New York-The Canadian Securities Administrators (CSA), regulator of Canadian financial markets, is expected to release new soft dollar regulation which goes beyond the current regulation in London and New York. The comment period on the proposed legislation, National Instrument 23-102, closed last October and the regulation is expected to be adopted this quarter. If implemented as proposed, the regulation will require significantly more commission transparency than is current market practice because it will force asset managers to itemize each service received as part of bundled commissions and allocate those costs to each of their clients.
Bundled commissions are soft dollars
Like the SEC, the CSA views soft dollars as encompassing the bundled research and other services included in the equity commissions by securities firms: “[the term] ‘soft dollar arrangements’ includes both bundled services provided to advisers by dealers and allocations by advisers of part of the commissions paid to dealers to third parties.” The CSA notes that soft dollars for third party research requires a formal arrangement whereas bundled commissions from a bulge firm have heretofore been informal arrangements (although this is changing with commission sharing arrangements).
[As an aside, one of the reasons that “commission management” is now the fashionable new term for soft dollars is that the scope of the services has expanded to include the securities firms’ own proprietary research.]
The proposed regulation applies to all types of securities, including fixed income, provided a commission is generated. The SEC took a slightly narrower view in its soft dollar guidance which permits fixed income trades only if executed on an agency basis. The FSA only permits equity, options and warrants.
Conflicts
The CSA had noted a number of potential conflicts in a concept paper published in 2005, noting that soft dollar arrangements give incentives for advisors to place their own interests ahead of their clients, including:
¨ an incentive to direct trades to dealers for goods and services that benefit the advisers, and not their clients
¨ dealers may be selected for the soft dollar arrangements rather than for the quality of trade execution
¨ an adviser could potentially reduce costs in a poorly performing portfolio by allocating low commission trades to the portfolio but still use research and execution services paid for by other portfolios.
The CSA also noted that the bundled nature of commissions makes it difficult to determine best execution.
In the CSA’s view, the adviser should have adequate policies and procedures in place to ensure that a reasonable allocation of the services received is made to its client(s). This is a key concept because in order to allocate services advisors need to parse the bundled commissions into their respective components. Further, the detailed client-level disclosure that the CSA is likely to mandate is a direct result of this principle.
Definition of research is narrower than U.S.
The CSA definition of research is similar to the FSA’s: “research should include original thought and the expression of reasoning or knowledge.” Unlike in the U.S., market data does not qualify. Examples of permitted research include traditional research reports and advice on the value of securities and advisability of investing in them, quantitative analytical software, and post-trade analytics from prior transactions (based on the assumption that post-trade analytics will help improve future trades).
The CSA also would exclude seminars, as well as mass-marketed or publicly-available information or publications, similar to the FSA. The SEC is more lenient, permitting seminars, provided they contain the expression of reasoning or knowledge and relate to the subject matter of Section 28(e). The SEC also allows financial newsletters and trade journals intended to serve the interests of a narrow audience.
Commission disclosure goes beyond the FSA
From our perspective, the most important facet of the pending CSA soft dollar regulation is the new ground it would break on commission disclosure. The proposed regulation mandates initial and annual detailed disclosure by advisers to each of their clients about the use of brokerage commissions spent on their behalf and requires advisers to maintain detailed records of all goods and services received in return for brokerage commissions paid for at least five years. Advisers are required to disclose to each client the total brokerage commissions, broken down by security class (for example, equity, options, etc.), that were paid by advisers on behalf of each client and on behalf of all clients, for comparison purposes.
Reports must include the arrangements entered into relating to the use of brokerage commissions as payment for order execution services or research, the names of the dealers and third parties that provided these goods and services, and the general types of these goods and services provided by each of the dealers and third parties (for example, algorithmic trading software, research reports, trading advice, etc.).
Advisers are also required to separate the trades as follows: trades where clients receive only order execution from dealers and no other services; trades where they receive bundled services; and trades where part of the commission paid is directed to third parties. The latter category is further sub-divided into third-party research, other third-party services, and the dealers’ portion. The advisers must make reasonable estimates, for each client and for all clients in aggregate, of the brokerage commissions for each one of these categories of trades as a percentage of the total brokerage commissions paid and disclose these percentages to their clients. Advisers are also required to estimate and disclose the weighted average brokerage commission per unit of security corresponding to the commissions underlying each of those percentages.
Conclusion
If implemented as proposed, this level of client-level disclosure will provide more detail than required by the FSA. U.S. asset managers which have clients based in Canada would now have to not only itemize each service received as part of bundled commissions, but allocate those costs to each client. Even more importantly, clients will review these costs and ask inconvenient questions, such as “Why are you paying 10x for this broker’s research compared to third party research?”
The other interesting dynamic will be the impact on the SEC, which has yet to weigh in on commission disclosure. One of the reasons that the SEC is a lagging its regulatory peers is the way it is organized. Matters relating to 28(e) are generally handled by the Division of Market Regulation, which regulates securities firms, exchanges, SROs and other market participants. However, commission disclosure is the purview of the Division of Investment Management which regulates asset managers. The CSA’s proposed regulation increases the pressure on the SEC to keep up with its regulatory peers. Counterbalancing this is not inconsiderable lobbying power of the SIA (now SIFMA) and ICI which not surprisingly oppose greater commission transparency. Historically, the SEC’s Division of Investment Management has had a particularly close working relationship with the ICI, although that has declined somewhat in the wake of the market timing scandals.
However, despite the SEC’s sluggishness on the topic, the market is moving forward. Commission sharing arrangements (CSAs-not to be confused with the CSA) are being aggressively promoted by the bulge firms. CSAs unbundle the equity commissions, although they do not require that the information be shared with the clients of asset mangers. But once the commission is unbundled, how long will clients remain in the dark? Once Fidelity has to generate this report for Ontario Teachers, how long will it take for CALPERs to expect a similar report?
The full text of NI 23-102 and the requests for comments can be found here.