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New York – In a presentation on SEC examination procedures, the following “common mistakes” were noted:

• Not performing any review of soft dollar arrangements
• Separating soft dollar review from an overall review of execution and broker relationships
• Focusing only on third-party arrangements and ignoring relationships with broker providing proprietary research

In particular, the SEC’s Interpretive Guidance (Release No. 34-54165: file S7-13-06) released in July 2006 clarifies these items, by defining the eligibility criteria for research services, as follows:

“For purposes of safe harbor, a person provides … research services insofar as he –

(a)   furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchases or sellers of securities;

(b)   furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts…”

We guess that this is about as clear as the SEC gets.

The last of these oversights is the most important. Under a CSA, the executing broker named under the arrangement is the only broker that can conduct the execution of these trades, but the research may include the broker’s proprietary research and/or third party research.

For the prime brokers, therefore, this would seem to represent and opportunity to expand trade flow, as the general consensus is that the prime broker will be able to execute trades at a lower cost than the smaller brokers. Additionally, the prime brokers’ strategies seem to include adding services to their offerings to keep a large proportion of the money managers’ commission spend in house.

While we have little information on the breakout of CSAs in the US, we do have two important data points from the European CSA environment. For the total of all European institutions surveyed (37) by Greenwich Associates, the allocation of commission breakdown is 21% retained for proprietary research, 33% retained for execution and 46% paid to third-party research.

However, for the largest of the brokers (7) commissions segregated as 21% for proprietary research, 54% retained for execution services and only 26% paid away for third-party research.  This could indicate that the largest prime brokers have some degree of pricing power in the commission business.

In the options market the value of the option is the cost of separating the right from the obligation in a particular transaction. In the world of CSAs, the option of separation of research from execution services represents a call option for the money manager.

But even though the money managers have this option and the legal fiduciary responsibility for making a “full faith determination that commissions paid are reasonable in relation to value of the products and services provided by broker-dealers in connection with the managers’ responsibilities to the advisory accounts for which the managers exercise investment discretion[1]”, they indicate in private that they have little concrete knowledge of the price of the research services they are receiving.

What seems to be needed is a “price discovery” mechanism for what the buy-side should be paying for sell-side and third-party research. At least with this information, the money managers can ensure that they are in the ball park on the research spend component of their commission expenditures.