Cox’s About Face On Soft Dollars Confuses Many

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New York, NY – Last week, a speech made by the Chairman of the Securities and Exchange Commission to the National Italian American Foundation, and an article published by the Wall Street Journal, revealed that Chairman Cox was now seeking an outright ban on “soft dollars” – a complete about face on this important issue for alternative research firms, money managers, and financial services institutions.

Chairman Cox’s seriousness about the issue was evident in his speech before the National Italian Foundation on Thursday, when he explained that, “soft dollars need to see the light of day.”  He added, “this witch’s brew of hidden fees, conflicts of interest and complexity of application is at odds with the investor’s best interest.”

This move by the SEC Chairman caught many in the financial services industry off guard (ourselves included) as the SEC moved as recently as last summer to validate a money manager’s use of client commissions to purchase defined execution and research services.  As a result of this change of position, many have asked us “Why has Cox changed his mind?” and “What will this mean for the financial services industry?”  We will try to address these issues in today’s blog.
Soft Dollars Defined

Before we can have a discussion about Chairman Cox’s recent comments regarding soft dollars, it is important that we define exactly what the SEC means when they talk about soft dollars.

According to the most recent interpretive guidance to Section 28(e) of the Securities and Exchange Act of 1934, issued last July, the SEC clarified that soft dollars are ALL equity commissions paid in excess of the pure execution rate that can be used by money managers to purchase either execution or research services on behalf of their clients.

The cost of execution on electronic trading platforms ranges from .5 cents to 1.0 cents per share, whereas agency only trading at full-service firms ranges from 1 cent to 2 cents per share.  This means that money managers are using “soft dollars” any time they are paying above .5 to 2 cents per share for execution, and they are receiving various execution or research services from that broker that benefits their clients.

In reality, money managers are using “soft dollars” to pay for both third-party research from independent research firms and proprietary research from their brokers.  Consequently, U.S. money managers are currently spending approximately $6.5 billion in “soft dollars” to acquire various execution and research services (not the $1.0 billion many experts seem to think).
Cox’s Past Position on Soft Dollars

Prior to last week’s remarks, Chairman Cox has spoken on the topic of “soft dollars” countless times.  However, it is clear from an examination of these comments that Cox was never a strong advocate of the practice.

In fact, even his comments in July of 2006 when the commission released its interpretive guidance of Section 28(e) revealed that the Chairman thought soft dollars could be at “odds with clarity in describing fees and costs to investors”, that the SEC needed to be wary that soft dollars wouldn’t “distort the normal market incentives to money managers to seek best execution”, and that the “use of soft dollars for research doesn’t interfere with the full disclosure of actual management costs.”

More recently, Cox’s comments before the Mutual Fund Directors Forum on April 13, 2007 revealed that the commissioner wasn’t becoming any more comfortable with soft dollars, despite the SEC’s interpretive guidance.  The following is an excerpt of Cox’s speech on the topic of soft dollars:

“Your organization has consistently focused on the significant conflicts of interest that fund directors face in connection with soft dollars, and the Commission plans more work here, as well.

Soft dollars can serve as an incentive for fund managers to disregard their best execution obligations, and also to trade portfolio securities inappropriately in order to earn credits for research and brokerage. Soft dollars also represent a lot of investors’ hard cash, even though it isn’t reported that way. The total of soft dollars runs into the billions each year for all investment funds in the United States.

An agency focused on ensuring full disclosure to investors has to be very concerned about this, because soft dollars make it more difficult for investors to understand what’s going on with their money. Hard dollars eventually end up being reported as part of the management fee the fund charges its investors. But soft dollars provide a way for funds to lower their apparent fees – even though, in the end, investors pay for the expense anyway.

The very concept of soft dollars may be at odds with clarity in describing fees and costs to investors. The 30-year old statutory safe harbor, in Section 28(e) of the Exchange Act, was probably thought to be a useful legislative compromise when it was packaged with the abolition of fixed commissions. But surely in enacting Section 28(e) Congress meant to promote competition in research, not to create conflicts of interest by permitting commission dollars to be spent in ways that benefit investment managers instead of their investor clients.

That is why the Commission is continuing to examine the potentially distortive effects that soft dollars can have on what should be the normal market incentive to seek best execution. And we’re looking to ensure that when soft dollars are used to pay for research, it doesn’t interfere with the full disclosure of actual management costs. In particular, the Commission will consider whether fund boards could better assess soft dollar arrangements if the Commission were to mandate better disclosure of the research and brokerage services that the adviser gets in return for a bundled commission. If directors are able to compare the broker’s execution-only commission rate with its bundled rate, they could make more meaningful inquiries into the value of the additional services that the fund shareholders are getting.

Our recent interpretive guidance was a step forward in this area, but it may not be enough to wipe out the abuses that the Commission has discovered, such as soft dollars used to pay for membership dues; carpeting; entertainment and travel expenses; and lavish expenditures for interior decorators and beachfront villas. So while the Commission’s soft dollar release was important, you can rest assured it won’t be our last word on this subject.”

It is clear from these comments that Chairman Cox’s initial concerns about soft dollars never really changed.  His comments last month revealed that he was increasingly concerned that the use of soft dollars might create extreme conflicts of interest to a money manager’s fiduciary duty to seek “best execution.”   In addition, Cox noted that he thought fund boards could provide better oversight if they received more disclosure about the research and execution services an adviser was getting as a result of a bundled commission.
Seeking a Ban

However, Chairman Cox’s discomfort with soft dollars recently turned to outright opposition to the practice when on May 17th, 2007 he issued a letter to Senate Banking Committee Chairman Christopher Dodd, and House Financial Services Committee Chairman Barney Frank requesting that the legislature consider banning soft dollars altogether.  The following is the opening paragraph of Cox’s letter to Senator Christopher Dodd.

“I am writing to urge the Senate Banking Committee to consider legislation that would repeal or substantially revise Section 28(e) of the Securities Exchange Act of 1934, which provides a safe harbor for certain “soft dollar’ arrangements between broker-dealers and money managers.  I am concerned that this overly complicated provision of the law hurts investors and US capital markets by protecting arrangements that involve substantial conflicts of interest, may contribute to higher brokerage costs, is difficult to administer, and may operate to impede the further development of efficient markets for brokerage as well as certain advisory services.”

In his letter, Chairman Cox goes on to outline in detail his specific concerns about the various negative consequences of permitting money managers to continue using client commissions to pay for execution and research services in the manner that is currently taking place.

A few of the concerns Cox mentioned about soft dollars is that these arrangements create a conflict of interest that interfere with a money manager’s fiduciary obligation to seek “best execution” and they might encourage money managers to trade excessively with client assets to generate soft dollar credits.  In addition, Cox was concerned that the use of soft dollars might lead to higher brokerage costs, which ultimately are not borne by the asset managers, but rather by investors and pension fund participants.  Lastly, Cox expressed concerns that soft dollars were a practice that was difficult for the SEC and the financial services industry to administer.

Consequently, Chairman Cox felt that his only recourse was to take his case to Senate Banking Committee Chairman Christopher Dodd, and House Financial Services Committee Chairman Barney Frank, as a legislative action would be required to make any substantive change in the 28(e) safe harbor.

However, it must be noted that Chairman Cox’s letters and his statements regarding banning soft dollars are his own and do not reflect the views of the other four Commissioners, his own staff, or any influential legislators.
Potential Reasons for this Change

In the wake of this surprising move, many executives of the sell-side, buy-side, and among the ranks of the alternative research industry have been asking the question, “Why did Cox take this stand now?”  After considerable analysis and discussion we think there are three (3) reasons Chairman Cox might have decided to take his concerns over soft dollars to the legislature.  These include:

Strategic: The first thought that came to our minds at Integrity Research was that Chairman Cox had decided that it was time to turn up the heat on the mutual fund and financial services industries to address the issue of disclosure and commission transparency.  It was clear in July of last year, that several Commissioners, including Cox, wanted to introduce a commission disclosure regime – a project that has stalled for various unknown reasons.  In addition, Cox is in the midst of discussions with the mutual fund industry about eliminating 12-b1 fees – a move that is probably not terribly popular with them.  It is probably good if Chairman Cox has some pieces to sacrifice in this chess match.

Political: The second reason that some have suggested for Cox’s recent letters and statements are that the Chairman is using the “soft dollar” issue to score some quick political points by positioning himself as a “protector of the small investor.”  This is particularly given the fact that the SEC has been facing growing criticism from Chairman of the Financial Services Commission, Barney Frank that the SEC may be siding too often with companies rather than investors as it sets and implements its regulations.  Frank’s office has invited SEC chairman Christopher Cox and the other four commissioners for a hearing in June to discuss the SEC’s policy regarding shareholder lawsuits, as well as general oversight issues, staffing, and budgeting, etc.

Personal: Another reason for Cox’s move on soft dollars could be a personal frustration that he has not been able to substantively reform this practice, particularly given his obvious concerns about the conflicts of interest associated with the use of soft dollars.  It is certainly clear from an examination of the record since Christopher Cox became SEC Chairman that he was never very personally comfortable with soft dollars, but he probably went along with his staff’s recommendations on the “interpretive guidance.”

Based on a variety of factors, it is our guess that Chairman Cox’s recent move to propose a ban of soft dollars is a result of all three of the motives listed above, including personal, strategic, and political rationale.


Consequences of this Shift

So, what, if anything, does the change in Chairman Christopher Cox’s views on soft dollars mean for the financial services market?  It certainly would be easy to ignore Cox’s recent comments, and conclude that the legislature will have very little real interest to tackle the soft dollar issue given the lobby that is likely to try and fight it.  However, it is possible that “soft dollars” could gain some political momentum, particularly given the way Chairman Cox has positioned the issue – investor protection, lower commission costs, and increased fiduciary oversight.

Another factor which could create concern among financial services and mutual fund executives is the fact that the EBSA has already proposed new reporting requirements on brokerage fees and commissions paid by pension funds and plan sponsors, enabling them to fulfill their fiduciary duty to control and account for investment expenses in the wake of numerous high profile lawsuits and scandals in the industry.

A third factor which could add some fuel onto the “soft dollar” fire is the mutual fund industries desire to potentially use this issue to create a “level playing field” with the burgeoning hedge fund industry.  Many hedge funds do not have to comply with soft dollar rules if they disclose how they plan to use client commissions in their prospectuses.

Consequently, we suspect that Chairman Cox’s call to ban soft dollars will, in addition to the other factors discussed above, create more willingness on the part of the securities and mutual fund industries, to try and come up with a meaningful and workable plan to disclose how asset managers are using client commissions to purchase execution and research services.  As a result, we expect to see an increased dialogue of how to provide mutual fund boards, pension funds, and plan sponsors with better insight about how client commissions are being spent – thus enabling investors to make more informed decisions.

We will discussing Chairman Cox’s apparent change of heart on soft dollars in more detail at the upcoming AQ / Integrity Research Conference which is scheduled to be held in New York, on Friday, June 15th.  Please click on the banner ad to the left of this blog to find out more about how to register for this upcoming conference.

Comment by Bill George:
Now I get it!

It’s all about soft dollars and hedge fund regulation.

If you are trying to fathom the latest moves by the Chairman of The SEC, The Investment Company Institute (ICI) and other industry lobbyists, put them all in the context of going back to square-one to create “a level playing field” between regulated advisory structures (mutual funds, pension plans, and bank trust departments) and hedge funds.

The SEC lost in its effort to regulate hedge funds (because the court decided the SEC didn’t have jurisdiction) and a the same time the ICI was pressuring for mandated action on the use of client commissions by hedge funds (a level playing field). Nobody got what they wanted.

The only way to reach the desired ends, apparently, was to punt the whole issue to Congress for a rewriting of the regulations relating to the appropriate use of institutional client’s brokerage commissions.

Read two curiously similar letters submitted to the SEC on what was scheduled to be the last day of the comment period on the Interpretive Guidance Regarding The Use of Client Commissions Under Section 28(e) of the Securities Exchange Act of 1934. The two letters, both Dated September 7, 2006, are one from Elizabeth Krentzman, General Counsel of the Investment Company Institute, and one from Darrell Braman, Henry Hopkins, Chief Legal Counsel, et, al. of TRowe Price Associates, Inc. view these letters.

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