What Are Soft Dollars? How Do They Work Today?

Soft dollars, according to the Barron's Finance and Investment Handbook, are "the paying of brokerage firms for their services through commission revenue, rather than through direct payments, known as hard-dollar fees."

Ted Aronson of Aronson+Johnson+Ortiz, offers a simple definition."Soft dollars are any commissions that are not used to achieve best execution." However, there's a Catch 22 to Aronson's explanation. "No one knows how to define best execution," he conceded. Whatever soft dollar arrangements are – and there are more than a few professionals who would disagree with Barron's or Aronson's version – they have a considerable history.

Soft dollars were legally sanctioned not by the market, but by Congress and the regulators in the wake of May Day 1975 when commission rates were de-regulated. Back then the SEC enacted Section 28(e), an amendment to the Securities Act of 1934. Investment advisers using soft dollars, under the section, must use the credit to provide "lawful and appropriate assistance" to the account manager carrying out responsibilities, the SEC said.

Ultimately, this critical section was put on the books because of fears that the elimination of fixed commissions – bringing competition to a business that had never had this competition before – would lead to dirt-cheap prices. Without this safe harbor, managers who passed up the brokerage 99 cent store could be accused of breaching their fiduciary obligations. Still, the key goal of May Day 1975 was giving the retail investor a better deal.

For example, Aronson says in the days of fixed commissions, the average was 29 cents a share and there was a pre-cursor of soft dollars called "giveups." This was where a broker executed a trade at 29 cents a share, directing a portion of that business that produced research. "So soft dollars existed even when they weren't necessary," Aronson said.

The regulators of the mid-1970s obtained part of what they wanted. The four-cent average was what the regulators were hoping to achieve, but they also feared that this competition would be too tough for smaller brokerages.

And that would mean smaller broker dealers would not be able to afford research services. Section 28(e) was also born because the regulators believed that investment managers, or funds, would be so concerned about obtaining the cheapest commissions, they would no longer care about the quality of a broker dealer's execution. Soft dollars were born.

How does it work?

Here is one example of this type of transaction: A mutual fund might offer to pay for the research of a brokerage by executing trades generated by that research through the brokerage. The brokerage, working with that fund, might sign on to a soft-dollar arrangement if the fund manager agreed to generate at least $100,000 in commissions with the broker that year.

Another example of a typical soft-dollar transaction could involve third parties – the soft- dollar broker, a third-party research firm and an investment management firm. The investment manager buys services for the research firm using soft dollars. The manager selects a soft-dollar broker. The research firm then bills a broker on behalf of the investment manager for the actual amount, say $50,000. The soft-dollar broker sends a check in the full amount to the research firm. The investment manager has fulfilled its obligations to the research firm.

The broker now issues soft-dollar credits to the investment firm. It's usually at the industry standard ratio of 1.5, which, in this case, would amount to $75,000. The investment firm can use these credits as the equivalent of trading commission dollars. The investment firm goes ahead and executes various trades with the soft dollar brokerage, decreasing its balance by the amount of commissions spent on each trade.

Directed brokerage is often confused with soft dollars, according to numerous officials queried for this story. It calls for an account manager to direct trades to a specific broker dealer. The broker agrees to pay certain fund expenses. Fund prospectuses disclose these practices, but sometimes they're in a fee table footnote.