PHOENIX - Vanguard Group General Counsel Ari Gabinet likes to recall the time he was asked to speak on soft-dollar best practices at a recent conference.
"I said, no," Gabinet said coyly, tongue firmly planted in cheek.
What makes Gabinet's anecdote so humorous, of course, is the fact that "soft dollars" were originally designed as a harmless way for brokerage houses to add value to their services. But, as the scandal revealed, brokers over the years had begun offering more than just research tools in exchange for trade execution, kicking back to mutual funds everything from swanky vacations to tickets to high-profile sporting events.
As Gabinet, a former enforcer in the Securities and Exchange Commission's Philadelphia office, further recalled, he once discovered in a broker's soft dollars a Talbots credit card receipt belonging to the wife of a portfolio manager.
So, to mention soft dollars and best practices in the same breath these days would indeed seem a bit absurd, but the fact remains that soft dollars is a $10 billion annual business, according to one industry estimation. It's probably safe to assume, then, that soft dollars are here to stay.
But new rulemaking, experts say, has created an enormous dilemma for funds and their brokers. While some larger money managers burned by suspect soft-dollar practices have gone so far as to demand that brokers separate, or unbundle, research from the trade execution, that request risks placing some brokers outside of other SEC laws. That development, coupled with what could be viewed as competing regulations recently passed by the Financial Services Authority in the United Kingdom, has led to a host of new questions surrounding the use of soft dollars.
Adding a dose of irony to the situation is the fact that the SEC issued an interpretive release last year that was meant to mitigate any potential misunderstandings over its soft-dollar rule, a 30-year-old mandate known officially as Rule 28(e). In short, the SEC's clarification didn't outline exact products or services that would be lawfully considered research or brokerage, but instead left it to the advisor to make that determination. Advisors must also make a good-faith determination that the price of those products or services is reflective of their usefulness. This, investor advocates have claimed, has broadened, rather than narrowed, the definition of research and will only exasperate questionable soft-dollar usage.
So it could be suggested that funds and brokers are more lost today than they were three years ago, when Federal and state regulators first began sniffing around commission arrangements. In fact, experts at the Investment Company Institute's 2006 Mutual Funds and Investment Management Conference, held here recently, said the dilemma has the potential to capsize some brokers and jeopardizes what many advisors consider a key decision-making tool.
But for starters, Gabinet said his former bosses should get up to speed with their colleagues overseas and determine exactly where a trade begins and ends.
"The FSA trumped the SEC," Gabinet said, noting that the disparity has imposed unfair difficulties on money managers with international operations.
While the SEC is fuzzy over when the trade a begins, which is a key factor in determining what can be lawfully included as research, he said the FSA's new regulations state that it begins when the portfolio manager makes his decision, not when the order is received. That means, for example, expensive order-management systems could be included as research under FSA rules. Under SEC guidance, which seeks to separate hardware from software, it could be considered outside the regulator's recent interpretive release. The FSA also issued recent guidance on what would be considered soft dollars, or "soft commissions" as they say, in a rule. The SEC, meanwhile, issued an interpretive release that isn't quite as specific.
The FSA also went so far as to demand that funds disclose soft-dollar arrangements to investors, a step the SEC has chosen to delay.
However, SEC Division of Investment Management Associate Director Robert Plaze maintained that the FSA and the SEC rules on soft dollars are more similar than they are different. Both agree, for instance, that overhead items like telephone lines and office equipment do not constitute research. But, he said, "The FSA didn't trump the SEC. Actually, the SEC worked closely with the FSA on their conceptual rulemaking."
Plaze also indicated that the SEC has received several "interesting" comments in recent months regarding the exact timing of order placement. "We'll have to look closely at those," he said.
Most experts agree, however, that, unlike the FSA, the SEC probably won't seek to mandate the unbundling of research from brokerage. Plaze confirmed that the Commission would probably await the outcome of market forces, where, most notably, Boston fund giant Fidelity Investments recently began requiring that Lehman Brothers unbundle its services. Investor advocates have aggressively lobbied the SEC to demand that funds pay for research in hard dollars, but Plaze said arriving at a price for the research isn't easy. For example, the cost of a piece of research is best known to the broker, he offered, but the value of the research is known best by the advisor.
"That is the eternal question. What is the value of a good or service that is not paid for in dollars?" he asked. "Do you average cost, marginal cost or inherent value to the user?"
The FSA punted this question to the U.K.'s largest trade association, which decided that the price should be negotiated with the goal of arriving at a number that's 50/50 between research and execution. Plaze said those same "seeds of change" appear to be under way here in the U.S. with Fidelity at the lead, but whether it might compel smaller industry players to adopt the model remains to be seen.
Consultants have estimated that Fidelity will pay $7 million annually for equity research from Lehman, in addition to a 2.0- to 2.5-cent charge per trade. That's a costly proposition for some smaller fund shops. In fact, 85% of asset managers surveyed by Darien, Conn.-based Integrity Research said they'd be sticking to soft dollars.
"It's difficult to determine whether this is a long-term development," Plaze said.
Either way, he added, it should illustrate more clearly to the industry exactly how tricky it is to regulate soft dollars. With so much money sloshing around between advisors and brokers, it's almost impossible to eliminate conflicts of interest.
"We're not saying a good agreement can't be reached," between advisors and brokers, he said, it's just that soft-dollar arrangements "provide a problem area for control when you have all this money available for different purposes."
But Stephanie Monaco, a partner at Mayer Brown Rowe & Maw in Washington, claims that a "good agreement" cannot be confidently reached. If a broker were to unbundle its research and receive payment for it in hard dollars, it would be dispensing investment advice and could be in violation of SEC Rule 202(a)(11)-1 of the Investment Advisor's Act of 1940. The rule allows a broker to dispense investment advice only if it's incidental to the brokerage service, or in other words, if it's bundled together with execution.
"If you pay hard dollars for research, now the brokerage is receiving special compensation," she explained. "While you have achieved the unachievable, which is to divert the whole soft-dollar problem, you've stumbled into another problem. The SEC has the solution for part of the problem, but not the other part of the problem."
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