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November 1, 1998

SEC Soft-Dollar Report: Surprise Surprise?

By Jeffrey L. Winograd

Are there any real surprises contained in the Securities and Exchange Commission's recent report on soft-dollar practices? Yes and no.

On the surface, the report, based on the SEC's sweep of 75 broker dealers and 280 investment advisers, seems tame.

It contains, for instance, a series of staff recommendations aimed at improved reporting and disclosure. The report also notes an undisclosed number of referrals to the SEC's Division of Enforcement for further investigation, as well as the voluntary repayment by advisers of approximately $4 million to clients, "as a direct result" of the sweep and earlier inspections.

Careful Reading

But a careful reading suggests it would not be wise to leave the report to collect dust, one expert says. "There is an awful lot in it," said Lee Pickard, the Washington-based counsel to the Alliance in Support for Independent Research, a soft-dollar trade group.

For example, the sweep found that 35 percent of the broker dealers and 28 percent of the advisers scrutinized provided and received non-research products and services in soft-dollar arrangements.

Some advisers were found to be using soft dollars to pay for office rent, cellular telephone service, legal expenses and hotel and rental-car costs.

Inadequate disclosure of soft-dollar arrangements by advisers to their clients, and the improper allocation of the cost of so-called mixed-use items, were also problematic, according to the report.

Under soft-dollar practices, products or services other than executions of securities transactions are obtained by an adviser from or through a broker dealer in exchange for the adviser directing client brokerage transactions to the broker dealer.

SEC rules require an individual or firm to exercise investment discretion over an account in order to use client commissions to obtain research under Section 28(e) of the Securities Exchange Act of 1934.

After the SEC abolished fixed commission rates in 1975, Congress created a safe harbor under Section 28(e). The safe harbor was designed to protect advisers from claims they had breached their fiduciary responsibilities, by causing clients to pay more than the lowest available commission rates in exchange for research and executions.

The test is whether products and services obtained by advisers with soft dollars provide lawful and appropriate assistance to the adviser in the performance of investment decision-making responsibilities.

Recognizing the conflict of interest that exists when an investment adviser receives research, products or other services as a result of allocating brokerage on behalf of clients, the SEC requires advisers to disclose soft-dollar arrangements to their clients.

The SEC's staff recommendations outline four areas of concern:

* The need to clarify the scope of the statutory safe harbor, and to emphasize the obligations of all participants in soft-dollar arrangements. Safe-harbor protections relating to the uses of electronically-provided research and items that may facilitate trade execution also warrant clarification.

* The adoption of recordkeeping requirements that would provide greater accountability for soft-dollar transactions and allocations.

* The revision of reporting requirements to ensure more meaningful disclosure about the products received that are not used in the investment decision-making process. Advisers should also be required to provide more detailed information when requested by clients.

* The strengthening of adviser and broker-dealer internal-control procedures regarding soft-dollar activities.

Step Forward

Pickard views these recommendations as "a step forward, yet not a radical step forward. For the first time since 1983, the staff has at least been talking about the definition of research under Section 28(e)."

Rep. John Dingell (D-Mich.), the ranking Democrat on the House Commerce Committee, disagreed.

"The SEC has found serious, and in the case of disclosure, widespread violations and problems," he said. "But, the SEC's recommendations for addressing the problems fall woefully short."

The sweep examined $274 million in soft-dollar payments for third-party research. This represented an estimated 32 percent to 41 percent of all soft-dollar commissions paid for third-party research by advisers from January 1996 through October 1996.