New York, NY - The Securities and Exchange Commission announced that it plans to meet this coming Wednesday to consider whether to issue guidance to mutual fund directors on the use of “soft dollar” arrangements.
Many in the industry (ourselves included) have been waiting for the SEC to take substantive action to create transparency on how investors’ commission assets are being spent by investment managers. And while we hope this takes place on Wednesday, we are continuously amazed how little the SEC has done to rectify the gross under-reporting of soft dollar use that is currently taking place in the US.
According to the SEC, “soft dollars” are any commission payment made by an investment advisor that is in excess of the “cost of execution”. In Section 28(e) of the Securities Exchange Act of 1934, the SEC acknowledged that a money manager would not have breached their fiduciary duty if they used the soft dollar commissions of their advised accounts to obtain legitimate research and brokerage services.
This means that if an asset manager pays more than the cost of execution (say 1.5 cents per share) and they receive research from the executing broker-dealer, investment bank, or third-party independent firm, then they are deemed to have paid for this research with “soft dollars”. Of course, this use of client commissions is completely acceptable, being protected by Section 28(e).
Unfortunately, most investment advisers still don’t get it. They continue to report that they are spending much less in soft dollars than they actually are. And while it is unclear whether asset managers are doing this on purpose to mislead investors or not, it is clear that investors are not seeing the complete picture - and that is just how much of their money is being spent by their investment managers on external research.
Below we have included an excerpt from a recent copy of the SEC’s ComplianceAlert newsletter that reveals the extent of the problem. In this newsletter, the SEC discusses the results of a number of registered investment advisers use of soft dollars.
What is shocking is that the average percentage of soft dollars to overall commission dollars spent was reported as just 20% (with a range of 3% to 100%). The reason this is so surprising is that these advisers also reported that the average commission rate they paid was $0.05 per share (with a range of $0.01 to $0.08 per share). In my book, these advisers either overpaid for execution (which is highly unlikely), or else they paid close to 70% of their commissions as “soft dollars” to pay for investment bank, brokerage, and independent research (this was determined using the following formula ($0.05 - $0.015) / $0.05).
Of course, the reason the advisers reported 20% of their commissions was spent in soft dollars is probably because they mistakenly don’t consider the amount paid for proprietary sell-side research as “soft dollars”. However, the SEC examiners should understand this subtlety and have corrected the advisers they examined. Unfortunately, this did not take place.
So, while we are anxious to see if on Wednesday the SEC will issue guidance to Mutual Fund Directors on the use of soft dollars, we are not terribly confident that any guidance provided will actually help investors understand how their investment advisers are spending their commission dollars.
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Soft Dollar Practices of Investment Advisers
Examiners recently reviewed the soft dollar arrangements maintained by a number of registered investment advisers. The focus of these examinations was to gain a better understanding of: the extent to which advisers to institutional clients, including hedge funds, use soft dollar arrangements to obtain third-party and/or proprietary services or products; the disclosures advisers provide to their clients regarding soft dollar practices; and the policies and procedures that advisers who receive soft dollar benefits use to meet their fiduciary duty to seek best execution.
In reviewing soft dollar transactions, examiners generally review arrangements that an adviser may have with both third-party and proprietary providers. Generally, examiners will review documents and information regarding the adviser’s policies and procedures related to brokerage, trading, and soft dollar arrangements. In addition, examiners will consider the identity of broker-dealers and service providers used and the products and services received from them, as well as trade journals, commission runs, disclosure documents, investment advisory contracts, any written agreements relating to soft dollar arrangements (including commission sharing arrangements), and any documentation of the adviser’s periodic evaluation of execution quality.
In our recent review, examiners observed the following:
- Products and services. The advisers examined generally received both proprietary and third-party products and services through soft dollar arrangements with broker-dealers. Research and trade execution assistance products and services were the most common. Many advisers received “mixed-use” products or services and a few advisers received products and services outside those that are defined in the safe harbor under Section 28(e) of the Securities Exchange Act of 1934.
- Total commissions directed. All of the advisers examined who had soft dollar arrangements told examiners that they had informal commission “targets” with the broker-dealers who provide them with third-party or proprietary research services. Advisers stated that these commission targets were intended as guides and did not obligate the advisers to firm commitments. On average, 20% of these advisers’ total client commissions were directed to broker-dealers through which the advisers earned soft dollar credits, though the percentage among all of the advisers ranged from about 3% to 100%. Commissions on transactions that earned soft dollar credits ranged from $0.01 to $0.08 per share, with an unweighted average commission rate on soft dollar trades of $0.05 per share.
- Best execution analyses. Most advisers documented their efforts to seek best execution, as required. Advisers typically conducted “periodic” execution quality reviews on an annual, semi-annual, or quarterly basis. To ensure consistency with regulations and internal compliance policies and procedures, many advisers chose to assign the responsibility for such reviews to brokerage or compliance committees. Examiners evaluated the quality of firms’ best execution reviews, which varied - some were more detailed and comprehensive than others.
Most of the advisers examined who were relying on the Section 28(e) safe harbor made determinations that commissions were reasonable in light of the brokerage and research services received, as required. Some advisers, in making such determinations, elected to regularly compare the amount they might have been “paying up” against the actual value of the research. In situations where advisers have not evaluated the value of the research received through the use of soft dollar credits and the commissions are higher than examiners would expect for the instruments traded, examiners may question whether the advisers have overpaid for such research.
A few advisers accumulated large soft dollar credit balances at broker-dealers, up to millions of dollars in value. As a result, examiners analyzed further whether the commissions paid may not have been reasonable, especially when some advisers were paying higher commission rates and were not receiving products or research. For example, examiners evaluated whether an adviser had the opportunity to misappropriate client assets, such as if an adviser accepted cash rebates offered by broker-dealers for the outstanding soft dollar credit balances maintained with the broker-dealers.
- Disclosures. Most of the advisers disclosed the types of products, research and services received in exchange for soft dollars, as required. Advisers also generally complied with regulatory guidance by disclosing: that clients may pay commissions higher than those obtainable from other broker-dealers in return for the research, products and services; that research is used to service all accounts and not just those accounts paying for it; and, the procedures they follow when they direct client transactions to particular broker-dealers in return for products, research and services received.
Most advisers complied with their obligation to disclose the existence of conflicts of interest from their receipt of research obtained with soft dollars, including the adviser’s incentive to use client brokerage commissions to purchase research that the adviser might otherwise have to purchase with its own money. They also, as required, disclosed that certain products and services may have a mixed-use and the extent of the allocation between hard and soft dollars. However, examiners commented when an adviser does not disclose conflicts of interest, such as when an adviser has acquired research with soft dollar payments from a research company in which affiliated persons have an ownership interest.
Examiners also commented when advisers that acquired products and services outside the Section 28(e) safe harbor, such as internet domain fees, wireless services for a Blackberry, and telecommunications and computer equipment, did not disclose this practice to clients. Examiners also may comment if an adviser expressly represented to clients that it would only engage in soft dollar arrangements within the Section 28(e) safe harbor, but nonetheless earned soft dollar credits by trading in accounts for which the adviser does not have brokerage or investment discretion.
- Compliance policies, procedures, and/or controls. Most advisers examined had policies and procedures related to soft dollar practices. While these policies and procedures varied per firm, examiners noted that effective practices required the adviser to maintain reports of soft dollar arrangements and transactions, reconcile commissions on a periodic basis, review mixed-use product allocation, and ensure that its chief compliance officer or a committee approve, in advance, specific products and services acquired with soft
