Canada Limits Use of Soft-Dollar Commissions

Canadian fund managers will now be limited in the range of services they can pay for with commissions from clients for brokering transactions, based on newly adopted legislation.

This is the fallout of the introduction of National Instrument 23-102, on the “Use of Client Brokerage Commissions,” which became effective in Canada as of June 30.

The regulation, initially floated for public comment in 2006, closely follows regulations in the United States and the United Kingdom, where client brokerage commissions, called “soft dollars,” must be strictly used for execution or research services.

The Canadian Securities Administrators, the umbrella organization for all of Canada’s provincial regulators, says that fund managers can use soft-dollar commissions to pay for goods and services such as order management systems, algorithmic trading software, post-trade analytics, research reports, market data, and quantitative analytical software. They cannot do so for computer hardware and compliance systems, which are “hard dollar” purchases and must be paid for with income from other fees.

The new Canadian regulation, also establishes the disclosure obligations of advisors as being “narrative” and not quantitative “To go further than the requirements of the SEC or other international regulators at this time would create difficulties for Canadian advisers conducting business in multiple jurisdictions, particularly those that contract a foreign sub-advisor subject to lesser disclosure requirements in their home jurisdiction (who may not be willing to undertake systems changes to provide the needed information),” said the CSA. “This could have an impact on costs to Canadian investors, or result in differences in the quality of disclosure.

A soft-dollar arrangement is one in which the investment manager directs part of the commission generated by the transaction to another party in exchange for services that are for the benefit of the client. Case in point: to cover fees for research, some buy-side firms direct order flow to the sell-side service provider, which charges them a higher fee than for an “execution-only service.” Over the past few years some fund managers have completely eliminated the use of soft-dollars – instead opting to pay for all the services they receive in hard cash.

In 1975, the Securities and Exchange Commission defined the range of items that qualify as trade execution and research under the so-called safe harbor rule. The U.S. regulator clarified what services can and cannot be included in soft-dollar commission practices in 2006.