New York–One of our asset manager clients recently decided, after reviewing the SEC’s July 2006 guidance on soft dollars, to poll broker dealers on the pricing of their proprietary research. As client commission arrangements (CCAs) become more prevalent, so does more transparent pricing for research. Our client reasoned that any such pricing should be an input to their own valuation of the research they receive. This approach is explicitly addressed in the recent soft dollar guidance: “…where a broker-dealer also offers its research for an unbundled price, that price should inform the money manager as to its market value and help the manager make its good faith determination.”
We thought this was an interesting development, and turned to one of the leading experts on soft dollars, Larry Bergmann of Willkie Farr. Until 2006, Larry was Senior Associate Director in the SEC’s Division of Market Regulation, putting him squarely in the middle of all matters pertaining to Section 28(e). We are delighted to be able to share Larry’s perspective on research pricing and the good faith determination of value under the Section 28(e) safe harbor:
“Good Faith” and Value
Larry E. Bergmann, Willkie Farr & Gallagher LLP
Money managers that seek to avail themselves of the “safe harbor” provided by Section 28(e) of the Securities Exchange Act of 1934 must determine in good faith that the amount of client commissions that the manager paid to broker-dealers was reasonable in relation to the value of the brokerage and research services provided by the broker-dealers (“good faith determination”). The Securities and Exchange Commission has referred to this good faith determination as the manager’s “essential obligation” under Section 28(e). While the SEC recently has shed considerable light on what can be acquired by a manager under the safe harbor (eligible brokerage and research products and services) and how those items can be obtained (client commission arrangements), the Commission has provided less insight into how a money manager can demonstrate whether it has satisfied this essential good faith determination. Because of the individual and contextual nature of the good faith determination, it continues to be more art than science. Is there data or other information that a money manager can use to show to a fund’s board of directors or to SEC examiners that it has made a good faith determination?
The statute shows that the key is value: the value of the eligible products and services must be determined by the manager to be reasonable in relation to the client commissions paid. Value is critically related to the manager’s actual use of eligible items. If an acquired item is not used by the manager in performing its investment decision-making responsibilities, then it has no value for this purpose. As the SEC has noted, two managers may purchase the same eligible item with commission dollars. If one manager properly uses the item in investment decision-making for its clients’ accounts, but the second manager does not use the item for that purpose, only the first manager can rely on Section 28(e). While it is clear that the second manager must assign zero value to the item for purposes of the safe harbor, the first manager also must determine in good faith that the value of the item as used was reasonable in relation to the commissions paid for it. “Mixed use” items (products and services with eligible and ineligible components) present special value allocation challenges.
Of what relevance in determining the value of an eligible item is the price that a broker-dealer or research provider charges for it? As indicated above, value is related to use. And the only use that counts is use in performing the manager’s responsibilities to the accounts over which it exercises investment discretion. So, for example, if the commission flow to a broker-dealer or the price charged by a third party research provider for an item includes payment for products or services (such as “shelf space”) that benefit only the money manager, then the item has limited or no value for Section 28(e) purposes. Therefore, while price may be relevant, it is not determinative in assessing value.
One of the thornier aspects of this thicket of issues is how to value the eligible research component of “bundled” products and services offered by so-called full service broker-dealers in return for the commissions paid by the manager. Where the research is produced by the broker-dealer, i.e., proprietary research, it may be unable or unwilling to put a separate price tag on it. As a result, the manager has fewer reference points for the valuation of such research. Recently, however, some broker-dealers have been accepting separate payments for their proprietary research, often in connection with the new client commission arrangements facilitated by the SEC’s July 2006 interpretive guidance on Section 28(e). In this context, the SEC has said that price can be relevant: “[W]here a broker-dealer also offers its research for an unbundled price, that price should inform the money manager as to its market value and help the manager make its good faith determination.” Accordingly, the price charged by a broker-dealer for its research can be useful to a money manager in making its value determinations of bundled products, although, as discussed above, price is not determinative of value. What is less clear is whether this suggestion by the SEC will become an expectation in reviewing a manager’s satisfaction of the requirements of Section 28(e). Put differently, will the SEC staff (or the manager’s clients) expect that the manager will ascertain whether a broker-dealer sells its research for an unbundled price and, if it does, has the manager taken that fact into consideration in making its good faith determination?
Larry E. Bergmann is special counsel in the Corporate and Financial Services Department of Willkie Farr & Gallagher LLP in Washington. A former Senior Associate Director in the Securities and Exchange Commission’s Division of Market Regulation, Mr. Bergmann concentrates on complex SEC regulatory matters.
Mr. Bergmann specializes in securities law matters, with a focus on trading and underwriting issues, broker-dealer compliance, securities analysts, issuer repurchases, transfer agents, and Enforcement-related matters.