New York—The Department of Labor Employee Benefits Security Administration (EBSA), the regulator of ERISA plans, recently approved the final changes to its disclosure requirements of indirect expenses incurred by investment managers on behalf of their pension fund clients. After lobbying by both investment managers and the brokerage industry, the EBSA reduced its disclosure requirements for soft dollars, allowing investment managers to use current disclosure such as the Form ADV.
A year ago, EBSA proposed significant changes to Form 5500, the annual report that pension plans file with the Department of Labor, Internal Revenue Service and Pension Benefit Guaranty Corporation. Under the original guidelines, pension plans were required to disclose the amounts of indirect expenses incurred by investment managers on behalf of the plans. Included in this would be the commission amounts spent by investment managers in purchasing proprietary (ie, investment banking research) and third party research.
As we reported last January, the Securities Industry and Financial Markets Association (SIFMA) and the Investment Company Institute (ICI), among others, contested these changes, arguing that the SEC was about to propose disclosure requirements (still pending) and that providing the information required would be difficult, if not impossible.
In releasing its final version of Form 5500, EBSA reiterated that monitoring indirect expenses are part of plan sponsors fiduciary responsibilities:
"The Department believes that an annual review of plan fees and expenses as part of the annual reporting process is part of a plan fiduciary's on-going obligation to monitor service provider arrangements with the plan."
As such, Form 5500 still requires the reporting of indirect expenses, such as soft dollars. However, EBSA also provided an "alternative reporting option", which most, if not all, pension funds will follow for the soft dollar reporting requirements. The alternative reporting option allows pension funds to rely on Form ADV disclosure and any disclosures in the investment management contract. The information required is 1) whether the investment manager is receiving soft dollars, 2) the reason for receiving soft dollars, 3) the amount of soft dollars or the formula used to determine soft dollars. Proprietary research is exempted from the requirement to disclose the amount of soft dollars because "it may not be practicable".
"Similarly, 'soft dollars' received by an investment manager in the form of research or other permissible services in connection with securities trades on behalf of plan clients need not be separately reported on the Schedule C [of Form 5500] if disclosures in the SEC Form ADV, together with disclosures in the investment management contract, advised the plan administrator that the manager is receiving 'soft dollars,' the reason the person was receiving the 'soft dollars' payment, the amount of 'soft dollars' or the formula used to determine the amount of 'soft dollars' that the manager receives in connection with each securities transaction, and the party or parties from whom the investment manager is receiving the 'soft dollars.' The Department recognizes that it may not be practicable to provide a formula or estimate to calculate the value of certain types of 'soft dollars' non-monetary compensation at the plan level, particularly so-called 'proprietary' soft dollar arrangements, such as access to information from certain research specialists. In such circumstances, a description of the eligibility conditions sufficient to allow a plan fiduciary to evaluate them for reasonableness and potential conflicts of interests would satisfy the 'amount of compensation' prong of the disclosure alternative for Schedule C reporting."
The good news for disclosure and transparency is the even with this significantly reduced requirement, the Department of Labor is in the vanguard of soft dollar disclosure in the US. The new Form 5500 requirements will require investment managers to make sure their Form ADV reporting is correct—many investment managers have erroneously reported that they do not use soft dollars when in fact they use commission payments for proprietary research. Although the amounts paid for proprietary research will not be disclosed, the fact that they are being paid for proprietary research will be a revelation for most plan sponsors (and sadly, some fund trustees.)
The fact that the DOL is in the vanguard of soft dollar disclosure is another reflection of the disarray at the SEC. As we said last January, it is a sad state of affairs when the SEC gets lapped by the Department of Labor. That is what has in fact happened. There are some who maintain that the SEC will release soft dollar disclosure guidelines this year, but it is already December…
The big issue for third party research, or alternative research as we call it, is that the playing field has gotten less level. Third party soft dollars have not gotten a pass, as proprietary research has. Investment managers will now have to report third party research spending on a plan basis. In other words, if an investment manager spends a total of $1 million in third party soft, the manager must estimate what portion of this total pertains to each plan. This may be a significant disincentive for investment managers. Endowments are not regulated by ERISA.
The changes to the Form 5500 are effective for 2009, which is filed in July 2009.
investment research, alternative research, alternative research providers, independent research, independent research providers, independent equity research, U.S. investment research, U.S. equity research, pension funds, soft dollars, 28(e) safe harbor, SEC, Securities Exchange Commission
Posted at 08:01 am by Sanford (Sandy) Bragg
 | Posted by Bill George @ 12/04/2007 10:07 AM PST | |
In 1975, when the U.S. Congress amended The Securities Exchange Act of 1934, by the passage and addition of Section 28(e), Congress gave the SEC the authority to interpret and enforce Section 28(e).
In the context of this article it may be important to add the SEC’s definition of soft dollars, which I have copied and pasted here, from the SEC Office of Compliance, Inspections and Examinations’, “Inspection Report On the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds” (published September 22, 1998).(1)
Begin Quote:
Soft Dollars Defined:
The Commission has defined soft dollar practices as arrangements under which products or services other than execution of securities transactions are obtained by an adviser from or through a broker-dealer in exchange for the direction by the adviser of client brokerage transactions to the broker-dealer.7 An individual or firm must exercise "investment discretion" over an account, as defined in Section 3(a)(35) of the Exchange Act, in order to use client commissions to obtain research under Section 28(e) of the Exchange Act ("Section 28(e)").
End Quote:
Reading the above quote, it seems clear that the SEC has defined soft dollars as all brokerage expenses above the execution related expenses in securities transactions. Some soft dollar expenses fall within the “safe harbor” of Section 28(e) and should be tested for compliance with the SEC’s “Commission Guidance Regarding Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934”.(2) Other soft dollar expenses / practices fall outside of the limited protection of the “safe harbor” of Section 28 (e) and should be tested against standards defining the parameters of the fiduciaries’ investment discretion.
I’ve often wondered how the SEC and other regulators perform the tests for the appropriate uses of soft dollars under the “safe harbor” of Section 28(e) and / or compliance with standards for fiduciary discretion. Approximately ninety-percent of all institutional brokerage transactions are done in bundled undisclosed brokerage arrangements. How do the SEC and other regulators identify the elements and costs within the undisclosed non-transparent bundle of proprietary brokerage services? Can these brokerage arrangements be tested for such compliance without identification of the elements of the bundled services and their costs?
Footnotes:
(1) Inspection Report On the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds” (published September 22, 1998).
http://www.sec.gov/news/studies/softdolr.htm
(2) Commission Guidance Regarding Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934.
http://www.sec.gov/rules/interp/2006/34-54165fr.pdf
Other reading:
Tooled by Semantics
http://www.scribd.com/search?query=Bill+George+Fiduciary+dollars+commissions
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