Despite the hurly-burly set off by Securities and Exchange Commission Chairman Christopher Cox's request that Congress eliminate soft-dollar safe harbors, industry insiders argue that such a change will result in nothing but toil and trouble for retail investors.
The real antidote to what Cox called "a witch's brew of hidden fees," according to a recent survey, is simple disclosure.
But when it comes to what that disclosure might look like, investment managers and plan sponsors alike, are looking back to regulators for the magic ingredients.
"There is a general feeling among market participants that current 28(e) regulations regarding research and brokerage provides value, but current disclosure practices are ambiguous and inconsistent," said Kristi Wetherington, the chief executive of Dallas-based broker/dealer Capital Institutional Services (CAPIS). "As such, it seems that plan sponsors and many investment managers have come to the conclusion that the disclosure issue is best settled by SEC guidance," according to a white paper published by CAPIS in conjunction with Greenwich Associates, a consulting firm based in Greenwich, Conn.
Passed in 1975, Section 28(e) of the Securities Exchange Act of 1934 frees money managers from the fiduciary responsibility of always choosing the lowest-cost brokers, provided that the higher commissions buy research that helps managers make higher-quality decisions for their investors.
Soft-dollar spending, which accounts for about $11 billion in commissions a year, has been the subject of scrutiny for several years, as in the past, commissions had been directed to purchases not in the best interest of investors, on things ranging from vacations to college tuitions for managers' children.
Last year, the SEC passed guidelines that delineated what so-called "soft" money could be used for. For example, soft dollars for research was in, but using commission fees for office space, or telecommunication lines used to access research, was out.
And while everyone understands the rules, not everyone knows what commission dollars really pay for, since there is no uniform method of reporting it. Only 35% of managers said they report to clients the total commissions paid, and only half of plan sponsors ever ask.
"Ultimately, the reason plan sponsors aren't pushing this is that they really don't understand," said Michael Mayhew, chairman and chief executive of Integrity Research, an independent research company based in New York. In theory, plan sponsors' chief investment officers would agree that understanding the expenses of the plans in which participants are enrolled is part of their function as fiduciaries, but in practice, commissions remain an opaque, and relatively minor, part of their jobs, Mayhew said. "While it is an important issue, when you look at all the other jobs they have running these large plans, on the list of 20 things to do, it's probably 21st."
In fact, 7% of investment managers said that they feel the intense pressure to disclose fees from their own internal management and fund directors, while 45% said they feel no pressure at all from sponsors, and as of April, 44% said they felt none from regulators, either. John Feng, a consultant with Greenwich Associates, suggested the internal pressure comes from a desire of management to use transparency as a competitive advantage when marketing their services, or to stay ahead of regulators.
Even when commissions are reported, everyone, it seems, does it differently. Of the 35% of investment managers that report commissions, only about 25% report what portion of that sum goes to research.
Such murkiness is what Cox cited in his May 31 speech as "at odds with investors' best interests," resulting in conflicts, complexity and inflated costs. Cox warned that soft dollars may spur managers to trade more than necessary to raise revenue, or use one client's commission to cover research for another. In some cases, soft dollars have been used to cover referral fees paid to clients who recommend others, Cox said.
Calling them as "out-of-date as the Betamax, leisure suits and Welcome Back Kotter,'" Cox called for Congress to eliminate or significantly revise the safe harbor legislation.
Elimination isn't the answer, Wetherington said. "Today's call for transparency would address the concerns of the SEC," she said. And unlike the elimination of soft dollars, simply reporting the amount allocated to trading versus execution will not put small and mid-size broker/dealers, like CAPIS, out of business.
The question is what that disclosure should look like.
In the survey of 43 institutional investment managers and 37 plan sponsors, 60% of managers and 67% of sponsors said they would like the SEC to define how commissions should be reported, and soft-dollar spending disclosed.
Where they differ is in how involved they want regulators to be.
While plan sponsors want the SEC to play a prominent role in prescribing how these fees are broken out, "investment managers said, Please tread lightly,'" Feng said. "Commissions are the currency between the buy side and the sell side," he said.
Cox in his speech also suggested that soft dollar spending may encourage conflicts of interest, whereby money managers pay with commissions for expenses which they would otherwise pay out of pocket.
The need for those services and research will not go away just because soft dollars do, he said. "Institutions will just find another way to pay," said Feng, alluding to higher expense ratios, or new, add-on fees.
The alternative, said CAPIS Chief Operating Officer Jim Morrow, is investment managers skimping on research to keep expenses down, or even relying on brokers' in-house research. Only the largest broker/dealers would be in a position to compete, and small research companies and broker/dealers alike, both known as fonts of industry innovation, would likely close shop or be acquired.
After all, even companies like Fidelity, which, through an agreement with Lehman Brothers last year, announced "unbundled" commissions, still directs a vast majority of commissions to research, Morrow said.
"This would be a $6 billion problem," said Mayhew. And the people picking up the tab would, ostensibly, be the investors Cox purports to protect. "Don't let anyone bamboozle you by telling you it's an independent research problem. It's a problem for every single brokerage firm, from the largest on down," Mayhew said.
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