New York, NY – A few weeks ago, Securities and Exchange Commission Chairman Christopher Cox stunned the financial services industry by sending letter to Senate Banking Committee Chairman Christopher Dodd, and House Financial Services Committee Chairman Barney Frank requesting that the legislature eliminate soft dollars completely.
In his letter, and a subsequent speech before the National Italian American Foundation, Chairman Cox noted a variety of concerns he had about soft dollars – ultimately expressing his view that soft dollars "hurts investors and the US capital markets". However, we believe that Chairman Cox seriously underestimated the consequences that banning soft dollars could have on the very investors he is trying to protect.
When do soft dollars make sense?
We want to make it clear that the team at Integrity Research Associates agrees that soft dollars do not make much sense in a free market environment, and we would not recommend their use if we were building our financial markets again.
However, it is clear to us that the significant costs associated with eliminating them at this stage are too high for all involved – including retail investors. As a result, we now feel strongly that the commission needs to focus its attention on trying to help investors clearly understand how their commission assets are being spent, thereby enabling investors to make well informed investment decisions.
The Chairman Slips Up
Before we discuss the various negative consequences of banning soft dollars, we need to make it clear that Chairman Cox was seriously mistaken in his speech before the National Italian American Foundation when he explained that close to $1.0 billion dollars were currently being spent on soft dollars.
The reality (at least according to the SEC's own definition) is that institutional investors are currently spending almost $6.5 billion in soft dollars. This includes close to $1.0 billion in soft dollars for third-party independent research and almost $5.5 billion in soft dollars for proprietary sell-side research.
In fact, the SEC's interpretive guidance released in July of 2006 made it abundantly clear that the commission saw no difference between sell-side and independent research when it came to soft dollars. Unfortunately many journalists, money managers, and (apparently) even the SEC commissioner sees it differently.
However, it is extremely important that we have an accurate understanding of what comprises soft dollars so we can clearly understand what the negative consequences would be of banning them altogether.
Some Will Lose Access to Research
The first consequence of banning $6.5 billion in soft dollars would be to drastically reduce the amount of research from both independent research providers and from sell-side broker-dealers and investment banks. Now some would not see this as a dire consequence as they argue that too much research is currently being produced.
However, we need to understand that the loss of investment research would hurt a number of parties – many of whom cannot afford to produce this research on their own, including retail investors, micro and small cap companies, and mid and small money managers.
This could not be a good outcome as the investment playing field would become unlevel as the largest investors would be able to afford the best research, while the small players would have little or no research.
In fact, this outcome would be in direct conflict with past regulatory efforts to create a "level playing field" for investors, including Sarbanes Oxley, Regulation Fair Disclosure, and the Global Research Analyst Settlement.
Investors Will Lose Investment Options
The loss of sell-side and independent research will have a substantial impact on small and mid-sized money managers as most of these firms do not have the assets under management to be able to afford to build their own internal research departments, nor will they be able to pay enough for access to the limited research produced by Wall Street's remaining research departments.
Consequently, small and mid-sized money managers will probably either close up shop, or they will merge with larger firms in order to create the economies of scale necessary to be able to compete in the marketplace.
Not only will this reduce the number of options for investors, but it is also likely to reduce the performance of remaining investment options. Numerous studies have shown that very few money managers generate performance in excess of the market in general.
However, studies also show that the best performing money managers year after year are the small to mid sized funds. We suspect that the consolidation that is likely to occur as a result of eliminating soft dollars will not just reduce the number of money managers, but it will paradoxically eliminate the very managers that were generating the best returns.
Investors Could Actually Pay More
One of the arguments that Chairman Cox makes for banning soft dollars is that investors might be able to pay less if the practice were abolished. And at first glance, this argument makes sense as commissions could fall if all money managers were only paying for execution with client commissions.
However, this ignores the fact that many mutual funds and money managers will be faced with the prospect of having to pay for research (either internal or external) out of their own pockets if soft dollars were banned. As a result, we suspect that money managers will have an incentive to raise their management fees to cover these higher costs of operations.
US Will Lose Its Competitive Edge
Another cost of banning soft dollars in the US is the fact that we will inevitably become less competitive in the global financial markets. This is not terribly dissimilar to the trend currently taking place with small cap companies, who are taking their companies public overseas to eliminate the regulatory and financial burden of Sarbanes Oxley. Similarly, we would not be surprised if smaller money managers, broker-dealers, and independent research firms were to move their operations to the UK, Europe, and other regions where soft dollar regulations are less onerous.
A related cost associated with banning soft dollars in the US would be the creation of significantly varied regulatory regimes between various countries. This would result in increased costs of doing business for multinational firms as they would have to establish different compliance procedures for different regulatory regimes. This could contribute to companies' desire to do business in the US.
Who Might Win with No Soft Dollars
Besides the negative consequences of banning soft dollars, Chairman Cox has also missed the political ramifications of who benefits from eliminating the practice. It is clear to us that the three segments that actually benefits from banning soft dollars are the largest asset managers, the largest broker-dealers, and most hedge funds.
As was shown in the 4th Quarter of 2005, when Fidelity struck deals with Lehman Brothers and Deutsche Bank to pay for their research in hard dollars, some firms could actually win if soft dollars were banned. This is due to the fact that the largest money managers have sufficient assets under management to be able to afford to pay for internal or external research out of their management fees. Smaller players, however, don't have the scale to be able to compete.
In addition, the largest investment banks can also afford to maintain their research departments even if soft dollars are banned. These firms can, if they decide to, subsidize their research departments with the profits generated from investment banking, proprietary trading, and prime brokerage. In addition, reduced competition in the investment research business will increase the value of the research produced by the firms that are able to remain standing after soft dollars are eliminated.
Lastly, most hedge funds can, if they want to, circumvent the 28(e) safe harbor thereby reducing their need to use soft dollars. For example, hedge funds can include language in their Offering Documents enabling them to use client commissions to pay for research or any other fund expenses that management wants to. Consequently, hedge funds could legally continue using client commissions to pay for research even if soft dollars were banned.
In Summary
As we mentioned earlier, Integrity agrees with Chairman Cox's sentiment that the practice of using client commissions (soft dollars) to pay for research services creates many conflicts of interest that may not be in the best interests of the investor. However, it is also clear to us that the consequences of eliminating soft dollars are much too high to warrant such a precipitous move. In addition, we wholeheartedly believe that the SEC could address most of Chairman Cox's concerns and conflicts by mandating a commission disclosure regime in the US like the one adopted in the UK by the FSA. The big question is why hasn't he moved in this direction?
