Section 28(e) is a provision of the US Securities Exchange Act of 1934. It's what's known as a “safe harbor” that allows investment managers to use their clients' commission dollars to pay for “research and brokerage services” from broker-dealers. In simple terms, it lets a fund manager pay a broker a bit more for executing a trade, provided that the broker also gives the manager valuable research that ultimately helps their clients. This is a big deal because, without this rule, paying anything other than the lowest possible commission could be seen as a breach of the manager's fiduciary duty to act in their clients' best interest. The arrangement where commissions are used to pay for services is often referred to as a soft dollars arrangement.
At its core, Section 28(e) addresses a fundamental conflict. A fund manager has a duty to get the best possible deal for their clients when buying or selling securities, a principle known as best execution. This usually means finding the lowest commission fee. However, what if a broker charges a slightly higher commission but also provides brilliant, exclusive research reports that help the manager make much better investment decisions for those same clients? Section 28(e) says this is permissible, as long as the manager determines in good faith that the commission paid is reasonable in relation to the value of the brokerage and research services received. It's a trade-off: a slightly higher execution cost for (supposedly) superior investment insights that benefit the end investor.
This is where things get tricky. The US Securities and Exchange Commission (SEC) has defined what qualifies as legitimate research, but there's still a lot of room for interpretation.
Generally, services that help the manager in their investment decision-making process are allowed.
Things that are more about running the business than making investment decisions are a no-go.
The temptation for managers to use client commissions to cover their own operating costs is obvious, which is why this is a hotly debated topic.
For a value investor, transparency and aligned incentives are paramount. Section 28(e) can look like a direct threat to both.
The core problem is that soft dollar arrangements can incentivize a manager to direct trades not to the broker who offers the best price, but to the one who provides the most “goodies.” Are those “goodies” genuinely market-beating research that benefits you, the investor? Or are they just perks that make the manager's life easier, paid for with your money? It creates a classic agency problem where the manager (the agent) might not be acting purely in the interest of the client (the principal). A diligent investor should question whether their fund manager is truly getting value or simply outsourcing their research costs.
If you're an investor in Europe, the landscape is dramatically different thanks to a regulation called MiFID II (Markets in Financial Instruments Directive II), which took effect in 2018. MiFID II effectively dismantled the soft dollar system in the EU by forcing a great “unbundling.”