Soft Dollars, Commission Sharing and Research Payments: What a Cayman Hedge Fund Can Pay For

The soft dollars hedge fund managers use to buy research are the fund's money, not the manager's. Section 28(e) of the US Securities Exchange Act of 1934, read with the SEC's 2006 interpretive release, gives a US manager a safe harbour for paying higher commissions in return for eligible brokerage and research. It does not cover rent, salaries, travel or administrative software, and it says nothing about a UK or EU manager. Those managers must pay from their own resources, from a research payment account, or through a disclosed joint payment permitted in the UK since 2024 and in the EU since June 2026. For the Cayman fund, the controls are the offering document, the investment management agreement and a board that reviews research payments as a conflict.

"We ask one question of every manager who pays for research through commissions: if investors saw the invoice, would they agree the fund should be paying it? Section 28(e) tells a US manager what will not be treated as a breach of duty. It does not tell a Cayman board what is appropriate for its fund, and it says nothing to a manager regulated in London or Dublin. The disclosure has to be specific, the allocation has to be documented, and the board has to see the numbers. Commission-funded research is a fund expense that never appears in the expense ratio, which is exactly why it needs oversight." David Lloyd, Chief Executive Officer at CV5 Capital

Executive Summary

Research paid for through commissions is a fund expense controlled by the manager. The rules are jurisdiction specific, and the Cayman fund's own documents and board supply the controls.

• Section 28(e) is a US safe harbour for a manager who pays a broker more than another would charge, in exchange for eligible brokerage and research.
• The SEC's 2006 release sets a three-step test: statutory eligibility, lawful and appropriate assistance in investment decision-making, and a good faith determination on reasonableness.
• Rent, salaries, travel, hardware, compliance tools and mass-marketed publications sit outside the safe harbour, and commission sharing works only where the executing broker genuinely provides the research.
• MiFID II unbundled research from execution; the FCA reintroduced a guarded joint payment option from 1 August 2024, and the EU's amended Article 24(9a) applies from 6 June 2026.
• For the Cayman fund, the offering document, Form ADV Part 2A Item 12 for US advisers, and documented board review under CIMA's governance measures are the operative controls.

Who Actually Pays for Research

A hedge fund pays commissions when it trades. Part of each commission covers execution, clearing and settlement. Anything above that pays for something else, and in equity strategies that is usually research: analyst reports, corporate access, market data and analytical tools. The fund bears the cost. The manager receives the benefit, because it does not have to buy those inputs from its own fee.

That is the conflict in every soft dollar arrangement. A manager deciding where to route orders has an interest in the research it will receive, which may not match the fund's interest in best execution. It also has an interest in classifying as much of its own cost base as possible as research. Research can benefit investors, but the manager is spending investor money on its own inputs, and that needs eligibility, valuation, disclosure and oversight.

There is also an accounting consequence. Commissions are netted against trade prices rather than charged as an expense, so research bought this way never appears in the expense ratio. A fund with a lean disclosed ratio can still carry a substantial research bill through its trading, which is why CV5 reads research payments alongside the expense allocation policy that separates fund-borne from manager-borne costs.

The Section 28(e) Safe Harbour and the Three-Step Test

Section 28(e)(1) protects a person exercising investment discretion over an account. That person is not deemed to have acted unlawfully or breached a fiduciary duty solely because the account paid a broker more commission than another broker would have charged. The condition is a good faith determination that the commission was reasonable in relation to the value of the brokerage and research services provided. It is a safe harbour from a specific US claim, not a licence to spend.

The SEC's interpretive release of July 2006, Release No. 34-54165, sets out the framework. First, the product or service must fall within Section 28(e)(3). That covers advice on the value of securities or the advisability of investing, and analyses and reports on issuers, industries, securities, economic factors, portfolio strategy and account performance. It also covers effecting transactions and incidental functions such as clearance, settlement and custody. Second, the item must actually provide lawful and appropriate assistance in the manager's investment decision-making. Third, the manager must determine in good faith that the commissions paid are reasonable in light of the value received.

One further limit matters. The safe harbour covers commissions on agency transactions and fees on certain riskless principal transactions, not principal trades or instruments traded net with no explicit commission. A credit, FX or futures manager therefore has far less room to use Section 28(e) than an equity manager. The release also says the prudent way to show eligibility is to document the arrangements fully.

Inside and Outside the Safe Harbour

The 2006 release drew the line more tightly than its predecessors. Eligible research must reflect the expression of reasoning or knowledge. Products with inherently tangible or physical attributes, such as telephone lines and office furniture, cannot be advice, analyses or reports. Mass-marketed publications are treated as overhead. Where a product has a mixed use, the manager must allocate its cost reasonably according to use and keep adequate records of the split.

Mixed use is where most disputes arise. A trade analytics package used both to inform trading and to test whether the manager achieved best execution is, in the release's own words, a mixed-use product. The compliance portion must be paid with the manager's own money. The release adds that the allocation decision is itself a conflict that should be disclosed, so the methodology belongs in the board's record. Corporate access follows the same logic: a meeting at which executives discuss performance can be eligible research, but the travel and entertainment around it are not.

Commission Sharing and Client Commission Arrangements

A commission sharing arrangement, which the 2006 release calls a client commission arrangement, lets a manager concentrate execution with brokers that trade well while buying research from providers that do not. The executing broker keeps the execution component of each commission and credits the balance to a research pool. The manager then directs the broker to pay research providers from that pool, including independent firms. The decision about where to trade is separated from the decision about whose research to buy.

The release makes this work by reinterpreting the statutory requirement that research be provided by the broker effecting the transaction. A broker not itself obligated to pay for the research can still provide it, and the release identifies three attributes that support that conclusion. It pays the research preparer directly. It reviews the services for red flags indicating they fall outside Section 28(e) and agrees with the manager to use commissions only for eligible items. And it maintains procedures so that research payments are documented and paid promptly.

The release is equally clear about what the arrangement cannot become. A broker that merely pays obligations the manager owes to a third party is not providing research. The practical test for a Cayman board is whether the pool pays named research providers for defined services, or has become a general account from which the manager's bills are settled. The first is a client commission arrangement. The second is an undisclosed fee.

Commission sharing also interacts with trade allocation. Research bought with the fund's commissions may benefit managed accounts that did not pay for it. The pari passu logic CV5 sets out for running a fund and managed accounts side by side applies to research credits as much as to fills.

The UK and EU Position: Unbundling and What Changed

MiFID II took a different route. Article 24(8) of Directive 2014/65/EU prohibits a portfolio manager from accepting and retaining fees, commissions or any monetary or non-monetary benefit from a third party, other than clearly disclosed minor non-monetary benefits. Broker research received in exchange for commissions is a benefit of that kind. Article 13 of Commission Delegated Directive (EU) 2017/593 supplies the exemption: research is not an inducement if paid for from the firm's own resources or from a separate research payment account controlled by the firm. That account must be funded by a specific research charge to the client, based only on a budget and not linked to the volume or value of transactions.

Many firms found the research payment account operationally heavy and paid for research from their own profit and loss account instead, which the UK's Investment Research Review identified as a constraint in 2023. The FCA responded with Policy Statement PS24/9 in July 2024. The amended rules in COBS 2.3B came into force on 1 August 2024 and allow joint payments for third-party research and execution, provided the firm meets the guardrails in the table below. PS25/4 extended an equivalent option to UK fund managers through COBS 18 Annex 1 from 9 May 2025.

The European Union followed. Article 24(9a) of MiFID II, inserted in 2021 with a joint payment option limited to research on issuers below EUR 1 billion in market capitalisation, was amended by Directive (EU) 2024/2811 under the Listing Act. The cap is removed. Joint payments are permitted where the firm has an agreement with the provider establishing a remuneration methodology, informs clients whether it pays jointly or separately, and assesses annually the quality, usability and value of the research used. Member States had to apply the amendment from 6 June 2026.

The manager's home rules follow the manager, not the fund. A UK manager that wants to pay for research through a Cayman fund's commissions must operate the joint payment guardrails or a research payment account, and the offering document must describe the route used. The US safe harbour is irrelevant to that manager's own position. It still matters to US brokers on the other side, and the FCA noted in PS24/9 the difficulty UK managers face in receiving research from US firms registered both as broker-dealers and investment advisers.

What the Offering Document and Form ADV Must Say

Section 4(6) of the Mutual Funds Act (2025 Revision) requires the offering document of a regulated mutual fund to describe the equity interests in all material respects. It must also contain such other information as is necessary to enable a prospective investor to make an informed decision. Whether the fund's commissions will pay for research, on what basis and for whose benefit is information of that kind. CIMA's Statement of Guidance on Corporate Governance for Mutual Funds and Private Funds adds that the conflicts of interest policy should be clearly described in the offering documents.

The disclosure should be specific. It should state that the manager may cause the fund to pay higher commissions than another broker would charge in return for research. It should describe the categories of research and brokerage obtained, and say whether the manager relies on Section 28(e) or on a UK or EU route. It should explain how research credits are allocated between the fund and other accounts, and confirm that the manager pays for anything outside the applicable regime. Investors who know what the offering memorandum should contain and why will look for this section, and its absence is a diligence finding in itself.

For a US registered adviser, Form ADV Part 2A Item 12 governs the disclosure. The adviser must explain that it benefits from soft dollars because it does not have to pay for the research. It must disclose that it may have an incentive to select a broker for the research rather than for the client's interest in most favourable execution, and whether it causes clients to pay up. It must say whether the benefits serve all accounts or only those that paid, describe the products acquired with client commissions in the last fiscal year, and explain how it directed transactions in return. Conflicts and fee disclosure remain examination priorities, as CV5 set out in its review of the SEC's 2026 examination priorities for offshore managers.

The investment management agreement should match the disclosure: authority for client commission arrangements on the terms described, an obligation to keep the records the applicable regime contemplates, and a right for the board to periodic reporting. An agreement silent on research payments leaves the manager relying on general authority if an investor later challenges a specific payment.

The Cayman Fund Board's Oversight Role

The fund pays the commissions, so its governing body must satisfy itself that the arrangement is appropriate. CIMA's Rule on Corporate Governance for Regulated Entities, effective 14 October 2023, requires the governing body to establish a documented conflicts of interest policy and to record conflicts in the minutes of the meeting to which they relate. The policy must include procedures for related party transactions on an arm's length basis. The Statement of Guidance provides that operators must suitably identify, disclose, monitor and manage all conflicts of interest and should require regular reporting from the investment manager. Commission-funded research is a standing conflict within those measures.

Commission arrangements are rarely tabled unless someone asks. The request belongs on the board's wider risk oversight agenda. The table below sets out what the board should see.

An annual deep review with a standing quarterly summary is proportionate for most funds, consistent with the size and complexity standard in CIMA's measures. What matters is that the minutes show the conflict was identified, the numbers were tabled and the board reached a conclusion. A board that has never seen the research budget cannot evidence oversight of it, and operational due diligence will ask. The pattern is the one boards already apply to cross trades and principal transactions: disclosure plus documented independent review.

Common Mistakes

• Relying on Section 28(e) for a UK or EU manager, whose own inducement rules govern what it may receive from brokers.
• Treating commission-funded research as free because it does not appear in the expense ratio; the expense ratio benchmarks by AUM exclude it entirely.
• Using commissions for mixed-use tools without a documented allocation, or for travel, data terminals and compliance software that fall outside every regime.
• Letting a client commission arrangement become a general payment facility for the manager's invoices.
• A board that has approved the conflicts policy but has never been shown the research budget, and so cannot evidence the oversight the policy promises.

Key Takeaways

• Identify at formation which regime governs the manager's research payments, because the US, UK and EU routes require different records.
• Write a specific soft dollar and research payment section into the offering document and align the investment management agreement with it.
• Require the manager to maintain an eligibility list, a mixed-use allocation methodology and a documented value assessment, and have the board see them at least annually.
• Report commissions split between execution and research in the same board pack as the expense ratio, so the full investor cost is visible.
• Confirm in writing how research credits generated by the fund are allocated across managed accounts and other vehicles.
• Keep the execution decision separate from the research decision and evidence it through the manager's own best execution policy and review.

Frequently Asked Questions

What are soft dollars in a hedge fund?

Soft dollars are the portion of brokerage commissions paid by a fund that a broker uses to provide research or other services to the manager, rather than to execute trades. The fund bears the cost through higher commissions and the manager receives the benefit. In the United States, Section 28(e) of the Securities Exchange Act provides a safe harbour where the research is eligible and the manager determines in good faith that commissions are reasonable relative to the value received.

What can a manager pay for under the Section 28(e) safe harbour?

Eligible research includes research reports, analyst discussions, meetings with corporate executives, substantive seminars, market and economic data, and analytical software that reflects reasoning or knowledge. Eligible brokerage covers execution, clearing and settlement from order transmission until the trade settles. Overhead such as rent, salaries, travel, hardware, compliance tools and mass-marketed publications is outside the safe harbour and must be paid by the manager.

How does a commission sharing agreement work?

The executing broker retains the execution component of each commission and credits the remainder to a research pool. The manager directs the broker to pay research providers from that pool, including independent research firms. The SEC's 2006 release expects the broker to pay the provider directly, review the services for items outside the safe harbour and maintain procedures so payments are documented and made promptly. This separates the choice of execution broker from the choice of research provider.

Does Section 28(e) apply to a UK or EU manager of a Cayman fund?

No. Section 28(e) is a US statute that protects a manager against a claim of breach of duty under US law. A UK or EU manager is governed by its own inducement rules, which require research to be paid for from the manager's own resources, from a research payment account, or through a joint payment made under the FCA's COBS 2.3B guardrails or the amended MiFID II Article 24(9a). The Cayman fund's offering document must describe whichever route the manager uses.

Can a UK manager use bundled commissions to pay for research again?

Yes, subject to conditions. The FCA's Policy Statement PS24/9 introduced a joint payment option for investment firms from 1 August 2024, and PS25/4 extended an equivalent option to UK fund managers from 9 May 2025. The firm needs a written policy, a methodology that separately identifies the research cost, a budget not linked to trading volumes, a fair allocation across clients, an annual value assessment and client disclosure. Own resources and research payment accounts remain available.

What should a Cayman fund board review on soft dollars?

The board should see total commissions split between execution and research, the manager's list of products paid for and their eligibility classification, the mixed-use allocation methodology, the good faith or value assessment, how research credits are allocated across accounts, and evidence that broker selection was driven by execution quality. CIMA's corporate governance measures require conflicts to be identified, disclosed, monitored and minuted, and commission-funded research is a standing conflict of that kind.