Disclosure by Investment Advisers Regarding Soft Dollar Practices

SUMMARY: The Commission is proposing for comment a new rule and form

under the Investment Advisers Act of 1940 that would require certain

investment advisers to provide clients with an annual report regarding

their use of client brokerage. The proposed report would include

disclosure about an adviser's use of its clients' brokerage commissions

during the previous year, including information about research and

other services obtained by the adviser with those commissions. The

proposed annual report is intended to provide investment advisory

clients with important information about the brokerage commissions they

pay and their advisers' receipt of ``soft dollar'' benefits from those

commissions.

DATES: Comments should be received on or before May 19, 1995.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G.

Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,

N.W., Washington, D.C. 20549. All comment letters should refer to File

No. S7-5-95. All comments received will be available for public

inspection and copying in the Commission's Public Reference Room, 450

Fifth Street, N.W., Washington, D.C. 20549.

FOR FURTHER INFORMATION CONTACT: Eric C. Freed, Special Counsel, or

Robert E. Plaze, Assistant Director, (202) 942-0721, Office of

Disclosure and Investment Adviser Regulation, Division of Investment

Management, Securities and Exchange Commission, 450 Fifth Street, N.W.,

Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission today

is proposing for comment:

(1) rule 204-4 (17 CFR 275.204-4) under the Investment Advisers Act

of 1940 (15 U.S.C. 80b-1 et seq.) (``Advisers Act''), which would

require an investment adviser registered or required to be registered

under the Advisers Act to deliver to its clients an annual report on

the adviser's direction of client brokerage transactions and its

receipt of research and other services in connection with those

transactions; and

(2) Form ADV-B under the Advisers Act, which would set forth the

information required to be included in the annual report.

Executive Summary

The Commission is proposing a new rule and form under the Advisers

Act to require each investment adviser (``adviser''), registered or

required to be registered under the Advisers Act, that has the

discretion to direct client brokerage transactions and receives

services other than execution in exchange for that brokerage, to

provide its clients with a report that would contain information about

its use of client brokerage. The report would disclose for the

adviser's most recently completed fiscal year, (1) the twenty brokers

to which the adviser directed the largest amounts of commissions and

certain other transaction-related payments (collectively,

``commissions''), (2) the three brokers substantially all of whose

services for the adviser were execution services (``execution-only

brokers'') to which the adviser directed the largest amounts of

commissions, (3) the aggregate amount of commissions directed by the

adviser to each broker listed and the percentage of the adviser's total

discretionary brokerage this amount represents, (4) the average

commission rate paid to each broker listed, and (5) for each broker

other than an execution-only broker, information concerning products or

services obtained from the broker. The report would also disclose the

percentages of the adviser's total commissions that are directed to

execution-only brokers, to other brokers, and at the request of

clients. The report would require only information about an adviser's

use of client brokerage on an aggregate basis; it would not require

separate information about the brokerage of the adviser's various

clients. The report would be provided to existing advisory clients

annually and to prospective advisory clients no later than the time

that an advisory agreement is entered into.

I. Background

Soft dollar practices are arrangements under which products or

services other than execution of securities transactions (``soft dollar

services'') are obtained by an adviser from or through a broker in

exchange for the direction by the adviser of client brokerage

transactions to the broker.\1\ Soft dollar practices are common in the

institutional brokerage market. According to an informal annual survey

of investment advisers and other institutions, nearly ninety percent of

these institutions engage in soft dollar arrangements, and more than

forty percent of commissions are directed primarily for the purpose of

obtaining research services.\2\

\1\See Securities Exchange Act Rel. No. 23170 (Apr. 23, 1986)

[51 FR 16004 (Apr. 30, 1986)] (``Release 23170'') at Sec. I; Robert

J. Moran & Cathy G. O'Kelly, Soft Dollars and Other Traps for the

Investment Adviser, 1 DePaul Bus. L.J. 45, 45 n.5 (1989).

\2\Greenwich Associates, Soft-Dollars: Opportunities and

Challenges (special presentation of May 10, 1994); Greenwich

Associates, Institutional Equity Investors 1994 (statistical supp.)

3, 17.

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Soft dollar practices originally developed as a means by which

brokers provided discounts on brokerage commissions that were fixed

pursuant to exchange and commission rules. In 1975, the Commission

prohibited fixed commission rates\3\ and, later that year, Congress

codified the Commission's action.\4\ After the Commission abolished

fixed rates, concerns were raised whether the soft dollar practices

that had developed in the context of fixed rates would continue to be

consistent with various state and federal laws, including the Advisers

Act.\5\

\3\Securities Exchange Act Rel. No. 11203 (Jan. 23, 1975) (40 FR

7394 (Feb. 20, 1975)).

\4\Securities Acts Amendments of 1975, Pub. L. No. 94-29, 89

Stat. 97, 107-08 (enacting Section 6(e)(1) of the 1934 Act (15

U.S.C. 78f(e)(1))).

\5\S. Rep. No. 75, 94th Cong., 1st Sess. 70 (1975).

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Underlying these concerns is an adviser's fundamental obligation

under the Advisers Act (and state law) to act in the best interest of

its clients.\6\ This duty requires the adviser to obtain best execution

of client transactions,\7\ and precludes the adviser from using client

assets for its own benefit or the benefit of other clients, at least

without client consent.\8\ Upon the Commission's eliminating fixed

commission rates, some argued that an adviser could be deemed to have

violated this duty if the adviser caused a client's account to pay

anything but the lowest commission rates. If this view was upheld, soft

dollar arrangements could have been effectively precluded by the

decision to eliminate fixed commission rates.

\6\See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180,

194 (1963).

\7\Delaware Management Co., 43 S.E.C. 392, 396 (1967). An

adviser is obligated to use reasonable diligence to select a broker

who will ``execute securities transactions for clients in such a

manner that the client's total cost or proceeds in each transaction

is most favorable under the circumstances.'' Securities Exchange Act

Rel. No. 23170 (Apr. 23, 1986) [51 FR 16004 (Apr. 30, 1994)]

(``Release 23170'') at Sec. V (citing Kidder, Peabody & Co., 43

S.E.C. 911, 915 (1968)). An adviser should consider the full range

and quality of the broker's services, including the value of

research received, in assessing whether a broker will provide best

execution. Id.

\8\Restatement (Second) of Trusts Sec. 170 comment a, Sec. 216

(1959). [[Page 9751]]

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Congress, in codifying the abolition of fixed commission rates,

responded to these concerns by enacting Section 28(e) of the Securities

Exchange Act of 1934 (the ``1934 Act'') [15 U.S.C. 78bb(e)], which

provides a safe harbor for certain soft dollar arrangements.\9\ Section

28(e) provides, in pertinent part, that an adviser with investment

discretion over an account will not be deemed to have acted unlawfully

or to have breached its fiduciary duty by causing the account to pay a

higher commission to a broker that provides research benefiting the

adviser's accounts. To rely on the Section 28(e) safe harbor, an

adviser must determine in good faith that the commissions paid are

reasonable in relation to the value of the brokerage and research

services provided, either in terms of the particular transaction or the

adviser's overall responsibilities towards its discretionary

accounts.\10\

\9\Securities Acts Amendments of 1975, Pub. L. No. 94-29, 89

Stat. 97, 161-62.

\10\The Commission has stated that a product or service may

legitimately be considered a ``brokerage or research service''

covered by the safe harbor if it provides ``lawful and appropriate

assistance to the [adviser's] decision-making process.'' Release

23170, supra note 1. The Commission's Division of Market Regulation

has addressed the types of transactions that are afforded the

protection of the safe harbor. See U.S. Department of Labor (pub.

avail. July 25, 1990) (safe harbor does not extend to principal,

riskless principal and futures transactions); Hoenig & Co. (pub.

avail. Oct. 15, 1990) (same); Instinet Corporation (pub. avail. Jan.

15, 1992) (safe harbor does apply to agency transactions in equity

securities on a computer-based real time market information and

brokerage system and after-hours order matching system).

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Section 28(e) modifies a fiduciary's strict duty to act in the best

interest of each client with respect to the management of each client's

assets. Thus, it permits an adviser to cause a client to pay higher

commissions than otherwise are available to obtain research that may

not be used exclusively for the benefit of the client or used to

benefit the client at all. Section 28(e), however, does not afford a

safe harbor with respect to all conflicts of interest between the

adviser and its clients that may arise from soft dollar arrangements.

For example, soft dollar arrangements may cause an adviser, in order to

obtain soft dollar services, to violate its best execution obligations

by directing client transactions to brokers who could not adequately

execute the transactions. Soft dollar arrangements also may give

advisers incentives to trade client securities inappropriately to

generate credits for soft dollar services.\11\

\11\See Securities and Exchange Commission v. Galleon Capital

Management, Litigation Rel. No. 14315 (Nov. 1, 1994). The

Commission's complaint in Galleon, in addition to alleging excessive

trading in order to generate soft dollar credits, alleged that the

adviser requested brokers to make soft dollar payments to a

consulting firm, and that these payments eventually were rebated to

the adviser. See also Letter from Bradford P. Schaaf, Chairman, and

Victor J. Fontana, President and Chief Executive Officer, Autranet,

Inc. to Barry P. Barbash, Director, Division of Investment

Management and Brandon Becker, Director, Division of Market

Regulation (Nov. 10, 1994) (``Autranet Letter'') (proposing that the

Commission prohibit a broker from requiring an adviser, by contract

or understanding, to commit to direct any specified amount of

commissions to the broker in order to receive soft dollar services).

Soft dollar practices also diminish the ability of a client to

evaluate the expenses it incurs in obtaining portfolio management

services and may hinder the ability of the client to negotiate fee

agreements, because the costs of soft dollar services are ``hidden''

from investors in brokerage commissions. By permitting advisers to use

their clients' transactions to pay for research services that they

otherwise would have to purchase with ``hard dollars,'' soft dollar

arrangements permit advisers to charge fees that do not fully reflect

the cost of portfolio management. Advisers that do not engage in soft

dollar arrangements may be put at a competitive disadvantage if they

pay for services with hard dollars and attempt to pass the cost of

these services on to clients through higher fees.

Congress recognized the conflicts that soft dollar practices

present and provided in section 28(e) authority for the Commission to

require advisers to disclose to their clients their policies and

practices with respect to the use of client commissions.\12\ The

Commission has never adopted rules under section 28(e),\13\ but has

instead required certain disclosure in Part II of Form ADV, which

specifies the content of the disclosure document or ``brochure'' that

an adviser is required to provide to clients before entering into

advisory relationships.\14\ If soft dollar arrangements are a factor in

selecting brokers to effect client transactions, the brochure must

disclose the nature of the adviser's soft dollar practices, including:

(i) the services that the adviser obtains through soft dollar

arrangements; (ii) whether clients may pay higher commissions (``pay

up'') as a result of the arrangements; (iii) whether soft dollar

services are used to benefit all client accounts or only those accounts

the brokerage of which was used to purchase the services; and (iv) any

procedures that the adviser uses to allocate brokerage.\15\

\12\Section 28(e)(2) (15 U.S.C. 78bb(e)(2)).

\13\In 1976, the Commission proposed rule 28e2-1 under the 1934

Act, but the rule was never adopted. See note 41 infra.

\14\Rule 204-3 under the Advisers Act (17 CFR 275.204-3)

requires that a registered investment adviser deliver the brochure

to a prospective client before entering into an advisory contract

with the client, and, annually thereafter, provide or offer to

provide the client with the brochure. The Commission is not at this

time proposing to amend the Form ADV requirements regarding

disclosure of soft dollar arrangements. The Commission, however, is

considering whether changes to these requirements would be

appropriate, and may propose changes in connection with future

revisions to Form ADV.

\15\Item 12 of Part II of Form ADV. Registered investment

companies are required to include similar disclosure in their

Statements of Additional Information. See, e.g., Item 17 of Form N-

1A (17 CFR 239.15A, 274.11A).

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Two broker-dealers, Goldman, Sachs & Co. and Morgan Stanley Group

Inc., themselves providers of research services to advisers, have

strongly criticized the effectiveness of current disclosure

requirements.\16\ Current disclosure primarily focuses on the policies

and practices that the adviser intends to follow with respect to the

use of client brokerage.\17\ This disclosure does not, Goldman, Sachs

and Morgan Stanley assert, adequately disclose to clients the extent to

which an adviser has soft dollar commitments or the specific benefits

that accrue to the adviser from the use of the client brokerage. These

brokers have proposed that the Commission adopt a requirement that

advisers periodically report to clients the soft dollar benefits that

they have received and the specific value of those benefits, as well as

certain information about how the brokerage of each client was directed

(the ``Goldman/Morgan Proposal'').\18\ Other participants in soft

dollar arrangements, organized by the Alliance in Support of

Independent Research, have argued that current client disclosure by

advisers is adequate and that the Goldman/Morgan Proposal is

anticompetitive and discriminatory.\19\

\16\See Future of the Stock Market: Soft Dollars, Hearing Before

the Subcomm. on Telecommunications and Finance of the House Comm. on

Energy and Commerce, 103d Cong., 1st Sess. (1993) (``1993

Hearings'') (testimony of David M. Silfen, Partner, Goldman, Sachs &

Co. and Anson M. Beard, Jr., Managing Director, Morgan Stanley Group

Inc.).

\17\The Commission has instituted a number of enforcement

actions against advisers based, at least in part, on the failure to

disclose soft dollar arrangements adequately. See, e.g., Securities

and Exchange Commission v. Galleon Capital Management, supra note

11; Kingsley, Jennison, McNulty & Morse, Inc., Investment Advisers

Act Rel. No. 1396 (Dec. 23, 1993); DeMarche Associates, Investment

Advisers Act Rel. No. 1392 (Nov. 23, 1993); Jack Allen Pirrie,

Investment Advisers Act Rel. No. 1284 (July 29, 1991); Robert

Michael Lee, Investment Advisers Act Rel. No. 1249 (Sept. 17, 1990);

Patterson Capital Corp., Investment Advisers Act Rel. No. 1235 (June

25, 1990).

\18\The Goldman/Morgan Proposal will be placed in the public

comment file for the Commission's proposal.

\19\See Letter from The Alliance in Support of Independent

Research to Jonathan G. Katz, Secretary, Securities and Exchange

Commission (Oct. 17, 1994), Commission File No. S7-22-94 (``Alliance

Letter''); see also Autranet Letter, supra note 11. The Alliance in

Support of Independent Research is ``a group of broker-dealers,

money managers and research firms sharing a common interest in

fostering a favorable regulatory environment in which independent

research services and products may be furnished to the money

management community.'' [[Page 9752]]

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The difference in the views of these two groups may reflect the

differences in the ways the two groups provide research services to

advisers and the effect that the Goldman/Morgan Proposal would have on

each group. Goldman, Sachs and Morgan Stanley operate as ``full service

brokers'' and provide a variety of execution, research and related

services to clients. An adviser who executes client securities

transactions through these firms typically receives research services

developed by the firms (``proprietary'' soft dollar services), much of

which is provided without being directly requested by the adviser. The

cost of such services generally are bundled in the overall commission

charged by the full service broker. In contrast, a ``soft dollar

broker'' typically provides advisers with services prepared or produced

by parties other than the broker (``third-party'' soft dollar services)

in exchange for the allocation of specified amounts of commission

dollars.\20\ In these types of arrangements, an explicit price

denominated in commission dollars, rather than in hard dollars, is

typically attached to the research.\21\

\20\In 1980, the Commission stated that research provided

through third-party arrangements falls within Section 28(e) of the

Exchange Act, even if the money manager participates in selecting

the research services provided to it and the research is delivered

directly to the money manager by the third party. Securities

Exchange Act Rel. No. 17371 (Dec. 12, 1980) (45 FR 83707 (Dec. 19,

1980)). The Section 28(e) safe harbor is not available to third-

party soft dollar arrangements unless, among other things, the

broker is obligated to the third party to pay for the services.

Release 23170, supra note 1, at Sec. III; Kingsley, Jennison,

McNulty & Morse, Inc., supra note 17.

\21\Some full service brokers also will enter into third-party

soft dollar arrangements with advisers.

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The Goldman/Morgan Proposal would affect the two groups of brokers

differently. Because proprietary soft dollar services are not offered

for a specific price in commission dollars, under the Goldman/Morgan

Proposal, disclosure would be required only about the price and value

of third-party soft dollar services. Soft dollar brokers argue that if

the Commission required more extensive disclosure of third-party soft

dollar services than proprietary soft dollar services, advisory clients

might be led to believe that advisers derive benefits from soft dollar

brokers at the clients' expense that they do not derive from full

service brokers, when, in fact, both types of firms confer benefits on

advisers.\22\ As a result, advisers might be discouraged from using

soft dollar brokers.

\22\See Alliance Letter, supra note 19.

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Representatives of some investment advisers have asserted that

current disclosure requirements are adequate.\23\ According to these

advisers, clients rarely request information about the soft dollar

benefits that the adviser receives, and those that are interested

currently may obtain the information on request.\24\ Other investment

advisers, however, argue that the nature of the conflicts involved in

soft dollar arrangements warrant more extensive client disclosure than

is currently required.\25\

\23\See, e.g., 1993 Hearings, supra note 16 (statement of Holly

A. Stark, Senior Vice President, Dalton, Greiner, Hartman, Maher &

Co.).

\24\Many pension plans require some form of soft dollar

reporting from their money managers, primarily in response to a

pronouncement of the Department of Labor, the principal federal

regulator of employee benefit plans under the Employee Retirement

Income Security Act of 1974 (``ERISA''), concerning the ongoing duty

of plan fiduciaries to monitor the use of soft dollars by managers.

See ERISA Technical Release No. 86-1.

Section 15(c) of the Investment Company Act of 1940 (15 U.S.C.

80a-15(c)) requires the directors of a registered investment company

to request and review, and the company's adviser to supply, such

information as may reasonably be necessary to evaluate the terms of

the advisory contract between the adviser and the investment

company. As discussed above, soft dollar arrangements may bear upon

the reasonableness of advisory fees. See text accompanying note 12

supra. Investment company advisers that engage in soft dollar

arrangements therefore must provide their boards of directors with

information regarding soft dollar arrangements. See Release 23170,

supra note 1, at Sec. IV.B.3.

Various institutional investors have expressed their views on

soft dollar arrangements. See 1993 Hearings (statement of Fred G.

Weiss, Chairman, Financial Executive Institute's Committee on

Investment of Employee Benefit Assets (``CIEBA'')). Mr. Weiss stated

that CIEBA, which represents 150 corporate benefit plan sponsors

with assets of approximately $600 billion, was unable to develop a

clear consensus on whether soft dollar practices were desirable or

not. CIEBA did, however, call for more comprehensive reporting of

soft dollar arrangements at a firm-wide level to supplement the

client-specific information that most of its members currently

receive. Other institutional investors believe that current

disclosure is adequate. See 1993 Hearings (written statement of

State Board of Administration of Florida). In addition, the

Institutional Investors Committee of the National Association of

Securities Dealers, Inc. (``NASD Committee''), which includes

representatives of institutional investors, advisers, and brokerage

firms, submitted a recommendation to the Commission's staff for

additional soft dollar disclosure. The NASD Committee's

recommendation was approved by the NASD's Board of Governors. The

NASD Committee's recommendation will be placed in the public comment

file for the Commission's proposal.

\25\See Letter from Louis R. Cohen and Marianne K. Smythe,

Wilmer, Cutler & Pickering to Jonathan G. Katz, Secretary,

Securities and Exchange Commission (Oct. 17, 1994) (on behalf of

Investors Research Corp.) (``Investors Research Letter''),

Commission File No. S7-22-94.

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The Commission staff considered issues related to soft dollars in

its ``Market 2000'' report on the equity markets released in January

1994.\26\ In that report, the staff recommended that quantifiable

information about soft dollar services be required to be provided to

advisory clients.\27\ The report also stated that ``[m]ost importantly

* * * any new disclosure requirements should apply equitably. Thus,

research and other services obtained either from (full service) firms

or (soft dollar) firms should be subject to disclosure.''

\26\See U.S. Securities and Exchange Commission, Division of

Market Regulation, Market 2000: An Examination of Current Equity

Market Developments (Jan. 1994).

\27\Id. at V-15.

II. Discussion

The Commission believes that, in light of the conflicts of interest

presented by soft dollar arrangements, additional disclosure about

these practices may be warranted. While current disclosure may provide

sufficient notice to a client that the adviser has these conflicts, it

may not provide the client with sufficient information to permit it to

assess the extent to which the adviser obtains soft dollar services or

pays up for those services, or the types of services that the adviser

obtains through soft dollar arrangements. Enhanced disclosure may

provide existing clients with information useful in negotiating limits

on the use of their brokerage, and enable prospective clients to make

better informed choices of advisers.

The Commission is therefore proposing that certain registered

advisers be required to provide clients with annual reports setting

forth certain information about their use of client brokerage and the

soft dollar services each adviser received during its most recently

completed fiscal year.28 The proposal is intended to provide an

advisory client with information that can be used to evaluate the

extent to which the client benefits from the adviser's brokerage

practices, the extent to which the adviser benefits, and whether the

client should attempt to limit the adviser's use of its brokerage.

Consistent with the recommendations of the staff in the Market 2000

report, the proposed disclosure requirements would not impose different

[[Page 9753]] requirements on third-party and proprietary soft dollar

arrangements.

\28\The proposed amendments would not require that advisers

provide each client with information about how that client's

transactions were directed. See Section II.F infra.

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A. The Annual Report in General

The Commission is proposing a new rule under the Advisers Act, rule

204-4, that would require any adviser, registered or required to be

registered under the Advisers Act, that has brokerage discretion29

over any client account and that receives soft dollar services to

deliver an annual report to clients on its use of client brokerage. The

contents of the annual report would be specified in new Form ADV-B.

\29\The definition of ``brokerage discretion'' is discussed at

notes 58-59 and accompanying text infra.

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The core of the annual report would be a table disclosing

information regarding the adviser's direction of client brokerage. The

table would list the twenty brokers other than execution-only brokers

(``research brokers'') to which the adviser directed the greatest

amount of client commissions,30 and the three execution-only

brokers to which the adviser directed the greatest amount of client

commissions during its most recent fiscal year.31 For each broker

listed, the table would disclose: the aggregate amount of commissions

directed by the adviser to the broker; the percentage of the adviser's

discretionary brokerage commissions that this represents; the average

commission rate (in cents per share) paid to the broker; and a

description of the soft dollar services provided by the broker.32

\30\For the purposes of the amendments, ``commissions'' would

include amounts of mark-ups and mark-downs on principal transactions

if those amounts are included on the confirmation of the transaction

required under rule 10b-10 under the 1934 Act. See Section II.E

infra. These mark-ups and mark-downs, however, are not commissions

for purposes of Section 28(e). See note 10 supra.

\31\The definition of ``execution-only broker'' is discussed at

notes 36-38 and accompanying text infra.

\32\Items 2-3 of proposed Form ADV-B. For purposes of

determining the amount of commissions and the corresponding

percentage of the adviser's discretionary brokerage that this amount

represents, sales loads on transactions in investment company shares

would be considered commissions. Because sales loads typically are

not calculated on a cents per share basis and could potentially

distort the average commission rate data, sales loads would not be

considered in calculating average commission rates. Instruction 3 to

Item 2 of proposed Form ADV-B.

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The table would provide an overview of the brokers used by an

adviser to execute client transactions, the commissions charged by the

brokers, and the soft dollar services received from research brokers.

This disclosure is intended to assist an advisory client in evaluating

the adviser's use of its brokerage, including whether the client could

be paying lower commissions, whether the adviser is obtaining soft

dollar services that can be used to benefit the client, and whether the

advisory fee charged to the client is appropriate in light of the

services that the adviser pays for with client commissions.

Institutional clients using the services of more than one adviser and

prospective clients considering different advisers will be able to use

the table to compare advisers' use of brokerage, including the

commission rates that they negotiate and the types of services that

they receive. The disclosure regarding execution-only brokers would

assist clients in making these determinations by providing information

about the availability of brokerage alternatives, and, by implication,

the effect that soft dollar services may have on commission

rates.33

\33\The Commission recognizes that the use of execution-only

brokers would not be appropriate or possible in many circumstances.

The proposed disclosure about execution-only brokers is not intended

to imply that such brokers could have been used in all

circumstances. Furthermore, an adviser would be permitted to explain

its policies regarding the use of execution-only brokers in a

narrative portion of the annual report. See General Instruction 6 to

Proposed Form ADV-B.

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The table would be followed by certain data concerning the

adviser's direction of brokerage: the percentages of the adviser's

total brokerage that are directed (1) by the adviser to research

brokers, (2) by the adviser to execution-only brokers, and (3) pursuant

to specific client instructions.34 This data would provide clients

with an overall picture of how the adviser directs brokerage.

\34\Item 4 of proposed Form ADV-B.

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B. Disclosure of Brokers

As noted above, the report would be required to include information

about twenty research brokers and three execution-only brokers.35

Limiting the required disclosure to this number of brokers is intended

to result in reports that provide useful information in a relatively

concise manner. Comment is requested whether the proposed numerical

thresholds are appropriate. Comment is also requested whether, as an

alternative, disclosure should be required about brokers to which the

adviser directed more than a specified percentage of its brokerage,

such as one percent.

\35\For purposes of the annual report, a ``broker'' would

include a bank that is not registered as a broker-dealer under the

1934 Act. Instruction 1 to Item 2 of proposed Form ADV-B.

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For the purposes of the amendments, a broker would be considered an

``execution-only'' broker if substantially all of the services that the

broker provides to the adviser are execution services, i.e., effecting

securities transactions and performing functions incidental to or

required in connection with effecting those transactions.36

Consequently, a broker would not be permitted to be considered an

execution-only broker if it provided any significant amount of soft

dollar services to the adviser, even if the services were not solicited

or used by the adviser.37 If a broker provided only execution

services to an adviser, however, the adviser would include the broker

as execution-only even if the broker provided additional services, such

as research, to its other customers. The definition of execution-only

broker would include automated trading systems (e.g., the Instinet and

Lattice systems) if the adviser received only execution and execution-

related services as a result of using the system, regardless of whether

the system itself is required to be registered as a broker-dealer under

the 1934 Act.38

\36\Instruction to Item 3 of proposed Form ADV-B. The definition

of execution-only broker is derived from Section 28(e)(3)(C) of the

1934 Act [15 U.S.C. 78bb(e)(3)(C)]. Under that section, custody of

securities is a function incidental to effecting a transaction in

the securities.

\37\A broker would be permitted to be considered an execution-

only broker if it provided a minimal amount of soft dollar services

to the adviser, such as a single research report or a single contact

with a securities analyst.

\38\Instruction to Item 3 of proposed Form ADV-B. Typically, the

sponsor of an automated trading system will be required to be

registered as a broker-dealer under the 1934 Act. An automated

trading system would be included in the definition of broker in Form

ADV-B if a fee is charged for using the system, regardless of the

basis for the fee (e.g., a flat usage fee or transaction-based

fees).

An adviser that did not utilize any research brokers or that did

not utilize any execution-only brokers would be required to so state

under the appropriate heading in the table.39 An adviser that

directed client commissions to fewer than twenty research brokers and/

or fewer than three execution-only brokers would be required to

disclose under the appropriate headings those brokers to which it did

direct client commissions. As a result, an adviser's annual report

would always include some reference to the existence of execution-only

brokers. Comment is requested whether there are better ways to disclose

to clients the availability and cost of brokerage alternatives. For

instance, comment is requested whether an adviser should be required to

disclose execution-only brokers that offered to execute client

transactions. Similarly, comment is requested whether the table should

include [[Page 9754]] disclosure regarding all brokers used by the

adviser.40

\39\Items 2 and 3 of proposed Form ADV-B.

\40\In order to keep the report at a manageable length, an

adviser could be permitted merely to indicate whether or not it

received soft dollar services, rather than to identify the services

received, from brokers that were not among those it used most

frequently (e.g., the top twenty).

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Comment is requested generally on the definition of an execution-

only broker, and whether the proposal's classification of brokers into

two types, execution-only and all others, is appropriate or

practicable. Instead of classifying brokers by type, the Commission

considered proposing that advisers be required to classify brokers or

specific trades based upon the purposes for which the trades were

directed to the broker (e.g., execution or research). Under this

approach, trades directed to a broker that provided soft dollar

services could be considered to be directed for the purposes of

execution if the services were a minimal factor in directing the

brokerage. The Commission is not proposing this approach because

determining the purposes for which brokers are used or individual

trades are directed may be impracticable and burdensome.41 The

proposed approach, which would not permit an adviser to treat a broker

from whom it receives significant soft dollar services as an execution-

only broker, seeks to reduce the burden on advisers by providing a more

objective basis for classifying brokers. Nevertheless, comment is

requested whether the annual report should require advisers to classify

brokers or trades by the purposes for which the adviser directed the

brokerage.

\41\In 1976, the Commission proposed rule 28e2-1 under the 1934

Act, which would have required advisers to make certain disclosures

to clients concerning soft dollar practices in a separate annual

report. Securities Exchange Act Rel. No. 13024 (Nov. 30, 1976) (41

FR 53356 (Dec. 6, 1976)). The proposed rule, which was not adopted,

would have required, among other things, narrative disclosure

concerning research received ``in return for'' brokerage. Commenters

stated that it was impracticable to determine whether research was

obtained ``in return for'' specific services, particularly when the

research was not solicited. See Securities Exchange Act Rel. No.

10569 (Jan. 30, 1979) (44 FR 7864 (Feb. 7, 1979)) (``Release

10569'').

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C. Disclosure of Products and Services Received

The annual report would describe the soft dollar services received

by the adviser from each research broker listed. Except as discussed

below, soft dollar services would be required to be identified

specifically.42 The producer of a third-party soft dollar service

would be identified unless its name was evident from the name of the

product. This information is intended to permit a client to assess

whether it benefits from the soft dollar services that the adviser

receives and, consequently, whether it should attempt to limit the

adviser's use of its brokerage.

\42\Instruction 7 to Item 2 of proposed Form ADV-B.

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In many cases, an adviser receives research reports from a broker

or is given access to the broker's securities professionals in exchange

for the direction of brokerage. An adviser would not be required to

list separately every report that it received or each professional with

whom it had contact. Instead, an adviser would be permitted to refer to

these services generically according to the following categories: (1)

Analyses and reports on specific securities, issuers or industries, (2)

political or economic analyses or reports, or (3) access to securities

analysts.43 All other services, including computer hardware,

software, databases, and on-line services, financial or other

publications available by subscription, and any products or services

falling outside the scope of Section 28(e) of the 1934 Act, would be

required to be identified specifically.

\43\Id.

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Comment is requested whether soft dollar services should be

identified in this manner. Should the Commission require more specific

disclosure of research reports or access to securities analysts or

other professionals, or permit general descriptions of other services?

Comment is requested whether, either in lieu of or in addition to

separate identification of the services received, soft dollar services

should be required to be classified into specified categories, and, if

so, what those categories should be.44

\44\In connection with its annual survey of institutions

regarding their brokerage practices, see note 2 and accompanying

text supra, Greenwich Associates uses the following nine categories

of soft dollar services: performance measurement, third-party

research, corporate fundamental databases, technical analysis

software, portfolio modeling and strategy software, on-line stock

price quotations, specialized political or economic analyses,

terminals and computers, and custody services. Greenwich Associates,

Institutional Equity Investors 1994 (statistical supp.) 19.

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In addition to requiring a description of the soft dollar services

received, the Goldman/Morgan Proposal would have required that an

adviser disclose the price in commission dollars and fair market value

of each third-party soft dollar service (which typically will be

provided at an explicit price). As noted above, the Goldman/Morgan

proposal would not require this disclosure regarding proprietary soft

dollar services, as these services are not explicitly assigned a price.

Price and fair value information may be useful as an expression of the

value of the soft dollar services obtained by the adviser.45 The

Commission is concerned, however, that unless the values of proprietary

soft dollar services are also included in the report, the information

provided to the client would be incomplete and may distort client

understanding about the benefits that advisers receive through client

brokerage. Clients, for example, may incorrectly believe that soft

dollar services are not a consideration in an adviser's direction of

client brokerage to full service brokers or that third-party soft

dollar services are of greater value (either to advisers or clients)

than proprietary soft dollar services. Moreover, the Goldman/Morgan

Proposal may provide an investment adviser an incentive to direct

brokerage to a full service broker rather than a soft dollar broker for

the same types of soft dollar services, simply because of differing

client reporting requirements. This consequence may not be in the best

interests of advisory clients and may be unfair to soft dollar brokers.

Thus, consistent with the staff's recommendations in the Market 2000

report, the Commission is not proposing that only third-party soft

dollar services be valued.

\45\The Commission recently proposed that estimates of the value

of non-monetary payments for order flow be disclosed to customers of

brokers receiving such payments. Securities Exchange Act Rel. No.

34903 (Oct. 27, 1994) (59 FR 55014 (Nov. 2, 1994)). Payment for

order flow is payment by a broker, dealer, securities exchange,

securities association or exchange member to a broker or dealer in

return for the routing of customer orders to the broker, dealer,

securities exchange, securities association, or exchange member.

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The Commission also considered requiring advisers to report the

fair market value of all soft dollar services, regardless of their

source. Because there often is no agreed upon price for proprietary

soft dollar services, their fair market value may not readily be

ascertainable. One approach might be to require advisers to disclose

the cost to the broker of producing proprietary soft dollar services.

The cost of producing services, however, may not reflect their fair

market value, and an adviser may not be able to verify cost information

provided by brokers.46 Alternatively, the value of soft dollar

services to the adviser receiving them could be [[Page 9755]] required

to be disclosed, but it may be inappropriate and misleading to reflect

services that the adviser did not solicit or use as having no

value.47

\46\In addition, it is unclear how a broker's ``cost'' should be

determined. An ``average cost'' could be obtained by dividing the

cost of producing the services by the number of recipients.

``Marginal cost'' would measure the actual cost of providing the

research to the last adviser. Full service brokers frequently

distribute to advisers and other customers research services that

were initially produced for other purposes. The marginal cost of

such research might be only the cost of its distribution.

\47\An adviser could be required to report only those

proprietary soft dollar services for which it specifically directed

brokerage. Such a limitation, however, would require highly

subjective determinations by advisers, and, as a practical matter,

might elicit disclosure about only third-party soft dollar services.

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An adviser could be required to make a good faith estimate of what

the proprietary soft dollar services would have cost in an arms-length

transaction.48 This approach would require advisers to report

positive values for unsolicited and unused services, which could lead

investors to believe that the adviser (or the client) substantially

benefited from the direction of the brokerage when, in fact, receipt of

the services was incidental to brokerage direction decisions made

wholly on the basis of the broker's execution capabilities. In

addition, good faith estimates may be very difficult to make if the

services provided are unlike those available for hard dollars. In this

regard, the Commission is concerned with the burden that a good faith

estimate requirement would impose on advisers and brokers and the

accuracy of the information that would be reported to clients.49

\48\This approach was suggested by one commenter on the

Commission's recent proposal to require that mutual fund expenses

paid by brokers should be included in fund expense and performance

data. See Investors Research Letter, supra note 25. In that

proposal, the Commission requested comment whether the value of

research services received by a fund's adviser should also be

included in fund expenses, and how the research should be valued.

See Investment Company Act Rel. No. 20472 (Aug. 11, 1994) (59 FR

42187 (Aug. 17, 1994)), at Sec. II.A.1. Most commenters on the

proposal, however, opposed the inclusion of research services in

fund expenses, and those commenters that favored it generally

provided little guidance regarding how to value proprietary

services.

\49\In proposing rule 28e2-1, the Commission proposed that the

fair value of non-research services be disclosed, and requested

comment on the feasibility and desirability of requiring disclosure

of specific dollar amounts of brokerage commissions paid to receive

research services. Commenters asserted that it would be

impracticable to value soft dollar services or to separate

commissions into their research and execution components. See

Release 10569, supra note 41.

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The disclosure that the Commission is proposing to require is

designed to alert a client that the adviser receives soft dollar

services from directing client commissions, and provide some indication

of the extent to which the client benefits from that direction. The

commission rate information, including the commission rates of

execution-only brokers, may provide valuable information on the costs

of soft dollar arrangements and may render valuation estimates

unnecessary. If additional information is desired, the client can

request it from the adviser.

Comment is requested whether the commission price and fair market

value of particular soft dollar services, or the soft dollar services

obtained from a broker in the aggregate, should be required in the

annual report. Commenters favoring inclusion of this information should

discuss how the price and value of proprietary soft dollar services

should be determined.

D. Client-Directed Brokerage

Many clients of investment advisers instruct their advisers to

direct some or all of their transactions to a particular broker or

brokers. A client may direct its brokerage, among other reasons, to

obtain services for its own benefit or because of a pre-existing

relationship with the broker.

In addition to disclosing the percentages of an adviser's total

commissions that are directed to execution-only and research brokers,

the proposed annual report would be required to disclose the percentage

of commissions that is directed by clients.50 Client restrictions

on an adviser's brokerage discretion may be of interest to other

clients of the adviser because they may cause a larger proportion of

the brokerage of the other clients to be used to obtain soft dollar

services for the adviser. Information on client-directed brokerage,

therefore, may be useful to clients in determining the amount of

brokerage available to the adviser to purchase soft dollar services.

Comment is requested whether the proposed disclosure of the percentage

of client-directed brokerage would be useful, and whether the

Commission should require that the data be accompanied by disclosure

explaining its usefulness.

\50\Item 4 of proposed Form ADV-B.

E. Principal Transactions

Proposed Form ADV-B would require an adviser to include in the

commission and commission rate in the table mark-ups and mark-downs

paid in connection with principal transactions if the amounts of these

mark-ups or mark-downs are included in the confirmations of the

transactions required under rule 10b-10 under the 1934 Act. Rule 10b-10

requires that a dealer include transaction cost data in confirmations

of (1) riskless principal transactions in equity securities if the

dealer is not a market maker in the securities, and (2) transactions in

a listed equity securities and certain Nasdaq securities.51

\51\Paragraph (a)(8) of rule 10b-10 [17 CFR 10b-10(a)(8)].

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Proposed Form ADV-B would not require disclosure of information

about other principal transactions or the mark-ups, mark-downs or

spreads paid on these transactions. It may be difficult to accurately

determine transaction costs associated with these principal

transactions. Furthermore, disclosure about adviser direction of

principal transactions may not be necessary, as soft dollar

arrangements involving principal transactions may be less common than

those involving agency transactions because principal transactions are

not afforded the safe harbor provided by Section 28(e).52

\52\The safe harbor does not encompass soft dollar arrangements

under which research services are acquired as a result of principal

transactions. See note 10 supra. Notwithstanding the lack of

availability of the safe harbor, the Commission understands that

full service brokers sometimes provide research and other services

based, at least in part, on principal transactions. If an adviser

were required to list a broker in its annual report because the

broker is used frequently for agency transactions, the adviser would

be required to take all of the soft dollar services obtained from

the broker into account in responding to the report's requirement to

list the services obtained, even if some of the services could be

deemed to be received as a result of principal transactions not

within the scope of the proposed amendments. Instruction 7 to Item 2

of proposed Form ADV-B.

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Comment is requested whether the annual report should include

information on all principal transactions, and, if so, how the

associated costs should be determined. Comment is also requested

whether disclosure requirements that apply primarily to agency

transactions would cause more transactions to be executed on a

principal basis.

The proposal would require disclosure of the brokers to which the

greatest amounts of commissions had been directed. Alternatively, the

obligation to disclose information about a broker could be based on the

dollar amount of transactions, both principal and agency, directed to

the broker. The resulting disclosure might be more useful to clients in

assessing any relationship that may exist between the adviser's use of

principal transactions and its receipt of soft dollar services. Comment

is requested whether the basis for requiring a broker to be listed in

the annual report should be the dollar amount of transactions directed

to the broker, rather than the amount of commissions.

F. Client-Specific Information

The proposed amendments would not require that an adviser provide

each client with information about how that [[Page 9756]] client's

brokerage was directed (``client-specific information''). Client-

specific information could assist a client in comparing the use of its

brokerage with that of the adviser's other clients.53 The benefits

of a requirement to disclose client-specific information, however, may

be outweighed by the time and cost to advisers of preparing separate

reports for every client. This cost would likely be passed on to

advisory clients. Furthermore, advisory clients currently receive or

have access to confirmations of their transactions that disclose the

identities of the brokers used and the amounts of commissions

charged.54 Comment is requested whether client-specific

information should be required in the annual report and, if so, what

information should be required.55

\53\To the extent differences between the manner in which an

adviser uses a particular client's brokerage and the brokerage of

the adviser's other clients is caused by client-directed brokerage,

the requirement of the proposal to disclose the percentage of

client-directed brokerage might render client-specific information

unnecessary. See Section II.D supra.

\54\See rule 10b-10 under the 1934 Act [17 CFR 240.10b-10]

(requiring broker-dealers to send immediate confirmations of

transactions to their customers). The confirmations, or quarterly

statements containing all of the information required in the

confirmations, must be sent to the holder of the account, rather

than any fiduciary managing the account. See Securities Exchange Act

Rel. No. 34962 (Nov. 10, 1994) [59 FR 59612 (Nov. 17, 1994)] at

Sec. II.A.2.

\55\As noted above, an adviser to an investment company is

required to provide information about its soft dollar arrangements

to the company's board of directors. See note 24 supra. The

information provided by the adviser generally should include

specific information about the adviser's use of the investment

company's brokerage. The proposed annual report would supplement

this fund-specific information.

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G. Delivery and Filing

Reports on Form ADV-B would be prepared on an annual basis and

would report on brokerage directed during the adviser's most recently

completed fiscal year.56 The report would be required to be filed

with the Commission and delivered to clients no later than sixty days

after the end of the fiscal year, and delivered to prospective clients

no later than the time that an advisory contract is entered

into.57

\56\Paragraph (a) of proposed rule 204-4; General Instructions 1

and 5 to proposed Form ADV-B. The table in the annual report would

be required to disclose commissions paid during the adviser's most

recently completed fiscal year even if soft dollar services paid for

with those commissions had been or will be received during another

fiscal year. Conversely, disclosure of soft dollar services received

during a fiscal year would be required even if commissions were or

will be directed to pay for those services during another fiscal

year. General Instruction 5 to proposed Form ADV-B.

\57\Paragraphs (a) and (b) of proposed rule 204-4; General

Instructions 3 and 4 to proposed Form ADV-B. Rule 204-3 under the

Advisers Act, which generally requires advisers to furnish a

disclosure brochure to prospective clients no later than 48 hours

prior to the time that the advisory contract is entered into,

permits the brochure to be delivered at the time that the contract

is entered into if the contract can be terminated without penalty

within five business days. Paragraph (b)(1) of rule 204-3 [17 CFR

275.204-3(b)(1)]. Proposed rule 204-4 would not similarly

differentiate between providing the annual report before or at the

time that the contract is entered into. Generally, however, the

determination of when a contract is entered into would be the same

for the purposes of both rules.

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Because the report would provide information about brokerage over

which the adviser has discretion, the report would be required to be

delivered only to those clients over whose accounts the adviser has or

will have brokerage discretion. An adviser would be considered to have

brokerage discretion over an account if it (1) had the authority to

determine, without obtaining specific client consent, the brokers to be

used or the commissions paid in connection with any transactions for

the account, or (2) significantly influenced the selection of brokers

by a client and received soft dollar services from a broker chosen by

the client.58 An adviser would not be required to provide the

report to a client that, without the adviser's influence, directed that

a single broker execute its transactions, or prior to each transaction

approved the broker to be used for the transaction.59 Comment is

requested whether this definition of brokerage discretion is

appropriate, and whether the report should be required to be delivered

to clients over whose accounts the adviser does not have brokerage

discretion.

\58\Paragraph (c)(1) of proposed rule 204-4; General Instruction

2 to proposed Form ADV-B. An adviser would not be deemed to have

brokerage discretion over an account if substantially all of the

client's transactions were directed to a broker that was compensated

for executing the transactions based upon a percentage of the assets

managed by the adviser, such as in a ``wrap fee'' program, even if

the adviser could in certain circumstances direct the client's

transactions to other brokers.

\59\An adviser would be required to deliver the annual report to

a client if the adviser had discretion over any of the client's

brokerage, even if some or most of the client's brokerage was

directed by the client. Delivery of the annual report also would be

required if the adviser had the authority to select brokers for

particular transactions from a list previously approved by the

client.

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The Commission is proposing that the report be prepared on an

annual basis. More frequent reporting would be more costly and may not

be necessary for clients to monitor an adviser's brokerage direction

practices. Furthermore, an annual report may provide a more

representative sample of an adviser's brokerage practices. Comment is

requested whether the report should be required to be prepared more

frequently than annually, such as quarterly.60

\60\The Morgan/Goldman Proposal would have required quarterly

reporting.

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H. Goldman/Morgan Proposal

The Goldman/Morgan Proposal differs from the Commission's proposal

in a number of respects. The Goldman/Morgan Proposal would, among other

things, require quarterly rather than annual reporting, require

disclosure of the commission price and value of specific third-party

soft dollar services, and require disclosure of certain client-specific

information. The Commission has requested comment on these elements of

the Goldman/Morgan Proposal separately in this Release. The Commission

also requests comment whether the Goldman/Morgan Proposal generally

would be preferable to the Commission's proposal.

III. Disclosure By Brokers Providing Soft Dollar Services

The amendments being proposed in this Release would require

disclosure by advisers that receive soft dollar services from brokers.

In a letter to the staff, Autranet, Inc. (``Autranet''), a broker

providing third-party soft dollar services to advisers, proposed an

entirely different approach that would impose certain recordkeeping and

disclosure requirements on brokers providing third-party soft dollar

services to ensure that the services were provided within the safe

harbor of Section 28(e) of the Exchange Act.61 Under the Autranet

[[Page 9757]] proposal, these brokers would be required to demonstrate

that they incurred a legal obligation to provide soft dollar services

to an adviser. This obligation could be demonstrated either by a

contract that indicates the broker's financial obligation to purchase

the soft dollar services from an independent research originator, or by

an invoice showing the broker's payment for the services for those soft

dollar services not typically the subject of a contract.

\61\Autranet also has proposed that the Commission prohibit

understandings that commit an adviser to a predetermined amount of

commissions in exchange for soft dollar services. The Commission

requests comment on the feasibility of this proposal. In particular,

the Commission requests comment whether prohibiting a stated

commission ratio in exchange for soft dollar services will deter the

negotiation of commission rates and cause advisers that are less

sophisticated or influential to pay higher commissions.

In addition, Autranet proposed that the Commission ensure that

an independent research originator make its services available to a

number of brokers and not enter into exclusive agreements. For

instance, under ``bump up'' or bonus arrangements a vendor will

assign a cash value to its product and offer it to the public at

large for a lower price than charged to a broker providing the

product pursuant to a soft dollar arrangement. In other

arrangements, a vendor will tie the availability of its product to a

single affiliated or unaffiliated broker, thus causing all trades to

go through that broker in exchange for the service. Autranet

believes that by eliminating commission commitments and exclusivity

arrangements, a client can be better assured that the adviser

obtained the best execution of the client's order. The Commission

requests comment on the feasibility of a prohibition on exclusivity

and bonus arrangements and whether such a proposal would accomplish

the objective of assuring best execution. The Commission also has

forwarded these proposals to the NASD for its consideration under

its authority to promulgate just and equitable principles of trade.

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In addition, Autranet proposes that third-party soft dollar brokers

be required to provide a description of the soft dollar services

provided in an arrangement and specify how the product assists an

adviser in its investment decisions. A broker would be required to make

this description available to the managed account upon request and

provide the managed account a quarterly report showing the cost of the

soft dollar service. For products having a mixed-use, Autranet proposes

that the broker providing such a product obtain from the adviser a

description of the adviser's use of the product and the adviser's

allocation between the research and non-research functions of the

product.

Autranet proposes that these descriptions be reflected in an annual

report that third-party soft dollar brokers would file with the

Commission and provide to the advisers receiving soft dollar services

and to the clients of those advisers whose commissions were used to

obtain the soft dollar services. Autranet proposes that the report

include (1) a disclosure statement describing the business of the third

party broker; (2) a financial summary, quantifying on an aggregate

basis the value by category and, if necessary, sub-category, of the

soft dollar services provided; (3) a compliance report, demonstrating

that the soft dollar services were in compliance with the requirements

set forth above and within the safe harbor of Section 28(e); and (4) an

independent auditor's report. Autranet believes that such a reporting

requirement would not be costly to third-party brokers because the

information required is readily available and the reporting

requirements should reflect compliance procedures already established

by third-party brokers providing soft dollar services.

The Commission requests comment on whether some or all of the

Autranet proposals would be practical additions to the disclosure

currently required and proposed of advisers. In particular, the

Commission requests comment on the costs associated with this

disclosure approach and the ease with which this information could be

obtained by brokers and provided to advisers and their clients. In

addition, the Commission requests comment on the extent to which full

service brokers providing proprietary soft dollar services could or

should be subject to any of the reporting requirements proposed by

Autranet.

IV. General Request For Comments

Any interested persons wishing to submit written comments on the

proposals that are the subject of this Release, to suggest additional

changes, or to submit comments on other matters that might have an

effect on the proposals that are contained in this Release, are

requested to do so.

V. Cost/Benefit Analysis

The rule and form proposed today are intended to provide material

information to clients and prospective clients of investment advisers

that can be used to evaluate an adviser's brokerage direction and soft

dollar practices. The proposals would enable an advisory client to

better assess whether its adviser is directing its brokerage in

accordance with its best interests, and whether the advisory fee it

pays is appropriate in light of the services provided and costs

incurred directly by the adviser.

Adoption of the proposal would impose some additional costs on

advisers required to prepare the report and deliver it to clients. The

Commission believes, however, that the proposals appropriately balance

the need for additional disclosure with the costs of providing that

disclosure. The information that would be required by the proposal

should readily be determinable by an adviser. A number of alternatives

that would make the disclosure requirements more burdensome, such as

requiring advisers to disclose the value of soft dollar services

received or report on the use of each client's brokerage, are not being

proposed. Furthermore, because the report would need to be prepared and

delivered only annually, the costs of preparing and delivering the

report should be minimized. In short, the Commission believes that the

costs of the proposals would be outweighed by the benefits to advisory

clients in receiving more useful information about their advisers'

direction of client brokerage.

VI. Summary Of Initial Regulatory Flexibility Analysis

The Commission has prepared an Initial Regulatory Flexibility

Analysis in accordance with 5 U.S.C. 603 regarding the proposed

amendments. The analysis notes that the rule and form proposed in this

Release are intended to provide investment advisory clients for whom

the adviser selects brokers to execute client transactions with

information about the services the adviser receives from those brokers

and the commissions charged by those brokers. Other aggregate cost-

benefit information reflected in the ``Cost/Benefit Analysis'' section

of this Release also is reflected in the analysis. A copy of the

Initial Regulatory Flexibility Analysis may be obtained by contacting

Jana M. Cayne, Securities and Exchange Commission, 450 Fifth Street,

NW., Mail Stop 10-6, Washington, DC 20549.

VII. Statutory Authority

The Commission is proposing rule 204-4 and Form ADV-B under the

authority set forth in Sections 204, 206(4) and 211(a) of the Advisers

Act [15 U.S.C. 80b-4, 80b-6(4) and 80b-11(a)] and Section 28(e)(2) of

the 1934 Act [15 U.S.C. 78bb(e)(2)].

Text Of Proposed Rule And Form Amendments

List of Subjects in 17 CFR Parts 275 and 279

Investment advisers, Reporting and recordkeeping requirements.

For the reasons set out in the preamble, title 17, chapter II of

the Code of Federal Regulations is proposed to be amended as follows.

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

1. The authority citation for Part 275 is amended by adding the

following citation:

Authority: 15 U.S.C. 80b-3, 80b-4, 80b-6A, 80b-11, unless

otherwise noted.

* * * * *

Section 275.204-4 is also issued under 15 U.S.C. 78bb(e)(2).

2. By adding Sec. 275.204-4 to read as follows:

Sec. 275.204-4 Annual report on brokerage practices.

(a) Each investment adviser, registered or required to be

registered under Section 203 of the Act on the last day of its most

recently completed fiscal year, that exercised brokerage discretion

over the account of any client during that fiscal year and obtained

services other than execution services from a broker to which it

directed client brokerage during that fiscal year shall file a report

on Form ADV-B with the Commission no later than 60 days after the end

of that fiscal year, unless the investment adviser's registration was

[[Page 9758]] withdrawn, cancelled or revoked after the end of the

fiscal year.

(b) An investment adviser required to file a report on Form ADV-B

pursuant to paragraph (a) of this section shall furnish such report for

its most recently completed fiscal year:

(1) No later than 60 days after the end of each fiscal year, to

each advisory client over whose account the investment adviser

exercises brokerage discretion; and

(2) No later than the time that a written or oral investment

advisory contract is entered into, to each new or prospective advisory

client over whose account the investment adviser will or proposes to

exercise brokerage discretion.

(c) For purposes of this section:

(1)(i) An investment adviser exercises ``brokerage discretion''

over a client's account if it:

(A) Has authority to determine, without obtaining specific client

consent, the broker to be used or the commission rates paid in

connection with any transaction of the client; or

(B) Significantly influences the selection of brokers by the client

and receives services other than execution services from a broker

chosen by the client.

(ii) An investment adviser does not exercise brokerage discretion

over a client's account if substantially all of the client's

transactions were directed to a broker that was compensated for

executing such transactions solely based upon a specified percentage of

the assets managed by the investment adviser; and

(2) Execution services mean those services set forth in paragraph

(e)(3)(C) of Section 28 of the Securities Exchange Act of 1934 (15

U.S.C. 78bb(e)(3)(C)).

PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF

1940

3. The authority citation for Part 279 is amended by adding the

following citation:

Authority: The Investment Advisers Act of 1940, 15 U.S.C. 80b-1,

et seq.

Section 275.204-4 is also issued under 15 U.S.C. 78bb(e)(2).

4. By adding Sec. 279.9 and Form ADV-B to read as follows:

Sec. 279.9 Form ADV-B, annual report on investment adviser's brokerage

direction practices.

This form shall be filed annually by an investment adviser,

registered or required to be registered under the Investment Advisers

Act of 1940, that has the authority to select brokers to execute the

transactions of any client and that obtains services other than

execution from a broker to which it directs client brokerage.

Note: Form ADV-B is attached as Appendix 1 to this document. The

Form will not appear in the Code of Federal Regulations.

Dated: February 14, 1995.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

Appendix 1

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U.S. Securities and Exchange Commission, Washington, DC 20549

Form ADV-B

Annual Report on Brokerage Practices for Registered Investment Advisers

Having Discretion Over Client Brokerage

Applicant:-------------------------------------------------------------

SEC File Number: 801---------------------------------------------------

Date:------------------------------------------------------------------

MM/DD/YY

General Instructions for Preparing and Filing Form ADV-B

1. Applicability of Form Requirement. A report on Form ADV-B

must be prepared and filed by every investment adviser that (i) was

registered or required to be registered under the Investment

Advisers Act of 1940 on the last day of its most recently completed

fiscal year (unless the adviser's registration has since been

withdrawn, cancelled or revoked), (ii) exercised ``brokerage

discretion'' over the account of any advisory client during that

fiscal year, and (iii) obtained services other than ``execution

services'' from a broker to which it directed client brokerage

during that fiscal year.

2. Definitions.

Brokerage Discretion. An investment adviser exercises brokerage

discretion over a client's account if it (i) has the authority to

determine, without obtaining specific client consent, the broker to

be used or the commission rates paid in connection with any

transaction of the client, or (ii) significantly influences the

selection of brokers by the client and receives services other than

execution services from a broker chosen by the client. An investment

adviser does not have discretion over a client's account, however,

if substantially all of the client's transactions were directed to a

broker that was compensated for executing such transactions solely

based upon a specified percentage of the assets managed by the

adviser, even if the adviser has the discretion to direct certain of

the client's transactions to other brokers.

Execution Services. Execution services mean those services

described in Section 28(e)(2)(C) of the Securities Exchange Act of

1934, i.e., effecting securities transactions and performing

functions incidental thereto or required in connection therewith by

rules of the Securities and Exchange Commission or a self-regulatory

organization.

3. Format and Filing of Report. The report required by this form

should be prepared as a separate document, not on copies of this

Form. The report shall be filed in triplicate with the Securities

and Exchange Commission, 450 Fifth Street NW., Washington, DC 20549.

Each copy of the report filed with the Commission should be attached

to a completed copy of this page, although only one such copy need

be manually executed. The report shall be filed no later than 60

days after the end of the adviser's fiscal year.

Execution: The undersigned represents that he or she has

executed this form on behalf of, and with the authority of, said

investment adviser. The undersigned and the investment adviser

represent that the information and statements contained herein,

including exhibits attached hereto and other information filed

herewith, all of which are made a part hereof, are current, true,

and complete.

Dated the ________ day of ____________________, 19______

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(Name of registrant)

By:--------------------------------------------------------------------

(Signature and title)

4. Delivery.

Existing Clients. Rule 204-4 under the Investment Advisers Act

of 1940 requires that the report be furnished no later than 60 days

after the end of the investment adviser's most recently completed

fiscal year to each advisory client over whose account the adviser

exercises brokerage discretion (as defined in Instruction 2 above).

Prospective Clients. Rule 204-4 also requires that the report be

furnished no later than the time that a written or oral investment

advisory contract is entered into to each new or prospective

advisory client over whose account the adviser will or proposes to

exercise brokerage discretion.

5. Period of Required Data. An investment adviser must provide

the requested information for its most recently completed fiscal

year. Brokerage commissions directed or services received during a

fiscal year should be included in the table, even if the services

corresponding to commissions directed during the fiscal year were or

will be received during another fiscal year, or the commissions

corresponding to services received during the fiscal year were or

will be directed during another fiscal year.

6. Additional Information. An investment adviser may, in

addition to providing the required information, provide other

information, including additional data and explanations of the

required information, about its brokerage practices in its response

to this Form.

Information Required in Annual Report

Item 1. General Description of Report

In an introduction to the report:

(a) explain that the report contains information about the

adviser's practices in selecting brokers to execute transactions for

its investment advisory clients that can be used to evaluate whether

the adviser directs [[Page 9759]] client transactions consistent

with the best interests of its clients;

(b) explain that the information contained in the report is

provided on a firm-wide basis, that the report does not include

specific information about the brokerage of any particular client or

the extent to which services obtained are used for the benefit of

any particular client, and that clients should refer to the

confirmations or quarterly account statements provided by their

brokers or contact the adviser for information about the brokers

used to execute their transactions;

(c) explain, if applicable, that the report does not include

information about many transactions executed on a ``principal''

basis, that, in principal transactions, transaction costs typically

are included in the price of the securities purchased or sold and

are not charged as separate commissions, and that transactions in

certain types of securities typically are executed on a principal

basis; and

(d) provide an address or phone number at which a client can

contact the adviser to request more information.

Item 2. Information Regarding the Twenty Most Frequently Used

Brokers

Using the captions and tabular format illustrated below, provide

the required information for the twenty brokers (other than

``execution-only'' brokers as defined in Item 3) to which the

investment adviser directed the greatest amount of client

commissions. If no or fewer than twenty such brokers were used,

state either ``no brokers used that provided services other than

execution'' after the title or ``no additional brokers used'' after

the last broker listed.

The Twenty Brokers to Which the Greatest Amounts of Client Commissions Were Directed

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Commissions paid to

Aggregate amount of broker (as a Description of

Name discretionary percentage of Average commission services obtained

of commissions paid to adviser's rate (in cents/ (other than

broker broker (in dollars) discretionary share) execution services)

commissions)

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Instructions

1. For the purposes of this Form, brokers include broker-dealers

registered under the Securities Exchange Act of 1934, banks, and, as

set forth in Item 3, automated trading systems.

2. ``Discretionary commissions'' are those commissions, mark-ups

and mark-downs that are disclosed on the transaction confirmations

required under rule 10b-10 under the Securities Exchange Act of 1934

and that are paid in connection with transactions for which the

investment adviser had the authority to determine, without obtaining

specific client consent, the broker or dealer to be used or the

commission rates paid.

3. Commissions include sales loads paid in connection with

transactions in investment company shares, although sales loads

should not be considered in calculating the average commission rate.

If the adviser directed transactions in investment company shares to

a broker other than the principal underwriter of the investment

company, that broker, rather than the principal underwriter, should

be considered to have executed the transaction.

4. For purposes of this Form, commissions do not include fees

for brokerage services that are based upon a specified percentage of

the assets managed (i.e., fees paid under ``wrap fee'' programs).

5. Calculate average commission rates on a ``share-weighted''

basis (i.e., by dividing the total amount of client commissions that

the investment adviser directed to the broker by the total number of

shares, exclusive of investment company shares, purchased or sold by

the broker for the adviser's clients).

6. For the purposes of determining commission amounts and

average commission rates, convert any commission charged in foreign

currency to dollars (and cents per share). The investment adviser

may use any reasonable means and times for determining the

applicable exchange rate as long as those means and times are used

on a consistent basis.

7. Under ``Description of Services Obtained,'' products or

services obtained by the investment adviser from each broker,

including computer hardware, software, databases, and on-line

services, publications available by subscription, and services

falling outside the scope of Section 28(e) of the Securities

Exchange Act of 1934, generally should be identified separately and

specifically. Research reports and contacts with securities analysts

or professionals, however, may be described generally by the

following terms: (i) analyses and reports on specific securities,

issuers, or industries, (ii) general political or economic analyses

or reports, or (iii) contacts with securities analysts. The party

that produced a specifically identified product or service should

also be identified unless the producer's name is evident from the

name of the product or service. An adviser should report all

products or services received from a broker, even if some of the

services could be deemed to have been received as a result of

principal transactions the costs of which are not required to be

reported in the table.

Item 3. Information Regarding Three Most Frequently Used Execution-

Only Brokers

Using the captions specified under Item 2 (except ``Description

of Services Obtained''), provide a table titled ``The Three

Execution-only Brokers to which the Greatest Amounts of Client

Commissions were Directed'' that includes the required information

for the three execution-only brokers to which the investment adviser

directed the greatest amount of client commissions. If no or fewer

than three execution-only brokers were used, state either ``no

execution-only brokers used'' after the title or ``no additional

execution-only brokers used'' after the last broker listed.

Instruction

For the purposes of this Item, a broker should be considered an

execution-only broker if substantially all of the services that it

provides to the adviser are execution services (see the definition

in Instruction 2 of the General Instructions). An automated trading

system should be considered an execution-only broker if

substantially all of the services received by the adviser in

connection with using the system are execution services and if a fee

is charged for using the system, regardless of the basis for the fee

(e.g., a flat usage fee or transaction-based charges).

Item 4. Information Regarding Brokerage Business Directed by

Clients

Provide the following information under the following captions:

Percentage of Total Commissions Directed to Brokers Providing

Research and Other Services in Addition to Execution:

Percentage of Total Commissions Directed to Execution-only

Brokers:

Percentage of Total Commissions Directed by Clients:

Instruction

For the purposes of this Item, commissions directed by clients

are those commissions paid by accounts managed by the adviser that

were directed pursuant to client requests or instructions. Total

commissions equal the sum of the adviser's discretionary

commissions, as defined in Item 2, and the commissions directed by

clients.

[FR Doc. 95-4160 Filed 2-17-95; 8:45 am]

BILLING CODE 8010-01-P