Our Comment Letter on Fund Director Guidance, Part 2


Here is the conclusion to our comment letter on the SEC’s proposed guidance to mutual fund directors on brokerage commissions.  Part 1 of the letter was posted yesterday.   Last call for comments, which are due tomorrow, October 1, 2008.  The proposed guidance can be found at http://www.sec.gov/rules/proposed/2008/34-58264fr.pdf.   Part 2 of our comment letter:

Policy Issues

Part of the problem may be difficulty in developing a clear and consistent policy regarding soft dollars.  SEC Chairman Christopher Cox has publicly called for the abolition of soft dollars, and the proposed guidance stresses in a few places that the 28(e) safe harbor should not be construed by fund boards as requiring them to approve soft dollars.  It appears that some elements of the SEC (including the current Chairman) wish to eliminate soft dollars, and other elements seek better regulation.

A consistent policy approach is badly needed because the current regulation is creating significant distortions in the market for investment research.  There is no pricing mechanism for the majority of investment research since it is bundled into ‘full-service’ commissions.

On the one hand, producers of research have trouble determining how profitable their research activities truly are.  Execution prices ranging from 1 cent to 2 cents per trade give a notional value of the research, ranging from 2 to 4 cents per trade.  However in the bundled world, there is considerable argument over which groups get credited.  Traders argue they should receive higher allocations; institutional sales requires allocations for the services it provides.  Management access is believed to be important to investors, and this also needs an allocation.  In the end, what is left for the actual security analysts may be meager scraps.  And people wonder why analysts are fleeing to the ‘buy side’ or to alternative research.

Investors meanwhile are deluged with research.  Portfolio managers and investment analysts complain of the volume of emails, calls, and IMs they receive from research providers.  They invest in costly mechanisms such as research management systems or alpha networks to filter the research.  They conduct more primary research, utilizing expensive tools such expert networks, channel checkers, surveys and panels.  Frustrated with the declining quality of proprietary research, they turn to alternative research.

Alternative research, which for the most part does have pricing mechanisms, has been growing.  Despite overall declines in commission spending, spending on alternative research grew to $1.9 billion in 2007 from $1.81 billion in 2006.[1]  Growth has been fueled by increasing demand for primary research tools, as well as growing use of alternative fundamental, economic and specialized research.[2]

Unlike proprietary research, alternative research is subject to market mechanisms.  It can easily capitalize on new needs and requirements from investors, and it receives precise market feedback on what works and what doesn’t.  Producers of proprietary research, on the other hand, have little incentive to launch new services because it is difficult to get paid incrementally for the new offering.[3]

One policy option would be to seek repeal of the 28(e) safe harbor, as previously suggested by Chairman Cox.  This would address the potential conflicts which concern the Commission, as well as the research market dislocations.  The disadvantage to this approach would be that it would create a significant disruption in the current market for investment research, potentially impacting the functioning of the markets. It was precisely this concern which prompted the creation of the 28(e) safe harbor in 1975 when fixed commissions were eliminated.  The market has evolved since then, with a viable market for alternative research, so perhaps with planning and foresight it can be managed.  Market participants would at a minimum need a long lead time to prepare.

The other approach would be to require increased transparency, and, where possible, pricing mechanisms.  This appears to be the approach favored the SEC’s UK counterpart, the Financial Services Authority (FSA).   The FSA implemented commission disclosure requirements in 2006 and is now preparing second generation modifications to the disclosure regime.  CSA adoption in the UK is reportedly at 60-70% of investors.  Both investors and research providers laud the increased transparency and dialogue, making it easier for investors to signal which research is valuable and providers to focus their resources on what investors appreciate.  In contrast, the US, lacking a similar disclosure regime, has CCA adoption of around 20-30%.

Increased Disclosure  

If the SEC does not opt for a ban of soft dollars, we believe the SEC should require increased disclosure of commission spending.  Fund brokerage spending, in aggregate and by broker, should be disclosed.  Disclosure should include the aggregate amounts and the commission rates paid.  Also included in the disclosure should be execution-only commission rates.  Clients should also receive information on how their fund brokerage commissions are being spent.

We understand that such disclosures would be unpopular with the entities the SEC regulates.  However, we believe that only by requiring such disclosures can the SEC ensure that there is a level of transparency to protect against the conflicts inherent in soft dollars.  Further, disclosure will also promote dialogue between investors and research suppliers, and between investors and their clients, helping to mitigate the market imbalances currently created by bundled commissions.  At worst, if this policy is ineffectual, the market would be better prepared for an outright ban of soft dollars.


We do not believe that fund directors, no matter how well guided, can address the challenges posed by soft dollars.  While we support the SEC’s guidance to directors, it is an insufficient policy response.  Even worse, where the proposed guidance appears to urge directors to ban soft dollars, it gives the appearance that the SEC has attempted to abrogate its responsibilities by ‘back-dooring’ a soft dollar ban.  We urge the SEC to step forward with a clear and consistent policy.  Either ask Congress for a repeal of the 28(e) safe harbor, or put in place an effective set of disclosures for commission spending.


Sanford Bragg

President & CEO

Integrity Research Associates LLC

53 West 36th Street, Suite 1002

New York, NY  10018  

[1] The estimates for alternative research spending are from Integrity Research.  Greenwich Associates estimates that overall commission spending declined from $12.6 billion in 2002 to $10.3 billion in 2007.[2] Specialized research includes specialists in a variety of different research approaches, including forensic accounting, earnings quality, ESG (Environmental, Social, Governance), litigation analysis, mergers and arbitrage research, to name a few.

[3] In 2002, when Credit Suisse acquired Holt Value Associates, a well regarded provider of economic value analysis (EVA), Holt suffered a significant defection in subscribers who argued that the Holt subscription fees they previously paid should be included in the bundled commissions paid Credit Suisse.


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