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."
Transaction Costs
Kos notes that transactions costs are notoriously hard to pin down. For institutional orders, for instance, a trade executed through a block trading desk is going to cost more in commissions than one sent through a direct-access broker, or ECN. Trades that are more difficult to execute, or less liquid, can also cost more between the commission, spread and market-impact costs.
But don't bet the SEC will soon abolish soft dollars.
"Personally, I don't think soft dollars are going to go away within the next few years," said Gene Gohlke, associate director in the SEC's Office of Compliance, Inspections and Examinations, "but maybe there will be some changes around the edges." Indeed, he told the conference the SEC may make some rule changes in the area of soft dollars.
But a stigma will likely persist. Soft dollars – and the related directed brokerage and commissions recapture practices – will continue to be depicted in many media as another way to fleece investors. That's been the case for over a quartercentury, with various reports and studies casting a cold eye on this explosive and somewhat secretive business.
It is a business associated with the listed agency market. In practical terms, it is based on a simple formula: Buyside institutional accounts are provided "free" third-party research and other services out of each unit amount of dollars spent on commissions. Directed brokerage is initiated by the fund and benefits the fund directly. In commission recapture, the broker sends cash to the client. Alternately, the broker can pay the client's direct fund expenses.
The average soft-dollar industry ratio is 1.49 to 1, according to a recent study by Greenwich Associates. That means $1 in "free" services are provided to the buyside for every $1.49 in commissions. Buyside firms that conduct significant amounts of business usually can negotiate ratios of between 1.25:1 and 1.35:1, according to some traders.
"The bedrock threshold issue is best execution," said attorney Marshall. The critical question, he noted, is whether best execution is attained, curtailed or otherwise impacted by the presence of soft dollar and directed brokerage arrangements.
Congress recently held hearings on the subject and new legislation is pending. Over the last year, the SEC has issued a number of tough interpretive comments.
SEC Sweep
In the mid-1990s the SEC conducted a "sweep" to flush out a range of soft-dollar practices. Since then some abuses have been stemmed. However, brokerage commissions continue to be used to purchase items that are not considered research – like office rent and conference travel expenses. Many record-keeping practices at trading firms have been criticized by regulators.
Only a few years ago, Paul Myners, the then-chairman of Gartmore Investment Management, conducted a study of institutional investment for the U.K. Treasury. His 2001 report, which identified soft-commission practices and problems, found that managers are better placed than clients to control execution costs. Still, they have less incentive to limit them. The report recommended unbundling commissions and possibly ending them.
The U.K's Financial Services Authority subsequently did its own study of bundled brokerage and soft-commission arrangements, a study known as FSA Consultation Paper 176. Bundled brokerage arrangements in the FSA report are similar to full-service brokerage arrangements in the U.S. Soft-commission arrangements in the U.K. correspond to what are third-party soft-dollar arrangements in the U.S.
The FSA paper, released in April, recommended limiting the goods and services beyond execution that can be bought with brokerage commissions. It also recommended limiting the costs that can be passed along to customers without their knowledge. C.P. 176 remains out for comment until next month.
Questions about the propriety of soft-dollar research in the U.K. have now upped the regulatory ante in the U.S.
Paul Roye, director of the SEC's Division of Investment Management, sent a lengthy report to Congress outlining mutual fund sales and distribution practices. A few months earlier, the General Accounting Office, the Congressional watchdog agency, produced a report on rising mutual fund fees.
In July, on the heels of the Roye report, Congressman Richard Baker's bill came down the pike in Washington. H.R. 2420, the "Mutual Funds Integrity and Fee Transparency Act of 2003," would mandate more disclosure of mutual fund soft-dollar practices, fees, and distribution arrangements. And it would require the SEC to study whether soft-dollar research provisions in existing laws should be altered or abolished.
The SEC has had discussions on the regulation of soft dollars with the U.K's FSA, said the SEC's Gohlke. In the meantime, the SEC may do some rulemaking. Part II of Form ADV for investment advisors, which is undergoing change, is still under consideration, said Gohlke. In the broker dealer area, a point-of-sale document could also be required.
With the negative attention on research, he added that bundled proprietary Wall Street research from full-service brokers could face the same demands likely to be felt in third-party soft-dollar arrangements. That's a demand for more transparency. There's an explicit cost for third-party research, he noted, but "theoretically [proprietary research] should be covered too, if anything is done with soft dollars." However, he conceded this would be difficult since soft-dollar relationships have become the customary way to deliver research to clients.
Gohlke also spoke out about a practice called revenue sharing. That occurs when a fund's investment adviser transfers money from asset management fees to broker dealers whose customers generated those assets in the funds. Some funds also use brokerage commissions to stimulate distribution.
"There's a big difference between a fund that executes a trade through a traditional full-service firm and one that executes through a clearing firm for an introducing broker where the introducing broker does nothing other than sell fund shares," he said.
Policy Reversals
Regulators and investors have been persistent critics of soft dollars. Many trading firms have been defenders of the practice over the years. But the politics of soft dollars sometimes have resulted in interesting policy reversals.
In Congressional hearings in 1993, Goldman Sachs and Morgan Stanley attacked the effectiveness of disclosure requirements for firms that used soft-dollar brokerage. They argued that clients did not understand the financial impact of brokerage commissions for third-party research. Despite the Naderesque concern for investors caught in the grip of money managers lapping up costly independent research with little accountability, they did not think the same logic applied to research and related services bundled into full-service brokerage. That's because they said that these services were generally provided "free" to clients.
Since then, there's been an about-face. Morgan Stanley and Goldman Sachs have retreated from their earlier positions, introducing soft-dollar programs. Michael McCreesh, a vice president in equities at Goldman Sachs, put the change in perspective at the recent industry soft-dollar conference. Goldman's earlier decision was wrong, he said. "It [soft dollars] was a business that was going to become core to many of our clients," he said. He said the business wasn't about to disappear and, in fact, it wasn't as bad as was popularly depicted. Morgan Stanley has also changed its position.
Legal Issues
In setting up a soft-dollar program, said McCreesh, brokers must understand the needs of investment managers, brokers, pension funds and directed intermediaries. It's critical to focus on legal and compliance issues, he added. Goldman requires clients to sign contracts outlining what is provided. A firm must also finesse the post-trade operational flow since problems in that area could erode a trading relationship.
Goldman does not have a separate trading desk for soft-dollar and directed trades. "We have an internal mechanism that allocates trades," said McCreesh, "so if a client has a 1-million-share trade, it may do 100,000 shares soft, another 50,000 directed." Goldman does soft, directed, capital and straight research trades for clients.
At the industry conference, sponsored by the Institute for International Research, J. David Griswold, director of global regulatory policy at Frank Russell Company, a global institutional services firm – and an early player in the directed brokerage arena – outlined how his firm organizes its buyside routine for research.
Griswold stressed the importance of establishing clear standards and good record-keeping. A money manager must know what research was purchased, the benefits, and the impact on investment decisions. Firms must also scrutinize the suitability of soft-dollar purchases and the quality of the disclosures. To satisfy proper oversight of research purchases, Russell has a soft-dollar committee that includes representatives from senior investment management, operations, the user side, as well as trading.
Meanwhile, mutual funds must clean up their act, if they want to stay on the good side of regulators, experts warn. Mutual funds are allowed to pay brokers for sales and distribution, but not under the Section 28(e) safe harbor. That is reserved solely for the investment manager's acquisition of brokerage and research services. Instead, a fund has two options. It can pay for distribution under NASD Conduct Rule 2830 or under Section 12b-1 of the Investment Company Act of 1940.
Rule 2830 governs the sale and distribution of mutual funds and other securities. Section 12b-1 outlines specific disclosure requirements, making the fee payments transparent, said Robert Wands, a first vice president at Capital Institutional Services, an institutional brokerage. However, complex accounting issues abound, so discerning what portion of five-cent trades paid for research vs. distribution is difficult. NASD also caps these fees at 1 percent of shareholder assets per year.
Wands' recommends "good legal counsel." Still, he noted that the trend in using fund brokerage to pay for distribution is to include commission payments in 12b-1 fees – especially since NASD 2830 does not encourage transparency and has gray areas. An investment manager with sub-advised plans may also prefer to take the 12b-1 route because of the specific disclosure requirements mandated.
Hedge Funds
Another group, hedge funds, must also consider their approach to disclosure. Marshall, the attorney with Kirkpatrick & Lockhart, notes that he's been questioned the most about Portfolio Advisory Services LLC, a hedge fund charged by the SEC last year with failing to seek best execution for its advisory clients. The hedge fund executed over-the-counter trades on a principal basis. It then instructed its prime broker to add a 5-cents-per-share commission to certain clients' trades, which was then sent to the referring brokers for those clients. That was done even though they provided no execution services.
Clearly, in an era of potential radical regulatory reform, no trading firm can afford to be complacent. Soft dollars is an issue, said Marshall, "that just won't go away."
