Quick Answer
Soft dollars are commissions an investment manager pays above the lowest available rate in exchange for research and brokerage services. The federal soft dollar safe harbor protects managers from fiduciary-breach claims when they determine in good faith that the commission was reasonable in relation to the value of qualifying services received. Using soft dollars for non-qualifying overhead breaks the safe harbor.
Investment managers who direct client commissions to a particular broker-dealer face a built-in conflict: paying more than the lowest available commission spends the client's money to buy something for the manager. The soft dollar safe harbor resolves that conflict for a defined category of purchases.
What Is a Soft Dollar Arrangement?
- Soft dollars describe the practice of an investment manager causing client accounts to pay commissions above the lowest available rate, in exchange for research and brokerage services from the executing broker-dealer
- Without a safe harbor, directing client commissions above the market rate could be a breach of the manager's duty to seek best execution and could expose the manager to a fiduciary-breach claim
- The federal soft dollar safe harbor protects a manager from that claim, but only when its conditions are met
What Does the Safe Harbor Require?
- The manager must determine, in good faith, that the commission paid was reasonable in relation to the value of the brokerage and research services received
- That determination can be judged against the value of the particular transaction or against the manager's overall responsibilities for all the accounts under its management
- The safe harbor applies to a person exercising investment discretion over an account who directs commission business subject to these conditions
Exam Tip: Gotchas
The safe harbor requires a good faith determination of reasonableness, not certainty or the lowest possible price. A manager does not have to prove the research was worth every dollar of the extra commission, only that it made a reasonable, good-faith judgment that it was.
Which Services Qualify for the Safe Harbor?
| Category | What Qualifies |
|---|---|
| Research and analysis | Advice on the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or buyers/sellers |
| Reports and analyses | Reports and analyses concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and account performance |
| Brokerage and execution services | Effecting securities transactions and performing functions incidental to execution, such as clearance, settlement, and custody |
Only commissions paid for services inside these three categories are covered. A manager who pays above-market commissions for something outside them gets no protection from the safe harbor for that portion of the arrangement.
What Falls Outside the Safe Harbor?
- Services unrelated to brokerage or research do not qualify, even if the manager finds them useful for running its business
- Typical non-qualifying items include office rent, furniture and equipment, employee salaries, travel, marketing and entertainment expenses, and general telephone or overhead costs
- Using client commissions (soft dollars) to pay for non-qualifying expenses gets no protection from the safe harbor, since the manager is spending the client's money on the manager's own overhead without a qualifying service in return; without adequate disclosure to the client, that is a breach of fiduciary duty
- The safe harbor does not apply to security futures products
Exam Tip: Gotchas
Research reports and execution services qualify. Office rent, furniture, salaries, and marketing expenses do not. If a question describes an adviser using undisclosed soft dollars to cover office rent, that is a fiduciary-duty violation: there is no safe harbor for overhead, and spending client money on the manager's own expenses without telling the client is exactly what the safe harbor exists to prevent.
What Should You Check on Exam Day?
- Soft dollars are commissions paid above the lowest available rate in exchange for research and brokerage services.
- The soft dollar safe harbor is a protection, not a guarantee: it shields a manager who makes a good-faith determination that the commission was reasonable relative to the value of the services received.
- Qualifying services fall into three categories: research and advice, reports and analyses, and brokerage/execution services.
- Non-qualifying expenses (office rent, salaries, furniture, marketing, travel, general overhead) are not covered by the safe harbor; paying for them with undisclosed soft dollars is a fiduciary breach.
- The safe harbor does not extend to security futures products.