Darien, CT – Conversations with money managers in recent weeks have reflected a wide range of views on the topic of unbundling and commission disclosure, with some large asset managers expressing a high level of confidence that the commission disclosure trends started in the UK will formerly take hold in the U.S. in the not too distant future. Other influential money managers, however, are convinced that regulators in the US will not force unbundling here.
While we agree that the SEC will probably not force actual unbundling, we do believe it will be extremely difficult for US regulators to argue that clients do not deserve transparency about how their commissions are being spent by their money managers — particulalry when a large number of pension fund and plan sponsor customers need this information to effectively perform their fiduciary duties.
International Developments
The first reason we expect US regulators will formally back commission disclosure in the US is that regulators in many parts of the world have already adopted and implemented rules in this area. For example, in July, 2005 the UK’s Financial Services Authority mandated that money managers disclose how much of their client’s commissions they were spending on execution and research services. This rule has now been in effect for fifteen months, with no obviously adverse effects to pension funds, the money managers that serve them, or the brokerage firms that provide execution and research to the buy-side.
In fact, the rather benign impact of the UK rules encouraged French regulators to follow suit by proposing a similar commission discosure rule. Other European regulators are playing a wait and see game to determine how best to move forward with unbundling.
Last summer, the Canadian Securities Administrators published proposed policies to regulate the use of soft dollar commissions by investment advisers and dealers governed by Canada’s provincial and territorial securities regulators.
Not only did the proposed policy define “execution” and “research” services, but it also went a long way in mandating serious disclosure requirements. For example, the proposed Canadian policy would require that an adviser provide each of its clients with specific disclosure of all of its soft dollar arrangements, with the names of the dealers and third parties involved, and the relevant
goods and services provided.
This policy would also require the disclosure of the amount of commissions paid by the adviser on a client by client basis during the period. Estimates of the dollar amounts paid for research and execution services would also be included in these reports, and advisers would also be required to make certain other soft dollar related information available to their clients.
Impact of Globalization
Some expect that the market, left to itself, will naturally move to an unbundled environment as large pension fund and plan sponsor clients who currently employ UK asset managers, will start to demand the commission disclosure reports they are getting from their UK managers, from US managers.
We agree that this will eventually take place. However, this process could take an extremely long time — a period in which U.S. pension funds and plan sponsors would not be able to effectively meet their fiduciary requirements to actively monitor the various expenses (including commission expenses) of their plans on behalf of their investors.
Thus, even though some regulators might think the market will fix itself, it is clear to us that this approach will leave unprotected the interests of millions of unsophisticated investors who have signifcant portion of their wealth in various pension funds, defined benefit, and defined contribution plans.
Revision of Form 5500
Last July, the Employee Benefits Security Administration (EBSA) — the regulator of the $4 trillion pension industry — surprised many in the financial markets when it took an extremely aggressive approach to the issue of commission disclosure.
EBSA proposed signficant changes to its annual Form 5500 disclosure filing. In the past, many in Congress, including the General Accountability Office, criticized Form 5500 as a useless disclosure document for helping to regulate pension plans.
EBSA’s proposal includes disclosing how much client commissions are being spent for execution and research services on a plan-by-plan and broker-by-broker basis in the new Form 5500. EBSA’s initial proposal is expected to be finalized into formal regulation in the next few months.
EBSA also plans to propose another rule this spring targeting organizations that service pension plans, such as money managers. The rule will require them to give customers information regarding the compensation and fees they receive.
As you might imagine, EBSA’s proposed changes to Form 5500 have been denounced by many asset managers and brokers as unnecessary and overly expensive to implement. In fact, the sell-side trade organization, SIFMA, and the mutual fund trade goup, the ICI, have sent extensive complaints to the EBSA arguing the negative consequences of the proposed regulation.
In addition, both organizations contended that EBSA should not be involved in issues related to commission transparency, as it is normally the domain of the SEC. They added that EBSA’s proposal was particularly unnnecessary as the the SEC was expected to address commission disclosure by the end of 2006.
Unfortunately, the SEC did not meet that unofficial deadline.
Lesser of Two Evils
However, some industry watchers believe that the SEC’s Division of Investment Management is now under great pressure to come out with some form of proposed regulation to address commission disclosure — particularly given the onerous proposal put forth by the Department of Labor’s EBSA.
In fact, it is quite clear that an FSA-type of commission disclosure would be far less objectionable than either EBSA’s proposal or the Canadian Securities Administrator’s plan.
Consequently, some cynics might conclude that it would now be in the best interests of the ICI and SIFMA to encourage the Division to Investment Management to put out a proposal that would eliminate the need for the EBSA regulation as it would be the lesser of two evils.
The Upshot
Based on the various developments both at home and abroad over the past few years, we suspect that commission disclosure will become a reality in the US by the end of 2007 as securities regulators become convinced that plan fiduciaries have a right (in fact a need) to know how their investors’ assets are being spent.
However, we need to be extremely clear that we do not expect that US regulators will go so far as to mandate the unbundling of equity commissions. Instead, we think that US regulators will require that money managers disclose to their clients how much of their commissions are being spent on execution and how much is being spent on third-party research, including research produced by sell-side investment banks and brokerage firms and boutique alternative research providers.
Of course, this type of disclosure will lead to a number of developments, including the move by many money managers to selecting their execution partners separately from the choice of their research providers. In turn, this will encourage many who are not already doing so to concentrate their brokerage list and adopt CSAs as a means to pay for their research. Finally, we expect these developments will lead asset managers to develop more formal processes to evaluate the quality of the research they purchase (similar to a TCA for research); it will force them to establish more proactive research procurement procedures (similar to the procurement procedures seen in most industries); and it will lead money managers to push for more transparency about the price they are paying for the research they purchase.
Comment by Bill George:
It’s been estimated that total institutional brokerage commissions amounted to thirteen billion dollars in 2006. Approximately ten billion dollars of these institutional commissions were paid to full-service brokerage firms offering a variety of ‘services’ in bundled undisclosed brokerage programs. For 2006, conservative estimates place the dollar value of institutional clients’ brokerage commissions paid in excess of the costs of execution in bundled commission programs at approximately six billion dollars. So, it appears that for 2006, the uses of nearly half of all institutional clients’ brokerage commissions are unknown.
Institutional clients’ brokerage commission disclosure is one of the most important issues facing the SEC presently. It should be emphasized that it’s a fiduciary obligation of plan trustees, plan sponsor organizations and mutual fund directors to monitor, protect and conserve investment plan participants’ brokerage commissions.
For several years the U.S. Securities and Exchange Commission has spent countless hours and significant resources auditing and investigating third-party brokerage firms and independent research providers.(1) Historically the SEC had not focused nearly as much attention on soft dollar arrangements in bundled undisclosed commission programs which include proprietary ‘services’. Then in late 2000 New York State Attorney General, Eliot Spitzer began to use the Martin Act to expose brokerage and advisory conflicts of interest. Many of these conflicts of interest were motivated by client commissions “paid-up” in excess of the costs of execution, by fiduciaries, in exchange for favors provided by full-service and investment banking brokerage firms. The details of the Global Analyst Research Settlement (2) are evidence that the ‘services’ received in exchange for institutional clients’ commissions did not accrue to the “direct benefit” the institutional clients’ investment accounts. These uses of clients’ brokerage commissions were breaches of advisors’ fiduciary duty to their institutional clients.
Without disclosure of brokerage commissions “paid-up” in excess of the costs of execution in bundled commission arrangements is it possible for the SEC to monitor and regulate the terms of Section 28(e) of the Securities Exchange Act of 1934? Without disclosure of brokerage commissions “paid-up” in excess of the costs of execution in bundled services arrangements is it possible for fiduciaries to monitor and protect client brokerage commission expenditures and to assure clients receive the “direct benefit” for the use of their assets?
The SEC’s recent Interpretive Guidance Regarding The Use of Client Commissions Under Section 28(e) of The Securities Exchange Act of 1934 has redefined commission sharing arrangements (CSA’s),(3) and the SEC’s recent “No Action Letter” on Goldman Sachs’ Research Xpress (sm) service has redefined client commission arrangements (CCA’s)(4). The new definitions for these institutional brokerage commission arrangements makes it even more important that research and other services in bundled service arrangements be fully disclosed. Otherwise regulators, fiduciaries and clients cannot monitor the ‘services’ being exchanged for clients’ commissions, and they cannot know if the services accrue to the ‘direct benefit’ of the clients’ accounts. Furthermore without such disclosure they cannot perform tests to determine if the services conform to the requirements of ‘appropriate research’ as defined by Section 28(e) or to determine if services fall outside the “safe harbor” of Section 28(e), but are appropriately within advisors’ fiduciary discretion.
Under the new definitions of CSA’s and CCA’s it is extremely important that bundled proprietary services be priced and fully disclosed in order to assure executing brokers and fiduciaries allocate clients’ commission expenditures fairly and appropriately between bundled proprietary services and independently produced (alterative) research.(5)
Footnotes:
(1)Inspection Report on the Soft Dollar Practices of Broker Dealers Investment Advisors and Mutual Funds
(2) The Global Research Analyst Settlement and Chairman of the SEC Arthur Levitt’s Speech before Securities Industry Association’s Annual Meeting in Boca Raton, Florida – November 9, 2000.
(3) Interpretive Guidance Regarding The Use of Client Commissions Under Section 28(e) of The Securities Exchange Act of 1934 See File Number 34-54165 issued July 18, 2006
(4) SEC’s recent “No Action Letter” on Goldman Sachs’ Research Xpress (sm) service
(5) SEC Petition for Rulemaking on Disclosure and Transparency in Client Commission Arrangements (File Number 4-531 published February 10, 2007)