The Distinction Between Free Custodian Services and Soft Dollars

Let's consider two somewhat similar situations.

In the first, an investment adviser recommends that its clients custody their assets with a large institutional custodian, like Schwab or Fidelity. As part of that relationship, the custodian gives the adviser access to a variety of products and services, like trading technology, billing tools, reporting tools, market data, customer support, practice-management resources, and investment research. The adviser doesn't pay separately for any of these services, which are included as part of the custodial relationship.

In the second situation, an adviser is specifically deciding where to execute client trades. Broker A charges a low commission. Broker B charges more, but tells the adviser, "If you send your trades to me, I'll provide you with investment research." The adviser chooses Broker B because the research is useful.

Soft dollars?

As a practical matter, these arrangements seem quite similar. In both cases, the adviser sends client business to a financial institution, which makes money from the adviser’s clients and provides the adviser with products or services that the adviser may otherwise have to pay for itself.

You may be surprised to learn that the first arrangement -- receiving institutional products and services for using a particular custodian -- does not, merely because the custodian provides those services, constitute the kind of client-commission arrangement for which the Section 28(e) safe harbor is needed.

By contrast, the second arrangement -- paying up for brokerage services in exchange for research and services -- does indeed constitute “soft dollars.” It must be disclosed as such on Form ADV and is contemplated by the safe harbor found in Section 28(e) of the Securities Exchange Act (provided that the safe harbor will only apply if its conditions are met).

However, the underlying incentives and relationships appear quite similar. It's no wonder, then, that some advisers conclude that these are both so-called "soft dollar" arrangements and disclose them as such in their Form ADVs and Firm Brochures -- even though they do not actually have an arrangement that qualifies for the Section 28(e) safe harbor. (I'll spare the advisers making this mistake any citations to their materials.)

What is the safe harbor?

To understand the distinction between these two arrangements, let's begin with what Section 28(e) actually says:

No [investment adviser] shall be deemed to have acted unlawfully or to have breached a fiduciary duty . . . solely by reason of his having caused the account to pay a [broker-dealer] an amount of commission for effecting a securities transaction in excess of the amount of commission another [broker-dealer] would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by such [broker-dealer] . . . .

In other words, as the SEC explains, "Section 28(e) provides a safe harbor to money managers who use the commission dollars of their advised accounts to obtain investment research and brokerage services." SEC 28(e) Interpretive Release. Section 28(e)(3) goes on to define what constitutes "brokerage and research services" in this context.

Why do we need Section 28(e)?

An investment adviser is a fiduciary and, as such, has an obligation to seek best execution when selecting broker-dealers. As the SEC has made clear, best execution doesn't necessarily mean selecting the broker-dealer with the lowest commission: Advisers are allowed to consider the full range and quality of a broker’s services, including execution capability, commission rates, financial responsibility, responsiveness, and research. See, e.g., SEC Fiduciary Release.

But there is an additional problem when the adviser uses client assets to obtain something for itself. As the SEC explained in its principal Section 28(e) interpretive release, fiduciary principles prohibit advisers from using client assets for their own benefit, but: "The purchase of research with the commission dollars of a . . . client, even if used for the benefit of . . . the client, could be viewed as also benefiting the money manager in that he was being relieved of the obligation to produce the research himself or to purchase it with his own money."

That is where Section 28(e) comes in. It provides a safe harbor that explicitly says advisers are allowed to have clients pay more than the lowest available commission, as long as the commission is reasonable in relation to the value of qualifying brokerage and research services received.

Distinguishing custodial services from actual soft dollars

In the classic soft dollar arrangement, Broker A is cheaper but Broker B provides research, so the adviser goes with Broker B and causes clients to pay more for brokerage services. In this case, the client commissions directly function as the currency used to obtain a benefit for the adviser. The adviser may do this under the Section 28(e) safe harbor (if the requirements of the safe harbor are met).

But this isn't the same as a typical custodial relationship in which a large custodian (with a broker-dealer arm) operates a platform for investment advisers. Advisers direct their clients to custody assets with the custodian. The custodian provides custody and brokerage services to the clients and makes a variety of institutional services available to the advisers.

Of course, the custodian has an economic incentive to provide these services. It wants advisers to bring clients onto the custodial platform, at which point the custodian has the opportunity to earn money from those client relationships through brokerage fees, margin lending, offering proprietary products, and various other services.

And the adviser also benefits, which creates an obvious conflict of interest. If the custodian provides the adviser with billing software, reporting tools, customer support, and research, the adviser may avoid expenses it would otherwise have to incur. The adviser thus has an incentive to recommend the custodian, which provides things of value to the adviser. While the conflict needs to be disclosed and addressed, the mere receipt of these institutional services does not create a Section 28(e) arrangement. The safe harbor becomes relevant only if client brokerage commissions are being used to obtain the services.

So how do we know when the safe harbor does apply? The important question is whether client brokerage commissions are being used to obtain adviser benefits. In the traditional soft-dollar arrangement, there is a direct link between client brokerage and the benefit received by the adviser.

The SEC has defined soft-dollar practices as arrangements in which an adviser obtains products or services other than execution from or through a broker-dealer “in exchange for the direction by the adviser of client brokerage transactions to the broker-dealer.” SEC Soft Dollar Inspection Report. As noted above, the SEC has similarly described Section 28(e) as protecting managers that “use the commission dollars of their advised accounts to obtain investment research and brokerage services.” SEC 28(e) Interpretive Release.

The adviser generates commissions, and those commissions procure research or brokerage services. By contrast, in a typical custodial relationship in which some large custodian provides institutional support services to the advisers on its platform, the custodian makes its institutional services available as part of the overall relationship. The institutional services are not typically tied to the amount of commissions generated by particular client trades. That is quite different from an arrangement in which the adviser directs client brokerage to a broker in exchange for specified products or services.

One useful fact is whether the products and services are contingent on the amount of brokerage business directed to the custodian. If an adviser receives the same basic institutional platform regardless of whether its clients trade frequently or infrequently, that seems like good evidence that client commissions are not being used to purchase the services. As noted above, the question is: Are client brokerage commissions functioning as the consideration for the products or services the adviser receives? Are client brokerage commissions the currency used to obtain research and brokerage services?

Where the answer is yes, Section 28(e) may be implicated. Where the answer is no, Section 28(e) is not the relevant safe harbor. The adviser still must address any resulting conflicts under its ordinary fiduciary, disclosure, and best-execution obligations.

Parting thoughts

Section 28(e) is a safe harbor. An arrangement must qualify to benefit from its protections. In other words, if an adviser isn't using client brokerage commissions to obtain research or brokerage services, then the adviser can't bring the arrangement within the safety of Section 28(e). However, being outside the safe harbor doesn't mean an arrangement is prohibited. Advisers routinely receive products and services from the custodians and broker-dealers they recommend to clients. Those arrangements can be entirely permissible even though Section 28(e) doesn't apply. They just have to be evaluated under ordinary fiduciary principles, including the adviser’s obligation to seek best execution and to disclose material conflicts of interest.