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May 10, 2006

Commission Sharing Deals Come Under Fire

By Nina Mehta

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  • Commission Sharing Deals Come Under Fire
  • Page 2

Commission sharing arrangements are threatened by proposed guidelines from the Securities and Exchange Commission.

The regulator wants to impose stiff new requirements on the small "introducing" brokerages that provide research to money managers under the popular arrangements.

That could push some of these research shops out of CSAs and make it harder for money managers to pay for third-party research.

The proposal has put some independent research providers and Wall Street broker-dealers on the defensive. "By allowing introducing brokers to provide research, these arrangements make the research business more competitive," says Lee Pickard, senior partner at law firm Pickard and Djinis and a former director of the SEC's Division of Market Regulation.

"This [proposal] will reduce competition because smaller broker-dealers will have to struggle to meet these conditions."

Pickard, on behalf of the Alliance in Support of Independent Research, and several top brokerages have petitioned the SEC to rethink its recent pronouncements.

Commission sharing arrangements allow money managers to use commissions to pay for independent research without directing the trade to the provider. The trade is directed to an executing broker who shares part of the commission with the typically smaller broker-dealer supplying the research.

The arrangements are legit under Section 28(e) guidelines if the research brokers conform to certain standards.

CSAs have become more popular in the last few years as a way for money managers to pay for third-party research without compromising their best execution obligations.

Large shops such as Goldman Sachs, Morgan Stanley and Instinet have launched major commission sharing programs in recent years. These programs are now at risk.

Last October the SEC proposed guidance to clarify what constitutes brokerage and research under Section 28(e) of the Securities Exchange Act of 1934. The 28(e) safe harbor permits money managers to use client commissions to pay for brokerage and research services without breaching their fiduciary duty to clients.

As part of its reinterpretation of 28(e), the SEC also proposed conditions for CSAs to qualify for the safe harbor.

The SEC's proposal stresses the original intent of 28(e), which said research brokers must help in "effecting" the transaction and must do more than simply collect a check for providing research.

This was originally done to preclude give-ups, in which a money manager instructs an executing broker to give up part of its commission to another broker-dealer who may have had no role in that transaction and is not a "normal and legitimate correspondent" of the executing and clearing broker.

CSAs usually involve clearing arrangements that fall under SRO rules-NYSE Rule 382 or NASD Rule 3230-which lay out the respective functions of introducing brokers and clearing brokers.

However, the SEC said that SRO rules do not necessarily satisfy the 28(e) criteria. Its proposal suggested that the introducing broker must 1) be financially responsible to the clearing broker for customer trades until the clearing broker is paid; 2) make or maintain records relating to customer trades, including blotters and order memoranda; 3) monitor and respond to customer comments concerning the trading process; and 4) generally monitor the trading process and settlements.