New York, NY – Only five days are left in the “Comment Period” for the Security and Exchange Commission’s proposed amendments to Part 2 of Form ADV (the last day for filing is Friday, May 16th, 2008). As a result the team at Integrity Research Associates has been working on comments we would like to share with the Commission. The following is a preliminary draft of this letter.
May 11, 2008
Nancy Morris, Secretary
U. S. Securities and Exchange Commission
100 F Street NW
Washington, DC 20549-1090
Subject: File Number S7-10-00, Release No. 2711- Proposed Amendments to Form ADV
Dear Ms. Morris:First, we applaud the Securities and Exchange Commission for their desire to improve client disclosure by amending the form and content of Part 2 of Form ADV. It is clear that a “plain English” description will provide investors with more valuable insight than is available in the current “check the box” disclosure format. In addition, providing investors with the ability to electronically access an adviser’s brochure through the SEC website should be a useful feature for many investors. However, we do have a few concerns about the proposed amendments which we have outlined below.
Confusion and Inaccuracies. The proposed amendments to Part 2 of Form ADV do not address one of the greatest shortcomings of Form ADV, and that is the significant confusion and inaccuracies that have been included and reported to investors as part of this disclosure.
This view was made clearly by Ms. Lori Richards, the director of the SEC’s office of compliance inspections and examinations in a July 2006 Crain article written by Sara Hansard. Ms. Richards commented,
“One very common misperception among investment advisers is that when they obtain research from a proprietary broker-dealer, they don’t consider that to be a soft-dollar transaction,” she said. “That’s a misunderstanding. If they are acquiring research with client commission dollars, they’re engaged in a soft-dollar transaction.”
Unfortunately, it appears that this confusion continues today. Data collected from the Investment Adviser Registration Depository as of September 30, 2007 showed that only 60% of investment advisers registered with the Commission report that they use soft dollars.
This figure is surprisingly low. We are certain that more than 60% of investment advisers pay in excess of $.01 to $.015 per share in commissions (the lowest commission rate available). In addition, we suspect that most advisers also receive research from the sell-side brokers they transact with. As a result, Form ADV clearly understates investment advisers’ use of soft dollars to pay for proprietary brokerage research.
We wholeheartedly agree with the SEC’s stated desire to require full disclosure of arrangements that involve significant conflicts of interest. Consequently, we were quite surprised to discover that the Commission chose only to require disclosure of “third-party” arrangements rather than include bundled sell-side research as well. Clearly, the conflicts of interest associated with paying for third-party research with client commissions are identical to the conflicts associated with paying for proprietary research in this manner.
This is disconcerting given the fact that the amount of “paid up” soft dollars commissions spent on third-party research is dwarfed by the amount of soft dollars spent on proprietary sell-side research. Our estimates conservatively suggest that institutional investors spend four to five times more client commissions on proprietary research than they do on third-party research.
We are also quite concerned that by requiring the disclosure of soft dollars spent on “third-party” research and not “proprietary research” offered through a bundled arrangement, the Commission is unintentionally creating an unlevel playing field for third-party research providers. Certainly, if advisers feel that disclosure is an administrative burden, they may favor using proprietary research instead because less disclosure is required.
A View from Overseas
Recently, we had the opportunity to speak with staff members of the Financial Services Authority at an industry conference in London to discuss various developments in the UK and US related to commission transparency. They were extremely interested in why the SEC had not yet established a commission disclosure regime in the United States that was comparable to the rules in the UK, France or Canada. After explaining our views, the FSA staff members exclaimed, “Why should anyone be afraid of commission transparency? All they need to do is look at what has taken place in the UK. Nothing terrible has befallen the banks, brokers, or investment managers.”
Like the FSA staff members, we also wonder what is keeping the Commission from providing U.S. investors with the same amount of transparency that is currently mandated by the Financial Services Authority (FSA), the Autorité des Marchés Financiers (AMF), and the Canadian Securities Administrators (CSA).
As we mentioned previously, we commend the SEC for taking a variety of steps in the right direction to improve the disclosure for clients with amendments to Part 2 of Form ADV. However, we also feel that the Commission has a tremendous opportunity to provide a level of disclosure that will give U.S. investors something that UK, French, and Canadian investors already have – and that is accurate and transparent information about how their advisers are spending their commission assets, regardless of whether it is on third-party or proprietary research. We encourage the Commission to consider providing investors with this level of additional disclosure.
We appreciate this opportunity to comment on the SEC’s proposed amendments to Part 2 of Form ADV. If you have any questions about this letter, please feel free to contact me at (212) 845-9088 ext. 801.
Very Truly Yours,
Michael W. Mayhew
Chairman & Global Director of Research
Integrity Research Associates, LLC
1115 Broadway, 12th Floor
New York, NY 10010
Tel. (212) 845-9088 ext. 801
Fax. (212) 845-9091