soft dollar standard-cfa.pdf

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CFA Institute

Soft Dollar

Standards

Guidance forEthical PracticesInvolving

Client Brokerage


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Corrected content posted November 2011.November 2004 [reprint], August 1999 [reprint], 1998 by Association for Investment

Management and Research

All rights reserved. No part of this publication may be reproduced or transmitted in any form or

by any means, electronic or mechanical, including photocopy, recording, or any information

storage and retrieval system, without permission of the copyright holder. Requests for

permission to make copies of any part of the work should be mailed to: CFA Institute,

Permissions Department, P.O. Box 3668, Charlottesville, VA 22903.

Printed in the United States of America

November 2004


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Contents

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2Comparison with Current Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

CFA Institute Soft Dollar Standards

I. General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

II. Relationships with Clients . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

III. Selection of Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

IV. Evaluation of Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

V. Client-Directed Brokerage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

VI. Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

VII. Record Keeping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Appendix A: Recommended Practices for Client-Directed Brokerage Arrangements . . . . . . . . . . . . . . . 10

Appendix B: Permissible Research Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Appendix C: Case Study under the CFA Institute Soft Dollar Standards . . . . . . . . . . . . . . . . . . . . . . . . . 13

Appendix D: Analysis of Proposed Transactions under Applicable U.S. Law . . . . . . . . . . . . . . . . . . . . . 19

Appendix E: Analysis of Proposed Transactions under Applicable Canadian Law. . . . . . . . . . . . . . . . . . 21

Sample Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24


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ii CFA Institute

Soft Dollar Standards

(Guidance for Ethical Practices Involving Client Brokerage)

The AIMR Soft Dollar Standards were approved by the AIMR Board of Governors for use by AIMR mem-

bers worldwide who are involved in soft dollar issues. Soft dollar practices involve the use of client broker-age by an investment manager to obtain certain products and services to aid the manager in its investment

decision-making process. The practice of using client brokerage to purchase research has become extremely

complex, exceeding in large part the usefulness of the existing guidance as currently set forth in the AIMR

Standards of Professional Conduct. The AIMR Soft Dollar Standards endeavor to provide additional guidance

through the articulation of fundamental ethical principles applicable to investment managers who serve as

fiduciaries for client assets.

AIMR recognizes that guidance in this area is not static and will require future refinements to respond to

ongoing developments in technology, the law, and the investment management industry. The Standards will

be revised and interpreted as necessary to remain current, but will continue to honor the overriding fiduciary

principles that form the cornerstone of the Soft Dollar Standards.

The AIMR Soft Dollar Standards would not exist in this form were it not for the tremendous efforts of the

AIMR Task Force for Soft Dollar Standards, created in late 1997 to address this area. Through the dedicated

work of the individuals noted below, the Task Force has made a valuable contribution in raising the ethical

awareness in the soft dollar area. It is with much appreciation that AIMR acknowledges the following Task

Force members. Special appreciation goes to R. Charles Tschampion, CFA-Task Force Chair, who through

his diligence, patience, and tremendous moderating skills, was able to have this diverse group of extremely

talented professionals reach a consensus on such a controversial topic. AIMR would like to thank additional

Task Force members: Raymond L. Aronson; Eugene K. Bolton; Geoffrey I. Edelstein, CFA; David I. Fisher;

John W. Gomez; Thomas J. Healey, CFA; John E. Hull; Michael L. McCowin, CFA; John J. Nagorniak, CFA;

John H. Pieper, CFA; Howard J. Schwartz; Jan Twardowski; Deborah W. Veverka, CFA; Wayne H. Wagner;

and Arthur Zeikel.

Thomas A. Bowman, CFA

President and Chief Executive Officer

AIMR

September 1998


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CFA Institute 1

Introduction

CFA Institute Soft Dollar Standards provide guid-ance to investment professionals worldwidethrough the articulation of high ethical standards forCFA Institute Members dealing with soft dollarissues. CFA Institute Soft Dollar Standards areconsistent with and complement the existing CFAInstitute Standards of Professional Conduct that allCFA Institute Members and Candidates in the CFAProgram are required to follow.

The purposes of the Standards are to define softdollars, identify what is allowable research,establish standards for soft dollar use, create modeldisclosure guidelines, and provide guidance forclient-directed brokerage arrangements.

The Soft Dollar Standards are voluntary stan-dards for Members. If a CFA Institute Memberclaims compliance with the Standards, then certainof these Standards are mandatory (i.e., they mustbefollowed to claim compliance) and others arerecommended (i.e., they shouldbe followed). CFAInstitute strongly encourages Members to adopt therequired and recommended Standards. If the SoftDollar Standards are adopted, compliance will notsupplant the responsibility to comply with applica-ble law.1CFA Institute Members should comply atall times with the relevant laws of the countries inwhich they do business. In situations in which theseStandards impose a higher degree of responsibilityor disclosure than, but do not conflict with, local

law, the Member is held to the mandatory provisionsof these Standards.

Background

In 1975, the U.S. Congress created a safe harborunder Section 28(e) of the Securities and ExchangeAct of 1934 to protect investment managers fromclaims that they had breached their fiduciary dutiesby using their client commissions to pay a highercommission to acquire investment research than theymight have paid for execution services. According

to Securities and Exchange Commission (SEC) Staff,

the protection of Section 28(e) is available only forsecurities transactions conducted on an agencybasis.2 Since that time, the soft dollar area hasundergone considerable expansion, both in terms ofactual usage and the types of products and servicesfor which safe harbor protection is claimed. The

complexity of these practices, including technologi-cally sophisticated research tools and the existenceof mixed-use products, has resulted in a fairamount of legitimate confusion surrounding theappropriate use of soft dollars.

CFA Institute seeks to provide ethical standardsfor CFA Institute Members and those in the industrythat engage in soft dollar practices and also empha-sizes the paramount duty of the investment manager,as a fiduciary, to place the interests of clients beforethose of the investment manager. In particular, theSoft Dollar Standards focus on six key areas:

Definitionsto enable all parties dealing withsoft dollar practices to have a common under-standing of all of the different aspects of softdollars.

Researchto give clear guidance to investmentmanagers on what products and services areappropriate for a manager to purchase with clientbrokerage.

Mixed-Use Productsto clarify the managersduty to clearly justify the use of client brokerageto pay a portion of a mixed-use product.

Disclosureto obligate investment managers toclearly disclose their soft dollar practices andgive detailed information to each client whenrequested.

Record keepingto ensure that the client can (1)receive assurances that what the investmentmanager is doing with the clients brokerage canbe supported in an audit, and (2) receiveimportant information on request.

Client-Directed Brokerageto clarify the man-agers role and fiduciary responsibilities withrespect to clients.

1For example, in the United States, the SecuritiesExchange Act of 1934, Investment Company Act of 1940,and Investment Advisers Act of 1940 all address the use ofclient commissions in soft dollar arrangements. The U.S.Department of Labor also provides regulations regardingdirected brokerage practices concerning ERISA-coveredpension plans.

2According to the SEC staff, securities transactions con-ducted on a principal basis cannot claim Section 28(e)safe harbor protection. Both principal transactions andthose agency transactions unable to qualify for safe har-bor protection are not necessarily illegal but are evalu-ated based on the existence of full disclosure, informedclient consent, and other fundamental fiduciary princi-ples, including placing the clients interests first.


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2 CFA Institute

Overview

CFA Institute Soft Dollar Standards focus on theMembers obligations to its clients. Although theStandards primarily focus on the obligations of theMember as investment manager, they may beapplicable to other parties involved in soft dollarpractices, including brokers, plan sponsors, andtrustees. Each of these parties, however, has its ownset of obligations that should be considered prior toparticipating in any soft dollar arrangement.

CFA Institute Soft Dollar Standards are ethicalprinciples intended to ensure

full and fair disclosure of an investment manag-ers use of a clients brokerage3;

consistent presentation of information so that theclient, broker, and other applicable parties canclearly understand an investment managers

brokerage practices; uniform disclosure and record keeping to enable

an investment managers client to have a clearunderstanding of how the investment manager isusing the clients brokerage; and

high standards of ethical practices within theinvestment industry.

No finite set of standards can cover all potentialsituations or anticipated future developments con-cerning the types of investment research available toinvestment managers. However, meeting the objec-tive of full and fair disclosure and ensuring that the

client comes first obligates an investment managerto disclose fully and clearly to its client theinvestment managers practice when addressing anypotential conflict concerning the payment methodsfor investment research.

CFA Institute Soft Dollar Standards are basedon the following set of fundamental principles thatan investment manager should consider whenattempting to comply:

An investment manager is a fiduciary and, assuch, must disclose all relevant aspects concern-ing any benefit the manager receives through aclients brokerage;

Proprietary research and third-party research areto be treated the same in evaluating soft dollararrangements, because the research that aninvestment manager receives from each is paidfor with client brokerage;

Research should be purchased with clientbrokerage only if the primary use of the research,whether a product or a service, directly assiststhe investment manager in its investment deci-sion-making process and not in the managementof the investment firm; and

When in doubt, the research should be paid forwith investment manager assets, not clientbrokerage.

Comparison with Current Practices

CFA Institute Soft Dollar Standards seek to clarifycertain areas of brokerage practices that have been asource of confusion for CFA Institute Members. Byemphasizing the basic fiduciary responsibilities ofCFA Institute Members with respect to their clientsassets, the Soft Dollar Standards are intended toilluminate the line between permissible and imper-

missible uses of client brokerage. In this respect, theStandards do not create new law but address well-established principles applicable to the investmentmanagerclient relationship.

In other respects, a reiteration of the current softdollar practices would fail to adequately address theissues raised by the complexity of current brokeragepractices faced by CFA Institute Members. The SoftDollar Standards, therefore, depart from certain well-established practices in the soft dollar area andaddress practices beyondthose that currently claimSection 28(e) safe harbor protection.

The Soft Dollar Standards are not to be read asin any way changing the scope of activities that theSEC determines to fall within the safe harbor.Instead they are separate, ethical standards applica-ble to a variety of practices implicated in Soft DollarArrangements. Thus, these Standards will imposehigher standards of conduct in certain areas on CFAInstitute Members that voluntarily elect to complywith the Standards, as follows:

1. Definition of Soft Dollar Arrangements

a. Proprietary, in addition to third-party,research.

Traditionally, soft dollar arrangements areunderstood to address those products orservices provided to the investment man-ager by someone other than the executingbroker, products or services that are com-monly known as third-party research.Such an approach is deficient in light of therange of products and services provided by

3The term Brokerage is described in the definitionssection of the Standards.


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CFA Institute 3

both third-party research providers and in-house research departments of brokeragefirms. Thus, any meaningful Standardsmust also recognize the importance ofresearch provided by the executing broker,commonly known as proprietary or in-

house research.For purposes of the Soft Dollar Stan-dards, soft dollar arrangements includeproprietary, as well as third-party, researcharrangements and seek to treat both catego-ries the same. Although these Standards donotsuggest an unbundling of proprietaryresearch, they do require the investmentmanager to provide certain basic informa-tion regarding the types of research ob-tained with client brokerage throughproprietary research arrangements. More-over, these Standards should not be read to

require research obtained either throughthird-party or proprietary arrangements tobe attributed on an account-by-accountbasis or otherwise to require a tracing ofproducts or services.

b. Principal, in addition to agency, trades.

Traditionally, the term soft dollars refersto commissions generated by trades con-ducted on an agency basis.4However, suchan approach fails to recognize that researchmay be obtained through the use ofspreads or discounts generated by tradesconducted on a principal basis. For thepurposes of the Soft Dollar Standards, softdollar arrangements include transactionsconducted on an agency orprincipal basis.

2. Definition of Research

Traditionally, allowable research in the soft dollarcontext is evaluated by whether it provides lawfuland appropriate assistance to an investment managerin the investment decision-making process. Thisapproach, however, leaves CFA Institute Memberswith inadequate guidance. Consequently, the Soft

Dollar Standards embrace a definition of researchthat requires the primary use of the soft dollar productor service to directly assist the investment managerin its investment decision-making process and not inthe management of the investment firm.

In many cases, this determination may not lenditself to absolute precision, but an investmentmanager must use its best judgment as a fiduciary tojustify the use of client brokerage to pay for a productor service. The Standards suggest the use of a three-tiered analysis to aid CFA Institute Members in

determining whether a product or service is research.Such an approach is intended to provide neededguidance for CFA Institute Members in determiningwhen it is appropriate to use client brokerage topurchase a product or service.

3. Enhanced Disclosure

Disclosure of a CFA Institute Members brokeragepractices will provide the Members client with ameans of evaluating the Members soft dollarpractices and how client brokerage is used. Under theSoft Dollar Standards, the CFA Institute Membermust disclose to its clients certain information, themajority of which the Member is already requiredunder current law to disclose, or to maintain, in orderto meet federal disclosure requirements. Moreover,although the Soft Dollar Standards require the CFAInstitute Member to disclose the availability ofadditional information, this information does notactually have to be provided, unless it is specificallyrequested by the client.

4. Compliance Statement

Finally, the Soft Dollar Standards contemplate theuse of a voluntary statement of compliance. Only a

claim of compliance with these Standards requiresan investment manager to comply with all of themandatory provisions of these Standards and only asto the client brokerage that its compliance statementrelates. Thus, an investment manager that claimscompliance with the Soft Dollar Standards mustprovide the client with a statement that any brokeragearrangement with respect to that clients accountcomports with the mandatory provisions of theseStandards. Such a compliance statement will help toensure the continued integrity of the Standards andprovide clients with additional assurance with

respect to how their brokerage is used by theirinvestment manager.

Definitions

For purposes of the CFA Institute Soft Dollar

Standards, the following terms apply:

Agency Traderefers to a transaction involving thepayment of a commission.

4As noted above, the safe harbor provided by Section28(e) of the Securities Exchange Act of 1934, as inter-preted by the SEC staff, applies only to those transac-tions conducted on an agency, not principal, basis.


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4 CFA Institute

Best Executionrefers to executing Client transac-tions so that the Clients total cost is the mostfavorable under the particular circumstances at thattime.

Brokerrefers to any person or entity that provides

securities execution services.

Brokeragerefers to the amount on any trade retainedby a Broker to be used directly or indirectly as paymentfor execution services and, when applicable, Researchsupplied to the Investment Manager or its Client in

connection with Soft Dollar Arrangements or forbenefits provided to the Client in Client-DirectedBrokerage Arrangements. For these purposes, tradesmay be conducted on an agency orprincipal basis.

Brokerage Arrangementrefers to an arrangementwhereby a Broker provides services or products that

are in addition to execution. Brokerage Arrange-ments include Investment Manager-Directed and

Client-Directed Brokerage Arrangements.

Brokerage and Research Servicesrefers to servicesand/or products provided by a Broker to an Invest-

ment Manager through a Brokerage Arrangement.

Clientrefers to the entity, including a natural person,investment fund, or separate account, designated to

receive the benefits, including income, from theBrokerage generated through Securities Transac-tions. A Client may be represented by a trustee or

other Fiduciary, who may or may not have Invest-ment Discretion.

Client-Directed Brokerage Arrangementrefers toan arrangement whereby a Client directs that trades

for its account be executed through a specific Brokerin exchange for which the Client receives a benefitin addition to execution services. Client-DirectedBrokerage Arrangements include rebates, commis-sion banking, and commission recapture programs

through which the Broker provides the Client withcash or services or pays certain obligations of the

Client. A Client may also direct the use of limitedlists of brokersnot for the purpose of reducingBrokerage costs but to effect various other goals (e.g.,increased diversity by using minority-owned bro-kers) or geographical concentration.

Commissionrefers to the amount paid to the Brokerin addition to the price of the security and applicable

regulatory fees on an Agency Trade.

Fiduciaryrefers to any entity, or a natural person,including a CFA Institute Member, that has discre-tionary authority or responsibility for the manage-ment of a Clients assets or other relationships ofspecial trust.

Investment Decision-Making Processrefers to the

quantitative and qualitative processes and relatedtools used by the Investment Manager in renderinginvestment advice to its Clients, including financialanalysis, trading and risk analysis, securities selec-tion, broker selection, asset allocation, and suitabilityanalysis.

Investment Discretionrefers to the sole or sharedauthority (whether or not exercised) to determinewhat securities or other assets to purchase or sell onbehalf of a Client.

Investment Manager refers to any entity, or a

natural person, including a CFA Institute Member,that serves in the capacity of asset manager to aClient. The Investment Manager may have sole,shared, or no Investment Discretion over an account.

Investment Manager-Directed Brokerage Ar-rangement refers to Proprietary and Third-PartyResearch Arrangements.

Memberrefers to any individual who is required tocomply with the CFA Institute Code of Ethics andStandards of Professional Conduct in accordancewith the CFA Institute Bylaws.

Mixed-Userefers to services and/or products, provid-ed to an Investment Manager by a Broker through aBrokerage Arrangement, that have the capacity to beused for both the Investment Decision-MakingProcess and management of the investment firm.

Principal Traderefers to a transaction involving adiscount or a spread.

Proprietary Research Arrangement refers to anarrangement whereby the Investment Manager di-rects a Broker to effect Securities Transactions forClient accounts in exchange for which the InvestmentManager receives Research from, and/or access to,

the in-house staffs of the brokerage firms.

Provided by a Brokerrefers to (1) in ProprietaryResearch Arrangements, Research developed by theBroker and (2) in Third-Party Research Arrange-ments, Research for which the obligation to pay isbetween the Broker and Third-Party ResearchProvider, not between the Investment Manager andThird-Party Research Provider.


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CFA Institute 5

Researchrefers to services and/or products providedby a Broker, the primary use of which must directlyassist the Investment Manager in its InvestmentDecision-Making Process and not in the managementof the investment firm.

Section 28(e) Safe Harborrefers to the safe harbor

set forth in Section 28(e) of the U.S. SecuritiesExchange Act of 1934, which provides that anInvestment Manager that has Investment Discretionover a Client account is not in breach of its fiduciaryduty when paying more than the lowest Commissionrate available if it determines in good faith that therate paid is commensurate with the value of Brokerageand Research Services provided by the Broker.

Securities Transactionsrefers to any transactionsinvolving a Broker, whether conducted on an agencybasis or principal basis.

Soft Dollar Arrangementrefers to an arrangementwhereby the Investment Manager directs transactionsto a Broker, in exchange for which the Broker providesBrokerage and Research Services to the InvestmentManager. Soft Dollar Arrangements include Propri-etary and Third-Party Research Arrangements but do

notinclude Client-Directed Brokerage Arrangements.Soft Dollar Arrangements are sometimes referred toherein as Investment Manager-Directed BrokerageArrangements, where applicable.

Third-Party Research Arrangement refers to anarrangement whereby the Investment Manager di-rects a Broker to effect Securities Transactions forClient accounts in exchange for which the InvestmentManager receives Research provided by the Broker,which has been generated by an entity other thantheexecuting Broker.


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6 CFA Institute


I. General

Principles

A. These Soft Dollar Standards apply to all

CFA Institute Members Proprietary andThird-Party Research Arrangements, withor without Commissions, and recognizetwo fundamental principles:

1. Brokerage is the property of theClient.

2. The Investment Manager has anongoing duty to ensure the quality oftransactions effected on behalf of itsClient, includinga. seeking to obtain Best Execution,b. minimizing transaction costs, and

c. using Client Brokerage to benefitClients.

Required

B. An Investment Manager in Soft DollarArrangements must always act for thebenefit of its Clients and place Clientsinterests before its own.

C. An Investment Manager may not allocate aClients Brokerage based on the amount ofClient referrals the Investment Managerreceives from a Broker.

Clarification: With respect to mutual funds,the Investment Managers Client is thefund. However, in this context, the fundsboard, not the fund, establishes the policieswith respect to the use of certain brokers.

II. Relationships with Clients

Required

A. The Investment Manager must disclose tothe Client that it may engage in SoftDollar Arrangements prior to engaging insuch Arrangements involving thatClients account.

Recommended

B. The Investment Manager should assurethat, over time, all Clients receive thebenefits of Research purchased with ClientBrokerage.

1. Agency Trades.While it is permissi-ble for the Investment Manager to usea Clients Brokerage derived from

Agency Trades to obtain Researchthat may not directly benefit thatparticular Client at that particulartime, the Investment Manager should

endeavor to ensure that, over a reason-able period of time, the Client receivesthe benefit of Research purchasedwith other Clients Brokerage.

2. Principal Trades. The InvestmentManager should determine if theparticular Principal Trade is subjectto certain fiduciary requirements(e.g., ERISA, Investment CompanyAct of 1940) which require thatClient Brokerage derived from Prin-cipal Trades must benefit the Client

account generating the Brokerage. Ifsuch requirements do not apply, it ispermissible to use Client Brokeragederived from Principal Trades tobenefit Client accounts other than theaccount generating the Brokerage ifthe Investment Manager disclosesthis practice and obtains prior consentfrom the Client.

Clarification: Certain fiduciary statutesrequire that brokerage derived from aPrincipal Trade must directly benefit the

Client account generating the Trade. In suchsituations, even consent by the Client willnot waive this legal requirement. Compli-ance with the Soft Dollar Standards shouldnot be read to, in any way, absolve onesresponsibilities to comply fully with theapplicable law regarding Principal Trades.

III. Selection of Brokers

Principle

A. Selecting Brokers to execute Clients Secu-rities Transactions is a key component ofthe Investment Managers ability to addvalue to its Client portfolios. The failure toobtain Best Execution may result in im-paired performance for the Client.

Required

B. In selecting Brokers, the Investment Man-ager must consider the capabilities of theBroker to provide Best Execution.


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CFA Institute 7

Recommended

C. In evaluating the Brokers capability toprovide Best Execution, the InvestmentManager should consider the Brokersfinancial responsibility, the Brokers re-sponsiveness to the Investment Manager,

the Commission rate or spread involved,and the range of services offered by theBroker.

Clarification: These criteria are relevantcomponents to the Brokers ability toobtain the most favorable total cost underthe particular circumstances at that time.

IV. Evaluation of Research

Required

A. In determining whether to use Client

Brokerage to pay for Research, the Invest-ment Manager must use the followingcriteria:

1. Whether the Research under consid-eration meets the definition of Re-search contained in these Standards.

2. Whether the Research benefits theInvestment Managers Client(s).

3. Whether the Investment Manager isable to document the basis for thedeterminations.

4. Whether under certain fiduciary reg-ulations (e.g., ERISA, the InvestmentCompany Act of 1940) for PrincipalTrades, the Research directly benefitsthe Client account generating thetrade. If the Principal Trades are notsubject to such regulations, the Re-search may benefit Client accountsother than those generating the tradeif the Investment Manager has madedisclosure and obtained prior Clientconsent.

B. The inability to decide and document thatthe Research meets the above criteriarequires that the Investment Manager notpay for such Research with ClientBrokerage.

C. In determining the portion of Mixed-UseResearch to be paid with Client Brokerage,the Investment Manager must:

1. Be able to make a reasonable, justifi-able, and documentable allocation ofthe cost of the Research according toits expected usage.

2. Pay with Client Brokerage only theportion of the Research that is actu-

ally used by the Investment Managerin the Investment Decision-MakingProcess.

3. Reevaluate the Mixed-Use Researchallocation at least annually.

V. Client-Directed Brokerage

Principle

A. Because Brokerage is an asset of the Client,not the Investment Manager, the practice ofClient-Directed Brokerage does not violateany investment manager duty per se.

B. In a Client-Directed Brokerage Arrange-ment:

Required

1. The Investment Manager must notuse Brokerage from another Clientaccount to pay for a product or servicepurchased under the Client-DirectedBrokerage Arrangement.

Recommended

2. The Investment Manager should dis-close to the Client:

a. the Investment Managers duty tocontinue to seek to obtain BestExecution, and

b. that arrangements that require theInvestment Manager to commit acertain percentage of Brokeragemay affect the Investment Man-agers ability to (i) seek to obtainBest Execution and (ii) obtainadequate Research.

3. The Investment Manager should at-

tempt to structure the Client-DirectedBrokerage Arrangement in a mannerthat comports with Appendix A to theSoft Dollar Standards (Exhibit A tothis Topical Study).

VI. Disclosure

In addition to disclosure required elsewhere inthe Soft Dollar Standards:


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8 CFA Institute

Required

A. An Investment Manager must clearly dis-close, with specificity and in plain lan-guage, its policies with respect to all SoftDollar Arrangements, including:

1. To Clients and potential Clients. AnInvestment Manager must disclosewhether it may use the Research tobenefit Clients other than thosewhose trades generated the Broker-age. This disclosure must addresswhether the trades generating theBrokerage involved transactions con-ducted on a principal basis.

2. To Clients. An Investment Managermust disclose (i) the types of Re-search received through Proprietaryor Third-Party Research Arrange-

ments; (ii) the extent of use; and (iii)whether any affiliated Broker isinvolved.

Clarification: Description of the types anduse of Research should be appropriate tothe type of Research Arrangement in-volved. The disclosures required or recom-mended in the Soft Dollar Standards do notcontemplate an unbundling of Propri-etary Research Arrangements. Instead, thedescription of Research should, in thejudgment of the Investment Manager,

provide Clients with the ability to under-stand the type of Research involved in thedegree of detailappropriate to the sourceof the Research.

B. To claim compliance with these Standardsfor any Client account, an InvestmentManager must provide the Client with astatement that any Soft Dollar Arrange-ments with respect to the particular Clientaccount comport with the CFA InstituteSoft Dollar Standards. This statement mustbe provided at least annually.

Clarification: This statement is requiredonly if the Investment Manager is claimingcompliance with the Soft Dollar Standards.If applicable, the statement is to be providedto the individual Client to which the claimis being made.

C. An Investment Manager must prominentlydisclose in writing to its Client that addition-al information in accordance with the CFA

Institute Soft Dollar Standards concerningthe Investment Managers Soft Dollar Ar-rangements is available on request. Suchadditional information should include thefollowing on at least an annual basis:

Clarification: Although certain additional

information is suggested, the Soft DollarStandards are intended to preserve theability of the Client and Investment Man-ager to determine what other informationmay be relevant in light of particular Clientneeds or types of accounts.

1. On a firmwide basis. A description ofthe products and services that werereceived from Brokers pursuant to aSoft Dollar Arrangement, regardlessof whether the product or servicederives from Proprietary or Third-

Party Research Arrangements, de-tailed by Broker.

2. For a specific Client account:a. the total amount of Commissions

generated for that Client througha Soft Dollar Arrangement, de-tailed by Broker; and

b. the total amount of Brokerage di-rected by that Client through Di-rected Brokerage Arrangements.

Clarification: The disclosure required inthis section is intended to provide the

requesting Client with certain basic itemsof information: a description of what theentire firm obtained through Soft DollarArrangements, the identity of brokersproviding those products and services, thetotal amount of Directed Brokerage attrib-utable to the Client, and the total amountof Commissions generated for the request-ing Clients account.

3. The aggregate percentage of theInvestment Managers Brokerage de-rived from Client-Directed Broker-

age Arrangements and the amount ofthat Clients Directed Brokerage, asa percentage of that aggregate.

a. The Investment Manager is notobligated to report amounts ofClient-Directed Brokerage thatconstitute less than 10 percent ofthe Managers aggregate amountof Client-Directed Brokerage.


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CFA Institute 9

Recommended

When requested by a Client:

D. The Investment Manager should provide a

description of the product or service ob-

tained through Brokerage generated from

the Clients account.E. The Investment Manager should provide

the aggregate dollar amount of Brokerage

paid from all accounts over which the

Manager has Investment Discretion.

VII. Record Keeping

Required

The Investment Manager must maintain, when

applicable, all records that

A. are required by applicable law;

B. are necessary to supply Clients on a timely

basis with the information required by Soft

Dollar Standard VI;

C. document arrangements, oral or written,

obligating the Investment Manager to gen-

erate a specific amount of Brokerage;

D. document arrangements with Clients per-taining to Soft Dollar or Client-DirectedBrokerage Arrangements;

E. document any agreements with Brokerspertaining to Soft Dollar Arrangements;

F. document transactions with Brokers in-

volving Soft Dollar Arrangements, includ-ing (1) a list of Proprietary or Third-PartyResearch providers and (2) a description ofthe service or product obtained from theprovider;

G. document the bases of allocation indetermining to use Client Brokerage to payfor any portion of a Mixed-Use service orproduct;

H. indicate how the services and productsobtained through Soft Dollar Arrangementsdirectly assist the Investment Manager in

the Investment Decision-Making Process;I. show compliance with the CFA Institute

Soft Dollar Standards, including the identityof the Investment Manager personnel re-sponsible for determining such compliance.

J. copies of all Client disclosures and authori-zations.


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10 CFA Institute

Appendix A

Recommended Practices for Client-Directed Brokerage Arrangements

In Client-Directed Brokerage Arrangements:

A. When directed by a Fiduciary, the Investment Manager should receive written assurance from the

Fiduciary that the Client-Directed Brokerage Arrangement will solely benefit the Clients account.

B. The Investment Manager should attempt to structure Client-Directed Brokerage Arrangements so that

1. they do not require the commitment of a certain portion of Brokerage to a single Broker, and

2. Commissions are negotiated and seeking to obtain Best Execution is still relevant.

C. The Investment Manager should request from its Client in any Client-Directed Brokerage Arrangement

written instructions that

1. restate the Investment Managers continuing responsibility for seeking to obtain BestExecution,

2. list the eligible Brokers,

3. specify the approximate target percentage or dollar amount of transactions to be directed, and

4. state procedures for monitoring the Arrangements.

D. The Investment Manager should regularly communicate with the Client for the purpose of jointlyevaluating the Client-Directed Brokerage Arrangement, including

1. the potential for achieving Best Execution,

2. the list of Brokers and their trading skills,

3. the target percentage of transactions to be directed to the selected Brokers, and

4. the Investment Managers trading style and liquidity needs.


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CFA Institute 11

Appendix B

Permissible Research Guidance

Central to whether a product or service constitutesResearch that can be paid for with Client Broker-

age is whether the product or service provides lawfuland appropriate assistance to the Investment Manag-er in carrying out its investment decision-makingresponsibilities. This determination pivots on wheth-er the product or service aids the InvestmentDecision-Making Process instead of the generaloperation of the firm.

CFA Institute Soft Dollar Standards add guid-ance by requiring that the primary use of the Researchmust directly assist the Investment Manager in itsInvestment Decision-Making Process and not in themanagement of the investment firm.

Formulating what is allowable Research is notsubject to hard and fast rules. Rather, the context inwhich something is used and the particulars of anInvestment Managers business form the frameworkfor this determination. In evaluating a practice, thesubstanceofactualusage will prevail over theformof some possibleusage.

Three-Level Analysis

CFA Institute Soft Dollar Standards assist theInvestment Manager in making this determination bysetting forth a three-level analysis to assist the

Investment Manager in determining whether aproduct or service is Research. In the vast majorityof cases, if the criteria of all three levels are satisfied,the Investment Manager can then feel comfortable inusing Client Brokerage to pay for the Research. Whenconducting the analysis, the Investment Managermust consider the ethical framework of the SoftDollar Standards. In conjunction with the Soft DollarStandards Client disclosure requirements, an Invest-ment Manager must be able to explain to its Clienthow the Researchand when applicable, its compo-nent partsassists in the Investment Decision-Making Process. Stated another way, the Investment

Manager should only obtain Research with ClientBrokerage if the Manager would feel comfortabledisclosing and explaining the decision in a face-to-face meeting with the Client.

Level IDefine the Product or Service. Thefirst step is for the Investment Manager to define theproduct or service to be purchased with ClientBrokerage. In most instances, the product or serviceis clearly defined (e.g., an industry report). However,

many products and services consist of differentcomponents that are related only to the ability of the

product or service to assist the Investment Managerin its Investment Decision-Making Process (e.g., acomputer work station that runs Research software).For such multicomponent products or services, theInvestment Manager, consistent with the Soft DollarStandards ethical framework, must narrowly con-strue the component parts that are necessary for theproducts or services to directly assist the InvestmentManager in the Investment Decision-Making Process.

For example, the computer work station couldbe considered a closely related component of theproduct or service that constitutes the Research.The electricity needed to run the computer, however,

is not closely related and, if paid with ClientBrokerage, would violate the ethical principles of theSoft Dollar Standards.

Level IIDetermine Usage. The second stepis for the Investment Manager to determine that theprimary use of the product or service, as defined bythe Investment Manager in the Level I analysis, willdirectly assist the Investment Manager in its Invest-ment Decision-Making Process.

For example, an Investment Manager subscribesto the Bloomberg Service and uses this service onlyto enable all persons visiting the Investment Manag-

ers offices to look up the price of securities andanalyze market trends. Under the Level I analysis,the Investment Manager defines the service as themarket data received from Bloomberg, plus theBloomberg supplied terminal and the dedicated linenecessary to receive the Bloomberg service in theInvestment Managers offices. However, under theLevel II analysis, the Investment Manager does notuse the Bloomberg service to directly assist it in itsInvestment Decision-Making Process. To the con-trary, the Investment Manager subscribes to theBloomberg Service as a benefit to the firm. The

Bloomberg Service, therefore, cannot be paid forwith Client Brokerage.

Level IIIMixed-Use Analysis. The third stepoccurs only after the Investment Manager determinesthat the product or service is Research by completingthe Level I and Level II analysis above. TheInvestment Manager must then determine whatportion of the Research is used by the InvestmentManager to directly assist it in the Investment


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12 CFA Institute

Decision-Making Process. If less than 100 percent of

the Research is used for assistance in its Investment

Decision-Making Process, the Investment Manager

must consider the Research as Mixed-Use Research.

With Mixed-Use Research, the Investment Manager

can use Client Brokerage to pay for only that portion

of the Research used by the Investment Manager inthe Investment Decision-Making Process and not in

the management of the investment firm.

For example, if the Bloomberg service discussed

in the Level II analysis was actually used 50 percentof the time to determine market and industry trends

as part of the Investment Managers Investment

Decision-Making Process, the Investment Manager

could pay for 50 percent of the Bloomberg service

with Client Brokerage.

Conclusion

The Investment Manager can establish that the productor service is Research that can be purchased withClient Brokerage only after the Investment Managerhas taken two steps. First, the Investment Managermust have defined the product or service (Level I

analysis). Second, the Investment Manager must havedetermined that the primary use of the product orservice will directly assist the Investment Manager inthe Investment Decision-Making Process rather thanin the management of the investment firm (Level IIanalysis). The final step is for the Investment Managerto determine what portion of the Research will be usedby the Investment Manager in the Investment Deci-sion-Making Process and pay only for that portionwith Client Brokerage (Level III analysis).

A portion of the Research is usedto directly assist the Investment

Manager in its InvestmentDecision-Making Process

Research cannotbe paid for withClient Brokerage

Determine the portion of the Researchthat may be paid for with Client Brokerage

Level I

Level II

Level III

Define the product or serviceconstituting the Research

Will the primary use of the Researchdirectly assist the Investment Manager

in its Investment Decision-MakingProcess and not in the management

investment firm?

Is less than 100% of the Researchinvolved used by the InvestmentManager to directly assist in its

Investment Decision-Making Process?

No

Yes

Yes

A portion of the Research is not usedto directly assist the Investment

Manager in its InvestmentDecision-Making Process

Research cannot be paidfor with Client Brokerage

Research can be paid forwith Client Brokerage


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CFA Institute 13

Appendix C

Case Study under the CFA Institute Soft Dollar Standards

XYZ Firm is an Investment Manager that seeks tocomply with the CFA Institute Soft Dollar Standards

and claim such compliance. XYZ, a Member of CFAInstitute, manages a variety of accounts: separateaccounts, including accounts of employee benefitplans subject to ERISA, accounts of non-ERISAinstitutional investors, and accounts of wealthyindividuals; several collective investment vehicles,including a group trust for employee benefit planssubject to ERISA and/or governmental plans; ahedge fund for institutional and other sophisticat-ed individual investors; and three SEC-registeredinvestment companies, including an equity fund, afixed-income fund, and a money market fund.

XYZ executes trades for its Client accounts withseveral brokerdealers who conduct trades for XYZon both a principal and agency basis. Some of thebrokerdealers have offered to provide XYZ with thefollowing products and/or services for XYZs ownuse, to be paid for with XYZs Client Brokeragebusiness: (1) desks and office equipment; (2) tradingroom television sets that receive the Financial NewsNetwork and other financial news services suppliedby cable and satellite television services; (3) theBloomberg Service, which includes a Bloombergterminal; and (4) software that will assist XYZ in

analyzing economic trends in industries followed bythe Firm, as well as a widely available computer workstation on which to install and operate the software.In addition, XYZ has received the following requestsfrom Clients: (5) a pension fund Client subject toERISA has requested that XYZ direct a portion of itsBrokerage from its separate account to Broker ABCto obtain research information to be provided to theplan trustees; (6) a public pension plan has requestedthat XYZ direct a portion of its Brokerage to BrokerABC in return for cash credits to be paid to the Plan;(7) a non-ERISA institutional investor in XYZs

hedge fund has requested that XYZ direct a portionof the hedge funds brokerage to Broker ABC tocompensate Broker ABC for research servicesprovided to the institutional investor; and, (8) theSEC-registered investment companies have request-ed that XYZ direct a portion of the equity fundsBrokerage to Broker ABC in return for credits to beused to reduce or eliminate all of the registeredinvestment companies custodian fees.

What steps or other actions must or should XYZtake to comply with the Soft Dollar Standards and/

or other CFA Institute Standards of ProfessionalConduct?

Discussion

XYZ Firm is facing a set of decisions that typicallyconfronts Investment Managers in connection withtheir use of Client Brokerage. XYZ should approachthese decisions in a logical and systematic fashion toidentify all relevant issues and ensure compliancewith applicable law and CFA Institute Soft DollarStandards. As an initial matter, XYZ should clearlyisolate and identify the proposed transactions con-

templated. Then, in order to determine compliancewith applicable law and CFA Institute Soft DollarStandards, XYZ should (1) consider fundamentalprinciples that apply to the conduct of CFA InstituteMembers, (2) identify applicable laws and regula-tions and analyze the proposed transactions in lightof those laws and regulations, and (3) identify theCFA Institute Soft Dollar Standards and analyze theproposed transactions in light of those Standards.XYZ may pursue the proposed transactions only aftersatisfying itself that the transactions pass thissystematic, multilevel analysis.

Isolate and Define the Proposed Transactions.One of the benefits of the CFA Institute Soft DollarStandards is that they help Investment Managers toclearly define their practices as they relate to theirClients Brokerage. By referring to the definitionscontained in the Soft Dollar Standards, XYZ shoulddetermine that the brokerdealers offer to provide theproducts and services in Transactions 14 describedin the Facts section possibly constitutes a SoftDollar Arrangement. Because XYZ is contemplatingdirecting transactions to the brokerdealers to receiveexecution on trades and to receive products andservices that will benefit XYZ directly, this offer may

meet the CFA Institute Soft Dollar Standards defini-tion of a Soft Dollar Arrangement. An additionalmeasure of whether Transactions 14 qualify as SoftDollar Arrangements under the CFA Institute SoftDollar Standards is whether the products and servicesreceived by XYZ qualify as Research as defined inthe Soft Dollar Standards. Transactions 58 mayconstitute Client-Directed Brokerage Arrangements,as defined in the CFA Institute Soft Dollar Standards,


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14 CFA Institute

if XYZ determines that the clients are directing thattheir trades be routed through specific brokerdealersin order that the clients may receive benefits inaddition to execution services.

Fundamental Principles. In considering thetransactions that have been proposed, XYZ should

adhere to a set of fundamental principles contained inthree of the CFA Institute Standards that generallygovern a Members conduct in this area. Standard I(Fundamental Responsibilities) of the CFA InstituteStandards of Professional Conduct requires that aMember be familiar and comply with all applicablelaws governing their professional activities. XYZ isthus charged with a duty to know and apply theprovisions of law that are implicated by the proposedtransactions. Even if XYZ has adopted the CFAInstitute Soft Dollar Standards, compliance with theseStandards does not absolve XYZ of the responsibilityto comply with applicable law. For situations in whichthe CFA Institute Standards impose a higher degreeof responsibility or disclosure than, but do not conflictwith, applicable law, XYZ must adhere to theprovisions of the CFA Institute Standards in additionto any provisions of applicable law.

Moreover, Standard I of the CFA Institute SoftDollar Standards contains fundamental principles thatgovern any of XYZs activities involving Soft DollarArrangements. Standard I states that (1) Brokerage isthe property of the Client and (2) XYZ has an ongoingduty to ensure the quality of transactions effected onbehalf of its Clients, which includes

seeking to obtain Best Execution,

minimizing transactions costs, and

using Client Brokerage to benefit Clients.

These principles are reflected in the CFA InstituteSoft Dollar Standards requirement that XYZ, inconsidering a Soft Dollar Arrangement, must act forthe benefit of its Clients and place its Clientsinterests before its own.

Finally, Standard V of the CFA Institute SoftDollar Standards, governing Client-Directed Broker-age Arrangements, requires that XYZ must not use

Brokerage from another Client account to pay for aproduct or service purchased under the Client-Directed Brokerage Arrangement.

Applicable Laws and Regulations. Members areexpected at all times to comply with the applicablelaws of the countries in which they do business. Forexample, in the United States, the Securities Ex-change Act of 1934, Investment Company Act of1940, Investment Advisers Act of 1940, and Employ-

ment Retirement Income Security Act of 1974 wouldgovern certain or possibly all of the transactions thatXYZ is considering. Regardless of the country inwhich XYZ is doing business, as a threshold matter,it must analyze each transaction for compliance withapplicable law. Only those transactions that comply

with local laws are eligible for subsequent analysisunder the CFA Institute Soft Dollar Standards.

Applicable Relevant Standards. Assuming eachof the proposed transactions has survived the firsttwo stages of analysis, they must still comply withprovisions of the CFA Institute Soft Dollar Standardsin order for XYZ to pursue them. Because XYZ haspreviously determined that each of the transactionsqualifies as a possible Soft Dollar Arrangement(depending on whether the products or servicesqualify as Research under the CFA Institute SoftDollar Standards) or a Client-Directed BrokerageArrangement (depending on whether XYZs Clientis directing its trades to receive a benefit), XYZ mustsatisfy the following three broad requirements toclaim compliance with the Soft Dollar Standards:

Determine that each arrangement is permitted bythe CFA Institute Soft Dollar Standards.

Disclose the Investment Mangers Soft Dollarpolicies to its Clients.

Maintain the specified records.

A. Determinations of Eligibility. Standard III of theCFA Institute Soft Dollar Standards requires that,as an initial matter in selecting any broker, XYZ

must consider the capabilities of the broker toprovide Best Execution. Once XYZ has satisfieditself that a particular broker will provide BestExecution, XYZ must next evaluate any addi-tional research provided by the broker under thefollowing four criteria specified in Soft DollarStandard IV:

The research under consideration must meet thedefinition of Research contained in the SoftDollar Standards.

The Research must benefit XYZs clients.

XYZ must be able to document the basis for its

determination. Under certain fiduciary regulations (i.e., ERISA,

the Investment Company Act of 1940), for tradesconducted on a principal basis, the Research mustdirectly benefit the Client account generating thetrade. If not so limited by such regulations, theResearch must directly benefit the Client accountgenerating the trade, unless XYZ has madedisclosure and obtained prior Client consent.


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CFA Institute 15

The meaning of the term Research is crucialto XYZs evaluation under Soft Dollar Standard IV.Research is defined in the CFA Institute SoftDollar Standards to mean services and/or productsthe primary use of which must directly assist theInvestment Manager in its Investment Decision-

Making Process and not in the management of theinvestment firm.

Transaction 1Use of Client Brokerage toPay for Desks and Office Equipment.Transaction1 would not qualify for Research as defined in theSoft Dollar Standards because desks and officeequipment would not satisfy the Soft Dollar Stan-dards definition of Research. Although XYZ shouldbe able to determine that desks and office equipmentdo not qualify as Research based on the plain termsof the definition, the result becomes clear when XYZapplies the three-level analysis. Under that analysis,

XYZ would first define the products or services thatit desires to purchase with Client Brokerage. Thedesks are a discrete and simple product that can beclearly identified. Although office equipment is asomewhat general term, XYZ should also be able toclearly identify the office equipment being offered(e.g., photocopier, fax machine, etc.). XYZ nextwould analyze the primary use of these products todetermine whether they will directly assist XYZsInvestment Decision-Making Process. At this point,XYZ clearly should understand that desks and mostoffice equipment cannot be considered to aid directlyin the Investment Decision-Making Process and

hence do not qualify as Research under the CFAInstitute Soft Dollar Standards. Because the SoftDollar Standards only permit XYZ to receiveResearch as defined in the CFA Institute Soft DollarStandards, XYZ could not engage in Transaction 1and claim compliance with the CFA Institute SoftDollar Standards.

Transaction 2Use of Client Brokerage toPay for Trading Room Television Sets.Transaction2 involves a service that is more difficult than officeequipment to analyze under the definition ofResearch contained in the Soft Dollar Standards. The

service that XYZ desires to purchase is really acomposite of products and services that may or maynot qualify as Research under the definition providedin the Soft Dollar Standards. XYZs first task is todefine the service under the first level of analysis.Accordingly, XYZ should narrowly construe thecomponent parts that are necessaryfor the service atissue in this example (i.e., financial news networks)to assist XYZ in its Investment Decision-Making

Process. In this situation, XYZ could reasonablyconclude that the component parts (i.e., televisionsets, individual financial news services, and cable orsatellite providers) are necessary for the total serviceto assist XYZ in its Investment Decision-MakingProcess. Thus, the service is potentially eligible to be

paid for with client brokerage,provided that the totalservice satisfies the next levelof analysis.

Applying the next level of analysis would allowXYZ to conclude that the service may qualify asResearch if the primary use of the service is todirectly aid the Investment Manager in its InvestmentDecision-Making Process. Even if financial newsservices have a broader use than to provide data toInvestment Managers for purposes of making invest-ment decisions, it would be consistent with the SoftDollar Standards for XYZ to conclude that suchservices meet the primary use analysisif based onactual use.

Transaction 3Use of Client Brokerage toPay for the Bloomberg Service. Transaction 3involves a similar analysis under the definition ofResearch contained in the CFA Institute Soft DollarStandards. As with Transaction 2, XYZs first stepis to define the products or services that XYZproposes to purchase with Client Brokerage. Again,XYZ should narrowly construe the component partsand could reasonably conclude that the Bloombergterminal is a necessary component to receive theBloomberg Service.

In applying the next level of analysis, XYZ mayalso reasonably conclude that the primary use of theBloomberg Service, with its specific focus on real-time market news and analysis, does directly aid inthe Investment Decision-Making Process. The ser-vice, therefore, may satisfy the first two levels ofanalyzing the definition of Research contained in theSoft Dollar Standards. However, if XYZ uses theBloomberg Service and terminal to allow Clients toaccess financial information, the primary use of theservice would not be to assist XYZ in its InvestmentDecision-Making Process, and the service would notqualify as Research under the CFA Institute Soft

Dollar Standards. If XYZ uses the BloombergService and terminal both in its own InvestmentDecision-Making Process and for Client purposes, atthe third level of analysis, XYZ must make a goodfaith determination as to what portion of the serviceis actually used in the Investment Decision-MakingProcess. Only this portion may be paid for with ClientBrokerage. XYZ must reevaluate this allocation onan annual basis.


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16 CFA Institute

Transaction 4Use of Client Brokerage toPay for Software and Computer Work Stations.Atthis point, XYZ should be comfortable applying thethree-level analysis required to define Researchunder the Soft Dollar Standards. Transaction 4involves the same analysis that confronted XYZ in

the first three transactions. In defining the product inTransaction 4 (i.e., the research software), XYZmight reasonably determine that each of the compo-nent parts (the software and workstation) is necessaryfor the product to assist in the Investment Decision-Making Process.

Furthermore, XYZ might reasonably concludeunder the second level of analysis that the software(and its component parts) will directly aid XYZsInvestment Decision-Making Process. If the primaryuse of the software is to directly assist XYZ in itsInvestment Decision-Making Process (as indicatedby Level II analysis), XYZ may purchase thesoftware using Client Brokerage. However, as withTransaction 3, only that portion actually used byXYZ in its Investment Decision-Making Process (asdetermined by Level III analysis) may be paid forwith Client Brokerage, and any mixed-use allocationmust be reevaluated annually.

Client-Directed Transactions. The eligibility ofTransactions 58 must be determined under theportions of the CFA Institute Soft Dollar Standardsrelated to Client-Directed Brokerage Arrangements.Standard V of the CFA Institute Soft Dollar Standardsrequires that, in considering Transactions 58, XYZ

must not use Brokerage from another Client accountto pay for a product or service purchased under theClient-Directed Brokerage Arrangement. Standard Valso recommends that XYZ attempt to structure theClient-Directed Brokerage Arrangement in accor-dance with certain recommended practices under theCFA Institute Soft Dollar Standards.

Transaction 5Directing of Brokerage byERISA Client to Benefit Plan Trustees.In consider-ing Transaction 5, XYZ must be particularly cogni-zant of the definition of Client contained in the SoftDollar Standards. The Standards define Client to refer

to the entity, including a natural person, investmentfund, or separate account, designated to receive thebenefits, including income, from the Brokeragegenerated through Securities Transactions.

Although this definition of Client also recogniz-es that a Client may be represented by a trustee orother Fiduciary, XYZ must be sensitive to thefundamental principle contained in Standard I of theCFA Institute Soft Dollar Standards that stresses that

Brokerage is the property of the Client, not the trusteeor Fiduciary representing the Client. XYZ shouldimmediately question whether Transaction 5 quali-fies as a Client-Directed Brokerage Arrangementbecause the additional benefit flows not to the Clientbut to the Clients trustees. Because Transaction 5

likely does not qualify as a proper Client-DirectedBrokerage Arrangement, if XYZ were to pursue it,XYZ would be violating the fundamental principlethat requires the use of Client Brokerage to benefitClients. XYZ should, therefore, decline to pursueTransaction 5.

Transaction 6Directing of Brokerage by

Public Pension Plan to Obtain Cash Credits for

the Plan. Transaction 6, however, would be apermissible Client-Directed Brokerage Arrangementunder the Soft Dollar Standards because ClientBrokerage would be used to generate cash credits that

solely benefit the Client. XYZ should attempt tostructure the arrangement in conformity with therecommended practices for Client-Directed Broker-age Arrangements that are contained in the SoftDollar Standards, which would require XYZ to:

Disclose to the Client XYZs duty to continue toseek to obtain Best Execution.

Disclose to the Client that committing a certainpercentage of the Clients Brokerage to aparticular brokerdealer may affect XYZsability to seek to obtain Best Execution andpurchase adequate Research.

XYZ should receive written assurance from theplan trustees that the Client-Directed Broker-age Arrangement will solely benefit planbeneficiaries.

XYZ should attempt to structure the Client-Directed Brokerage Arrangement so that it doesnot require the commitment of a certain portionof Brokerage to a single broker and so thatcommissions are negotiated and seeking toobtain Best Execution is still relevant.

XYZ should request from the Client writteninstructions that (1) restate XYZs continuing

responsibility for seeking to obtain Best Execu-tion, (2) list eligible brokers; (3) specify thetarget percentage of transactions to be directed,and (4) state procedures for monitoring thearrangement.

XYZ should regularly communicate with theClient for the purpose of jointly evaluating theClient-Directed Brokerage Arrangement, in-cluding (1) the potential for achieving Best


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CFA Institute 17

Execution, (2) the list of brokers and their tradingskills, (3) the target percentage of transactions to

be directed to selected brokers, (4) XYZstrading style and liquidity needs, and (5) otherfactors identified by the Client as relevant to the

selection of brokers.

Transaction 7Directing of Brokerage byInstitutional Investor in Hedge Fund to Compen-

sate Broker for Research Provided to Investor.

Transaction 7 raises issues under Standard V of theCFA Institute Soft Dollar Standards because Stan-dard V requires that XYZ not use Brokerage fromanother Client account to pay for a product or servicepurchased under the Client-Directed BrokerageArrangement. In Transaction 7, XYZs hedge fundis a commingled pool containing numerous investors.The CFA Institute Soft Dollar Standards defineClient to refer to the beneficiaries of an entity,

including, as in this case, all of the beneficiaries ofan investment fund. However, the product or servicepurchased under this particular Client-DirectedBrokerage Arrangement has benefited only theinstitutional investor in the hedge fund, not all of theClients underlying investors and thus may beconstrued to violate the principles in Standard V ofthe CFA Institute Soft Dollar Standards. XYZ,therefore, should not pursue Transaction 7.

Transaction 8Directing of a Portion of One

Funds Brokerage by Three Investment Compa-

nies to Benefit All Three Companies.Transaction8 raises similar concerns as Transactions 5 and 7.XYZ is apparently directed by three distinct Clients(each of the three registered funds) to directbrokerage of one Client (i.e., the equity fund) tobenefit all three Clients. XYZ should not pursue thisarrangement because it would violate the principlein Standard V of the CFA Institute Soft DollarStandards, which states that brokerage from anotherClient account should not be used to pay for aproduct or service purchased under a Client-Directed Brokerage Arrangement.

B. Disclosure. In order to claim compliance withthe CFA Institute Soft Dollar Standards, XYZmust also meet specific disclosure obligationsrelating to its Brokerage practices. In addition toXYZs disclosure obligations described abovein the discussion of the transactions, XYZ mustclearly disclose the following information relat-ing to its Soft Dollar and Client-DirectedBrokerage Arrangements:

XYZ must disclose to Clients and potentialClients whether XYZ may use the Research to

benefit Clients other than those whose tradesgenerated the Brokerage and whether the tradesgenerating the Brokerage involved transactionsconducted on a principal basis.

XYZ must disclose to Clients (1) a description ofthe types of Research received through the

arrangements, (2) the extent of its use, and (3)whether any broker affiliate of XYZ was

involved.

XYZ must provide each Client with a statementthat any Soft Dollar or Client-Directed Broker-age Arrangements with respect to its account

comport with the CFA Institute Soft DollarStandards (this statement must be provided at

least annually).

XYZ must disclose in writing to its Clients thatadditional information in accordance with theCFA Institute Soft Dollar Standards concerning

XYZs Soft Dollar and Client-Directed Broker-age Arrangements is available on request. Such

additional information should include (1) afirmwide description of the products and servic-

es that were received from each broker pursuantto a Soft Dollar Arrangement, including theidentity of those Brokers; (2) for a specific Client

account, the total amount of Commissionsgenerated for the Client through Soft Dollar

Arrangements, detailed by Broker and reportingthe amount of Brokerage directed by the Client

to specific brokers; and (3) the aggregatepercentage of XYZ Brokerage derived fromClient-Directed Brokerage Arrangements and

the amount of the particular Clients DirectedBrokerage as a percentage of the aggregate,

subject to a 10 percent de minimisamount.

C. Record Keeping. In addition to the eligibilitydeterminations and disclosure obligations, inorder to claim compliance with the CFA InstituteSoft Dollar Standards, XYZ must also maintain,when applicable, all records that

are required by applicable law;

are necessary to supply Clients on a timely basis

with the information required by Soft DollarStandard VI;

document arrangements, oral or written, obligat-ing the Investment Manager to generate a

specific amount of Brokerage;


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18 CFA Institute

document arrangements with Clients pertainingto Soft Dollar or Client-Directed BrokerageArrangements;

document any agreements with Brokers pertain-ing to Soft Dollar Arrangements;

document transactions with Brokers involving

Soft Dollar Arrangements, including (1) a list ofProprietary or Third-Party Research providersand (2) a description of the service or productobtained from the provider;

document the bases of allocation in determiningto use Client Brokerage to pay for any portion ofa Mixed-Use service or product;

indicate how the services and products obtainedthrough Soft Dollar Arrangements directlyassist XYZ in the Investment Decision-MakingProcess;

show compliance with the CFA Institute SoftDollar Standards, including the identity of XYZ

personnel responsible for determining suchcompliance; are copies of all Client disclosures and authori-

zations.


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CFA Institute 19

Appendix D

Analysis of Proposed Transactions under Applicable U.S. Law

Section 28(e) of the U.S. Securities Exchange Act of

1934 provides a safe harbor for investment

managers from claims that they breached a fiduciaryduty owed to a client by causing a client to pay higher

commission costs in return for receipt of brokerage

and research services that benefit the investment

manager.5 Regulations under the U.S. Investment

Advisers Act of 1940 require investment managers

who are registered with the U.S. Securities and

Exchange Commission to provide disclosure to

clients regarding their allocation of client brokerage,

including whether the receipt of research that

benefits the manager is a consideration in allocating

brokerage. In addition, provisions of the U.S.Investment Company Act of 1940 govern transac-

tions that apply to investment company assets, and

provisions of the U.S. Employee Retirement Income

Security Act (ERISA) of 1974 will apply to any

transaction that involves the assets of a plan as the

term is defined in ERISA. Assuming XYZ is doing

business in the United States, XYZ is charged with

the responsibility under the CFA Institute Standards

of Practice of knowing and complying with the

relevant provisions of these laws.

Transactions 14. XYZ must first considerwhether Transactions 14 would satisfy the SECs

definition of permissible research for purposes of

Section 28(e). Research or brokerage products or

services are the only products or services that are

covered by the Section 28(e) safe harbor. Thus, XYZ

will only be protected from potential legal challenges

based on its paying a higher commission rate if the

goods or services offered in the proposed transactions

qualify as research as defined by the SEC. With the

exception of Transaction 1, each of the proposed

transactions would probably satisfy the SECs

definition of research, which is that the product or

service provides lawful assistance to XYZ in making

investment decisions. Because Transaction 1 would

likely not satisfy this standard, it would not qualify

for the protection of the Section 28(e) safe harbor and

would need to be analyzed in light of any restrictions

imposed by other applicable laws. Transaction 1

quite possibly would raise best execution concernsunder existing SEC interpretations and, if connected

with investment company brokerage, would raise

additional concerns under provisions of the Invest-

ment Company Act that restrict affiliates of a mutual

fund from receiving compensation as an agent for the

sale of the funds property. Moreover, if Transaction

1 involved plan assets as defined in ERISA, it would

raise concerns under provisions of ERISA that

require fiduciaries (including XYZ) to act solely in

the interest of the plans beneficiaries and for the

exclusive purpose of providing benefits to the plansbeneficiaries.

Transactions 58. Transactions 58 would not

fall within the Section 28(e) safe harbor because

Section 28(e) requires that the person selecting the

brokerdealer be the person exercising investment

discretion over the account. In XYZs case, because

the client is selecting the brokerdealer, Transac-

tions 58 would not fall within the Section 28(e)

safe harbor.

Nevertheless, because brokerage is an asset of

the client, such arrangements may still be accom-plished, provided they do not violate other relevant

provisions of U.S. law. Transaction 5 should raise

immediate concerns for XYZ because the benefit of

the research information is flowing to the plans

trustees and in-house staff, and is not used for the

exclusive benefit of the plan beneficiaries. XYZ

should conclude that to follow client instructions in

Transaction 5 would likely result in a violation by

XYZ of the substantive prohibitions of ERISA.

Similarly, Transaction 8 should raise immediate

concerns for XYZ under provisions of the Investment

Company Act because brokerage of the equity fund

is being used to reduce custody expenses of all three

registered investment companies. Such an arrange-

ment is likely prohibited by sections of the Invest-

ment Company Act that affirmatively prohibit joint

transactions among affiliated funds. XYZ should,

therefore, also determine that Transaction 8 is

prohibited by the Investment Company Act.

5As a safe harbor, Section 28(e) cannot be violated butoffers protection from violations that might otherwise bedeemed to occur under relevant laws.


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Summary. Transactions 1, 5, and 8 do notqualify for the safe harbor protection of Section28(e). Transaction 1 may be permissible underexisting law if XYZ provides full disclosure andobtains informed client consent, provided that thetransaction does not involve investment company or

benefit plan assets. Because Transaction 5 clearlyinvolves plan brokerage, it would be prohibited byERISA. Similarly, Transaction 8 is prohibited byprovisions of the Investment Company Act. Trans-action 5 and Transaction 8, therefore, do not surviveXYZs initial analysis under applicable U.S. law.


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Appendix E

Analysis of Proposed Transactions under Applicable Canadian Law

The Ontario Securities Commission (the OSC) andthe Commission des Valeurs Mobiliers du Quebec

(the CVMQ) have respectively adopted OSC PolicyStatement 1.9 and CVMQ Policy Statement No.Q-20, (the Soft Dollar Policies). The other securitiesadministrators have not released formal policies withrespect to soft dollars. The Soft Dollar Policies governthe use by dealers of commissions on brokeragetransactions as payment for goods or services otherthan order execution services,6 services directlyrelated to order execution, or investment decision-making services.7The negotiation of commissions onbrokerage transactions executed on behalf of amanager8 of a portfolio or fund of securities is

governed by the general obligation of the manager toact in the best interests of the beneficiaries of theportfolio or fund. Accordingly, such commissionsmust be used only as payment for goods or servicesthat are for the benefit of the beneficiaries and shouldnot be used as payment for goods or services that arefor the benefit of the manager.

The Soft Dollar Policies provide that a dealermay not use any portion of the commissions earnedon brokerage transactions executed on behalf of themanager as payment for goods or services providedto the manager, other than order execution services

or investment decision-making services. It alsoprovides that a manager may not direct brokeragetransactions to a dealer as payment for goods orservices provided to the manager, other than orderexecution services or investment decision-makingservices. As there is concern about widening the

categories of permissible soft dollar transactions, theOSC has decided that staff should only grant

exemptions on a case-by-case basis because they arecontemplated by the OSC Policy 1.9.

Disclosure. On request, managers must discloseto the relevant commission, beneficiary, or trustee ofa portfolio or fund the names of the persons orcompanies that have provided any investmentdecision-making services to the manager and asummary of the nature of those services that werepaid for by commissions on brokerage transactions.

Dealer as Principal. When transacting as prin-cipal, a dealer may not buy securities from or sellsecurities to a manager if the price of the securities

has been adjusted to compensate the dealer for goodsor services provided to the manager, other than orderexecution services or investment decision-makingservices.

Mutual Funds. Similarly, mutual fund manag-ers may not pay dealers for the distribution of sharesor units of the mutual fund by directing brokeragetransactions to the dealer or, at the request of thedealer, to a third party, unless the commission ratescharged are equivalent to those which would havebeen normally charged by the dealer if the dealer didnot distribute shares or units of the mutual fund and

if certain disclosure requirements are met. Inaddition, such payments cannot be made as induce-ment or reward for the dealer or the principaldistributor selling or having sold securities of themutual fund or maintaining or having maintainedparticular levels of securities of the mutual fund inaccounts of clients. Furthermore, all brokerage mustbe directed through representatives designated as theinstitutional representatives of the dealer, as opposedto retail representatives.

The offering documents of a mutual fund mustdisclose the actual use of commission dollars,

including the names of the persons or companies whohave provided any investment decision-makingservices to the mutual fund, a summary of the natureof those services, and a best estimate of the aggregateamount of any commissions on brokerage transac-tions that were directed to dealers since the date ofthe last offering documents for which the commis-sions were linked to the distribution of shares or unitsof the mutual fund by the dealers.

6Order execution services means (1) order executionand (2) services directly related to order execution, suchas clearance, settlement, and custody, whether the ser-vices are provided by a dealer directly or by a third party.7Investment decision-making services means (1)advice as to the value of securities and the advisability of

effecting transactions and securities, (2) analysis andreports concerning securities, portfolio strategy, perfor-mance, issuers, industries, or economic or political fac-tors and trends, and (3) databases or software to theextent they are designed mainly to support the servicesreferred to in (1) and (2), whether the services are pro-vided by a dealer directly or by a third party.8A manager is a person or company entrusted with themanagement of a portfolio or fund on behalf of third-party beneficiaries.


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Transactions. Assuming XYZ is doing businessin Canada, XYZ is charged with the responsibilityunder the CFA Institute Standards of ProfessionalConductof knowing and complying with the relevantprovisions of these laws.

Transaction 1Use of Client Brokerage toPay for Desks and Office Equipment. The use ofclient brokerage to pay for desks and office equip-ment would not qualify as investment decision-making services or order execution services asthese terms are defined by the Soft Dollar Policies.Thus, this transaction would be prohibited.

Transactions 24. Each of the proposed trans-actions would likely satisfy the OSCs definition ofinvestment decision-making services.

Transaction 2Use of Client Brokerage toPay for Trading Room Television Sets (IncludingIndividual Financial News Services and Cableor Satellite Providers). These services provide ananalysis of industries or economic or political factorsand trends. Therefore the services fit within thedefinition of investment decision-making services.

Transaction 3Use of Client Brokerage toPay for the Bloomberg Service. The BloombergService focuses on real-time market news andanalysis. Thus, the service fits within the definitionof investment decision-making services.

Transaction 4Use of Client Brokerage toPay for Software and Computer Work Stations.

The definition of investment decision-making servic-es specifically includes databases or software toservices such as analysis and reports concerningeconomic trends. The software is designed to analyzeeconomic trends in industries followed by the firm.Accordingly, this part of Transaction 4 would beallowed. Although the work station is not specificallyincluded in the definition of investment decision-making services, it is required to support the softwareand would be allowed by implication.

Transaction 5Directing of Brokerage byERISA Client to Benefit Plan Trustees. In Canada, aprivate pension plan governed by provincial pensionbenefits standards legislation or the federal PensionBenefits Standards Act would be the approximateequivalent of an ERISA plan under U.S. law. TheOntario Pension Benefits Act provides that theadministrator of a pension plan is not entitled to anybenefit from the pension plan other than pension

benefits, ancillary benefits, or a refund of contribu-tions and fees and expenses related to the adminis-tration of the pension plan and permitted by thecommon law or provided for in the pension plan.

Because Transaction 5 confers a benefit on thetrustee of the pension fund, rather than on the

beneficiaries or members of the pension plan, and aspecific benefit is not being conferred on theadministrator of the pension plan, this transactionwould be prohibited.

Of interest is the Canadian securities administra-tors concern regarding the practice whereby apension plan sponsor requires the pension planmanager to direct brokerage transactions to aparticular dealer who will use a portion of thecommission income from this transaction to providethe sponsor with goods or services.

Transaction 6Directing of Brokerage byPublic Pension Plan to Obtain Cash Credits forthe Plan. No direct parallel exists in Canada to a U.S.public pension plan concept wherein the plan is notsubject to some form of provincial or federal pensionstandards legislation (i.e., most public sector plansare subject to pension benefit standards legislation).

Transaction 6 would not violate Canadianlegislation. Because the goods and services contem-plated in Transaction 6 would not be provided to themanager from the dealer, the Soft Dollar Policywould not be violated and the manager would not be

in violation of the managers general obligation tobenefit beneficiaries.

Transaction 7Directing of Brokerage by anInstitutional Investor in a Hedge Fund to Compen-sate the Broker for Research Provided to theInvestor. The term hedge fund is not defined underCanadian securities law; the marketplace uses thisterm to refer to funds that leverage their assetsthrough the use of derivative contracts.

In this transaction, the dealer is not receivingpayment for goods or services provided to the

manager. Nevertheless, the manager has a generalobligation to act in the best interests of thebeneficiaries of the fund, including the requirementto satisfy best execution obligations when direct-ing brokerage. Consequently, commissions may onlybe used as payment for goods and services that arefor the benefit of the beneficiaries. Directingbrokerage at the request of one investor will notsatisfy these obligations.


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Transaction 8Directing of a Portion of OneFunds Brokerage by Three Investment Compa-nies to Benefit All Three Com

Documents

soft dollar standard-cfa.pdf