his having caused the account to pay a member of an exchange, broker, or dealer an amount of commission for effecting a securities transaction in excess of the amount of commission another member of an exchange, broker, or 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 member, broker, or dealer, viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion. This subsection is exclusive and plenary insofar as conduct is covered by the foregoing, unless otherwise expressly provided by contract: Provided, however, That nothing in this subsection shall be construed to impair or limit the power of the Commission under any other provision of this title or otherwise.

(2) A person exercising investment discretion with respect to an account shall make such disclosure of his policies and practices with respect to commissions that will be paid for effecting securities transactions, at such times and in such manner, as the appropriate regulatory agency, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of investors.

(3) For purposes of this subsection a person provides brokerage and research services insofar as he–

(A) furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities;

(B) furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts; or

(C) effects securities transactions and performs functions incidental thereto (such as clearance, settlement, and custody) or required in connection therewith by rules of the Commission or a self-regulatory organization of which such person is a member or person associated with a member or in which such person is a participant.

(4) The provisions of this subsection shall not apply with regard to securities that are security futures products.