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August 31, 2003

The Coming Changes For Soft Dollars: Regulatory Reforms Are Afoot, But How Much?

By Nina Mehta

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The massive flow of soft-dollar commissions continues to rile regulators and some investors. The source of the controversy is the big money paid for executions by many institutional money managers to Wall Street's trading firms. A percentage of the commission pays for execution, but a large proportion does not: It is "softed" to purchase research and other services for institutional customers.

Now there's a movement to rein in these soft-dollar payments, according to Jay Baris at the securities industry law firm of Kramer Levin Naftalis & Frankel. The regulators thought the "time hasn't been right" until recently to do anything, Baris said.

Baris was speaking at a recent conference on soft dollars. It was attended by some of the industry's most influential players, a group that provided a tantalizing glimpse of where this huge business is heading. For some the outlook may be grim in a commission business variously estimated to fetch between $1 billion and several billion dollars annually.

Joseph Corcoran, special counsel to the SEC's Division of Market Regulation, cited the concerns of agency staff with the law that gave birth to the modern soft-dollar business. It's referred to as Section 28(e), a "safe harbor" added to the Securities Exchange Act of 1934 in 1975, the year fixed commissions were finally abolished.

This safe harbor legally permits investment managers to pay more than the lowest available commission in exchange for various execution services and research. That's as long as the managers determine in good faith that the overall execution quality is competitive and fair. Before May 1, 1975, brokers competed for fund business by offering clients free research.

Corcoran said the staff's concern arises because Section 28(e) "allows money managers to use client commissions to pay for something they would otherwise have to pay for out of their own management fee."

"Historically it's been something the commission staff has been uncomfortable with," he added. "It's not a transparent process to the ultimate investor." Richard Marshall, a partner at the securities law firm of Kirkpatrick & Lockhart, suggested that the SEC views 28(e) as "collective bribery."

But if payment for research were to come out of the management fee rather than clients' commissions, management fees would rise, according to some experts. Lee Pickard, a partner at law firm Pickard & Djinis, which represents soft-dollar research providers, notes that new conflicts of interest would emerge. The change could cause a resurgence of principal trading, for instance, which would inhibit disclosure and transparency, said Pickard. Pickard headed the SEC's Division of Market Regulation in the mid-1970s.

Richard Kos, a vice president at Fleet Institutional Trading, suggests that the value of brokerage is sidelined in the debate on soft dollars. "We must bring the execution-quality piece of this into the analysis," he said. "I think research has been overpriced and execution has been underpriced."

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