Federal Register: August 6, 2008 (Volume 73, Number 152)
DOCID: fr06au08-20 FR Doc E8-18035
SECURITIES AND EXCHANGE COMMISSION
Securities and Exchange Commission
CFR Citation: 17 CFR Part 275
RIN ID: RIN 3235-AJ45
DOCUMENT ID: [Release Nos. 34-58264; IC-28345; IA-2763 File No. S7-22-08]
NOTICE: PROPOSED RULES
DOCUMENT ACTION: Proposed guidance; request for comment.
Commission Guidance Regarding the Duties and Responsibilities of Investment Company Boards of Directors With Respect to Investment Adviser Portfolio Trading Practices
DATES: Comments should be received on or before October 1, 2008.
The Securities and Exchange Commission is publishing for
comment this proposed guidance to boards of directors of registered
investment companies to assist them in fulfilling their fiduciary responsibilities with
respect to overseeing the trading of investment company portfolio securities. The guidance focuses on the role of an investment company board in overseeing the best execution obligations of the investment adviser hired to invest in securities and other instruments on the investment company's behalf. In this respect, we address the conflicts of interest that may exist when an investment adviser uses an investment company's brokerage commissions to purchase services other than execution, such as the purchase of brokerage and research services through client commission arrangements. The Commission also is requesting comment on whether to propose that advisers be subject to new disclosure requirements concerning the use of client commission arrangements to investment company shareholders and other investment advisory clients.
Commission Guidance Regarding the Duties and Responsibilities of Investment Company Boards of Directors with Respect to Investment Adviser Portfolio Trading,
FOR FURTHER INFORMATION CONTACT
Matthew N. Goldin, Senior Counsel, Karen L. Rossotto, Advisor to the Director, or Thomas R. Smith, Jr., Senior Advisor to the Director, Office of the Director, at 202551 6720, Division of Investment Management, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 205490506.
I. Introduction and Summary
Many investment advisers, in connection with trades placed on
behalf of their registered investment company, or ``fund,'' clients,
receive brokerage and research services in reliance on the safe harbor
provided under section 28(e) \1\ of the Securities Exchange Act of 1934
(``Exchange Act'').\2\ In recent years, changes in client commission
practices, evolving technologies, and marketplace developments have
transformed the brokerage and investment management industries and
securities trading practices. In recognition of changing market
conditions and current industry practices, in July 2006, we issued an
interpretive release that provided guidance to investment advisers with
respect to, among other things, the scope of the safe harbor provided
under section 28(e) when advisers use brokerage commissions to purchase
brokerage and research services for their managed accounts.\3\ In
addition to providing guidance to investment advisers on their use of
soft dollars, we believe it is important to provide guidance to fund
boards of directors concerning their responsibilities to oversee the
adviser's satisfaction of its best execution obligations, including the
adviser's use of fund brokerage commissions and the overall transaction
costs that the fund incurs when the fund buys or sells portfolio
securities.\4\ As we have stated previously, transaction costs are a
concern for fund investors for two reasons.\5\ First, for many funds,
the amount of transaction costs incurred may be substantial.\6\ Second,
fund advisers are subject to a number of potential conflicts of
interest in conducting portfolio transactions on behalf of clients that
are funds.\7\ Fund brokerage commissions, which are paid out of fund
assets, may, for example, be used to obtain brokerage and research
services under section 28(e) of the Exchange Act that might otherwise be paid for directly by the fund's investment adviser.
\1\ 15 U.S.C. 78bb(e). For a discussion of the section 28(e) safe harbor, see infra section III.C. Whereas section 28(e) refers to a money manager as a ``person * * * [who] exercise[s] * * * investment discretion with respect to an account,'' we refer to money managers to funds in this Release as ``investment advisers.'' \2\ 15 U.S.C. 78a.
\3\ Commission Guidance Regarding Client Commission Practices Under section 28(e) of the Securities Exchange Act of 1934, Exchange Act Release No. 54165 (July 18, 2006) [71 FR 41978 (July 24, 2006)] (``2006 Release'').
\4\ See infra section III (discussing fund directors'
obligations with respect to overseeing advisers' trading of fund portfolio securities). Broadly defined, a fund's transaction costs include all of its costs that are associated with trading portfolio securities. Transaction costs may include, among other things, commissions, spreads, market impact costs, and opportunity costs. Concept Release: Request for Comments on Measures to Improve Disclosure of Mutual Fund Transaction Costs, Investment Company Act Release No. 26313 (Dec. 18, 2003) [68 FR 74820 (Dec. 24, 2003)] (``Concept Release''), at section II.A. For purposes of this Release, the use of the term ``securities'' includes all instruments that an investment company may invest in under the Investment Company Act of 1940 [15 U.S.C. 80a] (``Investment Company Act''). \5\ See Concept Release at section I. However, we are aware that the interests of a fund's adviser and the fund's investors generally are aligned when an adviser places fund trades because advisers typically seek to minimize transaction costs due to the fact that such costs may detract from the fund's performance.
\6\ For example, one study estimates that the average annual trading cost for a sample of 1706 U.S. equity funds during the period 19952005 was almost 20 percent higher than the average expense ratio for those funds. These estimates include the effect of commissions, spreads, and market impact costs. Roger M. Edelen, Richard Evans & Gregory Kadlec, Scale Effects in Mutual Fund Performance: The Role of Trading Costs (working paper dated March 17, 2007), available at http://papers.ssrn.com/sol3/ papers.cfm?abstract_id=951367.
\7\ See Concept Release at section I.
We recognize that conflicts of interest are inherent when an
investment adviser manages money on behalf of multiple clients. As
discussed in section II of this Release, conflicts are also inherent in
the external management structure of funds. Investment advisers are
required to disclose material conflicts of interest to their clients,
and those conflicts should be managed appropriately. Fund directors
play a pivotal role in overseeing conflicts of interest investment
advisers face when they have funds as clients. As explained in further
detail in section III of this Release, fund transaction costs may not
be readily apparent to investors. It is imperative that the fund's
directors both understand and scrutinize the payment of transaction
costs by the fund \8\ and determine that payment of transaction costs
is in the best interests of the fund and the fund's shareholders.\9\ Although
directors are not required or expected to monitor each trade, they should monitor the adviser's trading practices and the manner in which the adviser fulfills its obligation to seek best execution when trading fund portfolio securities.\10\ In doing so, the fund's board should demand, and the fund's adviser must provide, all information needed by the fund's board to complete this review process.\11\ Without sufficient oversight by the fund's board, transaction costs might inappropriately include payment for services that benefit the fund's adviser at the expense of the fund and that the board believes should be paid directly by the adviser rather than with fund assets. \8\ See id. See also infra section II at note 26 and
accompanying text (discussing the external management structure of most funds).
\9\ See Role of Independent Directors of Investment Companies, Investment Company Act Release No. 24082 (Oct. 14, 1999) [64 FR 59826 (Nov. 3, 1999)], at nn.7 & 12 (``Mutual funds are formed as corporations or business trusts under state law and, like other corporations and trusts, must be operated for the benefit of their shareholders. * * * Under state law, directors are generally responsible for the oversight of all of the operations of a mutual fund.'').
\10\ The directors of an investment company have a continuing fiduciary duty to oversee the company's brokerage practices. See 2006 Release at n.6 (citing Order Approving Proposed Rule Change and Related Interpretation under section 36 of the Investment Company Act, Investment Company Act Release No. 11662 (Mar. 4, 1981) [46 FR 16012 (Mar. 10, 1981)]). See also 2 Tamar Frankel, Regulation of Money Managers 67 (1978) (``The directors should examine the adviser's practices in placing portfolio transactions with broker dealers and the use of the brokerage business for the benefit of the adviser or its affiliates, and ensure that there are no violations [ ] of the law. * * *'') (citing Lutz v. Boas, 39 Del. Ch. 585, 171 A.2d 381 (1961) and William J. Nutt, A Study of Mutual Fund Independent Directors, 120 U. Pa. L. Rev. 179, 181 (1971)). \11\ See Concept Release at section I.
We have received requests from fund directors for guidance on our
view of their responsibilities in overseeing the activities of the
investment advisers that trade their funds' portfolio securities. These
requests include inquiries as to how directors may properly fulfill
their responsibilities with respect to overseeing an adviser's
satisfaction of its best execution obligations, including the adviser's
trade execution practices and the adviser's use of fund brokerage
commissions.\12\ Today we are proposing guidance with respect to
information a fund board should request that an investment adviser
provide to enable fund directors to determine that the adviser is
fulfilling its fiduciary obligations to the fund and using the fund's
assets in the best interest of the fund. Our proposed guidance also is
intended to assist the board in directing the adviser as to how fund assets should be used.\13\
\12\ In connection with these requests for guidance, fund directors have informed us that fund boards are spending increasing amounts of time on trading practices in light of the growing complexity in this area.
\13\ At the July 12, 2006 open meeting at which the Commission considered the 2006 Release, several of the Commissioners
specifically noted that guidance for fund boards was a critical element in protecting investors against abuses in this area. An electronic link to an archived webcast of the open meeting is available at http://www.connectlive.com/events/secopenmeetings.
Our proposed guidance would not impose any new or additional
requirements. Rather, it is intended to assist fund directors in
approaching and fulfilling their responsibilities of overseeing and
monitoring the fund adviser's satisfaction of its best execution
obligations and the conflicts of interest that may exist when advisers
trade the securities of their clients that are funds.\14\ In developing
this proposed guidance, we have taken into account the wide variety of
funds and advisers in terms of size, asset classes, complexity, and
operations. We have also considered the changing market environment in
the brokerage and investment management industries.\15\ We feel that
with rapidly evolving market conditions and trading practices, it is
appropriate to give guidance at this time. For these reasons, we are
proposing guidance for fund directors to consider in performing their
responsibilities and in determining what is appropriate in light of their fund's particular circumstances.
\14\ See infra section III. See also 2006 Release at section II.A.
\15\ In light of the advancements in the market and the continuously evolving technology influencing industry practices, the Commission staff talked with a variety of investment advisers and industry representatives, including independent fund directors and directors' counsel, to help ensure that our proposed guidance today reflects actual market practices and is based on factual industry experience.
Our intention in this proposed guidance is to assist boards. We
wish to provide guidance that is relevant, useful, and beneficial to
fund directors in fulfilling their responsibilities to act in the best
interest of investors in this area. We request comment on all aspects
of our proposed guidance to help us in achieving this goal. In
addition, as the evolving nature of brokerage practices greatly
influences how directors approach their oversight responsibilities in
this area, we specifically request comment on the current state of the
brokerage and investment management industries and its effect on advisers' trading of fund portfolio securities.
II. Summary of Law Regarding Fiduciary Responsibilities of Investment Company Directors
In fulfilling their responsibilities to a fund that they oversee, fund directors should understand the nature and source of their legal obligations to the fund and the fund's shareholders. Because funds are generally formed as corporations, business trusts, or partnerships \16\ under state law, fund directors and trustees, like other corporate directors, are subject to a ``duty of care'' and a ``duty of loyalty'' under state and common law fiduciary principles,\17\ as well as the obligations imposed on them under the Investment Company Act.\18\
A director's duty of care generally requires a fund director to perform his or her oversight responsibilities with the care of an ordinarily prudent person in a like position under similar circumstances.\19\ The duty of care thus establishes the degree of attention and consideration required of a director in matters related to the fund he or she oversees. As such, a director's duty of care incorporates a duty to be informed, requiring that a director be reasonably informed about an issue before making a decision relating to that issue.\20\ To be reasonably informed about an issue, a director must inform him or herself of all material information regarding that issue reasonably available to him or her.\21\ In fulfilling these obligations, a fund director may rely on written and oral reports provided by management, auditors, fund counsel, the fund's chief compliance officer (``CCO''), and other experts and committees of the board when making decisions, so long as the director reasonably believes that the reports are reliable and competent with respect to the relevant matters.\22\
A director's duty of loyalty requires him or her to act in the best interests of the fund and the fund's shareholders.\23\ The duty of loyalty encompasses a director's obligations to avoid conflicts of interest with the fund and the fund's shareholders, not to put his or her personal interests before the interests of the fund and the fund's shareholders, and not to profit from his or her position as a fiduciary.\24\
In addition to statutory and common law obligations, fund directors
are also subject to specific fiduciary obligations relating to the
special nature of funds under the Investment Company Act.\25\ Unlike
typical operating companies, funds ordinarily do not have any employees
that are truly their own, but rather are generally formed and managed
by a separately owned and operated sponsor, commonly an investment
adviser.\26\ This external management structure of most funds may at
times create conflicts of interest for investment advisers with clients
that are funds. When it enacted the Investment Company Act, Congress
recognized the potential for abuse created by the unique structure of
funds.\27\ To protect fund shareholders, the Act requires that each
registered fund be governed by a board of directors with the authority
to supervise the fund's operations.\28\ The Act further requires that
at least 40 percent of a fund's board be independent in order to serve
as ``independent watchdogs'' in monitoring the fund's managing
organization.\29\ A fund board has the responsibility, among other
duties, to monitor the conflicts of interest facing the fund's
investment adviser and determine how the conflicts should be managed to
help ensure that the fund is being operated in the best interest of the fund's shareholders.\30\
III. Board Oversight of Investment Adviser Trading Practices
In overseeing the use of fund assets and in monitoring the
conflicts of interest faced by a fund's investment adviser, a fund
board must consider the investment adviser's practices when it trades
the fund's portfolio securities.\31\ A fund's investment adviser is a
fiduciary with respect to the fund and therefore must act in the fund's
best interest.\32\ Lower transaction costs generally are in the mutual
interest of a fund's adviser and the fund's investors, and advisers
typically seek to minimize transaction costs when trading fund
securities so as not to detract from the fund's performance. At times,
however, there may be incentives for an investment adviser to
compromise its fiduciary obligations to the fund in its trading
activities in order to obtain certain benefits that serve its own
interests or the interests of other clients. These conflicts of
interest may exist, for example, when an adviser executes trades
through an affiliate, when it determines the allocation of trades among
its clients, and when it trades securities between clients. In
addition, the use of fund brokerage commissions to pay for research and
brokerage services may give incentives for advisers to disregard their
best execution obligations when directing orders to obtain brokerage
commission services. It also may give incentives for advisers to trade
the fund's securities in order to earn credits for fund brokerage
commission services. In accordance with its fiduciary obligations and
provisions of the Advisers Act, an adviser must make full and fair
disclosure of these conflicts to a client and disclose how the adviser
will manage each conflict before the adviser may engage in conduct that constitutes a conflict.\33\
\16\ See, e.g., A. Joseph Warburton, Should Mutual Funds Be Corporations: A Legal & Econometric Analysis, 33 Iowa J. Corp. L. 745, 74849 (2008).
\17\ See, e.g., Md. Code Ann., Corps. and Ass'ns Sec. 2 405.1(a) (2008) (requiring a director to perform his duties: ``(1) In good faith; (2) In a manner he reasonably believes to be in the best interests of the corporation; and (3) With the care that an ordinarily prudent person in a like position would use under similar circumstances.'').
\18\ 15 U.S.C. 80a. See supra note 4.
\19\ See, e.g., Model Bus. Corp. Act Ann. Sec. 8.30(b) (3d ed. 2002); Md. Code Ann., Corps. and Ass'ns Sec. 2405.1(a)(3) (2008). \20\ See, e.g., Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (explaining that, although directors are assumed to have been informed in making a business decision, when the burden of proving that a board was insufficiently informed is met, the board will have been found to have breached its duty of care).
\21\ See id. at 872 (discussing the standard for determining whether a director's business judgment is informed).
\22\ See, e.g., Graham v. AllisChalmers Manufacturing Co., 188 A.2d 125, 130 (1963) (explaining that, under general principles of the common law, a director is entitled to rely on corporate summaries, reports, and records so long as he or she has not ``recklessly reposed confidence in an obviously untrustworthy employee, [ ] refused or neglected cavalierly to perform his duty as a director, or [ ] ignored either willfully or through inattention obvious danger signs of employee wrongdoing.''). A director should be satisfied not only that the person providing the report or opinion is doing so about a matter within his or her knowledge or expertise and has an appropriate basis for the opinion, but also that the scope of the report bears on the matter being decided. See Van Gorkom, 488 A.2d at 875. In addition, to fulfill the duty of care, a director needs a wellinformed decisionmaking process. This process may include, among other things, asking for and reviewing regular financial and other reports, questioning managers and outside experts about the meaning and implications of reports, and making inquiries when there are specific causes for concern. Id. \23\ See, e.g., Strougo v. Scudder, Stevens and Clark, Inc., 964 F. Supp. 783, 801 (S.D.N.Y. 1997) (citing Md. Code Ann., Corps. and Assn's Sec. 2405.1(a)(1) (requiring corporate directors to perform their duties in ``good faith'') and James J. Hanks, Jr., Maryland Corporation Law Sec. 6.6(b) (19951 Supp.) (explaining that a director's duty to act in `good faith' is generally synonymous with the duty of loyalty or the duty of fair dealing)). See also Pepper v. Litton, 308 U.S. 295, 310311 (1939) (stating that a fiduciary ``cannot serve himself first and his cestuis second'').
\24\ See, e.g., Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. Ch. 1939) (``Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests''); see also Pepper, 308 U.S. at 310311 (stating that a fiduciary ``cannot use his power for his personal advantage and to the detriment of the stockholders and creditors no matter how absolute in terms that power may be and no matter how meticulous he is to satisfy technical requirements.''). See also Fed. Regulation of Sec. Comm., Am. Bar Ass'n, Fund Director's Guidebook 98 (3d ed. 2006) (``Simply put, directors should not use their position for personal profit, gain, or other personal advantage.'').
\25\ See, e.g., Strougo, 964 F. Supp. at 798 (holding that a fund shareholder has a private right of action under section 36(a) of the Investment Company Act against the independent directors of a fund for breach of fiduciary duty involving personal misconduct). See also Protecting Investors: A Half Century of Investment Company Regulation, Division of Investment Management 251 (May 1992) (``Protecting Investors'').
\26\ See Protecting Investors 251 n.3.
\27\ See Investment Company Act section 1(b)(2) [15 U.S.C. 80a 1(b)(2)]; U.S. Sec. and Exch. Comm'n, Report on Investment Trusts and Investment Companies, H.R. Doc No. 76279, Part III (1939). See also Joseph F. Krupsky, The Role of Investment Company Directors, 32 BUS. LAW. 1733, 173740 (1977); William J. Nutt, A Study of Mutual Fund Independent Directors, 120 U. Pa. L. Rev. 179, 181 (1971). \28\ See S. Rep. No. 91184, at 490203 (1969) (``The directors of a mutual fund, like directors of any other corporation will continue to have * * * overall fiduciary duties as directors for the supervision of all of the affairs of the fund.'').
\29\ 15 U.S.C. 80a10(a). See also Burks v. Lasker, 441 U.S. 471, 484485 (1979) (``Congress' purpose in structuring the Act as it did is clear * * * it `was designed to place the unaffiliated directors in the role of ``independent watchdogs.'' ' (quoting Tannenbaum v. Zeller, 552 F.2d 402 (2d Cir. 1977)).
\30\ See Tannenbaum, 552 F.2d at 406 (noting that the
independent director requirements under the Investment Company Act, in particular, were designed to ensure that ``mutual funds would operate in the interest of all classes of [funds'] securities holders, rather than for the benefit of investment advisers, directors or other special groups.'').
\31\ See 2006 Release at n.6 (citing Order Approving Proposed Rule Change and Related Interpretation under Section 36 of the Investment Company Act, Investment Company Act Release No. 11662 (Mar. 4, 1981) [46 FR 16012 (Mar. 10, 1981)] (``The directors of an investment company have a continuing fiduciary duty to oversee the company's brokerage practices.'')). See also Compliance Programs of Investment Companies and Investment Advisers, Advisers Act Release No. 2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)] (``Compliance Release''), at Section II.A.2.b (requiring that a fund's board approve the policies and procedures of the fund's service providers, including its investment adviser; the approval must be based on a finding by the board that the policies and procedures are reasonably designed to prevent violation of the Federal securities laws by the fund's service providers). We have stated that we expect that the adviser's compliance policies and procedures will address, to the extent that they are relevant, the adviser's trading practices. See Compliance Release at II.A.1.
\32\ Investment advisers are fiduciaries and have an obligation under the Investment Advisers Act of 1940 [15 U.S.C. 80b]
(``Advisers Act'') and state law to act in the best interest of their clients. See Restatement (Second) of Trusts Sec. 170(1) (2008) (``The trustee is under a duty to the beneficiary to administer the trust solely in the interest of the beneficiary''); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191 (1963) (``The Investment Advisers Act of 1940 thus reflects a congressional recognition `of the delicate fiduciary nature of an investment advisory relationship. * * * ' '' (quoting 2 LOSS, Securities Regulation 1412 (2d ed. 1961))); Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979) (noting that the legislative history of the Advisers Act ``leaves no doubt that Congress intended to impose enforceable fiduciary obligations'' on investment advisers).
\33\ See Capital Gains, 375 U.S. at 191, 196197 (``The Investment Advisers Act of 1940 reflects * * * a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser, consciously or unconsciously, to render advice which was not disinterested.'').
The fund's board, in providing its consent on the fund's behalf,
should be sufficiently familiar with the adviser's trading practices to
satisfy itself that the adviser is fulfilling its fiduciary obligations
and is acting in the best interest of the fund. In some cases where the Commission has adopted
exemptive rules that permit funds to engage in transactions otherwise prohibited by the Investment Company Act, the Commission has imposed conditions designed to address certain conflicts of interest faced by advisers by mandating that directors take particular action in evaluating those conflicts.\34\ In other cases, the Commission has determined that the conflicts relating to a particular practice are unmanageable and has therefore prohibited advisers' activities in that area altogether.\35\
\34\ See, e.g., Investment Company Act rule 10f3(c)(10) [17 CFR 270.10f3(c)(10)] (fund boards must adopt procedures for purchases by the fund of securities from an affiliated underwriter and assess compliance on a quarterly basis); Investment Company Act rule 17a 7(e) [17 CFR 270.17a7(e)] (fund boards must adopt procedures for purchases from and sales to affiliated funds and assess compliance on a quarterly basis); Investment Company Act rule 17a8(a) [17 CFR 270.17a8(a)] (fund boards must make certain determinations in evaluating mergers with affiliated funds); and Investment Company Act rule 17e1(b) [17 CFR 270.17e1(b)] (fund boards must adopt procedures for brokerage transactions with affiliates and assess compliance on a quarterly basis).
\35\ See, e.g., Prohibition on the Use of Brokerage Commissions to Finance Distribution, Investment Company Act Release No. 26591 (Sep. 2, 2004) [69 FR 54728 (Sep. 9, 2004)], at section VII.E (explaining that the Commission's adoption in 2004 of Investment Company Act rule 12b1(h) [17 CFR 270.12b1(h)], which, among other things, prohibits a fund from using brokerage commissions to pay for the distribution of the fund's shares, was based on a conclusion that the practice of trading brokerage business for sales of fund shares poses conflicts of interest that the Commission believed to be ``largely unmanageable'').
Two specific areas where conflicts may arise when an adviser trades
a fund's portfolio securities concern the adviser's obligation to seek
best execution and to otherwise use fund assets, including brokerage
commissions, in the best interest of the fund. The following sections
provide guidance on the types of information a fund board should seek
in order to evaluate whether the adviser to its fund has fulfilled its obligations to the fund with respect to these concerns.
A. Board Oversight of an Investment Adviser's Duty To Seek Best Execution and Consideration of Transaction Costs
As a fiduciary to a client that is a fund, an investment adviser
has the duty to seek best execution of securities transactions it
conducts on the fund's behalf.\36\ As we have stated previously, in
seeking best execution, an investment adviser must seek to ``execute
securities transactions for clients in such a manner that the client's
total cost or proceeds in each transaction is the most favorable under
the circumstances.'' \37\ In this regard, in seeking to maintain best
execution on behalf of a client that is a fund, an adviser should
consider factors beyond simply commission rates or spreads,\38\
including ``the full range and quality of a broker's services in
placing brokerage. * * *'' \39\ These might include, among other
things, the value of research provided, execution capability, financial responsibility, and responsiveness to the adviser.\40\
\36\ See Interpretive Release Concerning the Scope of section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170 (Apr. 23, 1986) [51 FR 16004, 16011 (Apr. 30, 1986)] (``1986 Release''), at Section V (explaining that an investment adviser has the obligation to seek ``best execution'' of a client's transaction); Delaware Management Company, Inc., 43 S.E.C. 392 (1967); Arleen W. Hughes, 27 S.E.C. 629 (1948), aff'd sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949).
\37\ 1986 Release at section V.
\38\ A fund may incur spread costs rather than commissions when a dealer trades with it on a principal basis. Spread costs are incurred indirectly when a fund either buys a security from a dealer at the ``asked'' price or higher or sells a security to a dealer at the ``bid'' price or lower. The difference between the bid price and the asked price is known as the ``spread.'' Spread costs include both an imputed commission on the trade as well as any market impact cost associated with the trade. Dealer spreads compensate broker dealers for, among other things, maintaining a market's trading infrastructure (i.e., price discovery and execution services), the brokerdealer's cost of capital, and its assumption of market risk. Spreads may also reflect the impact of large orders on the price of a security. The proportion of these two components varies among different trades. Concept Release at section II.A.2.
\39\ 1986 Release at section V.
When trading portfolio securities of a client that is a fund, an
adviser should consider factors related to minimizing the overall
transaction costs incurred by the fund.\41\ Transaction costs consist
of explicit costs that can be measured directly, such as brokerage
commissions, fees paid to exchanges, and taxes paid, as well as
implicit costs that are more difficult to quantify. Implicit costs,
which may include, among other things, bid/ask spreads, the price
impact of placing an order for trading in a security, and missed trade
opportunity cost, may exceed greatly a transaction's explicit
costs.\42\ Price impact and opportunity cost can be influenced by a
variety of factorseach of which should be considered by an investment
advisersuch as the anonymity of the parties to the trade, the
willingness of the intermediary to commit capital to facilitate the
trade, and the speed and price of the execution. Investment advisers
also can take into account the quality and utility of any research provided by the brokerdealer.\43\
\41\ See id.
\42\ For a more detailed discussion of explicit and implicit transaction costs, see Concept Release at section II.A.
\43\ See 1986 Release at section V (``A money manager should consider the full range and quality of a broker's services in placing brokerage including, among other things, the value of research provided. * * *''). For further discussion regarding evaluation of brokerdealer research services, see infra section III.D.
An aspect of an adviser's best execution process that directors
should also consider is the adviser's decision whether to use an
alternative trading system. Newer trading venues, such as ``dark
pools,'' \44\ and the use of advanced mathematical models or
algorithmic trading systems, crossing networks, and other alternative
trading systems, are increasingly prevalent.\45\ Although the use of
such trading venues may provide funds certain benefits (such as
potentially lower execution costs),\46\ they can also raise challenges to funds in certain situations.\47\
\44\ For purposes of this release, our references to the term ``dark pools'' refer to markets that do not display quotes, but rather execute trades internally without displaying liquidity to other participants. A number of markets combine nondisplayed liquidity with display of quotes. A substantial portion of the trading volume of these markets may result from interaction of orders with their nondisplayed liquidity. See, e.g., Elizabeth Cripps, Shedding Light on the Dark Liquidity Pools, FTMandate, May 2007, available at http://www.ftmandate.com/news/printpage.php/aid/ 1442/Shedding_light_on_the_dark_liquidity_pools.html.
\45\ One recent report noted that although dark pools currently make up seven to ten percent of equities' share volume in the U.S., that percentage is steadily increasing. Celent, LLC, Dark Liquidity Pools in Europe, Canada, and Japan: A U.S. Phenomenon Goes Abroad (2007). See also David Bogoslaw, Big Traders Dive Into Dark Pools, Business Week, Oct. 3, 2007, available at http:// www.businessweek.com/investor/content/oct2007/pi2007102_394204.htm (noting that the Aite Group predicted in September 2007 that exchanges' market share of U.S. equity trading would continue to decline from the current 75 percent, before stabilizing at around 62 percent by 2011, with alternative trading systems, including dark pools, intensifying fragmentation of the marketplace).
\46\ Execution costs may be lower on alternative trading systems. See, e.g., Jennifer Conrad, Kevin Johnson & Sunil Wahal, Insitutional Trading and Alternative Trading Systems, 70 J. of Fin. Econ. 99 (2003).
\47\ For example, we understand that an adviser managing a fund that invests in companies with smaller capitalizations and more illiquid securities may need an executing brokerdealer to have experience and access to a particular market or one with expertise in a certain geographical area or industry. Advisers to these types of funds have indicated that they must rely on a relatively large number of brokersespecially where markets in niche securities have not developed on newer trading venuesto provide the execution and research they need with respect to a particular asset class.
We ask for comment on how changes in the brokerage industry should affect a fund board's oversight of the trading practices of the fund's adviser. Is our discussion of the brokerage industry (as relevant to funds and their advisers) accurate? Are there other considerations with respect to the brokerage industry we should take into account?
We understand that investment advisers with clients that are funds employ a wide range of procedures
when selecting brokerdealers for fund securities transactions.\48\ In consideration of the wide variety of advisers in terms of size and operations, each adviser should determine what trading intermediary selection process is most appropriate for its circumstances.\49\ However, as the Commission has stated previously, in its process for choosing trading intermediaries, an adviser should periodically and systematically evaluate the performance of brokerdealers handling its transactions.\50\ In addition, the Commission has stated that an investment adviser should address its best execution obligations in the compliance policies and procedures that advisers are required to adopt and implement under rule 206(4)7 under the Advisers Act.\51\ Rule 38a 1 under the Investment Company Act requires that the policies and procedures of a fund adviser be approved by the fund board based on the board's finding that the policies and procedures are reasonably designed to prevent the adviser's violation of the Federal securities laws.\52\
\48\ See infra note 77 and accompanying text (discussing the ``broker vote'' process employed by many advisers to evaluate brokerdealers' brokerage and research services).
\49\ See Compliance Release at section I.A.1 (explaining that, in mandating investment adviser compliance policies and procedures, we elected not to impose a single set of universally applicable required elements because advisers are too varied in their operations).
\50\ See 1986 Release at section V.
\51\ See Compliance Release at section II.A.1. Rule 206(4)7 under the Advisers Act [17 CFR 275.206(4)7] requires an investment adviser to have written compliance policies and procedures in place that are reasonably designed to prevent it from violating the Advisers Act and rules the Commission has adopted under the Act. The rule does not enumerate specific elements that an adviser must include in its policies and procedures. However, the Commission has stated that it expects an adviser, in designing its policies and procedures, to identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm's particular obligations, and then design policies and procedures that address those risks. See id.
\52\ 17 CFR 270.38a1. See also Compliance Release at section II.A.2.
Fund directors should seek relevant data from the fund's investment adviser to assist them in evaluating the adviser's procedures regarding its best execution obligations. These data should typically include, but not be limited to: (i) The identification of brokerdealers to which the adviser has allocated fund trading and brokerage; (ii) the commission rates or spreads paid; (iii) the total brokerage commissions and value of securities executed that are allocated to each broker dealer during a particular period; and (iv) the fund's portfolio turnover rates. Fund boards may also discuss related matters with the adviser, which may include the following, where applicable:
\53\ Although we are not suggesting that firms need to do so, we understand that some firms have employed thirdparty vendors to assist them in measuring best execution through a transaction cost analysis using comparative data from across the industry. We also have been informed that not all companies use the same methodology to measure trading costs and that there are no commonly accepted standards as to how to measure price impact.
\54\ Because subadvisory arrangements take various forms, directors should have an understanding of the structure of these arrangements and whether the adviser is appropriately overseeing the trading activities of the subadvisers.
We acknowledge that not all funds would require an evaluation of each of these factors by their boards. Different factors may be appropriate for different funds, depending on a fund's investment objective, trading practices, and personnel.
We also request comment regarding how boards should approach their obligations to oversee and evaluate the fund adviser's trading practices and procedures. Is there further information fund boards should request that the adviser provide to assist directors in their review?
Once the board receives from the adviser information with respect to the issues outlined above, fund directors should determine whether the adviser's trading practices are being conducted in the best interests of the fund and the fund's shareholders. If these interests are not being best served, the board should direct the adviser accordingly.
In addition, when an investment adviser seeks the fund board's
approval of the adviser's compliance policies and procedures, directors
should satisfy themselves that the adviser's policies and procedures
are reasonably designed, adequate, and being effectively implemented to
prevent violations of the Federal securities laws.\55\ Directors may
evaluate the adviser's compliance policies and procedures through
updates from different sources, which may include the fund's or the adviser's CCO or other appropriate sources.\56\
\55\ 17 CFR 270.38a1(a)(2)(3) (requiring that each fund ``[o]btain the approval of the fund's board of directors * * * of the fund's policies and procedures and those of each investment adviser * * * which approval must be based on a finding by the board that the policies and procedures are reasonably designed to prevent violation of the Federal Securities Laws by the fund, and by each investment adviser * * *'' and that each fund ``review, no less frequently than annually, the adequacy of the policies and procedures of the fund and of each investment adviser. * * *''). See also Compliance Release at section II.A.2. & II.B.2.
\56\ 17 CFR 270.38a1(a)(4)(iii) (requiring that the fund designate a CCO who must, ``no less than annually, provide a written report to the board that, at a minimum, addresses,'' among other things, ``[t]he operation of the policies and procedures of the fund and each investment adviser. * * *''). See also Compliance Release at section II.C.2.
Furthermore, with the rapid development of increased options for
trading venues, fund boards need to remain up to date in their
familiarity with the evolving market in this area. We understand that fund directors approach educating themselves on
industry developments in various ways.\57\
\57\ Some ways we have observed that directors educate themselves on developments in this area include: (i) Establishing a committee of the board to specialize in portfolio trading practices; (ii) requiring that the adviser form special committees to consider best execution and the use of client commissions and to provide reports to the board on the adviser's trading activities; (iii) requesting periodic summaries and analyses from officers of the adviser to explain the adviser's portfolio trading practices; (iv) attending trade association events, seminars and/or other education events relating to brokerage practices; (v) subscribing to third party information providers or retaining experts to ensure that board members remain knowledgeable with respect to market
developments; and (vi) periodically meeting with portfolio managers, business unit staff, trading personnel and other employees of the adviser.
B. Board Oversight of an Investment Adviser's Use of Fund Brokerage Commissions
When trading portfolio securities on behalf of clients that are
funds, there are a number of ways in which an investment adviser may
use a portion of fund brokerage commissions to benefit the fund beyond
execution of the securities transaction. First, a fund adviser may use
a portion of fund brokerage commissions to purchase research and/or
researchrelated services in accordance with section 28(e) of the
Exchange Act. The research may be ``proprietary'' research, produced by
the brokerdealer executing the securities transaction or its
affiliates,\58\ or it may be ``thirdparty research,'' produced or
provided by someone other than the executing brokerdealer.\59\
Investment advisers also may purchase thirdparty research themselves
using cash payments from their own account, or ``hard dollars.''
Furthermore, investment advisers may obtain proprietary and thirdparty
research through a ``client commission arrangement.'' In a client
commission arrangement, an investment adviser agrees with a broker
dealer effecting trades for the adviser's client accounts that a
portion of the commissions paid by the accounts will be credited to
purchase research either from the executing broker or another broker, as directed by the adviser.\60\
\58\ See Thomas P. Lemke & Gerald T. Lins, Soft Dollars and Other Brokerage Arrangements Sec. 1.04[A] (2005). Proprietary research is often provided to an investment adviser partly as a quid pro quo for brokerage business given by the adviser to the broker producing the research. Alternatively, proprietary research may be provided without being expressly requested and considered part of the services obtained in exchange for ``full service,'' or ``bundled,'' commissions that include a sufficient amount of compensation to cover the cost of research. Id.
\59\ See id.
\60\ See 2006 Release at section III (interpreting section 28(e) to permit the industry flexibility to structure arrangements that are consistent with the statute and best serve investors).
In addition to obtaining research and researchrelated services
with fund brokerage commissions,\61\ an adviser may use fund brokerage
commissions in other ways. For example, an adviser may utilize a
commission recapture arrangement, whereby the fund receives a portion,
or rebate, of the brokerage commission (or spread) charged by the
brokerdealer handling the trade. Additionally, an investment adviser
may use fund brokerage to pay certain providers for services utilized
by the fund through an expense reimbursement arrangement with a broker dealer and/or its affiliates.\62\
\61\ See infra note 70 (explaining that only commissionbased trades (as opposed to markups or markdowns or spreads) are covered under the safe harbor in section 28(e) of the Exchange Act). \62\ In expense reimbursement arrangements, also referred to as ``brokerage/service arrangements,'' a brokerdealer typically agrees to pay a fund's service provider fees (such as custodian fees or transfer agency fees) and, in exchange, the fund agrees to direct a minimum amount of brokerage business to the reimbursing broker. The fund adviser usually negotiates the terms of the contract with the service provider, and the fees charged under the contract are paid directly by the brokerdealer. Brokerage/service arrangements may be structurally similar to client commission arrangements. However, unlike client commission arrangements, where the receipt of a benefit by the investment adviser through the use of fund brokerage commissions gives rise to conflicts of interest, brokerage/service arrangements generally do not raise these concerns because they typically involve the use of fund brokerage commissions to obtain services that directly and exclusively benefit the fund. See Payment for Investment Company Services with Brokerage Commissions, Securities Act Release No. 7197 (July 21, 1995) [60 FR 38918 (July 28, 1995)] (``1995 Release''), at nn. 12 and accompanying text; see also 2006 Release at section II.A, n.27.
We specifically request comment on our discussion of the various uses of fund brokerage. Have we described the use of fund brokerage commissions and client commissions by advisers correctly? Are fund brokerage commissions used in ways that we have not addressed but should address in this proposed guidance?
Because fund brokerage commissions are fund assets, investment
advisers have a conflict of interest when they use commissions to
obtain research and related services that they would otherwise have to
pay for themselves. Advisers therefore are subject to certain
requirements when using fund brokerage in this manner. First, section
17(e)(1) of the Investment Company Act prohibits investment advisers to
registered investment companies from using soft dollars to obtain
research or services outside the confines of the safe harbor provided
by section 28(e) of the Exchange Act.\63\ Second, investment advisers,
as fiduciaries, generally are prohibited from receiving any benefit
from the use of fund assets,\64\ although an investment adviser's use
of soft dollars creates opportunities for the adviser to benefit in
ways that may not be in the best interest of the fund. These conflicts
of interest arise in a number of ways when investment advisers use fund assets in soft dollar programs. For example:
\63\ 15 U.S.C. 80a17(e)(1). Section 17(e)(1) of the Investment Company Act generally makes it unlawful for any affiliated person of a registered investment company to receive any compensation (other than a regular salary or wages from the company) for the purchase or sale of any property to or for the investment company when that person is acting as an agent other than in the course of that person's business as a brokerdealer. Essentially, section 17(e)(1) may be violated if an affiliated person of a registered investment company, such as an adviser, receives compensation (other than a regular salary or wages from the company) for the purchase or sale of property to or from the investment company. Absent the protection of section 28(e), which provides a safe harbor from liability under other federal and state law, an investment adviser's receipt of compensationincluding in the form of brokerage or research servicesunder a client commission arrangement for the purchase or sale of any property, including securities, for or to the investment company, may constitute a violation of section 17(e)(1). See U.S. v. Deutsch, 451 F.2d 98, 11011 (2d Cir. 1971), cert. denied, 404 U.S. 1019 (1972). If a fund adviser's client commission arrangement is not consistent with section 28(e), disclosure of the arrangement would not cure any section 17(e)(1) violation. See 2006 Release at n.31; 1986 Release at n.55.
\64\ An adviser's obligation to act in the best interest of its client imposes a duty on the adviser not to profit at the expense of the client without the client's consent. See, e.g., Restatement (Second) of Trusts Sec. 170 cmt. a, Sec. 216 (1959). Also, section 206 of the Advisers Act establishes federal fiduciary standards governing the conduct of investment advisers. Under sections 206(1) and (2), in particular, an adviser must discharge its duties in the best interest of its clients, and must fully disclose a conflict of interest with a client, before engaging in conduct that constitutes a conflict. See Transamerica, 444 U.S. at 17.
research that benefits the adviser's other clients, including clients that do not generate brokerage commissions (such as fixedincome funds), those that are not otherwise paying more than the lowest available commission rate in exchange for soft dollar products or services (i.e., ``paying up'' in commission costs), or those from which the adviser receives the greatest amount of compensation for its advisory services;
\66\ Although these types of arrangements do not involve the conflicts posed by soft dollars, they do raise issues related to how a fund's assets are being expended and other issues, such as disclosure. See Concept Release at section VI.
\67\ For a discussion of ``mixeduse'' items, see 1986 Release at section II.B and 2006 Release at section III.F. These releases stated, as an example of a product that may have a mixed use, management information services (which may integrate trading, execution, accounting, recordkeeping, and other administrative matters such as measuring the performance of accounts). In the 1986 Release, the Commission indicated that where a product has a mixed use, an investment adviser should make a reasonable allocation of the cost of the product according to its use, and should keep adequate books and records concerning the allocations. The Commission also stated: (i) That the allocation decision itself poses a conflict of interest for the investment adviser that should be disclosed to the client; and (ii) that an investment adviser may use client commissions pursuant to section 28(e) of the Exchange Act to pay for the portion of a service or specific component that assists the adviser in the investment decisionmaking process, but cannot use soft dollars to pay for that portion of a service that provides the adviser with administrative assistance. 1986 Release at Section II.B. The 2006 Release made clear that ``brokerage'' products and services, as defined in the release, may also require a mixeduse allocation. 2006 Release at nn.7273. For a discussion of section 28(e) of the Exchange Act, see infra section III.C.
When evaluating an adviser's use of fund brokerage commissions in
light of these conflicts, a fund board may determine that such use is in the best interests of the fund.\68\
\68\ Fund boards are not required to approve brokerage and research services simply because they fall within the section 28(e) safe harbor. Rather, board determinations regarding the purchase of brokerage and research services with fund brokerage commissions should be made in accordance with the fund's best interest. In this regard, section 28(e) contemplates that funds could enter into contracts to reduce or eliminate an adviser's ability to rely on the safe harbor. See Thomas P. Lemke & Gerald T. Lins, Soft Dollars and Other Brokerage Arrangements Sec. 4.09 (2005) (``[T]he language of the safe harbor itself recognizes that the parties to an investment management relationship may by contract opt out of Section 28(e).''); see also Section 28(e) of the Exchange Act [15 U.S.C. 78bb(e)(1)] (stating that the safe harbor does not apply where ``expressly provided by contract'').
C. Section 28(e) Under the Securities Exchange Act of 1934
Section 28(e) of the Exchange Act provides a safe harbor that
protects investment advisers from liability for a breach of fiduciary
duty solely on the basis that the adviser caused an account over which
it exercises investment discretion to pay more than the lowest
commission rate in order to receive brokerage and research services
provided by a brokerdealer, if the adviser determined in good faith
that the amount of the commission was reasonable in relation to the
value of the brokerage and research services received.\69\ As we have
stated, section 17(e)(1) of the Investment Company Act prohibits
investment advisers to registered investment companies from obtaining
brokerage and research services with fund brokerage commissions outside the section 28(e) safe harbor.\70\
\69\ 15 U.S.C. 78bb(e)(1). When fixed commission rates were abolished in 1975, investment advisers and brokerdealers expressed concern that, if an investment adviser were to cause a client account to pay more than the lowest commission rate available for a particular transaction, then the adviser would be exposed to charges that it had breached its fiduciary duty owed to its client. Congress addressed this concern by enacting section 28(e). See 2006 Release at section II.A.
\70\ See supra note 63. It should be noted that section 28(e) of the Exchange Act does not encompass trades that are not executed on an agency basis, principal trades (with the exception of certain riskless principal transactions as described below), or other instruments traded net with no explicit commissions. See 2006 Release at n.27. However, the Commission has interpreted the term ``commission'' in section 28(e) as encompassing fees on certain riskless principal transactions that are reported under the trade reporting rules of the Financial Industry Regulatory Authority, or FINRA (as successor to the National Association of Securities Dealers, or NASD). See Commission Guidance on the Scope of section 28(e) of the Exchange Act, Exchange Act Release No. 45194 (Dec. 27, 2001) [67 FR 6 (Jan. 2, 2002)], at Section II.
The 2006 Release provides guidance with respect to the appropriate
framework for analyzing whether a particular service falls within the
``brokerage and research services'' safe harbor of section 28(e).\71\ A
fund board should request that the fund adviser inform directors of the
policies and procedures the adviser uses to ensure that the types of
brokerage and research services the adviser obtains using fund
brokerage commissions fall within the safe harbor and that the adviser
has not engaged in excessive trading in light of the fund's investment
objectives. In turn, in approving the policies and procedures, a board
should consider whether they are reasonably designed to ensure that the
adviser's use of fund brokerage commissions complies with the section
28(e) safe harbor, as well as all the federal securities laws.\72\ \71\ See 2006 Release at section III.
\72\ See supra note 52 and accompanying text (discussing a fund board's obligation to approve an adviser's compliance policies and procedures).
In addition, as we stated in the 2006 Release, to rely on the
section 28(e) safe harbor, an adviser must: (i) Determine whether the
product or service obtained is eligible research or brokerage under
section 28(e); (ii) determine whether the eligible product actually
provides lawful and appropriate assistance in the performance of his
investment decisionmaking responsibilities; and (iii) make a good
faith determination that the amount of client commissions paid is
reasonable in light of the value of products or services provided by
the brokerdealer.\73\ We also reaffirmed an investment adviser's
essential obligation under section 28(e) to make this good faith
determination and that the burden in demonstrating this determination
rests on the investment adviser.\74\ An adviser should demonstrate to
the board that it has met this burden.\75\ We specifically request
comment on our proposed guidance in this regard. We also request
examples of effective practices fund boards employ when evaluating whether an adviser has made
the good faith determination required under section 28(e).
\73\ See 2006 Release at Section III.B.
\74\ See id.
\75\ See 2006 Release at n.150 and accompanying text (citing House Comm. on Interstate and Foreign Commerce, Securities Reform Act of 1975 (H.R. 4111), H.R. Rep. No. 94123, at 95 (1975) (``It is, of course, expected that money managers paying brokers an amount [of commissions] which is based upon the quality and reliability of the broker's services including the availability and value of research, would stand ready and be required to demonstrate that such expenditures were bona fide.'')); see also 1986 Release at Section IV.B.3 (explaining that, among the responsibilities of the disinterested directors of a fund may be to monitor the adviser's soft dollar arrangements).
D. An Investment Adviser's General Fiduciary Obligations to Clients that Are Funds When Using Soft Dollars
As we have stated, although a fund adviser may satisfy the requirements for using client commissions to pay for brokerage and research services under the section 28(e) safe harbor, a fund's directors still should evaluate the adviser's use of fund brokerage commissions to purchase research and services in order to determine whether the adviser is acting in the best interest of the fund. If a fund board determines that the adviser's use of brokerage commissions is not in the best interest of the fund, the board should prohibit or limit the use of fund brokerage commissions and direct the adviser accordingly.\76\
\76\ See supra note 68 and accompanying text.
In this regard, directors need to understand the procedures that
the fund's investment adviser employs to address any potential
conflicts of interest and ensure that fund commissions are being used
appropriately. For example, to try to address concerns that a broker
dealer may be chosen by an adviser for reasons other than the quality
of the brokerdealer's execution (including the brokerage and research
services it provides), some advisers, particularly larger ones, may use
an internal process referred to as a ``broker vote'' or ``broker
tolls,'' whereby the adviser's investment professionals, typically the
portfolio managers and investment analysts, assess the value of the
research and services different brokerdealers provide to determine
which brokerdealer's research and other services the adviser should purchase.\77\
\77\ Advisers have informed us that, although many employ a broker vote, the actual process of determining which brokers to use varies among firms, as do the factors upon which each firm's voting system is based. Often a system of rating or allocating points is used to set targets for each broker, with the betterrated brokers receiving additional orders. Other firms have substantially less formal brokerselection processes.
To assist the board in understanding the adviser's policies and procedures regarding the use of fund brokerage commissions to obtain brokerage and research services, the board should request that the adviser inform the directors as to such matters as the following: