1. Use of a broker affiliated with a fund A fund management company may have an affiliated broker-dealer and may use that broker-dealer to trade under certain circumstances. For example, Merrill Lynch may act as a broker on behalf of a fundfund to the NYSE for executionbroker in the trading crowd or an order held by the NYSE specialist. Rules adopted by the SEC under the 1940 Act generally permit a broker who is affiliated with a fund’s adviser to effect trades for the fund as an agent, so long as the commission charged is no more that the “usual and customary” commission prevailing in the market. The SEC’s rules require a fund’s board of directors to adopt procedures that are designed to monitor compliance in this regard and to make determinations on at least a quarterly basis that all trades carried out by a fund’s affiliated broker meet the “usual and customary” commission standard.

Although an affiliated broker may act as agent for the fund (and receive a brokerage commission for executing the fund’s trades), the 1940 Act broadly prohibits a fund’s adviser and affiliates of an adviser from acting as a dealer in relation to the fund—that is, from selling any security or other property to (or purchasing any security or property from) the fund. This core provision of the regulatory scheme is intended to preclude conflicts of interest that could arise if a fund’s affiliated broker “dumps” unwanted securities from its inventory into the portfolio of the fund.

FundsHowever, in certain instances (often involving municipal securities), there may be a scarcity of supply in the market or a limited number of market makers, and a broker• dealer affiliated with a fund’s adviser may be the leading market maker in the security. To allow for sales of securities in these circumstances, the SEC considers requests from broker-dealers for limited exemptions from the prohibition against trading as principal with an affiliated fund.

The 1940 Act contains a related prohibition that prevents a fund from purchasing shares being distributed in a public offering in which a broker-dealer affiliated with the fund’s adviser participates in the underwriting syndicate. This prohibition is intended to address the potential conflict of interest that could lead the broker-dealer to cause an affiliated fund to purchase securities in an offering, although such securities might be unattractive or unfavorably priced. By rule, the SEC has allowed a limited exception that permits funds to purchase up to 25% of the securities distributed in such an offering, provided that the funds do not purchase directly from the adviser’s affiliated broker-dealer participating in the syndicate and that the affiliated broker-dealer does not participate in any profits from the funds‘ purchases from other syndicate members. Here again, the SEC has placed special responsibility on the fund’s board of directors to adopt procedures to monitor compliance with this limited exception and to make quarterly determinations that fund purchases in underwritings in which an affiliated broker participates comply with the rule’s conditions.

  1. Use of soft dollars. Historically, brokers have offered “bundled” rates for the execution of trades and the provision of research and related brokerage services.This practice arose during the era of fixed commission rates (which were finally abolished in 1975). By receiving research and other services from brokers in return for the payment of brokerage commissions, institutional investors could obtain indirectly what they could not obtain directly before 1975: discounts from fixed commission rates. Bundled rates have survived the deregulation of commission rates, as brokers (other than so- called discount brokers) have sought to avoid posting rates for trade execution-only services. The lack of transparency in the pricing of institutional brokerage services has enabled brokers to negotiate different arrangements among their institutional customers, including mutual funds, for the provision of research and other related services for so-called soft dollars—that is, the portion of a brokerage commission that exceeds the level that might otherwise be paid for “execution-only” services.

When Congress amended the securities laws in 1975 to eliminate fixed commission rates, it added a provision, Section 28(e) of the Securities Exchange Act of 1934, that permits a fund adviser or other investment manager to pay commissions to a broker that exceed the rates offered by other brokers if the adviser makes a good-faith determination that the commissions are reasonable in relation to the brokerage and research services provided by the broker. Under the statute, the research services obtained through the payment of soft dollars need not benefit the particular client whose commissions paid for the research but may instead benefit other clients (or all clients) of the adviser—for example, all funds in a complex. For these purposes,”research” services are construed broadly by the SEC to include the full range of services that assist a manager in carrying out its investment decision-making responsibilities. Research services encompass the generation of investment ideas; financial, economic, political or legal analyses bearing on prospects for a company or industry; the transmission of securities trade and quotation data as well as financial news; the measurement or analysis of fund trading and other aspects of fund performance; and computer hardware and software used to transmit or store research.

In reliance on this broad authorization, a fund’s trader may decide not to send trades to a discount broker with low commissions for execution-only services and instead send those trades to a full-service broker that regularly provides useful securities research to the adviser or actively shops for matches on difficult fund trades. The research may be generated by the broker executing trades for the funds or may be obtained by that broker from another source (so-called third-party research).The research need not take the form of investment analysis, but may consist of electronic “feeds” of trade and quotation data from vendors such as Reuters or Bloomberg.

In managing the execution of fund orders, a fund’s trader has other possible objectives in addition to trade execution and research. First, although some brokers may be unwilling to negotiate explicit discounts from their posted bundled rates, they may be willing to remit or rebate part of their commission to offset other expenses of their institutional customers.A mutual fund may thereby be able to reduce some of its custody expenses or transfer agent expenses—for example, when a broker agrees to direct some of the commissions it receives to the custodian or transfer agent of the fund. Such “recapture” of a portion of a brokerage commission directly benefits the fund generating the commission by reducing its operating expenses.

Second, a fund’s trader may direct commissions to broker-dealers who also distribute the fund’s shares. Under the rules of the NASD, such “directed brokerage” is permitted so long as the practice does not undermine the ability of the fund to seek the best execution of its trades and the fund discloses in its prospectus the policy of considering the sale of fund shares as a factor in the selection of broker-dealers to execute portfolio transactions. The NASD rules also prohibit binding contractual commitments or conditions for the award of brokerage commissions to a broker-dealer in exchange for its distribution of fund shares.

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