Commission sharing arrangements are threatened by proposed guidelines from the Securities and Exchange Commission.
The regulator wants to impose stiff new requirements on the small "introducing" brokerages that provide research to money managers under the popular arrangements.
That could push some of these research shops out of CSAs and make it harder for money managers to pay for third-party research.
The proposal has put some independent research providers and Wall Street broker-dealers on the defensive. "By allowing introducing brokers to provide research, these arrangements make the research business more competitive," says Lee Pickard, senior partner at law firm Pickard and Djinis and a former director of the SEC's Division of Market Regulation.
"This [proposal] will reduce competition because smaller broker-dealers will have to struggle to meet these conditions."
Pickard, on behalf of the Alliance in Support of Independent Research, and several top brokerages have petitioned the SEC to rethink its recent pronouncements.
Commission sharing arrangements allow money managers to use commissions to pay for independent research without directing the trade to the provider. The trade is directed to an executing broker who shares part of the commission with the typically smaller broker-dealer supplying the research.
The arrangements are legit under Section 28(e) guidelines if the research brokers conform to certain standards.
CSAs have become more popular in the last few years as a way for money managers to pay for third-party research without compromising their best execution obligations.
Large shops such as Goldman Sachs, Morgan Stanley and Instinet have launched major commission sharing programs in recent years. These programs are now at risk.
Last October the SEC proposed guidance to clarify what constitutes brokerage and research under Section 28(e) of the Securities Exchange Act of 1934. The 28(e) safe harbor permits money managers to use client commissions to pay for brokerage and research services without breaching their fiduciary duty to clients.
As part of its reinterpretation of 28(e), the SEC also proposed conditions for CSAs to qualify for the safe harbor.
The SEC's proposal stresses the original intent of 28(e), which said research brokers must help in "effecting" the transaction and must do more than simply collect a check for providing research.
This was originally done to preclude give-ups, in which a money manager instructs an executing broker to give up part of its commission to another broker-dealer who may have had no role in that transaction and is not a "normal and legitimate correspondent" of the executing and clearing broker.
CSAs usually involve clearing arrangements that fall under SRO rules-NYSE Rule 382 or NASD Rule 3230-which lay out the respective functions of introducing brokers and clearing brokers.
However, the SEC said that SRO rules do not necessarily satisfy the 28(e) criteria. Its proposal suggested that the introducing broker must 1) be financially responsible to the clearing broker for customer trades until the clearing broker is paid; 2) make or maintain records relating to customer trades, including blotters and order memoranda; 3) monitor and respond to customer comments concerning the trading process; and 4) generally monitor the trading process and settlements.
The proposal generated a fair amount of pushback. Comment letters from both sides of the aisle-research brokers as well as execution and clearing firms-said the SEC's four conditions were vague and unclear, departed from the U.K.'s Financial Service Authority's more generous view of similar arrangements, and meddled unnecessarily in areas that the SROs already addressed.
"The proposed guidance should be revised," Instinet maintained in its comment letter. "If enacted, [it] could result in a de facto regulatory prohibition of certain commission sharing arrangements."
Money manager T. Rowe Price agreed. The section on CSAs has "created a number of concerns regarding the viability of such practices in the future," it said. Steven W. Stone, a partner and leader of the investment management practice group at law firm Morgan Lewis, points out that the SEC's proposal codifies existing guidance from 1986 and an earlier no-action letter involving SEI Financial Services. Consequently, the conditions weren't surprising.
However, he told Traders Magazine, "that doesn't mean that it makes sense in the current environment."
"The SEC ought to be concerned about the transparency of these arrangements, but also ought not create impediments to efficient arrangements," Stone says. In his view, there's a lot of variation in how CSAs are structured that was not factored into the SEC's proposed guidance. He hopes the SEC's final guidance, especially for cross-border trading, will be closer to the FSA's more accommodative approach toward CSAs.
Whatever the SEC decides, market participants remain stoic. "We can adjust our program accordingly," says Mike Plunkett, president of Instinet for North America, an institutional agency broker whose BrokerShare program is a CSA. BrokerShare paid out $14 million to the 200 research firms in its program last year, more than twice the amount paid in 2004.
Plunkett notes that not all clients are concerned about remaining within the safe harbor, but that for those clients that want their research within 28(e), Instinet would "create more of a defined third-party-type arrangement."
However, in his view certain benefits of CSAs might disappear if the proposed rules become law. "By separating their research and execution decisions, clients keep confidentiality about their trades throughout the entire trading process," Plunkett says. "Within the confines of the four conditions, that might not be possible."
Kristi Wetherington, president of Capital Institutional Services, an institutional agency brokerage and research provider based in Dallas, acknowledges that the SEC might be trying to cordon off 28(e) from smaller broker-dealers that are providing research and just receiving a check-"and if that's what it's doing, it makes sense," she says.
The head of an established independent research provider agrees. He suggests the SEC is trying to limit the activities of "file-cabinet brokers"-small broker-dealers that are not equipped to execute trades and are brokerages essentially in name only. Wetherington notes that if the four conditions go through as written, "there will be more record-keeping, but introducing brokers will rise to the occasion." Still, she thinks that how the responsibilities between introducing brokers and clearing brokers are divided should be determined by the parties involved, not by this interpretation by the SEC. The SEC's final guidance on client commissions and CSAs is expected sometime this spring, according to attorney Pickard.
