Proponents Fight Back to Defend Soft Dollars, Directed Brokerage
March 15, 2004
NEW YORK -- Soft dollars and directed brokerage are appalling and must be eliminated. That's the tune we've been hearing almost uninterrupted for the last several months as regulators and lawmakers have unleashed the hounds on the fund industry. But not all are on board with the efforts to kill the practices.
Many at the Institute for International Research's directed brokerage and soft-dollar practices forum here earlier this month argued that recent Congressional initiatives are misguided. Meanwhile, the Investment Counsel Association of America, whose membership consists of more than 300 investment advisory firms, urged the Securities and Exchange Commission to reject the Investment Company Institute's call for an all-out ban of third-party research from soft dollar practices.
While the SEC is considering prohibiting directed-brokerage agreements, there also is legislation pending in both the House and the Senate. The House's Mutual Funds Integrity and Fee Transparency Act of 2003, or the Baker Bill, now pending in the Senate, calls for increased disclosure and transparency. "I think HR 2420 means business as usual with a couple of caveats," said Lee Pickard, a partner with Pickard & Djinis, Washington, speaking at the IIR conference.
However, it is the Mutual Fund Reform Act of 2004, in the Senate, that packs a scarier punch, according to critics. Among a host of other things, the bill would prohibit soft dollars, directed brokerage and revenue-sharing arrangements. Plus, it would repeal the 12b-1 rule. The bill is being sponsored by Sen. Peter Fitzgerald (R-IL), Sen. Carl Levin (D-MI) and Sen. Susan Collins (R-ME), chairman of the Senate Governmental Affairs Committee.
"This bill is not benign," Pickard said. "There is no legal definition of soft dollars, but this bill has a definition, [calling them] arrangements, [or] payments, to broker/dealers for services other than trade execution. This bill would essentially eliminate not only secondary, but also proprietary research, whether Fitzgerald knows it or not."
One of several regulatory topics that Pickard took issue with was the industry's ability to explain to investors, in a meaningful way, the bid/ask spreads involved with transactions, which goes back to the issues of best execution and increased disclosure
"The whole issue of soft dollars can't be solved overnight with a simple two-line statute," said Jay Baris, partner at Kramer Levin Naftalis, New York. "There are many subtle issues and many factors that determine how an advisor determines best execution. It cannot be easily resolved with oversimplified legislation."
Carl Frischling, a senior partner, also with Kramer Levin Naftalis, and a speaker at the IIR conference, said Congress has done very little and left the bulk of the heavy lifting to the SEC. "I don't want to say legislation is not going to happen, but in terms of the substance of the issues, what the SEC has come out with, and I hear they are going to come out with additional things, we may not need legislation," he said.
However, Pickard says that the damage may already be done, with or without the passage of the current Congressional proposals. "The bill may not be going anyplace," he said of the proposal in the Senate, "but unfortunately it sets a precedent."
Pickard was not alone in his criticism. Due to the diversity of the investment advisory industry, there has been a varied reaction to proposals on soft dollars, according to ICAA. Some of its members have thrown their support toward eliminating soft dollars altogether, while other firms have volunteered to avoid the practice.
On the flip side, many firms have some serious concerns with the possibility of the elimination of soft dollars for third-party research. Those that oppose the ban say the move would result in less innovative and independent research, which in turn would hurt investors.
"We are persuaded that any proposal to eliminate soft dollars for third-party research, if adopted, would have unfortunate and untenable results," ICAA wrote in a recent statement. "It would result in an unjustifiable, unlevel playing field for many market participants."
The move could have negative consequences for those firms that benefit from third-party research, ramp up the costs for investment advisory firms, and hurt smaller firms. "Due to the widespread use of soft dollars, we believe that any major change in their usage may have significant and unpredictable consequences - for investors, investment advisors, third-party research providers, and full-service brokerage firms," according to a statement from the ICAA. "Given these potentially far-reaching implications, the SEC should take time to investigate the likely effects of any major changes in soft-dollar regulations."
TowerGroup also weighed in on the subject, saying the elimination of soft dollars would have a "distressing effect" on the brokerage and investment communities as well as possibly "paralyze" the industry and investors.
Robert Hegarty, the Needham, Mass.-based research and consulting firm's vice president, securities & investments, said the elimination of soft dollars could cause reduced spending on technology, as the money used to pay for the research evaporates. Even without legislation, soft-dollar spending is expected to drop more than 11% in the next five years, Hegarty maintained in a recent report.
Order flows would shift from brokers to electronic venues at an accelerated pace, soft-dollar brokers would become extinct, and investment managers would rely on external research on a less frequent basis, causing stagnation in innovative thoughts in the securities research field.
While some changes may be necessary in the soft-dollar system, the evolution should not occur immediately or all at once, Hegarty said. He suggests increasing transparency of these arrangements as well as mapping out a plan to phase out the use of soft dollars over time. "Because soft dollars are so entrenched in the brokerage and asset management industries and their interoperation, the rapid elimination of soft dollars would constitute a hard landing for both industries."
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