Soft-Dollar Dilemma Dogs Fund Industry: Unbundling Might Not Be the Solution, SEC Says
April 10, 2006
PHOENIX - Vanguard Group General Counsel Ari Gabinet likes to recall the time he was asked to speak on soft-dollar best practices at a recent conference.
"I said, no," Gabinet said coyly, tongue firmly planted in cheek.
What makes Gabinet's anecdote so humorous, of course, is the fact that "soft dollars" were originally designed as a harmless way for brokerage houses to add value to their services. But, as the scandal revealed, brokers over the years had begun offering more than just research tools in exchange for trade execution, kicking back to mutual funds everything from swanky vacations to tickets to high-profile sporting events.
As Gabinet, a former enforcer in the Securities and Exchange Commission's Philadelphia office, further recalled, he once discovered in a broker's soft dollars a Talbots credit card receipt belonging to the wife of a portfolio manager.
So, to mention soft dollars and best practices in the same breath these days would indeed seem a bit absurd, but the fact remains that soft dollars is a $10 billion annual business, according to one industry estimation. It's probably safe to assume, then, that soft dollars are here to stay.
But new rulemaking, experts say, has created an enormous dilemma for funds and their brokers. While some larger money managers burned by suspect soft-dollar practices have gone so far as to demand that brokers separate, or unbundle, research from the trade execution, that request risks placing some brokers outside of other SEC laws. That development, coupled with what could be viewed as competing regulations recently passed by the Financial Services Authority in the United Kingdom, has led to a host of new questions surrounding the use of soft dollars.
Adding a dose of irony to the situation is the fact that the SEC issued an interpretive release last year that was meant to mitigate any potential misunderstandings over its soft-dollar rule, a 30-year-old mandate known officially as Rule 28(e). In short, the SEC's clarification didn't outline exact products or services that would be lawfully considered research or brokerage, but instead left it to the advisor to make that determination. Advisors must also make a good-faith determination that the price of those products or services is reflective of their usefulness. This, investor advocates have claimed, has broadened, rather than narrowed, the definition of research and will only exasperate questionable soft-dollar usage.
So it could be suggested that funds and brokers are more lost today than they were three years ago, when Federal and state regulators first began sniffing around commission arrangements. In fact, experts at the Investment Company Institute's 2006 Mutual Funds and Investment Management Conference, held here recently, said the dilemma has the potential to capsize some brokers and jeopardizes what many advisors consider a key decision-making tool.
But for starters, Gabinet said his former bosses should get up to speed with their colleagues overseas and determine exactly where a trade begins and ends.
"The FSA trumped the SEC," Gabinet said, noting that the disparity has imposed unfair difficulties on money managers with international operations.
While the SEC is fuzzy over when the trade a begins, which is a key factor in determining what can be lawfully included as research, he said the FSA's new regulations state that it begins when the portfolio manager makes his decision, not when the order is received. That means, for example, expensive order-management systems could be included as research under FSA rules. Under SEC guidance, which seeks to separate hardware from software, it could be considered outside the regulator's recent interpretive release. The FSA also issued recent guidance on what would be considered soft dollars, or "soft commissions" as they say, in a rule. The SEC, meanwhile, issued an interpretive release that isn't quite as specific.
The FSA also went so far as to demand that funds disclose soft-dollar arrangements to investors, a step the SEC has chosen to delay.
However, SEC Division of Investment Management Associate Director Robert Plaze maintained that the FSA and the SEC rules on soft dollars are more similar than they are different. Both agree, for instance, that overhead items like telephone lines and office equipment do not constitute research. But, he said, "The FSA didn't trump the SEC. Actually, the SEC worked closely with the FSA on their conceptual rulemaking."
Plaze also indicated that the SEC has received several "interesting" comments in recent months regarding the exact timing of order placement. "We'll have to look closely at those," he said.