Friday, June 29, 2007

Former SEC Chairs Oppose Shareholder Vote

By James Hamilton, J.D., LL.M.

A group chaired by former SEC Chair William Donaldson has come out against a shareholder advisory vote. The proper means for shareholders to express their opinions on executive compensation, said the group, is through their votes for directors who represent them. The group also recommended the elimination of quarterly earnings guidance. The group is also composed of former SEC chairs Harold Williams and Rod Hills, as well as former PCAOB Chair William McDonough.

Against the backdrop of a pending House bill mandating a shareholder advisory vote on executive compensation, the former chairs expressed concern that such an advisory vote would send mixed and confusing signals, working against rather than for responsible engagement. The group described the shareholder vote as a crude instrument for communicating about a complex topic. For example, the group wondered how a no vote, or even a yes vote, should be interpreted. In addition, some shareholders might focus on the overall compensation policy, while others might vote on the basis of specific details and outcomes.

More broadly, the group sees no reason for shareholders to vote only on a company’s executive compensation plan rather than any of the other major decisions taken by a board of directors. Shareholders, for example, do not vote on a company’s investment policies, which may be more significant to the long-term, or even short-term, performance of the company.

Because the goal of those supporting a vote is to create a dialogue about pay issues, the former SEC chairs urged the company’s compensation committees to initiate such a dialogue up front. The group also encouraged U.S. companies to take steps within the current system to engage long-term investors on compensation practice and its link to value creation for the long term.

In their view, a good place to start would be for compensation committees to implement fully the new SEC requirement for a Compensation Discussion and Analysis” (CD&A). The CD&A is a principles-based disclosure requirement whose purpose is to provide material information and perspective about the company’s executive compensation objectives. The current year is the first in which CD&A reports are to be filed. The group knows of few, if any, companies that have met investor expectations of customized and tailored disclosure.

Indeed, SEC Chairman Cox has publicly complained that, relative to the SEC’s goals, submissions are unreadable, too long, and overly burdened with lawyers’ jargon. That assessment, reasoned the former SEC chairs, indicates that companies have missed an opportunity to explain to shareholders, equity analysts, and the market in general how the design of compensation practices is integrated with performance goals.

For their part, the former SEC officials urged companies to structure incentive compensation plans so that a significant portion of the income of senior corporate officers is tied to the achievement of well articulated long-term performance objectives in line with the corporate strategy.

Eliminate Quarterly Guidance

Quarterly guidance on earnings per share should be terminated, said the group, because such guidance encourages a focus on, and sometimes a distortion of, short-term financial results and attracts short-term, speculative trading rather than long-term investing. At present, about half of listed, public companies issue quarterly guidance on expected earnings.

The group also said that the current financial accounting system fails to provide investors with as much useful information as it could. One significant problem is that intangibles, such as the value of the company’s brand or its relationships with employees, suppliers and customers, which often drive company performance, are not well measured, or not
measured at all. The group recommended that financial reports be supplemented with non-financial indicators of value.

Wednesday, June 27, 2007

Dutch Advocate General Advises on LaSalle Bank Sale

Dutch Advocate General Timmerman has issued an advisory opinion that ABN AMRO was allowed to sell its US subsidiary LaSalle without the prior approval of company shareholders. An advisory opinion is independent legal advice to the Supreme Court of the Netherlands, which is expected to rule on the case next month. ABN AMRO Holding N.V. v. Vereniging Van Effectenbezitters (VEB)

This sale took place at the time the ABN AMRO board was involved in exclusive negotiations with Barclays regarding a share merger. Before the sale of LaSalle, a consortium of three banks had announced its intention to acquire the shares in ABN AMRO Holding.

Earlier, the Enterprise Chamber had ruled that, while it has not been established that the sale of LaSalle was executed in order to frustrate a competitive bid of the consortium, in view of the resolution by the board to seek an acquisition candidate, the sale of LaSalle exceeded the conduct of business area that is reserved to the board of directors and the supervisory board. In view of this rule and the circumstances of the case, it would be unacceptable if the shareholders of ABN AMRO Holding would not be allowed to express their views on the sale of LaSalle. The Enterprise Chamber further held that the principles of reasonableness and fairness laid down in section 2:8 of the Dutch Civil Code applied analogically to require that the execution of the sale of LaSalle must be suspended until the general meeting of shareholders has approved the transaction.

The advisory opinion starts with a comparative law study, in which the Advocate General pays attention to English and German law, as well as to the law of the State of Delaware. The Advocate General then focuses on the meaning and background of the Dutch Civil Code and the principles of reasonableness and fairness laid down in the code.

In recommending that the decision of the Enterprise Chamber be reversed, the Attorney General said that the principles of reasonableness and fairness embodied in the code did not grant the shareholders an approval right in relation to the LaSalle transaction. Only in very special circumstances, he continued, can the principles of reasonableness and fairness establish the authority of a corporate body. Such authority, which is not derived from the law or the articles of association, must be founded on a widely accepted legal conviction, which is not the case in the present matter.

In the advisory opinion, the Advocate General does not express his view on whether the board acted unlawfully with respect to its shareholders by selling LaSalle.

Tuesday, June 26, 2007

SEC Official Says US Rules Began with Principles

By James Hamilton, J.D., LL.M.

Against the backdrop of pending developments involving US GAAP and IFRS, the SEC’s Deputy Chief Accountant set forth principles-based initiatives that can be immediately implemented within the current framework. In remarks at the recent SEC and Financial Reporting Institute, James Kroeker said that meaningful improvements can be made right now by focusing on the objectives or principles underlying the accounting standards when considering how to account for a transaction. And, he continued, the vast majority of US standards were written with a principle in mind.

The deputy chief accountant also said it is not clear exactly what a principles-based standard setting regime should look like. In his view, it is even less clear that U.S. standards are inherently less principles-based than those established in London. In fact, he argued that the vast majority of U.S. standards were established with a principle or objective in sight. But he acknowledged that, over time, exceptions, bright-lines, application guidance and interpretations, what some may call rules, have blurred the principles.

He also asked standard-setters and regulators to resist the temptation to provide guidance on the host of potential financial accounting difficulties. Similarly, he urged preparers of financial statements and auditors to refrain from asking for such guidance. Rather than seeking detailed guidance, the given difficulty should be addressed by looking to the objective of a standard and applying professional judgment, which the senior official views as a valuable component of the financial reporting framework.

While not suggesting that existing accounting guidance can be ignored, he is saying that, when bright-lines, exceptions and rules do not exist, the regulated community should resist the temptation to ask for them. Accounting standards will be overly burdensome and detailed, he reasoned, if more and more interpretative work, scope clarifications, and the like are demanded.
He noted that the use of professional judgment will mean accepting some level of diversity in practice.

This has to be the case since there will certainly be times when reasonable people acting in good faith will not reach identical conclusions in practice. The SEC official recognizes that there will be situations when the reasonable application of judgment will result in more than one acceptable accounting or financial reporting conclusion. But the payoff is that the exercise of professional judgment by preparers and auditors should increase the transparency and comparability of financial reporting.

Monday, June 25, 2007

SEC Seeks Comment on Specific Issues as Part of AS5 Approval

In a surprise move, the SEC has posed a number of specific questions about the PCAOB’s new internal controls audit standard as part of the approval process. The Board adopted AS5 last month as part of a comprehensive and coordinated reform of the internal control reporting regime under Section 404 of Sarbanes-Oxley. At the same time, the SEC issued management guidance.

AS5 is now awaiting SEC approval, with a public comment period until July 12. The SEC seeks comment on whether AS5 is sufficiently clear about the extent to which auditors can use the work of others. The Commission also asks if AS5’s definition of material weakness, which is consistent with the definition the SEC adopted, appropriately describes the deficiencies that should prevent the auditor from finding that the internal controls are effective. Similarly, the SEC asks if the requirement that the auditor communicate any significant deficiencies to the audit committee will divert auditors’ attention away from material weaknesses.

More broadly, the SEC seeks comment on whether AS5 will reduce expected audit costs under Section 404, particularly for smaller public companies. It is similarly asked if AS5 inappropriately discourages or restricts auditors from scaling audits, particularly for smaller public companies.

The SEC also wants to know if the standard of materiality is appropriately defined throughout the standard in a way that provides sufficient guidance to the auditors. For example, the SEC questions if materiality is appropriately incorporated into the guidance regarding the matters to be considered in planning an audit and the identification of significant accounts.

Friday, June 22, 2007

Supreme Court Talks About Recklessness Being Tantamount to Scienter

As part of its opinion this week interpreting what constitutes a strong inference of fraud under the Private Securities Litigation Reform Act, the US Supreme Court also mentioned that it had previously reserved the question whether reckless behavior is sufficient for civil liability under Rule 10b–5. See Ernst & Ernst v. Hochfelder, 425 U. S. 185, 194, n. 12 (1976). In other words, the issue of whether recklessness is tantamount to scienter or an intent to defraud has never been decided by the Supreme Court. And, unfortunately, the question whether and when recklessness satisfies the scienter requirement is not presented in the Tellabs case.

But in fn. 5 of its opinion, the Court did say that every federal court of appeals that has considered the issue has held that a plaintiff may meet the scienter requirement by showing that the defendant acted intentionally or recklessly, though the Circuits differ on the degree of recklessness required. The Court cited the Fourth Circuit panel opinion in Ottmann v. Hanger Orthopedic Group, 353 F. 3d 338, CCH FSLR ¶92,465.

The type recklessness we are talking about here is an act so highly unreasonable and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it. Such severe recklessness is essentially a slightly lesser species of intentional misconduct.

Following the enactment of the PSLRA, questions had arisen concerning the validity of pre-PSLRA federal court decisions holding that scienter could be established by a showing of recklessness. See Nathenson v. Zonagen Inc., (5th Cir. 2001) 267 F.3d 400, CCH FSLR ¶91,548. In Ottmann, the Fourth Circuit panel concluded that the PSLRA did not alter the substantive standard for proving scienter in securities fraud actions.

It is possible that, in fn. 5, the Supreme Court was giving its tacit approval to the conclusion that the passage of the PSLRA did not affect judicial holdings that severe recklessness is tantamount to scienter. The Court reached out to mention that all of the federal appellate courts that have considered this issue have held that recklessness is tantamount to scienter for Rule 10b-5 purposes. The Court did not have to do this to decide the case.

Thursday, June 21, 2007

Supreme Court Endorses Strict Standard for Securities Fraud Actions

The requirement that investors in a private securities fraud action state facts that the defendants acted with a strong inference of scienter means that the fraud claim will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged. This was the US Supreme Court’s ruling on a provision of the Private Securities Litigation Reform Act providing that plaintiffs must .state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. (Tellabs, Inc. v. Makor Issues & Rights, Ltd., Dkt. No. 06-484)

Importantly, the allegations must also be considered collectively. A federal judge must not scrutinize each allegation in isolation, said the Court, but must assess all the allegations ``holistically.’’ In sum, the reviewing court must ask the question of when the allegations are accepted as true and taken collectively would a reasonable person deem the inference of scienter at least as strong as any opposing inference.

In an opinion written by Justice Ginsburg, the Court crafted what it called a ``workable construction’’ of the strong inference standard that is designed to achieve the PSLRA’s goal of curbing frivolous, lawyer-driven litigation, while preserving the ability of investors to recover on meritorious claims. Justices Scalia and Alito filed opinions concurring in the judgment; and Justice Stevens filed a dissenting opinion.

Congress included exacting pleading requirements among the control measures in the reform act. The Act requires plaintiffs to state with particularity both the facts constituting the alleged violation, and the facts evidencing scienter, which is an intent to defraud. But Congress left undefined the key term strong inference, noted the Court, and the federal courts of appeals have divided on its meaning.

In this case, the Seventh Circuit Court of Appeals held that the strong inference standard would be met if the complaint alleged facts from which, if true, a reasonable person could infer that the defendant acted with the required intent. Rejecting that formulation, the Supreme Court said that it does not capture the stricter demand Congress sought to convey in the PSLRA. It does not suffice that a reasonable fact finder plausibly could infer from the allegations the requisite state of mind. Rather, to determine whether scienter allegations can survive a threshold inspection for sufficiency, instructed Justice Ginsburg, a court must engage in a comparative evaluation and consider, not only inferences urged by the plaintiff, but also competing inferences rationally drawn from the facts alleged.

An inference of fraudulent intent may be plausible, yet less cogent than other, nonculpable explanations for the defendant’s conduct. To qualify as strong, reasoned the Court, an inference of scienter must be more than merely plausible or reasonable. It must be cogent and at least as compelling as any opposing inference of non-fraudulent intent.

Further, the judicial inquiry must be into whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard. Moreover, in determining whether the stated facts give rise to a strong inference of scienter, a federal judge must take into account plausible opposing inferences. The Seventh Circuit expressly declined to engage in such a comparative inquiry.

The Court also noted that the strength of an inference cannot be decided in a vacuum. The inquiry is inherently comparative and centers on how likely it is that one conclusion, as compared to others, follows from the underlying facts. To determine whether the alleged facts give rise to a strong inference. of scienter, a court must consider plausible non-culpable explanations for the defendant’s conduct, as well as inferences favoring the plaintiff.

The inference that the defendant acted with scienter need not be irrefutable, said the Court, that is it need not be of the ``smoking-gun genre,’’ or even the .most plausible of competing inferences. That said, however, the inference of scienter must be more than merely .reasonable or permissible. It must be cogent and compelling, thus strong in light of other explanations.


Finally, the Court dismissed as undue the Seventh Circuit’s concerns, raised on its own initiative, that the standard being adopted would usurp the jury’s role. In the Court’s view, mandating a comparative assessment of plausible inferences, while constantly assuming the allegations to be true, does not impinge on the Seventh Amendment right to a jury trial. As the creator of federal statutory claims, reasoned the Court, Congress has the power to prescribe what must be pleaded to state the claim. More specifically, Congress has the prerogative to allow, disallow, or shape the contours of securities fraud actions, including the pleading and proof requirements.

On this issue, the Court also emphasized that its construction of the strong inference standard does not force investors to plead more than they would be required to prove at trial. A plaintiff alleging fraud in a securities fraud action must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference.

Wednesday, June 20, 2007

Treasury Official Warns on Concentration of Hedge Fund Counterparties

A senior Treasury official has raised the specter of a major systemic shock to the markets due to the fact that a few large financial institutions serve as the principal counterparties and creditors to hedge funds. In remarks at a Managed Funds Association seminar, Anthony Ryan, Asst. Secretary for Financial Markets, cautioned that the improved sophistication of risk management programs cannot lull one into thinking that systemic risk has been defeated.

In this regard, he noted that E. Gerald Corrigan, chairman of the Counterparty Risk Management Group, recently testified to Congress that the potential damage that could result from such shocks is greater due to the increased spread, complexity, and tighter linkages that characterize the global financial system. Thus, although financial institutions have improved their capital positions and risk management practices over the past decade, acknowledged the Treasury officer, there is room for additional improvement.

In his view, the availability of information plays an important role. Only with accurate and timely information can counterparties, creditors, and investors understand and adequately assess their risk exposure. Similarly, if investors, counterparties and creditors are to define and create effective market discipline, he reasoned, they must have access to reliable and timely information. The point is that much of this information can only be disclosed by the hedge fund managers.

Market infrastructure is also important with increasing product innovation and trading volume. According to Mr. Ryan, not having effective and rapid clearing and settlement procedures could stimulate a systemic contagion effect if there were a failing counterparty or highly leveraged market participant.

He also described the recent guidelines set forth by the President’s Working Group on Financial Markets as a call to action to foster preparedness. The guidelines direct all stakeholders to mitigate the likelihood and impact of a systemic risk event. The guidelines highlight how potential systemic risk is best mitigated within the current regulatory framework by market discipline that is developed and applied by creditors, counterparties and investors.

More specifically, the guidelines call upon financial institutions to determine appropriate credit terms. In doing so, noted the official, they must assess credit and operational risk. He advised financial institutions to be disciplined and independent in quantifying valuations. Importantly, they need to guard against the risks to their reputation. The Treasury official cautioned banks that their regulators will closely monitor their management of these risks and assess whether their performance is in line with expectations set out in supervisory guidance.

To deal with these challenges, he continued, counterparties and creditors must maintain appropriate policies and protocols. They must clearly implement and continually enhance best risk management practices addressing how the quality of information from a client affects margin, collateral, and other aspects of counterparty risk management.
In order to combat the effects of increased risk concentration, the PWG guidelines encourage lenders to hedge funds to frequently measure their exposures, taking into account collateral to mitigate both current and potential future exposures

Monday, June 18, 2007

Supreme Court Rules on Antitrust Case

Antitrust class actions against investment banks that acted as underwriters in IPOs of companies were precluded by the federal securities laws, ruled the US Supreme Court, since allowing the antitrust suits threatened serious harm to the efficient functioning of the securities markets. The Court concluded that the securities laws are clearly incompatible with the application of the antitrust laws in this context since IPOs are an area of conduct squarely within the heartland of securities regulations; the SEC has clear and adequate authority to regulate the area and is engaged in active and ongoing regulation; and there is a serious conflict between the antitrust and securities regulatory regimes. (Credit Suisse Securities (USA) LLC v. Billing, No. 05-1157.)

The investors attacked underwriter efforts to collect commissions through certain practices, such as laddering and tying. The Court noted that the SEC actively enforces the regulations forbidding the conduct in question and any investors harmed by any unlawful practices by underwriters may obtain damages under the federal securities laws. In addition, the SEC proceeds with great care to distinguish the encouraged and permissible from the forbidden, said the Court, while the threat of antitrust lawsuits, through error and disincentive, could seriously alter underwriter conduct in undesirable ways.


Further, the effort of underwriters to jointly promote and sell newly issued securities is central to the proper functioning of well-regulated capital markets. The IPO process supports new firms that seek to raise capital; it helps to spread ownership of those firms broadly among investors; it directs capital flows in ways that better correspond to the public’s demand for goods and services.

The Court also emphasized that the SEC is itself required to take account of competitive considerations when creating securities-related policy and embodies such considerations in its regulations, which makes it somewhat less necessary to rely upon antitrust actions to address anti-competitive behavior.

Further, the Court reasoned that permitting the antitrust actions would allow the investors to dress an essentially securities complaint in antitrust clothing and thus risk circumventing the Private Securities Litigation Reform Act’s procedural requirements for the filing of securities actions.

Rejecting the Solicitor General’s suggestion that the trial court be permitted to determine if the allegations of prohibited conduct can be separated from conduct that is permitted by the securities regulatory scheme, the Court emphasized that the official’s proposed disposition does not convincingly address the difficulty of drawing a complex line separating securities-permitted from securities-forbidden conduct and the need for securities-related expertise to draw that line. Moreover, it does not address the likelihood that parties will depend upon the same evidence yet expect courts to draw different inferences from it, as well as the serious risk that antitrust courts will produce inconsistent results that, in turn, will overly deter syndicate practices important in the marketing of new issues.

Justice Breyer wrote the opinion for a solid majority of six. Justice Stevens concurred only in the judgment. He said that the alleged conduct of the investment banks does not violate the antitrust laws and urged the Court not to hold that Congress has implicitly granted them immunity from the antitrust laws. Justice Thomas dissented and Justice Kennedy took no part in the case.

Sunday, June 17, 2007

Former Commissioner Cox Was Prescient

Under the category there is nothing new under the securities regulation sun, I direct you to remarks made by former SEC Commissioner Charles Cox on Jan 7, 1986 on the occasion of the 13th annual AICPA conference on SEC developments. Commissioner Cox said that auditors need to assure both regulators and customers that they can and do maintain sufficient independence while performing management advisory or other non-audit services for their audit clients. He said that the challenge for the auditing profession will be to establish guidelines that eliminate even the appearance of impropriety in such engagements.

In concluding his remarks, and here is where he was really prescient, Commissioner Cox said that, although accountants have been given temporary control of their profession, they may find control wrested from them if they make misguided use of it. I have always believed that Commissioner Cox was one of the more thoughtful securities regulators we have had over the years.

Tuesday, June 12, 2007

CCH Analyst to Present Free Webinar on Reform of Section 404 Internal Control Regime

Jim Hamilton, CCH Principal Analyst, will present a free one-hour webinar on the new SEC and PCAOB Issuances on Internal Controls. Jim will explain and comment on the new regulations including:
* Why regulators felt a new approach was
necessary
* The broad principles behind the
guidance
* What the new issuances mean in practice
for auditors
Register today for your choice of June 15 or June 28. The webinar is free, but space is limited.

PCAOB Chief Auditor Examines New Internal Control Audit Standard

By James Hamilton, J.D., LL.M.

In the wake of the PCAOB’s adoption of a new auditing standard on internal control over financial reporting, the Board’s chief auditor, Thomas Ray, has examined AS5 and offered some important advice on this new principles-based standard. In remarks at the annual SEC and Financial Reporting Institute Conference, he said that the focus on fraud is an integral part of the identification and testing of entity-level controls (popularly known as company-level controls) under the new standard. In the chief auditor’s view, the area of entity-level controls is ripe for further innovation and development He also believes that the increased focus on principles in the new standard will permit the auditor to more easily and appropriately tailor the audit to a company's specific facts and circumstances.

According to the chief auditor, AS5’s top-down approach directs the auditor's attention to accounts, disclosures, and assertions that present a reasonable possibility of material misstatement to the financial statements. The risk of material misstatement, therefore, is an explicit focus of the approach.

Furthermore, this top-down approach describes the auditor's sequential thought process in identifying risks and the controls to test, not necessarily the order in which the auditor will perform the procedures. This thought process, emphasized Mr. Ray, is most important in identifying those controls that should be tested. The auditor is free to perform the testing in the order that makes most sense given the specific facts and circumstances of the company.
AS 5 drops the requirement that the auditor identify significant processes and major classes of transactions.

Rather, as a part of selecting the controls to test, the auditor should understand the flow of transactions related to the relevant assertions, including how those transactions are processed, and recorded. Thus, while these concepts of major classes of transactions and significant processes will continue to remain important and useful to auditors, observed the Board officer, to focus the auditor on them as an end in itself might have entailed work unrelated to risks of material misstatement. and reduced the ability of the auditor to tailor the work to the specific circumstances of the engagement. .

Monday, June 11, 2007

Using the Work of Others Is Integral Part of Internal Control Reform

An important aspect of the reform of the Sarbanes-Oxley internal control over financial reporting is allowing the outside auditors to use the work of others. The ability of auditors to use the work of others has a direct effect on the procedures that they must perform themselves. Auditors duplicating high-quality, relevant work that already has been performed by competent and objective individuals risks increasing effort without enhancing quality.

Thus, the PCAOB’s new internal control audit standard, AS 5, allows the outside auditor to use the work of others to obtain evidence about the design and operating effectiveness of internal controls. The standard uses a principles-based approach to determining when and to what extent the auditor can use the work of others.

These reforms are designed to drive down the costs of performing the audit of internal controls without sacrificing the integrity of the financial statements or investor protection generally.

Recognizing that issuers might employ personnel other than internal auditors to perform activities relevant to management's assessment of internal controls, the standard allows the auditor to use the work of the company’s internal auditors, other company personnel, and third parties working under the direction of management or the audit committee.

Consistent with the standard’s risk-based approach, the extent to which auditors may use the work of others depends on the risk associated with the control being tested. As the risk decreases, so does the need for auditors to perform the work themselves. Conversely, in higher risk areas, such as controls addressing fraud risks, using the work of others would be limited if such work could be used at all.

Importantly, AS5 also eliminates the principal evidence provision formerly contained in AS2. The principal evidence provision required that the auditor’s own work be the principal evidence for the auditor’s opinion. This provision had limited the use of the work of others, particularly in lower-risk areas.

Similarly, AS 5 eliminates the specific restriction in AS No. 2 on using the work of others for testing controls in the control environment. Application of the general principles in AS5 allows the auditor to use the work of others for testing certain aspects of the control environment when the competence and objectivity of the persons performing the work are sufficiently high.

Wednesday, June 06, 2007

Cox Calls for Repeal of Soft Dollars Safe Harbor

By James Hamilton, J.D., LL.M.

Noting that soft dollars are a ``witches brew’’ of hidden fees and conflicts of interest, SEC Chairman Christopher Cox has asked Congress to repeal or at least substantially revise the statutory safe harbor for soft dollars. In 1975, in order to facilitate the adjustment from fixed commissions to the new era of competition, Congress enacted Section 28(e) of the Exchange Act to allow investment advisers to pay higher than market rates for brokerage commissions as a way to cover the cost of research. The SEC chair said that the market considerations that gave rise to soft dollars are as out of date as the leisure suit. His remarks were delivered to the National Italian-American Foundation in NYC.

Since its passage in 1975, Section 28(e) has never been substantively amended; and many observers do not believe that it will be now. But even if it is not, the SEC chair has vowed that the Commission will continue to monitor the abuses in order to bring hidden soft dollar expenditures to light and ensure that, to the maximum extent possible, soft dollars are used only for research. The broad goal is to help investors get the information they need in a form they can readily use and understand.

Section 28(e) provides a safe harbor so that money managers do not breach their fiduciary duties solely on the basis that they have paid brokerage commissions to a broker-dealer for effecting securities transactions in excess of the amount another broker-dealer would have charged, if the money manager determines in good faith that the amount of the commissions paid is reasonable in relation to the value of the brokerage and research services provided by the broker.

Section 28(e) governs the conduct of all persons who exercise investment discretion with respect to an account, including investment advisers, mutual fund portfolio managers, fiduciaries of bank trust funds, and money managers of pension plans and hedge funds.

Conduct not protected by Section 28(e) may constitute a breach of fiduciary duty as well as a violation of the federal securities laws, particularly the Investment Advisers Act and the Investment Company Act.