New York, NY - This past week the SEC voted unanimously to issue guidance to mutual fund directors on what type of oversight boards should provide on soft-dollar arrangements used by a fund’s advisers. The release of the proposed guidelines will be followed by a public comment period which ends on October 1st. Besides the actual guidance provided, we were also interested in the fact that comments by senior SEC members revealed that a deep conflict currently exists within the commission over this topic.
Changing the Balance?
In comments regarding this guidance, SEC Chairman Christopher Cox noted that some fund boards might opt to instruct their advisers to eliminate the use of soft dollars altogether. He also suggested that the forthcoming guidance might “change the balance between board and adviser”. These comments are consistent with the Chairman’s comments in the past suggesting that soft dollars should be banned altogether.
However, Andrew Donahue, the director of the SEC’s Division of Investment Management explained that the purpose of this guidance would be to “promote a dialogue on best execution” - rather than focus on soft dollars in isolation. Donahue also disagreed with Chairman Cox’s characterization that the coming guidance would change the balance between board and adviser.
Purpose of the Guidance
Despite the obvious conflicts, what everyone does agree on is that mutual fund directors are being overwhelmed by the sheer volume of transaction data, and they need help and directions on how to better handle this deluge. The SEC’s guidance is meant to recommend information that mutual fund boards should request from advisers instead of trying to monitor each trade. This information is likely to include how advisers are using client commission dollars to pay for execution and research services.
Integrity’s Take
It is clear to us that Chairman Cox is continuing to wage his own personal war on that “witches brew” called soft dollars. However, it is also clear that few others are willing to jump on his bandwagon due to the severe consequences that eliminating soft dollars could have on the entire financial services industry.
What Chairman Cox seems to surprisingly miss is that soft dollars are not merely the $1.0 billion in commissions that money managers “pay up” for third-party services. Instead, soft dollars are the $5 to $6 billion in client commission dollars that is currently being spent over and above the lowest cost of execution for both sell-side and independent research. This distinction was made clear by the Commission in their 2006 Interpretive Guidance.
“Section 28(e) applies equally to arrangements involving client commissions paid to full service broker-dealers that provide brokerage and research services directly to money managers, and to third-party research arrangements where the research services and products are developed by third parties and provided by a broker-dealer that participates in effecting the transaction. Today, it remains true that, if the conditions of the safe harbor of Section 28(e) are met, a money manager does not breach his fiduciary duties solely on the basis that he uses client commissions to pay a broker-dealer more than the lowest available commission rate for a bundle of products and services provided by the broker-dealer (i.e., anything more than “pure execution”).”
Consequently, the elimination of “soft dollars” would mean that investment advisers would be forced to pay for all sell-side and independent research out of their own pockets. We suspect this would cause buy-side investors to slash a significant amount of what they currently spend on external research - a move that would obviously cause tremendous pain for sell-side and independent research providers. In addition, we think that money managers, faced with higher research expenses, would probably raise fees to investors. And these consequences don’t include the cost of lower investment returns caused by more limited research.
Fortunately, many others in the industry, including senior staffers at the SEC, and the lobby for the money management and the broker-dealer communities, all get the joke. As a result, we expect they all will continue to fight off Chairman Cox’s efforts to ban soft dollars.