NEW YORK - The Securities and Exchange Commission's proposed interpretive release on soft dollars has been on the comment block for a good three months now, which is a good two months beyond its intended period, and most industry experts are fairly confident that it will be affirmed in its current form.
SEC officials could not provide a status on the rule last week, although they did note that an open meeting, typically the next step in adopting a rule amendment, has not been scheduled.
But making sense of what falls within the SEC's new research and brokerage concepts is at times easy and at other times, well, not so easy.
For instance, the statement that "tangible products such as telephone lines or office furniture are not considered to be research," leaves little room for misinterpretation. Language surrounding the Commission's proposed stance on who is responsible for determining the value of a brokerage service, however, occupies a much grayer area. The Oct. 19 release says that the rule would require money managers "seeking to avail themselves of the safe harbor to make a good faith determination that the commissions paid are reasonable in relation to the value of the brokerage and research services received. The burden of proof in demonstrating this determination rests on the money manager."
Steve Stone, a partner with Morgan, Lewis & Bockius in Washington, said it's hardly a surprise that the SEC wants to task money managers with determining whether the amount of a commission is reasonable, but he wants to know the exact extent of the information a money manager must obtain from the broker to satisfy the SEC.
"More violin music," Stone said during a panel discussion on the topic of soft dollars at the recent Investment Adviser Compliance Forum held here. "How does a money manager make this feasibility judgment? What reports would they have to provide to mutual fund clients about what they're getting and what the value of that information is?"
For its part, the SEC says, "A money manager may not obtain eligible products, such as market data, to camouflage the payment of higher commissions to broker/dealers for ineligible services, such as shelf space." In that instance, the SEC states, the money manager could not make the determination, in good faith, that the value of the services were reasonable because they would be paying for non-eligible services. In addition, if those services were simply copied or repackaged items, the money manager could not make a good faith judgment that the value of the services was reasonable.
Jerry Lins, general counsel of ING Investment Management Americas in New York, noted that the SEC's intention is to create a framework, not a list of dos and don'ts.
"At some point, what this does do, is it keeps some reasonableness in the commissions," he observed.
For example, if a broker is booking five cents on every trade, it might not be unacceptable to earn seven cents without raising alarm at the SEC. But commissions of 15 cents to 20 cents are going to be much tougher to defend solely on the basis of reason, Lins said.
"This at least keeps an asset manager from saying, I paid 37 times the normal commission and based on good faith the research was O.K.' That had better have been some really, really good research," Lins remarked.
But what is research, according to the proposed guidance?
J. Christopher Jackson, general counsel for Hansberger Global Investors in Fort Lauderdale, Fla., noted that it would include market data, mass-market publications and seminars and conferences. It would exclude anything with inherently tangible or physical attributes, such as computer hardware and accessories, as well as anything that does not reflect the expression of reasoning or knowledge.
More specifically, examples of permissible research include traditional research reports that analyze the performance of a particular company or stock, financial newsletters and trade journals, and quantitative analytical software or software that provides analyses of securities portfolios. Additional items that would be excluded include office furniture, travel and expenses, entertainment, meals associated with attending seminars, Web site design, e-mail and Internet software, legal expenses and membership dues.
"For those of you who use soft dollars, I would suggest that you go back and analyze each service that you're currently utilizing with respect to soft dollars and see where you fit," Jackson said.
First, determine whether the item is an eligible item under the SEC's safe harbor as outlined in Section 28(e)(3)(A), (B) or (C), he continued. Secondly, ask whether the eligible product or service provides lawful and appropriate assistance in the performance of investment decision-making.
"We can all answer yes, but don't gloss over this. It's an important step," Jackson said, adding that the final question is of good faith in the value of the service.
Stone speculated that the SEC would also continue to hone in on multi-broker arrangements, such as situations where a transaction is conducted through one broker but a portion of the commission is awarded to another broker that may have provided research. It's commonly known as "give-up."
"You can't do it," he said. "There are programs currently structured that amount to that, and they'll have to be restructured. I don't think the SEC is going to sue a money manager because there was a flaw in the structure on the broker's part of the arrangement that they didn't know about, but they're going to be more focused."
But if a money manager sends a 500,000-share order to a broker and stipulates that 100,000 of the trades must be carved out to another broker as reimbursement for research, that "step-out" arrangement is within the proposed SEC guidelines.
"Give-ups are out. Step-outs are in," Stone said. "Go figure."
In a rather controversial move, the SEC has proposed that order-routing systems are in as a brokerage service, and order-management systems are out, he added. But Stone thinks this is one of the few areas where the SEC might adjust its stance before adopting the amendment, because of the functionality that order-management systems provide.
"Some of that functionality is research, and some of it is brokerage, but we shouldn't get caught up in labels. It's a functional determination. My guess is that they'll change that," Stone said.
Of course, Stone submitted, money managers could alleviate the risk of soft dollars altogether by simply writing a check for the additional services, or those functions that fall outside the strict execution of trade, that their broker provides.
Boston fund giant Fidelity Investments, for example, recently reached unbundling agreements with both Lehman Brothers and Deutsche Bank. Rumor is that Boston's Wellington Management will be the next major player to require unbundling.
Sure, smaller money managers might lack that sort of trading clout, Stone conceded, but brokers aren't jumping at the idea, either, as there are legal pitfalls. For instance, when a broker/dealer sells its research for hard dollars, it is acting as an investment advisor. For a broker with knowledge of large institutional trades, that could present a conflict of interest.
And how does a money manager determine the dollar value of that research? "At the end of the analysis, it is probably not going to be a good idea for the buy-side manager to pay in hard dollars," Stone said.
Besides, Lins added, hard dollars would jeopardize a key element of the investment management industry.
"This is a relationship business. To try and make it a dollars-and-cents business is going to be much more complicated than people think," he said. "Commissions are going down, so we're moving in the right direction."
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