Getting Tough
ON SOFT DOLLARS

The SEC's latest target could have sweeping repercussions
for both sides of the Street.

BY BEN MATTLIN

On March 31, the U.S. Senate Banking Committee invited testimony from Wall Street experts about a relatively esoteric brokerage practice known as soft dollaring. Eight days later, Securities and Exchange Commission (SEC) Chairman William H. Donaldson assured the same senators that he had set up task forces to investigate a number of brokerage and mutual-fund practices, including soft dollaring, which he considers a "very high priority."

Already the heightened attention on this heretofore little-known and even less well-understood practice has had a chilling effect. Vociferous advocates from every corner are writing scabrous letters to senators, the SEC, newspapers and shareholders, weighing the various options and preparing for the worst. Yet no high-profile scandals related to soft dollaring have emerged as of this writing. What's driving the move to rein in this complex, completely legal revenue stream? How far are reform efforts likely to go? And, most crucially, who stands to gain and lose when changes do come?

"SOFT DOLLARS" VS. "SOFT MONEY"

Soft-dollar purchases are estimated to have grown to some $10 billion a year, a "hidden cost" to shareholders, critics say, that Donaldson wants to see reformed by year-end.

"This could have tremendous impact on not only the brokerage industry but every business that serves it," cautions Richard Bové, an analyst at Hoefer & Arnett who specializes in financial services companies. "It'll significantly alter the way our industry functions."

To be sure, though its use has grown dramatically in recent years, soft dollaring is nothing new. Casual observers might associate it with the controversial "soft money" fundraising technique favored by certain political campaigns, but it's completely unrelated. In the securities industry, soft dollaring refers to using brokerage commissions not only to execute securities trades but to acquire research and related tools essential for making investment decisions and running a successful institutional portfolio.

The problem is that while every time a fund manager buys or sells a security, shareholders incur a brokerage fee, but funds only disclose the sum total of the fees they pass on. "Mutual funds by law have to report their expenses on an annual basis and deliver that data to shareholders," explains Lucas Garland, a research analyst at fund-tracker (and soft-dollar beneficiary) Lipper, a unit of Reuters. "But brokerage commissions are excluded from the total expense calculation. They typically appear in the Statement of Additional Information, which few shareholders view."

Garland believes average investors would be more than a little dismayed to learn that their mutual fund is also charging them for brokerage commissions on top of an expense ratio of, say, 4.5 percent. "Brokerage commissions could add another half a percentage point to shareholders' fees," he says. What's more, those commissions may be extra high because they're paying for research as well as transaction costs. No one can authoritatively calculate how much lower brokerage commissions might be if research and related services weren't thrown in, but estimates run from a discount anywhere from 40 percent to 90 percent.

That's another bone of contention: Like fund fees, brokerage commissions aren't itemized. Investors and often the fund managers themselves don't know what portion of brokerage commissions go to research and what to executing the trade. Neither is it clear what kind of research services (reports, analytical tools, data feeds, access to management?) were bought or how much value they add to the fund. "It wouldn't be very difficult to promote this data, to bring it to the forefront," insists Garland.

Garland isn't alone in championing a higher degree of transparency. Early in March, David Jones and Eric Roiter, two senior vice presidents at Fidelity Management & Research Co., wrote a letter to the SEC urging it to mandate full disclosure of soft-dollar research expenses to ensure there were no improprieties. For many would-be reformers, better disclosure is merely a first step. One voice calling for the SEC and Congress to go further is Benn Steil, a senior fellow at the Council on Foreign Relations. "Soft dollars are part of an industry-wide practice known as 'commission bundling,'" he says. "Mutual funds actually pay trading commissions to brokerage firms to buy computers, The Wall Street Journal subscriptions, conference registrations, accounting services, you name it."

Whether such seemingly extracurricular freebies are common -- or indeed justified -- will doubtless be considered by the SEC. At this point, if a case can be made that such products and services benefit shareholders, they are completely legal.

WHY SOFT DOLLARING IS LEGAL

The legalization of soft dollaring can be traced back to May 1, 1975, when the SEC deregulated trading commissions, which had been set at a fixed rate (then $0.75 per share). Before that, brokers competed for investor clients mainly by offering additional goods and services. But when the SEC set commissions free, it unleashed a tsunami of competitive fee slashing as brokerage firms struggled to hang on to their investor clients and snag new ones from other brokers. Ultimately, commissions settled at close to their current average of $0.06 per share traded.

Soon after, brokerages complained that commissions had sunk too low. Among other things, they could no longer afford to pay analysts, whose compensation had principally come from their cut of trades their buy and sell recommendations helped generate. (This, in turn, explains why so many analysts later rose to the aid of investment banking to earn their keep.) At the same time, money managers feared their new fiduciary obligation to find the lowest commission rates for their clients -- or more accurately, feared legal repercussions if they didn't, even if the clients received valuable research tools in return for inflated brokerage fees.

In response, as part of the Securities Acts Amendments of 1975 Congress created a new "safe harbor" provision under Section 28(e) of the Securities Exchange Act of 1934. This effectively gave investment advisors permission to pay higher commissions if they deemed them in the best interests of the fund. "Money managers prevailed upon Congress to insert legal protections specifically to allow soft-dollar practices," recalls Edwin (Ted) Laurenson, who specializes in securities law as a partner at New York's Baker & McKenzie.

DIFFERING OPINIONS

Today, some proponents of change advocate repealing Section 28(e), or outlawing soft-dollar transactions altogether. Others call for greater oversight and tighter definitions of what can and cannot be bought with soft dollars. "The problem isn't the soft dollars themselves but unscrupulous money managers who take advantage of them," asserts Max Rottersman, an independent fund consultant and editor of FundExpenses.com. Soft dollars, he says, should be used only for "original research, not Bloomberg terminals or magazine subscriptions."

Defenders respond that while undoubtedly there is misuse, machines like Bloomberg terminals aren't necessarily extravagances even at $2,000 a month because they offer sophisticated analytical tools that managers of technical or quantitative portfolios find essential. Similarly, subscriptions to esoteric trade journals may be appropriate for certain sector-fund managers. The distinction between frivolous expenditures and legitimate research expenses remains fluid and open to interpretation -- more a matter of context than codification.

Not that the SEC hasn't tried before to hone its definition of acceptable research under Section 28(e). In 1976 it disallowed products and services "commercially available" to the general public, but 10 years later it reopened the door to these items if they assist the money manager in "his investment decision-making responsibilities."

Nonetheless, Rottersman favors stricter enforcement of existing soft-dollar statutes. "Don't let a few bad apples ruin it for everyone else," he says. "Soft dollars are a great mechanism for funding small research shops that serve important niches." Indeed, regional and independent research organizations -- the type that don't have investment banking and, in many cases, are being tapped to provide the "third-party" research required by last year's legal settlements with the SEC and New York Attorney General Eliot Spitzer -- depend heavily on brokerage commissions.

Wall Street firms, on the other hand, have revenues from investment banking and other sources for their sustenance. "Soft dollars have promoted competition and therefore benefited all of us," says Michael Mayhew, CEO of Integrity Research Associates, a Darien, Conn.-based research consultant and ratings service. "We'd be in sorry shape if there was no independent research industry, especially in light of what we now know about Wall Street research from the Spitzer and SEC settlements."

For many, this is one of the biggest concerns about limiting or banning soft dollars: it would ring the death knell of independent research. Over the years, the SEC has intensely scrutinized the independent research providers that depend on soft dollaring, even while taking a more laissez-faire view of their Wall Street competitors. Many of the independents say they wouldn't mind -- would even welcome -- stricter regulations because they have nothing to hide. Not surprisingly, however, they are also among the staunchest defenders of Section 28(e).

"We already give detailed statements to the buy side, so they know exactly what their nickel pays for," says John Meserve, head of the Bank of New York Securities Group's BNY Jaywalk, an equity research consultant network, and Westminster Research, an independent research operation funded through soft-dollar commissions. "Clients get a breakdown of everything they acquire and what the hard dollar price was. There's an idea out there that third-party soft dollaring is nebulous and vague when in fact it's the opposite. It's the most transparent part of the entire commission pool."

It's also the smallest. Meserve estimates that 90 percent of commission dollars goes to Wall Street firms, not independent brokerages. There may be good reason: Big brokers offer huge capital resources, access to management, opportunities to trade initial public offerings and other advantages. But, he says, "These full-service firms benefit from the opaque bubble of bundled commissions."

In truth, big firms may suffer as much as if not more than small ones if soft dollaring is overhauled. For one thing, Wall Street research tends to be much more expensive than the "third-party" variety; clients may balk once they learn precisely what their commission dollars are buying.

THE SHAREHOLDERS' INTEREST

Beyond the disparity between Wall Street and soft-dollar-dependent third-party research, ardent opponents of soft dollaring cite deep-seated systemic concerns. "The biggest cost to investors is not the soft-dollar commission itself but the bad trades that result from this practice," argues the CFR's Steil. "Fund managers are giving their trades to brokers not based on their ability to execute trades but on their ability to kick back services."

In his view, soft dollaring pits fund managers' interests against those of their shareholders. If managers had no ulterior motives in their choice of brokers -- that is, if they did not receive soft-dollar incentives and merely picked brokers by their low fees and/or efficient execution of trades -- they could do a better job of representing shareholders' interests. However, not even he would suggest fund managers muddle through without research. "They need research," he affirms. "They have to pick stocks somehow. But let the research stand on its own merits. Fund managers should only pay for research they deem useful and valuable -- and bargain over the cost as a separate item, just like anything else in this world."

Another windfall of this scenario might be better, cheaper research as providers of all sizes compete to offer the most helpful value-added insights at a reasonable cost, also presumably in investors' interests. To Steil, though, the ideal reform would be to force fund managers to pay trading commissions out of their own assets. "This would immediately align managers' interests with their shareholders," he says, "because they would want to get the lowest possible execution rates and would invest in research only if it seemed likely to increase returns."

Even soft-dollar supporters concede the potential for abuse is great. "Soft dollars are too easy to spend because they don't come out of management's pocket," argues Rottersman of FundExpenses.com.

Others dismiss it as a nonissue. "Fund managers do a lot with other people's money," counters Mike Thompson, director of research at market watcher Thomson Financial -- another beneficiary of soft dollaring. "Every day, they make decisions that increase or lose other people's money." Though Thomson Financial has no official position on soft-dollar regulations, Thompson stresses the importance of letting free-market principles work things out. "What do investors care about most when they hand their money to a manager?" he asks. "Getting good returns. If the manager spends a lot for soft-dollar research, the fund better generate a lot of return or investors will walk away. I'm not even sure it's a bad thing to have investors absorb the costs of [brokerage] commissions, because the moment the fund's performance turns less impressive, investors will vote with their feet."

This assumes investors are well informed about performance and expenses, of course -- which is another tick for better disclosure of soft-dollar practices.

WALL STREET REACTION

Nevertheless, there are market watchers who associate soft dollaring with egregious malfeasance, kickbacks that extend beyond mere computer terminals to trips to Hawaii and the like. No such scandals have come to the national spotlight in recent memory, but Bové of Hoefer & Arnett insists that examples abound. "You take a bunch of clients to a World Series game, they pay you the next day," he says. "Is that what people put their money into mutual funds for?"

No doubt more stringent scrutiny and firmer regulations will help put a stop to this kind of mismanagement. Yet other repercussions of tightening soft-dollar controls are impossible to predict accurately. The SEC promises to make recommendations to Congress by the end of the year, but at least one regulatory agency isn't waiting for the results. In the United Kingdom, the Financial Services Authority (FSA), the SEC's British counterpart, recently restricted "soft commissions" to be used only for trade execution and proprietary research -- not data terminals or other services. And on May 7, the FSA delivered an ultimatum to U.K. fund managers: Itemize brokerage fees by year-end, or face legal action.

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Copyright© Buyside Magazine 2004 . All rights reserved.

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