With longstanding mutual fund practices such as directed brokerage and revenue sharing likely headed for the junk pile, the heated debate over the merits of soft-dollar research commissions has intensified.
The discussion over soft dollars is nothing new for the fund business, but the recent wave of impropriety that has permeated the nation's biggest fund houses has thrown gasoline on the fire. Securities regulators and Congress are stressing the importance of transparency and disclosure now more than ever. With respect to soft dollars, they're concerned about abuse of the safe-harbor provision of the Securities Exchange Act of 1934, which came into effect after the abolition of fixed commission rates in 1975. The amendment under Section 28(e) frees an investment advisor from breach of fiduciary duty claims for charging clients higher commissions for brokerage and research services.
At issue is the nature of these so-called brokerage and research services. Critics of the practice argue that these excess trading commissions that funds pay to brokerage firms, which are then rebated to the funds in the form of research and other services, remain hidden from fund shareholders. These inflated commission costs also pay for things such as Bloomberg terminals, computer hardware and software and office furniture. In most lines of business, these items would be considered overhead costs. For example, a carpenter who purchases tools from a hardware store and wood from a lumberyard would typically pay for them out of his own pocket.
In some instances, soft dollars have been used to pay for perks such as courtside seats, concert tickets and golf clubs for traders. Whether these specific abuses are an anomaly or not, the lack of clarity surrounding soft dollars has critics worried that investors are unwittingly footing the bill for in-house costs that may not necessarily be within the definition of research. Not to mention, most firms have no way of accounting for soft dollars because of the bundled nature of commissions.
"The conflicts of interest inherent in soft-dollar arrangements are exacerbated by current disclosure rules," said Mercer Bullard, founder of shareholder advocacy group Fund Democracy, in recent testimony before Congress. "The amount of fund assets spent on soft dollars is not publicly disclosed to shareholders, so they are unable to evaluate the extent, and potential cost, of the advisor's conflict of interest. Current disclosure rules reward advisors for using soft dollars because the practice creates the appearance that a fund is less expensive."
While clearly there is an opaqueness to soft dollars, agency brokers such as BNY Securities, a division of The Bank of New York, have a different perspective on the much-maligned practice. The firm argues that its soft-dollar program is fully disclosed and transparent. In fact, the firm provides its investment advisor clients detailed information regarding their brokerage commissions and services they receive.
"Our clients get a monthly statement, both physically and available online, that includes all the research services they pay for to the penny," said John Meserve, president of BONY's soft-dollar broker Westminster Research Associates. "They can see what the commissions were and exactly what the executing, clearing and settling rate was and, effectively, how much profit we made from doing that trade."
The company employed this strategy following a Securities and Exchange Commission task force examination of the soft-dollar industry in 1998, which led to reform recommendations that included enhanced recordkeeping, disclosure and internal controls. According to Meserve, most agency brokers acted on those recommendations by adopting procedures and controls designed to ensure compliance with the safe-harbor provision. However, the SEC never implemented a formal plan for disclosure of soft dollars, which only served to add to their ambiguity.
Since the mutual fund trading scandal emerged, a number of fund firms have publicly denounced the practice, indicating they would no longer use soft dollars to pay for research. Among them were MFS Investments and Janus Capital, two firms that have been hit hard by reckless market-timing arrangements in their funds. Fidelity Investments has also decided to buck up for its own research.
Meserve argues that these firms can now afford to give up using soft dollars because of their sheer size, yet that wasn't always the case. "They've grown their asset size on the back of soft dollars. They've paid Wall Street soft commissions for years to build up their assets and get the access to research from those firms. Now they've become so big they don't need Wall Street research anymore. Fido has 500 analysts, and MFS can afford to pay $10 million to $15 million on research and market data," he said.
"Soft dollars allow the smaller and medium size firms to compete. And I don't think you can look at today's landscape and say bigger money managers perform better than smaller ones," Meserve said. "The independent research community, as we know it today, could not survive without commissions as a currency for payment."
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