SOFT DOLLARS AND SECTIN 28(e) OF THE SECURITIES EXCHANGE ACT OF 1934: A 1985 PERSPECTIVE

• Published date: 01 June 1986
• Author: KARL O. HARTMANN,LEE B. BURGUNDER
• DOI: http://doi.org/10.1111/j.1744-1714.1986.tb00494.x
• Date: 01 June 1986

SOFT

DOLLARS

AND

SECTION

28(e)

OF

THE

SECURITIES EXCHANGE ACT

OF

1934:

A

1985

PERSPECTIVE

*LEE B. BURGUNDER

**KARL

0.

HARTMANN

Recently, the newswires have carried many stories about the ways

in which money managers and pension plan officers use brokerage

commission dollars to purchase

a

variety of products and services.' The

central focus of these accounts

is

section 28(e) of the Securities Exchange

Act of

1934:

This statute provides that

a

person who exercises investment

discretion cannot be found to have violated any fiduciary duty solely

because he employed a broker that charged a commission higher than

the lowest available rate, if the employing person, in good faith,

determined that the amount

of

commission paid was reasonable

in

relation

to the value

of

the brokerage and research services supplied by that

*

Associate Professor

of

Business Law, California Polytechnic

State

University, San

**

Luis Obispo, California.

Law Associate. Simpson, Fair

&

Rinaldo, Palo Alto, California.

'

See.

e.g.,

McMurray

&

Smith,

Wall Street

Is

Finding,

A@

10

Years, That

It

Enjoys

Unfized

Rates.

Wall

St.

J.,

Apr.

22.1985,

at

1;

Rohrer,

The

Great Rate

Shake-Up.

Institu-

tional Investor, Feb.

1985,

at

50;

Makin,

What

Will

Happen

To

Research?,

Institutional

Investor, Feb.

1985,

at

57;

Dannen.

Pasionst

Who's

InCharge

Here?,

Institutional Investor,

Feb.

1985.

at

62;

Chemoff,

End

Sought To

Use

Ofsoft

Dollars,

Pension

&

Investment Age,

Feb.

4,1985,

at

4;

Arthurs.

Sojt

Dollar Plana

By

Some

Brokers

Come

Under

Fire,

Legal

Times of Washington, Jan.

21,1985,

at

1;

Bleakley,

A

New

Brokerage FeeBattle,

The

N.Y.

Times, Dec.

6,1984.

at

29;

Chemoff,

Abuses

OfSofl

Dollars

To

Be

Studied.

Pension

&

Invest-

ment Age, Oct.

15,1984,

at

1;

Smith,

Pension

Funds Feud

With

Money Managers

Over

Brokers'

Rebates,

Wall

St.

J.,

Oct.

4.1984.

at

1;

Rohrer,

Soft

Dollurs:

TheBoom

In

Third-Party Research.

Institutional Investor. Apr.

1984.

at

73;

Bleiberg,

Ouler

People's

Money,

Barron's, Mar.

26,

1984,

at

49.

*

Exchange Act,

5

28(e),

15

U.S.C.A. $78bMe)

(Supp.

1985).

as

added

by

Securities Acts

Amendments of

1975.

$

2")

[hereinafter cited

as

Exchange Act,

$

28(e)].

140

1

Vol.

24

I

American

Business

Law

Journal

broker? In other words, section 28(e)

is

a safe-harbor provision for

a

money manager which allows him, to certain extents, to select a high-

priced broker to conduct securities transactions for his clients

so

that

the manager can receive products and services from that broker for his

own benefit.’ Thus,

if

the money manager directs his commission business

appropriately within the ambit of section 28(e), he will be secure from

challenges that he breached fiduciary duties

to

his clients by causing them,

in essence, to buy products and services for him.

The enormous rise in securities trading volume in the

last

four years

has brought an explosion

in

the amount of commission dollars available

to investment managers for buying certain products and services from

their brokers. Attracted by this rich source of capital, a variety of new

firms have entered the brokerage business to compete

for

these funds.

In addition, the clients of the money

managers

have become aware of

the potential uses of the commission dollars generated by the investment

of their

assets,

and have begun to demand that services be purchased

for their own accounts rather than for the use of the money managers.

Together, these competitive forces have brought to the forefront many

questions about the extent of the protections of section

=(el.

For

instance,

what products and services come within the statutory definition

of

research? Who must deliver these services to the money manager for

section 28(e) to apply?

Is

a

money manager protected by section 28(e) if

his client tells the manager to direct the securities business to

a

particular

broker? The answers to these and other questions are extremely

significant since they will determine the competitive structure of the

investment industry in the future. In the words of

Bawon’s,

such potential

changes “deserve more attention than they thus far have re~eived.”~

This article analyzes the purposes, protections, and consequences of

section 28(e). First, the article briefly considers the fiduciary duties of

a

money manager to his clients. Next, it explores the historical reasons

for

the passage of

a

statute that insulates a manager from the breach

of these fiduciary duties in his purchase of research services with

commission dollars. Next, the article undertakes a thorough review

of

section 28(e) as background

for

the controversy over the scope of

its

protections. Following this review, the article considers the legality

of

the new competitive arrangements in the industry in light of the

interpretations of section 28(e). The article concludes that the optimal

See

infra

text accompanying note 72 for text

of

$

28(e).

‘

Throughout this paper, the word “money manager” is personified as an individual,

although the term often

is

used to apply to a management firm consisting of a staff

or

team

of

managers, as well as to administrative, research, and support personnel.

’

Bleiberg.

.supru

note

1.

1986

I

Soft

Dollars

&

Section

28(e)

1

141

solution to the questions posed by these new developments

in

the industry

is

the elimination of section 28(e).

THE

MONEY

MANAGEMENT

ARRANGEMENT

AND

APPLICABLE

DUTIES

In the complex and increasingly specialized world of securities trans-

actions and investment management,

it

has become typical for investors

to rely on the expertise of money managers for their investment deci-

sions. This reliance takes different forms. Individual investors who have

significant personal assets often hire

a

professional money manager to

direct those

assets

into appropriate investment vehicles. Other in-

dividuals, who may have fewer funds to invest, deposit them in a mutual

fund. The pool of assets in the mutual fund, obtained from a large number

of smaller investors,

is

managed by a professional money manager.

Also,

the trustees of pension funds generally defer to the expertise of

a

money

manager for the investment of the pension fund assets! Under any of

these arrangements, the money manager usually receives a management

fee from the investor for directing securities transactions for the investor.'

In addition, although the investor may, through the management agree-

ment, give investment guidelines to the manager, typically he will grant

the manager a certain amount of investment discretion in the selection

of securities for the investor's funds and the traders through which those

funds may

be

invested.*

Also,

the investors' accounts usually

are

charged

for any commissions that the money manager must pay

to

brokers selected

by the manager to implement the investment decisions.s

In order satisfactorily to manage the funds for his investment clients,

the money manager must incur a number of business expenses.

For

in-

stance, he may have to rent office space, pay for utilities, hire clerical

and professional employees, purchase supplies, and obtain computer hard-

ware and software. In addition, as an expert, the money manager must

have access to the latest securities data and must stay well-informed

about the latest developments and research in the investment fields.'0

*

Any investment made for a private employee pension benefit plan must comply with

the

Employee Retirement Income Security Act (ERISA), Pub.

L.

No. 93-406.88 Stat. 829

(codified in scattered sections of 5.18,26,29,31,42,

U.S.C.)

[hereinafter cited

as

ERISA].

See

infra

text accompanying notes 54-64

for

a

review

of

the responsibilities of a money

manager under ERISA.

'

Pozen,

Monsy

Managers

And

Securities

Research,

51

N.Y.U.

L.

REV.

923,924 (1976).

Section NaN35)

of

the Securities Exchange Act of 1934 defines a person exercising

investment discretion

as

one who, among other things, directly or indirectly

"is

author-

ized

to

determine what securities or other property shall be purchased or sold by or for

the account

. . .

."

Exchange Act,

supra

note 2. at

5

78c(aM35).

*

Pozen,

supra

note

7.

at 924.

lo

H.

BINES, THE

LAW

OF

INVESTMENT

MANAGEMENT

(1978

&

Supp. 19831, at

f

9.06(3Mc).