July 28, 2006
On July 12, 2006, the SEC issued new interpretative guidance on the scope of permissible commission practices under Section 28(e) of the Securities Exchange Act of 1934. Section 28(e) provides a "safe harbor" for advisors who pay higher than the lowest available commission rates in return for brokerage and research services.
What has Changed?
With some exceptions, the new guidance from the SEC will not alter most of the existing practices for most hedge fund managers, traditional investment advisors, or brokers. Nevertheless, there are aspects of the new analysis that merit attention. Each of these items is discussed below, but in summary they are: the requirement that all research reflect intellectual content; the elimination of mass-marked publications and tangible goods, such as computer hardware, from the definition of research; the announcement of new "temporal standards for measuring brokerage; and the incorporation of a new standard of liability for brokers making payment for research at the direction of clients. While the SEC formally rejected commenters requests for lists of permissible practices, it comes close to creating such a list with numerous illustrations of items that do or do not fall within the safe-harbor.
What is "Research?" The Reasoning and Knowledge Standard
The new standard for determining whether an item is permissible research is whether it constitutes "advice," analyses," or "reports" that "reflect(s) the expression of reasoning or knowledge." Items that the SEC clearly defines as research include traditional research reports-whether provided by a brokerage firm or a third-party provider-as well as trade analytics, market data, and advice on market color and execution strategies. What now clearly is not research are "inherently tangible products and services," including computer hardware. For example, data terminals themselves are no longer considered research, even though a subscription for the content may be research. Mass-marketed publications, such as the Wall Street Journal, also are no longer considered research, while industry-specific publications, such as Rock and Gravel News, and specialized financial newsletters (assuming they reflect some reasoning) may still be obtained with client commissions. Advisors will continue to be permitted to make allocations for "mixed use" products, such as proxy services, that serve both investment management and administrative functions.
A New Standard of Care for Brokers?
Equally important, in the case of research, is the requirement that the research has been "provided by" the broker receiving the client commissions. The SEC asserts a warning in the release that a broker may be considered to have "aided and abetted" an advisor's fraud, if the broker "knows" that the advisor has represented that it will operate solely within the safe harbor, and then subsequently pays for goods and services that are not permitted. Where the broker has not participated with the advisor in selecting the research supplier, and does not have a contract with the research provider, the SEC stated that the broker should:
This new standard likely will force brokers to pay greater attention to many "mixed use" items and also generate debates about what expenses are paid from research credits carried by the broker, versus accounts maintained to recapture client commissions.
What is Brokerage? A New Temporal Standard
Most of the regulatory attention in recent years has been focused on the definition of research. However, the safe harbor also includes commissions spent for brokerage. Brokerage specifically includes executing transactions, as well as providing clearance, settlement, and custody. Under the new "temporal" standard announced in the interpretive release, systems that are used by advisors in connection with transactions will only be considered to fall within the term "brokerage" from the point that the order is transmitted to the broker for execution, through the end of the clearance and settlement process. More specifically, the SEC states that "brokerage begins when the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution and ends when funds or securities are delivered or credited to the advised account or the account of the holder's agent." Thus, pre-trade analytics must fall within the term "research," and may not be considered "brokerage." However, order management systems and direct market access systems are considered brokerage.
Who Must Provide the Brokerage?
In order to receive commissions under the safe harbor, the broker must be considered to have "effected" the transaction. This requirement has generated questions when a broker, such as an introducing broker, receives a portion of the commissions when it has not executed the transaction. In the new guidance, the SEC clarifies that even if the broker does not execute the transaction (including clearing and settling the trade), it may have commission dollars directed to it so long as it serves one of the four following functions:
Conclusion
While the new guidance will not affect the core activities of brokers, traditional advisors, or hedge fund managers, it does formulate new standards for analyzing many different products and services common in the investment industry. It also clearly outlaws certain items that had routinely been paid for with soft dollars. Portions of the release proposing a new standard of care for brokers are troubling. However, the SEC has invited further comment, and is allowing a six-month grace period for brokers and advisors to adjust their practices to come into conformity with the new guidance.
By Edward Gartenberg
On July 12, 2006, the Securities and Exchange Commission proposed amendments to Regulation SHO governing short sales. The comment period extends until September 19, 2006. The proposing release (34-54154) explains that the "proposed amendments are intended to further reduce the number of persistent fails to deliver in certain equity securities, by eliminating the grandfather provision, and narrowing the options market maker exception."
Regulation SHO became effective January 3, 2005. The regulation was implemented after several years of public debate and was designed to impose a new regulatory framework for short sales, focusing on failures to deliver and abusive naked short-selling. A failure to deliver occurs when a seller does not deliver the securities by the settlement date, generally T+3 (trade date plus three days). The SEC has expressed concern that large and persistent failures to deliver, which can arise either from a short sale or a long sale, can deprive shareholders of ownership benefits, such as voting and lending, and may be indicative of manipulative activities to artificially lower an issuer's stock price. The SEC has, however, recognized that there may be legitimate reasons for a failure to deliver, and that naked short selling itself may, in certain instances, positively contribute to market liquidity.
Among other things, Regulation SHO requires that a broker-dealer not accept a short sale order in an equity security, or effect a short sale in such a security for its own account, unless the broker or dealer had reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due. This "locate" must be made and documented prior to effecting the short sale.
As currently contained in Rule 203(b)(3) of Regulation SHO, if a registered clearing agency participant, or any broker-dealer for which it clears transactions, has failed to deliver certain securities known as "threshold" securities for 13 consecutive settlement days, the participant must close out the fail to deliver position by purchasing securities of like kind and quantity. A "threshold security" is defined in the Regulation as an equity security of an issuer required to register under Section 12 and file reports pursuant to Section 15(d) of the Exchange Act, for which the levels of fails is very high (at least 10,000 shares and 0.5% of the total outstanding), for a continuous period of five consecutive settlement days, and is included on a list disseminated to its members by an SRO.
The exceptions to Rule 203(b)(3) include a grandfather provision (excepting fails occurring before the effective date of the Regulation and fails for securities before the securities appeared on the threshold list) and an option maker exception (excepting fails in a threshold security resulting from short sales by a registered options market maker to establish or maintain a hedge on option positions created before the underlying security became a threshold security). The proposed amendment is principally designed to eliminate the grandfather exception and narrow the options market maker exception. In addition, the proposed amendment includes a technical amendment that would update the market decline limitation referenced in Regulation.
The grandfather exception was adopted because the SEC was concerned about creating volatility through short squeezes arising from a need to close out large pre-existing positions quickly after a security became a threshold security. The SEC's experience since the adoption of Regulation SHO, as well as input from the SROs and others, suggests that, although fails to deliver have declined, persistent fails may be principally attributable to the grandfather exception.
To eliminate the grandfather exception, the proposed amendment would require, upon its adoption by the SEC, any previously grandfathered fail to deliver position to be closed out within 35 days of the settlement date. For any security that becomes a threshold security after the effective date, a fail to deliver would be subject to the Regulation's mandatory 13-day close-out requirements.
The option market maker exception was intended to address concerns about liquidity and the pricing of options. Under the proposed amendment registered option market makers would be able to keep open fail positions in threshold securities being used to hedge open option positions if an option that was created before the underlying security became a threshold security had not expired or been liquidated. Once the underlying security became a threshold security and the specific option position has expired or been liquidated, the fails would be subject to the 13 day close-out requirement.
In his remarks at the Commission's open meeting on July 12 on the amendments, Chairman Cox encouraged comments, not only on the proposed amendments, but more broadly, stating: "Once published, the public and the industry will have the opportunity to comment on the specific Regulation SHO proposals, as well as provide us with any alternative approaches. We also will be seeking comment about other ways to modify Regulation SHO." Chairman Cox indicated that the Commission would consider all comments and accompanying data "in determining whether any modifications to the proposals are necessary."
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©2006 by Thelen LLP. The Hedge Fund e-Alert is published as an information service for clients and friends. Please recognize that the information is general in nature and must not be relied upon as legal advice. The authors or your Thelen contact would be pleased to discuss this information and its application to your specific situation in greater detail. We welcome your comments and suggestions.
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