On July 31, Securities and Exchange Chairman Christopher Cox testified before the Senate Banking Committee. Among the many issues broached was soft dollars. Two months prior, Cox had sent letters to the Senate banking and House financial services committees imploring representatives to “consider legislation that would repeal or substantially revise Section 28(e).” That is the section of the Securities Exchange Act of 1934 that permits money managers to use their customers’ commission dollars to pay for research. The letter was unexpected and unwelcome in many quarters of Wall Street and Washington. Most industry executives and legal types had believed the soft dollar issue was mostly closed after the SEC issued an “interpretation” last July clarifying and narrowing the definition of research. Sen. Charles Schumer (D-N.Y.), a member of the
banking committee, and closely identified with Wall Street, especially took umbrage with Cox’s letter. Schumer responded with his own letter, in which he questioned the need for Congress to act and emphasized his hope that the SEC would soon produce guidance on soft dollars disclosure. At the hearing, the New York senator expressed his displeasure with Cox’s move and questioned the need for legislative action. For his part, Cox, despite his letter’s critical stance, struck a conciliatory tone. Below are excerpts from the hearing.
Schumer: I’ve always believed there should be a vibrant independent research industry- well-regulated to protect investors. So I applauded the steps you took when you first became chairman to speed up the new process of issuing the new guidance on the appropriate use of soft dollars, which culminated in a unanimous SEC interpretive release in July of 2006.
Soft dollars, as we know, are critical to independent research, and the SEC’s release was an important first step in providing clarity on the appropriate use of soft dollar payments. There have been abuses, but we don’t want to throw out the baby with the bathwater. But this guidance by itself is not sufficient, as many people have pointed out. Disclosure rules are still necessary, and you acknowledged this when you publicly agreed to create new disclosure rules on soft dollars. Disclosure rules, if well crafted, would allow fund investors, managers and boards to see how their commission dollars are spent and evaluate the value of independent research. Since that time, when everyone thought we were making great progress, we haven’t heard of any new developments on SEC soft dollar disclosure rules. Instead, you sent, at least in my view, an unexpected, and, I think, inappropriate letter when you suggested that legislative intervention to fix the abuses of soft dollars was required. This came as a huge surprise, because it was unclear what evidence there was of soft dollar abuses. Since the SEC issued a report on soft dollars in 1998, there have only been three SEC enforcement actions involving client commissions-none of them involve 28(e).
Given all of this, what is the great need here to push comprehensive legislative solutions over the more easily available and more appropriate SEC rules? So with this in mind, I have three questions-they mirror the questions I sent to you in a letter on July 20: First, when do you expect the SEC to issue its disclosure guidance on soft dollar commissions? Second, as recently as July 2006, you supported new disclosure guidance for soft dollar commissions. Has your view changed since then? Finally, what factors support a need for immediate legislation without first exploring the available options under the SEC’s rule-making authority?
Cox: We are awaiting recommendations from the Division of Investment Management to require investment advisors to increase transparency, and our staff is simultaneously looking at NASD recommendations on this, too. And because of my own priority that I place on this, “ASAP” is the answer.
Schumer: Good. That couldn’t be a better answer.
Cox: Second, no, my view has not changed since 2006 on this. Third, what is the immediate need for legislation? In one sense, none at all, since this is such a hoary problem.
But the problem has been around for a long time. So the fact that we’ve gotten along with it for a while doesn’t mean that it shouldn’t be addressed. The problems that I see are persistent, and they are built-in. They start with the fact that this overly complicated approach that is completely a regulatory construct is difficult to administer. It probably results in higher brokerage costs for investors. And, in any case, it induces money managers to direct trades to broker-dealers that offer research that the money manager wants, rather than [those that] can best execute the advisory client’s transactions. That is just built into the way it works.
In a purely efficient market, where research was prized, the research would be priced according to quality and the efficiency of its production and its availability and timeliness and so on. We need to do everything possible to promote research. I think we are all square on that objective. Research is vital. The information that makes markets work is what we promote at the SEC, so anything that would harm research is something we should not just shy away from, but run away from. I think that in posing these questions and describing these problems, I didn’t presume to have the answers, but I will leave it at the water’s edge, as it were, for the SEC, because it is not within our statutory…
Schumer: Does the SEC have any knowledge of recent abuses? As I said, there have only been three enforcement actions. None of them involved 28(e) since 1998. Are you aware of things that we are not, in terms of abuses?
Cox: The abuses that have gone on in the past we hope we have gotten rid of as a result of our interpretive guidance-people were spending it on carpeting and country club memberships, etc.
Schumer: So why is there a need for legislation?
Cox: Now the problem is not abuse that we can go after legally because it is legal. The problem is what is legal and whether or not that is good. But we are not going to bring an enforcement action against anyone doing something perfectly legal.
Schumer: I still don’t quite get why there is a need for legislation when about six months or a year ago, everyone thought the disclosure rules would basically do the job.
Cox: The disclosure rules, and whatever we can do further by recommendation from the Division of Investment Management, will take us as far as we can go. It will exhaust our capacity to deal with soft dollars at all. So it may be that the Congress decides that 28(e) today in the 21st century makes just as much sense as it did when we got rid of fixed commissions.
Schumer: But you have no specific legislative recommendations to make to the Congress?
Cox: No.
Schumer: You are just saying if you want to go further that you need legislation.
Cox: Exactly.
Schumer: You are not taking a position as to whether we do or not.
Cox: Well, I am certainly taking a position on whether you ought to think about it. I want to be completely deferential beyond that.
Schumer: Thank you.
