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SEC Approves Guidance on Soft Dollars and Proposes Amendments to Reg. SHO

At Commissioner Cynthia Glassman's last SEC open meeting, the commissioners unanimously voted to adopt interpretive guidance on the use of soft dollars by money managers and to propose amendments to Regulation SHO to eliminate the grandfather provision for fail to deliver positions in threshold securities and to narrow the options market maker exception. SEC Chairman Christopher Cox and the other commissioners commended Glassman for her service at the SEC and for bringing an economist's perspective to their rulemaking initiatives.

The SEC's proposed interpretive guidance on the use of soft dollars was issued last October. Over 70 comment letters were submitted in response. A number of recommendations from commenters were included in the final interpretation. Glassman noted that she had pushed for comments in response to the proposed interpretive guidance and believes they were extremely helpful. The SEC did not seek comments on the soft dollar interpretive guidance that was issued in the past, she noted.

The interpretive release clarifies that the analysis of brokerage and research services under 1934 Act section 28(e) requires the application of the eligibility criteria, the lawful and appropriate use of the items acquired, and the money manager's good faith determination that the commissions that are paid are reasonable for the services that are received. The release also reiterates that eligible research services are limited to advice, analyses and reports.

Eligible brokerage services include products or services that relate to the execution of the trade. Where items have mixed uses, money managers must make a reasonable allocation between those that are eligible and those that are not.

The U.K.'s Financial Services Authority recently adopted client commission rules. Glassman asked whether the FSA's rules and the SEC's guidance are consistent. The staff advised that the FSA has adopted a somewhat stricter approach, but noted that the U.K. was working from a clean slate, while the SEC was working from a Congressional statute. Glassman questioned the utility of section 28(e), but agreed that unless Congress chooses to change the law, the SEC must ensure that the industry comports with its intent.

Commissioner Paul Atkins said that business practices have changed greatly in the 30 years since section 28(e) was adopted, but expressed concerns about drawing lines on which activities are permitted and which are not, saying it is a very slippery slope. Overall, he concluded that the SEC's guidance is a balanced approach. Atkins noted that the guidance does not take effect for six months. Until then, money managers and broker dealers may rely on the current guidance. In many ways, the new interpretive guidance is consistent with earlier guidance, but supersedes it in some areas, according to the staff.

The Division of Investment Management is drafting a companion disclosure release which it expects to bring before the Commission later this year. The SEC will also seek additional comments on commission sharing arrangements.

Regulation SHO

Robert Colby, the acting director of the Division of Market Regulation, noted that the staff has been monitoring the grandfather provision and the options market maker exception since Regulation SHO went into effect in January 2005. Glassman said she is pleased with the proposal and the staff's monitoring of Regulation SHO. While Regulation SHO has led to reductions in the failure to deliver securities to cover short sales, Glassman said that failures have persisted in two areas, which the proposed amendments will address.

Regulation SHO has a close-out requirement for threshold securities which are equity securities that are registered or that require the filing of reports with the SEC for which there is an aggregate fail to deliver position of 10,000 or more shares for five consecutive days at a registered clearing agency and that is equal to at least .5% of the shares outstanding. When a clearing agency participant has a fail to deliver position in threshold securities for 13 consecutive settlement days, the participant must take action to close out the position. Until the position is closed out, further short sales in that security may not be effected without borrowing or entering into an arrangement to borrow the security. Under the grandfather provision, the close-out requirement does not apply to positions that were established before the security became a threshold security or prior to the effective date of Regulation SHO.

The requirement to close out fail to deliver positions in threshold securities that remain for 13 consecutive settlement days does not apply to positions attributed to short sales by a registered options market maker if the short sales are effected to establish or to maintain a hedge on options positions that were created before the security became a threshold security. The proposal would limit the duration of the exception to 13 consecutive settlement days from the date on which the security becomes a threshold security or the options position expires or is liquidated, whichever is later.