Soft Dollar Arrangements (SEA Section 28(e))
Beyond direct fees and commissions, investment managers sometimes receive indirect compensation through soft dollar arrangements. Understanding what qualifies for the safe harbor (and what does not) is heavily tested on the exam.
Definition
- Soft dollars refer to the practice of an investment manager paying higher-than-market-rate commissions to a broker-dealer in exchange for research and brokerage services
- Instead of paying the lowest available commission rate, the manager "pays up" and receives valuable services in return
- Without a legal safe harbor, this practice could expose the manager to claims of breaching the fiduciary duty to seek best execution
The Section 28(e) Safe Harbor
SEA Section 28(e) protects investment managers from fiduciary liability when they cause client accounts to pay commissions that exceed the lowest available rate, provided:
- The manager determines in good faith that the commission was reasonable in relation to the value of the brokerage and research services provided
- The services fall within the qualifying categories
The reasonableness assessment may consider either the particular transaction or the manager's overall responsibilities for all accounts under management.
Important limitation: The safe harbor does not apply to security futures products.
Qualifying Services
The safe harbor covers three categories of services:
| Category | Examples |
|---|---|
| Research and analysis | Reports on issuers, industries, securities, economic factors/trends, portfolio strategy, account performance |
| Advisory services | Advice on the value of securities, the advisability of investing in, purchasing, or selling securities |
| Brokerage/execution services | Effecting securities transactions and incidental functions (clearance, settlement, custody) |
Non-Qualifying Expenses
The safe harbor does not cover services that are not related to brokerage or research. These must be paid from the adviser's own funds:
- Office rent
- Office equipment and furniture
- Employee salaries
- Travel expenses
- Marketing and entertainment
- Telephone lines
- Other general overhead or administrative costs
Exam Tip: Gotchas
The exam frequently presents a list of expenses and asks which ones qualify for soft dollar treatment. Research reports and trade execution = qualifying. Office rent, furniture, salaries, and marketing = not qualifying. Using soft dollars to pay for non-qualifying expenses is a breach of fiduciary duty; no safe harbor applies.
Good Faith Requirement
- The manager must make a good faith determination that the commission amount was reasonable relative to the value of services received
- "Good faith" means the manager genuinely evaluated the cost-benefit relationship, not that the outcome was perfect
- The evaluation can look at the value of services in relation to either:
- The specific transaction, or
- The manager's overall responsibilities across all managed accounts
Exam Tip: Gotchas
- The safe harbor requires a good faith determination of reasonableness, not just paying any amount for any service.
- Security futures products are excluded from the Section 28(e) safe harbor.