New York - A Financial Times Article this morning discusses a plan by Citi to reverse the changes it made in response to the Global Research Settlement, spearheaded by Elliot Spitzer when he was New York’s Attorney General.  As a consequence of the settlement, Citi’s equity research department had been moved to Smith Barney’s wealth management group. Now, Citi is considering moving the equity research department back to the institutional securities division.

The main reasons for the expected changes are the economies of scale and economies of information within the research function—including fixed income, economic and equity—that would be achieved if all the groups were together. Additionally, the move would place the equity research group within the group—institutional securities–that mostly pays for the research services.

In some investment banks, involved in the settlement, the equity research team had been separated from the bankers organizationally rather than moving them to another department. The Sarbanes Oxley legislation enforced theses “Chinese walls” between the bankers and the equity research team, but did not force them to physically move to other divisions within the bank.

Between the Lines

Citi’s expected move could be an initial salvo in reference to how investment banks in general will react to the end of the settlement. Citi seems to be indicating that the perhaps things will revert somewhat to business as usual after the settlement expires in the summer of 2009.

We expect that the main trend will be for the IBs to unwind their relationships with independent research providers that were solely a result of the settlement. Those relationships that do work may be maintained and the platforms that have been developed by Goldman and Merrill will continue to exist. One saving grace for the alternative research providers has been the development of CCAs and CSAs in the interim. These vehicles give the alternative research shops more scope to go direct-to-client without the need for broker dealer status and make easier for buyside clients to get highly valued alternative research while maintained limited brokerage relationships.

New York - Forrester Research Inc. announced on Thursday (July 31^st) that it was acquiring JupiterResearch for $23 Million cash. JupiterResearch will augment Forrester’s Marketing & Strategy Client Group, which accounted for $46.4 million of Forrester’s total 2007 revenue ($212 million). JupiterResearch posted revenues of approximately $14 million in 2007.

Forrester Research was founded in 1983 by George F. Colony, now Chairman of the Board and Chief Executive Officer, in the basement of his home in Cambridge, Mass. The company made its initial public offering of 2,300,000 shares in November of 1996, they made a secondary public offering of 626,459 shares in February of 2000. Forrester Research, Inc. (Nasdaq: FORR) is an independent technology and market research company that provides advice to professionals in business and technology. Forrester provides proprietary research, consulting, events, and peer-to-peer executive programs that focuses on the business implications of technology change. Forrester clients include marketing executives, business strategists, and IT professionals. Forrester’s clients have access to select research reports, the Forrester web site, research alerts, RSS feeds, and newsletters featuring analyst insight. Some of the reports which Forrester creates are Vendor Product Catalogs, which compare a wide array of available products and include actual user ratings and comments. They also have reports which focus on decision making tools, as well as reports that give advice about hot issues, emerging technologies, and consumer trends. Forrester has offices in Massachusetts, California, Washington D.C., Connecticut, Amsterdam, Frankfurt, London, and Paris.

JupiterResearch delivers research, analysis and advice, backed by proprietary data, to aid companies in determining how they can best profit from the impact of the internet and emerging consumer technologies. JupiterResearch offers an array of products and services which support business decisions at all technology-dependent companies. Their subscription-based syndicated research service provides access to a library of written research and data in dozens of technology, functional and industry vertical coverage areas. Analyst access is another main feature of Jupiter’s value. Jupiet also offers custom research services, which enable clients to direct the resources of JupiterResearch toward specific topics of importance. Another product, Web site review, delivers an unbiased third-party expert assessment of a company Web site and provides specific suggestions for improving the effectiveness of the site. Speaking engagements are also offered.

A number of people may read about this acquisition and wonder what the broader implications are. For starters, Josh Bernoff an analyst at Forrester, wrote in his blog that the acquisition “will increase Forrester’s research staff in the Marketing and Strategy area… by 58%.” He goes on to elaborate that their biggest problem is keeping up with client demand and that adding the new analysts from Jupiter is a quick way to alleviate this problem.

Further, this is not the first time that Jupiter has seen an interest from another research provider. In 1997 Gartner made a minority investment of 32% in Jupiter communications which was an ancestor of JupiterResearch. Acquisitions are an easy way to gain experienced headcount and nothing new in the industry. At $23 million, Forrester seems to have made itself quite a deal, especially considering that JupiterResearch reported revenues of $14 million in 2007. Forrester can also now take Jupiter’s client base and try to earn revenue from them utilizing their larger sales force.

Jupiter has a long history, having been founded in 1986 by Josh Harris as Jupiter Communications, going public in 1999, merging with Media Metrix in 2000, selling its syndicated research business to INT Media Group in 2002, being acquired by MCG Capital in 2006 and now being acquired by Forrester in 2008. One interesting item to note in this history is the fact that MCG Capital acquired Jupiter in 2006 for $10.1 million and just two short years later has managed to flip the company for more than twice that amount at a revenue multiple of more than 1.6. That’s a nice profit for MCG Capital, and one which possible stems from a greater interest right now in Industry consulting firms.

The original press release can be found below:

FOR IMMEDIATE RELEASE

Forrester Acquires JupiterResearch
Combined Companies To Provide Enhanced Offerings To Marketing & Strategy Professionals

Cambridge, Mass., July 31, 2008 . . . Forrester Research, Inc. (Nasdaq: FORR) today announced that it has acquired JupiterResearch, LLC, and its parent company, JUPR Holdings, Inc., from MCG Capital Corporation (Nasdaq: MCGC) for $23 million in cash plus assumed liabilities, subject to post-closing adjustments, in a strategic purchase that complements Forrester’s syndicated business model. JupiterResearch has 82 employees and 2007 revenues of approximately $14 million. Forrester, with 2007 revenues of $212 million, now has more than 1,000 employees. JupiterResearch joins Forrester’s Marketing & Strategy Client Group, which contributed $46.4 million to Forrester’s total revenue in 2007.

“Uniting JupiterResearch and Forrester brings together the two leading research brands used by Marketing & Strategy executives,” said George F. Colony, Forrester’s chairman of the board and chief executive officer. “JupiterResearch enhances our existing role-based strategy and offerings to bring unprecedented value to Forrester’s Marketing & Strategy clients. We welcome JupiterResearch employees and clients to Forrester.”

Forrester serves marketing and strategy, IT, and technology industry leaders across 19 professional roles. The addition of JupiterResearch will fortify Forrester’s existing data-driven insight, forward-looking research and analysis, objective advice, and best practices for Marketing & Strategy professionals globally. These professionals include CMOs, consumer market researchers, consumer product strategists, customer experience experts, direct marketers, interactive marketers, and eBusiness and channel specialists at major companies.

Like Forrester, JupiterResearch provides business professionals with syndicated research, analysis, and advice backed by proprietary data. JupiterResearch has a substantive and growing library of syndicated research and strong consumer data and excels at market forecasting.

“Acquiring JupiterResearch is a significant step in our growth strategy for the Marketing & Strategy segment of Forrester’s business,” said Dennis van Lingen, managing director of Forrester’s Marketing & Strategy Client Group. “JupiterResearch’s established offering, well-respected research team, and strong sales organization complement Forrester’s and solidify our long-standing leadership position as advisors to Marketing & Strategy professionals worldwide.”

“We are very excited to be joining the Forrester brand, culture, and community,” said David Schatsky, president, JupiterResearch. “For a quarter of a century, Forrester has been a trusted advisor to many of the top businesses and organizations in the world, and we are honored to bring the best of JupiterResearch to the Forrester name.”

Forrester will discuss the JupiterResearch acquisition today at 11 a.m. ET as part of the company’s second-quarter earnings call. Investors interested in listening to the Webcast can preregister at https://www.theconferencingservice.com/prereg/key.process?key=PUGCD66A3.

During the JupiterResearch acquisition, Forrester was represented by The Jordan, Edmiston Group, Inc., a New York City-based investment bank that specializes in the media and information industries.

About Forrester Research

Forrester Research, Inc. (Nasdaq: FORR) is an independent research company that provides pragmatic and forward-thinking advice to global leaders in business and technology. Forrester works with professionals in 19 key roles at major companies providing proprietary research, consumer insight, consulting, events, and peer-to-peer executive programs. For more than 25 years, Forrester has been making IT, marketing, and technology industry leaders successful every day. For more information, visit www.forrester.com.

This press release contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements, which include statements about the benefits of acquisitions, are based on Forrester’s current plans and expectations and involve risks and uncertainties that could cause actual future activities and results of operations to be materially different from those set forth in the forward-looking statements. Important factors that could cause actual future activities and results to differ include, among others, Forrester’s ability to anticipate business and economic conditions, technology spending, market trends, competition, industry consolidation, the ability to attract and retain professional staff, possible variations in Forrester’s quarterly operating results, risks associated with Forrester’s ability to offer new products and services, and Forrester’s dependence on renewals of its membership-based research services and on key personnel. Forrester undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. For further information, please refer to Forrester’s reports and filings with the Securities and Exchange Commission.

Contact:

Karyl Levinson
Vice President, Corporate Communications
Forrester Research, Inc.
+ 1 617/613-6262
press@forrester.com

Michael A. Doyle
Chief Financial Officer
Forrester Research, Inc.
+ 1 617/613-6181
investor@forrester.com

New York - Last week brought a setback for the development of efficient capital markets in China. The China Securities Regulatory Commission “suggested” to domestic fund managers that they avoid making any negative public statements about Chinese stocks. According to the South China Post, the securities regulator also required four financial newspapers to publish upbeat reports about the market.

We do not expect that this will do anything significant to prevent further volatility and losses in the stock market. Negative information will continue to flow through the internet and word of mouth, at least for those who are well connected. Institutional investors, both in China and abroad, will continue to be able to employ internal and external research analysts; it does not seem to have occurred to the Chinese authorities that there are thousands of analysts, consultants, market researchers, and economists who will continue to supply relatively high quality information to institutional investors. For those who can afford to pay for good research and information, the regulation is meaningless.

However, by preventing domestic fund managers and newspapers from issuing negative commentary to the public, the CSRC has ensured that small investors in China will receive even less useful information than they have now. In short, rather than preventing any slide in stocks, this measure gives institutional and foreign investors even more of an advantage over the domestic retail crowd. More than preventing “instability”, we expect this legislation will only exacerbate the eventual pain felt by small investors.

In the past, Western observers may have been able to feel some smugness when developing countries adopted illiberal and inefficient regulations. However, given the recent decision by Western regulators to focus on rumor-mongering and naked shorting, as opposed to the fundamental problems that caused banks to be so vulnerable to rumors and short-sellers, we are hardly in a position to criticize the Chinese ban on negative commentary. The dislike of skeptics truly transcends all cultural boundaries.

New York, NY - This past week the SEC voted unanimously to issue guidance to mutual fund directors on what type of oversight boards should provide on soft-dollar arrangements used by a fund’s advisers.  The release of the proposed guidelines will be followed by a public comment period which ends on October 1st.  Besides the actual guidance provided, we were also interested in the fact that comments by senior SEC members revealed that a deep conflict currently exists within the commission over this topic.

Changing the Balance?

In comments regarding this guidance, SEC Chairman Christopher Cox noted that some fund boards might opt to instruct their advisers to eliminate the use of soft dollars altogether.  He also suggested that the forthcoming guidance might “change the balance between board and adviser”.  These comments are consistent with the Chairman’s comments in the past suggesting that soft dollars should be banned altogether. 

However, Andrew Donahue, the director of the SEC’s Division of Investment Management explained that the purpose of this guidance would be to “promote a dialogue on best execution” - rather than focus on soft dollars in isolation.  Donahue also disagreed with Chairman Cox’s characterization that the coming guidance would change the balance between board and adviser.

Purpose of the Guidance

Despite the obvious conflicts, what everyone does agree on is that mutual fund directors are being overwhelmed by the sheer volume of transaction data, and they need help and directions on how to better handle this deluge.  The SEC’s guidance is meant to recommend information that mutual fund boards should request from advisers instead of trying to monitor each trade.  This information is likely to include how advisers are using client commission dollars to pay for execution and research services.

Integrity’s Take

It is clear to us that Chairman Cox is continuing to wage his own personal war on that “witches brew” called soft dollars.  However, it is also clear that few others are willing to jump on his bandwagon due to the severe consequences that eliminating soft dollars could have on the entire financial services industry.

What Chairman Cox seems to surprisingly miss is that soft dollars are not merely the $1.0 billion in commissions that money managers “pay up” for third-party services.  Instead, soft dollars are the $5 to $6 billion in client commission dollars that is currently being spent over and above the lowest cost of execution for both sell-side and independent research.  This distinction was made clear by the Commission in their 2006 Interpretive Guidance.

“Section 28(e) applies equally to arrangements involving client commissions paid to full service broker-dealers that provide brokerage and research services directly to money managers, and to third-party research arrangements where the research services and products are developed by third parties and provided by a broker-dealer that participates in effecting the transaction. Today, it remains true that, if the conditions of the safe harbor of Section 28(e) are met, a money manager does not breach his fiduciary duties solely on the basis that he uses client commissions to pay a broker-dealer more than the lowest available commission rate for a bundle of products and services provided by the broker-dealer (i.e., anything more than “pure execution”).”

Consequently, the elimination of “soft dollars” would mean that investment advisers would be forced to pay for all sell-side and independent research out of their own pockets.  We suspect this would cause buy-side investors to slash a significant amount of what they currently spend on external research - a move that would obviously cause tremendous pain for sell-side and independent research providers.  In addition, we think that money managers, faced with higher research expenses, would probably raise fees to investors.  And these consequences don’t include the cost of lower investment returns caused by more limited research.

Fortunately, many others in the industry, including senior staffers at the SEC, and the lobby for the money management and the broker-dealer communities, all get the joke. As a result, we expect they all will continue to fight off Chairman Cox’s efforts to ban soft dollars.

New York - Merrill Lynch has been charged with fraud by the Massachusetts Securities Division. The research department deserves a comment, but sales and marketing deserve two.

Conflict of interests reflected in research -again

Next in the line of sell side firms facing charges due to conflict of interests in their research is Merrill Lynch - yes, again. Yesterday, the Massachusetts Securities Division (MSD) charged this Wall Street giant with fraud, as well as dishonest and unethical conduct in dealings involving Action Rate Securities (ARS).

According to the MSD’s fraud complaint, and the 53 exhibits supporting it, Merrill violated several regulations since it created, and successfully implemented, a sales and marketing structure which misled investors and shook the stability of the entire auction market. According to the complaint such sales/marketing structure, and its interaction with the research department, rendered thousands of investors with illiquid investments.

Not surprisingly, Merrill has been in the headlines over the past 24 hours. Leading newspapers are slush with quotes such as the following, which appears in the complaint’s summary: “Particularly egregious, was the manner in which Merrill Lynch co-opted its supposedly independent Research Department to assist in sales efforts geared towards reducing its inventory of ARS.”  

Furthermore, the complaint, and of course the media, released a number of e-mail communications from sales and trading personnel showing attitudes and comments not aligned with their recommendations to investors. Almost seven years after Spitzer’s hit on Wall Street using their own e-mail messages as proof against them, it is shocking to still see executives being incriminated through their e-mails. In this particular case, microwave ovens needing to me moved (i.e. securities), and $2K dinners in fancy restaurants are part of the repertoire of communications that bring to light the managers’ real motivations.

Merrill has issued a statement in response to the MSD complaint. The firm assures that it sold ARS, not in an attempt to quickly get rid of underperforming securities, but because they thought they were a good investment opportunity for their clients.

Reddite ergo quae sunt Caesaris, Caesari  (Then give Caesar what is Caesar’s)

Despite the many similarities with the Spitzer’s era, this case has one particularity: analysts in the research department dutifully reported the risks with ARS. The MSD’s complaint establishes that “when Sales and Trading, including Auction Desk personnel, did not agree with the tone or context of a published research piece, Merrill Lynch managers permitted Sales and Trading to insist the published report to be retracted and replaced with a more sales friendly piece.”

The complaint includes evidence to the fact that the analysts refused to alter their report upon initial request from the Manager Director in charge of the auction desk. However, eventually the Research Department agreed to re-write the piece giving glowing recommendations for ARS.

The 2002 Global Research Settlement banned investment bankers, not sales personnel, from influencing analysts. Common sense, ethical principles, and the law indicate that analysts and research professionals should not yield to any external pressures. Neither their reports should give in to conflict of interests. However, giving Caesar what is Caesar’s, Merrill’s analysts initial report was accurate in denouncing the dangers of ARS. Management, sales, and trade personnel shoulder a big responsibility here. Defending themselves from these people’s pressures is not part of an analyst’s job description.

The enforcement section of the complaint seeks to repair the damage caused to investors and to punish the violator. Hopefully this will restore investors’ confidence in financial services research.

END

New York—Yesterday the SEC issued draft guidance for directors of registered 40 Act funds relating to ‘soft dollar’ practices.  In the ‘sunshine’ meeting in which the commissioners discussed the proposed guidance, it was clear that the SEC itself, exemplified by Chairman Christopher Cox, has some confusion on the subject.  Yet it is asking fund directors, already overburdened with multiple other responsibilities, to take up the mantle.  After failing to come up with any meaningful soft dollar disclosure guidance in its Form ADV proposals, the SEC is now trying to pass the ‘soft dollar’ buck to the fund directors.

Shockingly, Chairman Cox, after three years on the job, still doesn’t understand soft dollars.   He still thinks of soft dollars as extra commissions paid for third party research, and refers to soft dollars as ‘almost a billion dollars.’  Someone should inform the Chairman that, in fact, soft dollars includes payments to broker dealers for proprietary research and totals between $4 and $5 billion in the U.S.

It is also clear that the Chairman’s intent with the new guidance is to strong arm fund directors into banning soft dollars.  His opening remarks illustrated his ongoing hostility to soft dollars, and he repeatedly suggested that directors should ‘rein in’ the use of soft dollars.  He concluded with two ‘examples’ of how directors might respond to the guidance: 1) they might limit the use of soft dollars or 2) they might prohibit soft dollars.

Perhaps if the Chairman understood that over 90% of advisors pay some form of soft dollars for research he would have a more nuanced view of the situation.  Then again, perhaps not.  The issue is somewhat moot since the Chairman will be leaving soon.  However, it does raise the question: if the Chairman of the SEC doesn’t understand soft dollars, how can you expect fund directors to understand it?  This is the problem the SEC has set itself, aggravated by the fact that the SEC has done precious little to improve the overall disclosure of soft dollars.

Fund directors have a lot on their plate.  During yesterday’s open meeting, SEC staff described how fund directors are being given large ‘books’ of trade data, and have little sense of how to interpret it.  The SEC staff repeatedly used the adjectives ‘overwhelmed’ and ‘befuddled’ to describe fund directors on the topic of execution generally and soft dollars specifically.  In theory, the 38 page draft guidance will provide assistance directors in cutting through the confusion.  We’ll give a considered response once we’ve gone through the draft in detail.  However, the risk highlighted by Commissioner Atkins in his questions to SEC staff is that this becomes one more ‘check the box’ item given cursory attention.

Finally, those of you in the alternative research industry (independent research, if you prefer) should pay close attention to this current proposal.  If Chairman Cox had his way, this proposal would be a back door route to banning or limiting soft dollars.  His influence may be limited, but the sentiments die hard.  Comments on the proposed guidance must be received by the SEC by October 1^st.  The full document can be viewed at http://www.sec.gov/rules/proposed/2008/34-58264.pdf.  The webcast of the sunshine meeting can be viewed at http://www.connectlive.com/events/secopenmeetings/.    

New York – News yesterday that Auerbach Grayson is biting the bullet and switching to XBRL format for its research reports is good news. The research reports will become interactive documents compared to static documents and will be labeled Interactive Global Express Research.

To accomplish the transference of the data, Auerbach Grayson has partnered with SavaNet, an XBRL software specialist. XBRL has been mandated by the SEC as a standard format for companies to report their corporate filings and this can be easily translated into research once on the XBRL standard has been implemented. Auerbach’s global network of exclusive brokers will also adopt the standard, which will dramatically increase the comparability of research offering from emerging and frontier markets.

Auerbach Grayson & Company Incorporated is a stockbroker committed to serving the international needs of major US institutional investors. Through its worldwide network of broker partners, Auerbach Grayson offers research, execution and clearance in equities, derivatives and fixed-income instruments. The firm also provides and implements hedging and arbitrage strategies.

SavaNet XBRL Analyst was designed by former Wall Street equity analysts and by CFA® charterholders for use by professional institutional clients requiring the highest level of quality and accuracy. SavaNet Analyst uses the extreme detail available only in XBRL formatted financial reports, such as company-specific business segment information, industrial KPIs and complete notes to the financial statements, to perform analytical studies. Analysis and valuation work can be performed directly using the report content without the need to normalize or manually re-enter content.

Note: XBRL is Extensible Business Reporting Language and has its roots in XML Extensible Markup Language.

New York—When this bear market ends (this fall? next spring?) there will be plenty of cheap stocks, a great environment for value oriented asset managers (assuming all their investors haven’t redeemed in the meantime.)  This leads to the question of which types of research do value investors favor.  Presumably, value-friendly research will do well (if the firms are still around.)

Value oriented investors trace their roots to Benjamin Graham, who first popularized the discipline of valuation analysis.  Graham’s investment philosophy was to buy good assets cheaply, when they are out of favor.  Or, as Warren Buffet puts it, ‘finding an outstanding company at a sensible price.’

There are many flavors of value investors ranging from the growth oriented (growth at a reasonable priced, or GARP) to those that primarily focus on bargains (deep value).   At the far end of the spectrum are the distressed investors which invest in bankrupt or near-bankrupt companies (and are currently thriving.)  Many hedge funds are value investors, including many of the Tiger cubs.  The so-called father of hedge fund investing, Alfred Winslow Jones, was a disciple of Graham’s who decided to add short selling (and leverage) to the repertoire.

So what types of research do value investors use?  Value investors are naturally disposed toward fundamental research, but there are many ‘buts’ to add to this.   The biggest ‘but’ is that most fundamental research does not deviate greatly from consensus, and value investing goes against the grain (or at least that was the original intent.)   Yes, fundamental research is valuation oriented, but for the most part it doesn’t do a great job in finding value in unpopular or undiscovered stocks. 

The disaffection with conventional fundamental research has prompted a growing number of value investors to do their own primary research, sometimes for idea generation, more often for refining potential ideas.  There are a variety of primary research tools available: expert networks, market research, channel checking, data mining, even web scraping (or search-based research as we call it.)    The most popular primary research tools are expert networks, which are relatively easy to use and provide fast results.  Market research and channel checking take more time but often provide more thorough analysis.  Value investors are less likely to use data mining and search-based research than some other investors, in our experience.

Value investors also gravitate toward more specialized forms of research such as forensic accounting and earnings quality analysis, whether to help avoid those stocks which are correctly undervalued or to help refine short ideas.  Other specialist research of interest to value investors include spin-off research,  distressed and management quality analysis.

Some value investors use quant screens for idea generation, and turn to external sources of quant research.    Among the quant providers, those that use valuation models are most popular with value investors.  Providers of Economic Value Analysis (EVA), which is cash flow oriented, tend to also do well.

Value investors also use investment strategy firms for idea generation and sector weightings.

Sector specialists in ‘value-oriented’ industries, such as financial services (now extra, extra value), industrials, and consumer, also tend to be well used by value investors.   Industry analysis generally is of interest, and some value investors use industry consulting firms which specialize in providing analysis and forecasts of a specific industry—typically sold back into the industry followed. 

 So, during the darkest hours of this bear market, think of the silver lining—more investment opportunities and more sources for research to help find them.

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.

———————————————————————————————–

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 dollars.