A Witch's Brew: An Excerpt of Cox's Recent Comments on Soft Dollars

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New York, NY – As the financial services industry tries to make sense out of SEC Chairman, Christoper Cox’s recent about face on “soft dollars”, many analysts on the topic have been trying to divine clues to his motivations by reading Cox’s various public comments on the subject.  Cox’s most recent speech, given last Thursday to the National Italian-American Foundation, included his latest discussion on the practice.

The following is an exerpt from Chairman Cox’s speech dealing with the topic of “soft dollars”.

“There’s another way that the research business needs to keep pace with change. Some of our most important rules concerning investment research date back over 30 years, to 1975, when most stock research was in the form of paper reports. In that year, to help make the adjustment from fixed commissions to the new era of competition, Congress allowed investment advisers to pay higher than market rates for brokerage commissions as a way to cover the cost of research.

That was a very long time ago. Today, the market considerations that gave rise to so-called “soft dollars” are as out of date as the Betamax, leisure suits, and “Welcome Back Kotter” – all vintage 1975 as well.

In a “soft dollar” transaction, an investment adviser’s customer pays one price – say five cents a share – that covers both the cost of the trade and other research products and services as well. But while investors pay these costs, most investors are unaware of them. That’s because for all intents and purposes, these fees are hidden.

And it isn’t just retail investors, but even large sophisticated customers of money managers who have difficulty figuring out exactly what their money is buying. Soft dollars make life extremely difficult for investors of all kinds who are trying to understand where their money is going. Soft dollars need to see the light of day.

The fact that soft dollars are hidden from view means their use isn’t subject to the same robust scrutiny and oversight that investors apply to the costs that investors can see. And this lack of transparency has led to abuses. We’ve seen examples of money managers using their clients’ soft dollars to pay for office rent, furniture and equipment, lavish trips, theater tickets, and fancy meals. In fact, the most common abuse of soft dollars appears to be advisers using their clients’ money to pay others for referring new clients to the adviser. That’s not exactly the kind of “research” that will help investors’ portfolios.

Even aside from abuses, the lack of transparency may be contributing to higher costs. These higher costs are borne directly by investors in mutual funds, pension funds, and 401(k) plans. Today, when so many American investors are saving for retirement, these extra costs can shave off critical returns that amount to big money in the long run.

There are also inherent conflicts of interest in the use of soft dollars that offer perverse incentives to investment advisers to use them in ways that aren’t beneficial to investors. That’s because soft dollars offer the opportunity for money managers to use the client’s money to pay for expenses the money manager normally would pay itself. Using the client’s money may also remove the adviser’s incentive to keep its own costs down. And to generate soft dollars, the adviser has an incentive to trade even when it’s not in the client’s best interest.

Soft dollars can also create incentives to use one client’s commissions to pay for another client’s research. Beyond ill serving investors, all of this is unfair to money managers. Money managers should never be put in the position where they have an incentive not to put the client first.

As if all of this were not enough, we now have a whole cottage industry of lawyers who give advice on what is “soft dollarable,” and what’s not. The legal tests are complicated. The SEC’s staff spends a considerable amount of time answering questions about how to interpret our guidance.

Let me give you an example of the complexity: The Commission’s soft dollar interpretation allows a particular product to be considered both “research” and “not research” at the same time. These are so-called “mixed use” products, which can be paid partially in soft dollars and partially in real, hard dollars. The money manager has to allocate the costs, and disclose them separately. This is unnecessary complexity, which leads to unnecessary costs. And as always, it’s the investor who ends up footing the bill.

This witch’s brew of hidden fees, conflicts of interest, and complexity in application is at odds with investors’ best interests. We all know we can do better. That’s why I’ve asked Congress to consider legislation to repeal or at least substantially revise the 1975 law that provides a “safe harbor” for soft dollars.

For our part, we’ll continue to monitor the abuses in order to bring hidden soft dollar expenditures to light – and to ensure that to the maximum extent possible, soft dollars are used only for research. Here again, our goal is to help investors to get the information they need, in a form they can really use and understand.”

Comment by Bill George:
I believe Chairman Cox’s comments did not sufficiently differentiate between soft dollars used to purchase independently produced investment research and soft dollars used to buy bundled undisclosed proprietary research and other services from full-service brokers. I believe this lack of differentiation contributes to a misunderstanding of the entire issue of soft dollars. Also, I believe the Chairman’s definition of mixed-use services in this speech seems to be designed to raise questions about a practice about which the research and third-party brokerage industry has a clear understanding. In my opinion, his comment about mixed use services create unnecessary doubts and may stimulate bias relating to an area that is a fairly well understood concept / practice.

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