The debate over soft dollars nearly erupted into a barroom brawl on Capitol Hill last week, as the Senate Banking Committee held an open hearing on the much-maligned practice of mutual funds using brokerage commissions to pay for research and overhead costs.
The two-part session was the ninth in a series of hearings reviewing the current investigations and regulatory actions in the $7 trillion mutual fund industry, one highlighted by the exchange of heated words from both sides. The knock on soft dollars has typically been that they are the least transparent and least understood investment tool because they are packaged with trade execution costs, a completely separate service than stock research.
The Safety Dance
Harold Bradley, chief investment officer of growth equities at American Century Investments, took the first swing, urging legislators to amend or repeal Section 28e of the Securities Exchange Act, more commonly known as the "safe harbor" provision. He argued that it allows fund managers to have way too much latitude in determining what they will spend investor dollars on.
Using client assets to pay operating costs has "an awful nice impact on the profit margins of investment advisors," he said. He even went as far as to accuse his peers of using clients' money to pay rent for office space. Bradley said that American Century forfeits $10 million in profits each year because it "does the right thing" by not using soft-dollar payments. "A money manager should be able to pay for its own quotes from the New York Stock Exchange," he added.
Bradley noted that soft dollars increased significantly during the bear market as increasing pressure on profit margins prompted funds to dip further and further into client assets. He cited more than 1,200 companies that are considered soft-dollar vendors, a list that included Dell, Oracle, NYSE, Nasdaq and The Wall Street Journal. That number stood at 503 in 1995 and a paltry 264 in 1988. Citing a recent study by money manager Whitney Tilson, he estimated that investors paid $6.3 billion in 2002 for research and other "goodies." That means they're paying as much as 15 basis points in extra, undisclosed management fees.
Bradley suggested an overhaul of the safe harbor that would preclude soft dollars from being used for computer hardware and software, subscription publications, seminars and any third-party providers that are otherwise available for cash to the general public. Further, he suggested the SEC gather execution-only commission rate information from brokers and publish an industry average for comparative purposes.
Another critic of soft-dollar practices, Dr. Benn Steil, director of economics at the Council on Foreign Relations, offered a more liberal approach to what he dubbed an "industry-wide kickback system." He alleged that fund shareholders are paying roughly 70 basis points more than the headline number listed in the prospectus.
While Steil believes including these costs in the expense ratio would be ideal, he said it is too difficult. He proposed that funds only use commissions to pay for trading, thus eliminating the safe-harbor loophole altogether.
Another suggestion he offered, one that was widely unpopular at the hearings, was to encourage fund managers to pay trading commissions out of their own pocket, a recommendation based on a report prepared for the UK Treasury. Steil argued that this would not only align managers' interests with shareholders but also unbundle commissions and allow for better execution -- because it would be in their self-interest. He illustrated that a fund could cover the cost of trading commissions by raising its management fee by about 18 basis points, which would still leave the shareholder better off by about 50 basis points.
Keeping it Real
But the bout over transparency in broker fees wasn't all one-sided. In fact, the biggest blow was delivered by Sen. Chuck Schumer (D-NY), who referred to a ban on soft dollars as "borderline absurdity," accusing its advocates of "throwing the baby out with the bath water." A sharp-tongued Schumer blasted Steil's proposals as being "rarifying, academic" and "not making sense in the real world." His chief concern was that the quality of research would suffer greatly if the practice was prohibited, and it would be a backbreaker for the smaller fund shops. Additionally, he said that newspaper subscriptions do qualify as research because they help managers become more informed individuals. His solution to the problem was simple: enhanced disclosure.
He was not alone in his criticism of Steil and Bradley's sales pitch. Geoff Edelstein, managing director and co-founder of Westcap Investors, argued that soft dollars are "crucial" for startup asset managers and that banning them would create significant barriers to entry. He also said that a ban would have an "adverse effect" on smaller fund shops and set up an "unlevel playing field" that would favor the larger full-service firms.
"The single act of banning soft dollars would have a devastating effect [and] irreparably hurt the competition from boutique brokers and independent research providers," said Howard Schilit, chairman and CEO of the Center for Financial Research and Analysis (CFRA). He favors an "a la carte menu" of brokerage fees that would enable funds to choose what they want to pay for, as opposed to signing up for a package deal.
Eager to find some middle ground on such a conflict-ridden issue, Committee Chairman Richard Shelby (R-AL) acknowledged there is definitely a need for more disclosure in the soft-dollar area and that he will be introducing a bill in the coming weeks that will address it. Judging from his inquiries, it appeared he was not sold on the idea of abolishing soft dollars. Ranking member Paul Sarbanes (D-MD) appeared more open to the possibility of prohibiting the use of soft dollars, a move that would require Congress to intervene. Sarbanes was very curious about the use of soft dollars to pay for concert tickets, basketball games and other perks.
In a later session, Investment Company Institute Chairman Paul Haaga advocated a significant reduction in the scope of the safe harbor to exclude not only magazines and computers, but also third-party research. As expected, that notion drew overwhelming criticism from both panel members and lawmakers. That tactic would favor heavy-hitting full-service research firms and pose a serious threat to independent research outfits, which many believe provide better research than Wall Street.
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