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March 1, 2004

The Rise and Fall of Soft Dollars?

By Gregory Bresiger

Also in this article

  • The Rise and Fall of Soft Dollars?

The mutual fund industry's bitterest arguments have spread to the institutional trading world.

Soft dollars and directed brokerage are in the bullseye of trading and

Congressional critics. On Wall Street, the practices are the cause of repeated rows.

"It is a disgrace how soft dollars are used," said one buyside executive, who didn't want to be quoted by name. "Better tracking of the relationships is needed, mostly because the client just doesn't have an idea what is going on."

With comments like these frequently heard, could it mean soft dollars are headed for the dustbin of history?

Is it the end for these institutional trading arrangements, which were validated by the Securities and Exchange Commission's famous

section 28(e) rule of 1975. Soft dollars are now a vital part of the debate over reforming the mutual fund industry. This is the target of much criticism for its fee practices and its poor performance in the recent three-year bear market. The same kinds of arguments are present on the institutional trading side, says one industry professional. He says soft dollar abuses are rampant.

The lawmakers have heard these complaints before. Now several bills are pending on Capitol Hill that would do everything from ending soft dollars and directed brokerage to studying them and reducing permitted uses.

Universal Trouble

Ted Aronson, a portfolio manager and partner at institutional investment advisor Aronson+Johnson+Oritz, said his firm does not use soft dollars. He notes that the average institutional commission is 4.5 cents a share. However, Aronson says there is still a "lot of five and six cents a share transactions." Abuse is common, Aronson maintains, because the average broker "would have a tough time maintaining a straight face if he were to say that the costs of an average institutional trade exceed a penny a share."

Still, there's another reason besides the flow of commissions why regulators have a renewed interest in soft dollars. The SEC's Office of Compliance Inspections and Examinations (OCIE), some years ago, discovered a few abuses in a sweep of soft-dollar firms. But the regulators, many trading executives note, only found a handful of firms violating soft-dollar rules. And one ECN official said that the industry has been responding to complaints of soft-dollar violations.

"The heightened scrutiny is already having a positive effect," said William O'Brien, general counsel of Brut ECN. "The buyside is looking much more closely at how they spend their commission dollars. Before they were less sensitive to getting the lowest commission rate possible and the diversification of their commissions through multiple brokers."

Nevertheless, OCIE recommendations called for better record keeping by investment advisers and brokerages that use soft dollars, recommendations that have yet to be implemented.

So soft-dollar and directed brokerage relationships - along with 12b-1 and other mutual fund load charges - are now at the top of the to-do list of several lawmakers and trade group officials, who either want radical reform or termination.

Rep. Richard Baker (R-La), the chairman of the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, is pushing a bill that would require stronger soft- dollar disclosure standards, a bill that has been criticized by some in the trading industry.