DOL Mandates Soft Dollar Disclosure


New York-The Department of Labor Employee Benefits Security Administration (EBSA), the regulator of ERISA plans, recently approved regulation which, when and if implemented in 2008, would require the unbundling and separate valuation of brokerage and research services provided to pension funds.  All pension funds, excluding public entity plans, would require brokerage fees to be split into their component parts so that the information can be included in annual reports (Form 5500) pension plans have to file under ERISA.  The securities industry trade group, the Securities Industry and Financial Markets Association (SIFMA), filed a comment at the end of December protesting the new regulation and at minimum requesting a postponement of the regulation until 2009.

New ERISA reporting requirements

EBSA proposed new reporting requirements in July, 2006 as part of its effort to convert to electronic filing of annual reporting requirements under ERISA.  Brokerage fees and commissions, which had previously been exempt, are required to be reported for each broker receiving more than $5,000 worth of compensation.  Further, indirect compensation paid on behalf of the plan (including soft dollars, 12b-1 fees, float income, among others) has to be disclosed.  EBSA states that plan sponsors need to pay attention to the soft dollars being spent by investment managers on the plan’s behalf:  “The Department believes that an annual review of such expenses is part of a plan fiduciary’s on-going obligation to monitor service provider arrangements with the plan. Requiring the reporting of such information should emphasize that monitoring obligation.”

EBSA invited comments on the proposed regulation and the first comment period ended in September 2006.  The mutual fund trade group, the Investment Company Institute (ICI), filed a comment which, among other things, protested the disclosure of brokerage commissions on a plan basis, and asked that EBSA defer to the SEC on soft dollar disclosure, arguing that the SEC guidance on soft dollars was imminent: “SEC staff have stated publicly that they expect to present recommendations to the Commission by the end of the year [end of 2006].”  The Securities Industry Association (predecessor to SIFMA) also filed a comment in September outlining the difficulties of increased disclosure but did not focus on the soft dollar dimension specifically.

SIFMA protests

After EBSA finalized the new regulation, there was another brief, one-month comment period.  The SIFMA’s second comment letter, sent on December 27, 2006 to the head of EBSA, requests that the new requirements to report “soft dollars received by investment managers” be eliminated.  Half the letter is devoted to how difficult, if not impossible, it would be for securities firms and investment managers to determine the brokerage fees attributable to a particular plan.

As for soft dollars, SIFMA argues that EBSA has previously deferred to the SEC on soft dollar issues, and should continue to do so.  SIFMA repeats the ICI’s argument that the SEC will regulate soft dollar disclosure and that should be good enough for EBSA.  Putting aside questions of who has jurisdiction, SIFMA argues that the disclosure requirements are over the top: “[EBSA’s] proposed revision goes way beyond Section 28(e) by purporting to require the manager to ‘unbundle’ and separately value…’brokerage and research services’ provided to the manager.”

SIFMA challenges EBSA’s view that soft dollars are part of an investment manager’s indirect compensation.  Soft dollar services help the investment manager carry out their responsibilities of investment decision-making.  Soft dollar services principally benefit the investment manager’s client (ie, pension plans) rather than the investment manager.  [SIFMA omits to mention that soft dollar services are paid with commissions charged to the client.]

Even if soft dollars could be viewed as a form of indirect compensation, SIFMA continues, unbundling and separately valuing such services is extremely difficult.  SIFMA notes that the term ‘soft dollars’ applies to “proprietary research developed by the executing broker-dealer”, and, although third party research may be priced separately, proprietary research is bundled with execution at a single commission price.  Any attempt to value such bundled services would be extremely costly and time-consuming.

Any attempt to ‘unbundle’ would result in estimates that would be “inherently subjective and arbitrary.”  Such estimates would provide no meaningful information to plan sponsors.  The “close scrutiny being given to soft dollar arrangements by the SEC is sufficient to ensure that any potential abuses in this area are being addressed” and therefore oversight by plan sponsors is unnecessary.  Finally, at the very least, any changes should be put off until January 2009.  Full text of the SIFMA letter can be found here.

So where is the SEC?

It is a sad state of affairs when the SEC gets lapped by the Department of Labor.  Getting passed by London’s regulatory authority (FSA) on soft dollars was understandable.   As Hank Paulson has pointed out, the FSA has the advantage of being principle-based rather than heavily prescriptive.  And London is flexing its financial muscle, giving NY a good run for its money.  But then the Canadians passed the SEC on soft dollar disclosure.  (Click here to see our article on the proposed CSA soft dollar disclosure.  Interestingly, the disclosure proposed by the CSA is similar to that being required by EBSA.)  And now, the Department of Labor???

The calculus of what level of disclosure the SIFMA or ICI might now find acceptable shifts, thanks to EBSA.  The industry might accept a higher level of disclosure, as long as it is not as arduous as that proposed by EBSA.  And once the SEC does get around to issuing its own disclosure requirements, the industry will go back to EBSA and lobby hard to get the SEC standard (whatever that will be) adopted.  If only the industry can do the same with the CSA…

Comment by Bill George:
I am a strong advocate of independently produced research, and the third-party brokerage business model which evolved (after May 1975) in response to the requirements of Section 28(e). This business model provides clear disclosure of the costs of execution and the costs of research. Execution and research are the only services which qualify for the safe harbor of Section 28(e). In the third party brokerage business model each trade has a clear paper trail documenting commission uses.

In contrast, bundled brokerage commission arrangements are not disclosed and they are not transparent. This lack of identification and pricing of the services provided in bundled brokerage arrangements has provided opportunities for quid-pro-quo’s (between brokers and advisors) which have compromised advisors fiduciary duty. The lack of identification and accounting make it extremely difficult to oversee or regulate commission abuses in bundled institutional brokerage commission arrangements.

I have read SIFMA’s letter to the EBSA of the DOL several times now. I believe the letter contains inaccuracies and it implies things that are just not factual. The difficulty of accounting for services in full service brokerage arrangements should have been the first order of business, for the full service brokerage industry after, May 1, 1975. If the industry had addressed the problem in a forthright and immediate fashion then, the task would not have been as daunting as they claim it will be now. In my opinion an industry that can afford the cost and the embarrassment of The Global Research Analyst Settlement (see link ) should be able to bear the expense necessary to correct its accounting deficiencies to ensure the conservation and protection of institutional clients’ brokerage commissions.

On Saturday 1/20/07 I received three emails mentioning that the Securities and Exchange Commission was going to make an important announcement relating to soft dollar brokerage arrangements on Wednesday 1/24. I immediately, went to the SEC website to see if there was any information about any anticipated important announcements. Nothing specific is mentioned, however, I noticed that many of the SEC’s senior staff, including Commissioner Christopher Cox will be speaking at the 34th Annual Securities Regulation Institute, at the Hotel Del Coronado, Coronado Island, San Diego, CA. This would be a very fitting audience for an announcement about disclosure and transparency in brokerage commission arrangements.

Just in case an important announcement is made, I thought it might be helpful provide a little more information on soft dollars, bundled commission arrangements, and disclosure and transparency, for those who are interested. This might provide “context” for those who don’t follow these issues closely.

In 1975 the U.S. Congress mandated that the securities industry “fully negotiate” brokerage commissions with its clients. The implementation date of “fully negotiated” commissions was May 1, 1975. At that time, the securities industry and The U.S. Congress both understood that for clients to “fully negotiate” brokerage commissions, clients’ needed to know what services were provided by brokerage firms in exchange for the brokerage commissions paid out of client accounts.

During the time leading up to the May 1, 1975 implementation date for fully negotiated commissions the securities industry and its lobbyists argued and lobbied for an exemption from the understood interpretation of the terms of the mandate for “fully negotiated” brokerage commissions. The securities industry and its lobbyists requested that institutional investment advisors be allowed to continue to “pay-up” from their “fully negotiated” rate, and for the excess commission paid-up, receive investment research in addition to brokerage execution services. Shortly after May 1, 1975 Congress passed Section 28(e) as an amendment to The Securities Exchange Act of 1934. Section 28(e) provides a “safe harbor” for clients to “pay-up” from their “fully-negotiated” brokerage execution rate and receive investment research services in addition to execution. Section 28(e) requires that investment advisors make a “good faith determination” that the total amount of the commission payment is reasonable in relation to the value execution services and investment research services provided.*

Contrary to implications in a recent comment letter sent to the Department of Labor Employee Benefits Security Administration, Section 28(e) does not use the term bundled services, or bundle of services. For anybody who was in the brokerage industry at the time, and for most of those who objectively study the history of that period, it’s obvious that it was U.S. Congress’ intention to end brokerage commission price-fixing. Prior to May 1, 1975 fixed price brokerage commission arrangements were facilitated, in part, by obscuring the component services in brokerage commission arrangements through the use of bundled undisclosed brokerage commission arrangements.

I believe that the bundled services brokerage arrangements that still exist at full-service broker dealers facilitate conflicts of interest, disguise some advisors’ bad faith dealings with clients’ commissions, and facilitate uninformed client brokerage commission decisions. Such bundled arrangements prevent the full-negotiation of brokerage commissions, and as a consequence of these bundled commission arrangements institutional clients frequently pay more commissions than they should, and sometimes they do not receive direct benefit of the services purchased with their commission dollars.

* Section 28(e) is very specific. It only provides a “safe harbor” only for brokerage commission premiums “paid-up” above the cost of execution used to purchase investment research. Commission premiums paid-up to compensate for any other brokerage services (principal trading, IPO allocation, mutual fund shelf space and or mutual fund marketing assistance, late trading advantages, bachelor parties, golfing junkets, dwarf-tossing, good will, or etc.) must be tested under fiduciary law to determine if the use of institutional client commissions is appropriate under the advisors’ investment discretion. Interpretations of ERISA by the DOL add another test to the appropriate use of client brokerage commissions; the interpretation, the accounts paying the commission must receive “direct benefit” for the commissions paid.

Note – In the summary above I’ve used quotes around: fully negotiate, fully negotiated, paid-up, paying-up, safe harbor, and direct benefit, because these are the actual terms used in the statutes. I believe dwarf tossing is a term-of-the-art (see link )

For more on this subject, see past Chairman of the SEC Arthur Levitt’s remarks before the 2000 Meeting of the Securities Industry Association (now SIFMA) Boca Raton, Florida November 9, 2000; when the web-page opens scroll down to the section “Sticky Brokerage Commissions”.

In Anticipation of Wednesday,

Bill George


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