Our Comment Letter on Fund Director Guidance, Part 1


The deadline for comments on the SEC’s proposed guidance to mutual fund directors on brokerage commissions is October 1, 2008.   Here is the first part of our (draft) comment letter to the SEC on the topic.  The proposed guidance can be found at http://www.sec.gov/rules/proposed/2008/34-58264fr.pdf.   Part 1 of our comment letter:

October 1, 2008

Ms. Florence Harmon

Acting Secretary

U.S. Securities and Exchange Commission

100 F Street, N.E.

Washington, D.C. 20549-1090

Re: Commission Guidance Regarding the Duties and Responsibilities of Investment

Company Boards of Directors with Respect to Investment Adviser Portfolio Trading Practices [File No. S7-22-08]


Dear Ms. Harmon,

Integrity Research[1] supports the provision of additional guidance to directors of registered investment companies, particularly on the subject of brokerage commissions where there remains significant confusion.  We believe that this guidance should be accompanied by new disclosure requirements concerning the use of client commissions to investment company shareholders and investment advisory clients.

The proposed guidance provides useful clarification on a complex topic, namely ‘soft dollars’.  Given the rise of low-cost electronic trading and the increasing adoption of broker voting and client commission arrangements, there is increasing transparency on the cost of execution, the implicit costs of research, and the overall spending on research.  Guidance is therefore timely.

We also commend the Commission’s clarification that soft dollar spending includes spending on proprietary research.  It is surprising to us how little understanding there is of this fact, despite the Commission’s clarification of this in its soft dollar guidance issued in July 2006.

While we believe that the proposed guidance to directors is worthwhile, we do not believe it goes far enough.  The market for investment research is dysfunctional, primarily because of distortions created by bundled research commissions.  Portfolio managers complain of a glut of investment research.  There is a simple explanation for this:  bundled commissions provide a subsidy for research which has resulted in overcapacity.

As the regulator for both the brokerage industry and the mutual fund industry, the SEC has the ability, and we argue the obligation, to require more transparency in the payment of research commissions.  At a minimum, this should include regular disclosure of the amounts of commissions paid, both in aggregate and by broker.  Investment clients should also receive accounting of how their brokerage commissions are being spent.

Guidance to Boards of Registered Investment Companies

The proposed guidance is timely.  Electronic trading has provided greater transparency of the cost of execution which is often less than 1 cent per trade and nearly always less than 2 cents.  This suggests an imputed cost of 2 to 3 cents for research in bundled commissions.  Since research represents a significant portion of commission spending, it is certainly worthwhile for directors to understand how this is being spent.

Client commission arrangements (CCAs) are also providing more transparency on research spending since a portion of each trade is set aside for the payment of research.  As such, the Commission should be commended for facilitating the adoption of CCAs.  As an aside, we would urge the Commission to address any obstacles to payment for proprietary research through CCAs.[2]  There does not appear to be a similar impediment to paying for proprietary research through commission sharing arrangements (CSAs) in the United Kingdom and continental Europe.

Broker voting processes provide more transparency on how different research is valued, providing transparency on how commissions are allocated by broker.  Unfortunately, broker voting does not establish a price for research since it apportions commissions spent across brokers.  Brokers have attempted to set ‘minimums’ for commission spending in order to receive certain levels of research services.  Nevertheless, the challenge of this mechanism is that fluctuates with the levels of commission spending, providing windfalls to brokers during periods of high commission volume.

We believe that it makes sense for boards to review brokerage commissions in the context of Section 15(c) of the Investment Company Act.  Soft dollars are a material benefit to the advisor, which would otherwise need to pay for research through its own expenses rather than fund expenses.

Proprietary Research

One of the major benefits of the proposed guidance is to clarify (again) that soft dollars include payments for proprietary research, not just third party research.  There continues to be widespread misunderstanding of this.[3]  Most soft dollar scrutiny is of third party research.  This is partly from habit, and partly because it is easier.

The SEC itself appears to struggle at times with this issue.[4]  For example, the Commission’s July 2008 ComplianceAlert publication reported that on average soft dollars represented 20% of overall commission dollars spent (with a range of 3% to 100%) in the SEC’s recent examinations.  However, the newsletter also reported that the average commission rate advisors were paying was $0.05 per share (with a range of $0.01 to $0.08 per share).  Since the cost of execution averages around $0.015 per share (at most),  either these advisers overpaid for execution (which is highly unlikely), or else they paid close to 70% of their commissions as “soft dollars” to pay for proprietary research.   It is hard for us to reconcile an average of 20% spent on soft dollars with an average commission of $0.05.  It prompts the question about how diligently SEC examiners are probing this issue.  If the SEC’s own examiners are not pursuing this aggressively, how can the SEC expect fund directors to do so?

[1] Integrity Research Associates LLC is an information and solutions provider specializing in the alternative (third party) research industry.  The firm provides advisory services to mutual funds, hedge funds and investment advisors evaluating and recommending sources of research.  Integrity covers over 1,900 research firms in the U.S., Europe and Asia.   Additional information about Integrity can be found at www.integrity-research.com.

[2] Some broker dealers have indicated that they refuse to permit the payment for their proprietary research because of concerns that proprietary trading would require them to register as investment advisors.

[3] In a recent survey of compliance officers at SEC-registered investment advisors, 82% of the respondents indicated they pay bundled commissions for full-service brokerage research but only 33% of respondents said they rely on 28(e) for soft dollar purchases.  Source: 2008 Investment Management Compliance Testing Survey, conducted by ACA Compliance Group.  http://www.acacompliancegroup.com/documents/2008%20IM%20Survey%206-30-08.pdf

[4] SEC Chairman Christopher Cox refers to soft dollar spending as almost $1 billion, most recently in his statement during the open meeting when this guidance was discussed [http://www.sec.gov/news/speech/2008/spch073008cc_iaportfolio.htm]. In fact, soft dollar spending, including spending on proprietary research, exceeds $4 billion.


About Author

Leave A Reply