SEC Clears Up Under Reporting of Soft Dollar Use?


New York, NY – The Securities and Exchange Commission announced that it plans to meet this coming Wednesday to consider whether to issue guidance to mutual fund directors on the use of “soft dollar” arrangements. 

Many in the industry (ourselves included) have been waiting for the SEC to take substantive action to create transparency on how investors’ commission assets are being spent by investment managers.  And while we hope this takes place on Wednesday, we are continuously amazed how little the SEC has done to rectify the gross under-reporting of soft dollar use that is currently taking place in the US.

According to the SEC, “soft dollars” are any commission payment made by an investment advisor that is in excess of the “cost of execution”.  In Section 28(e) of the Securities Exchange Act of 1934, the SEC acknowledged that a money manager would not have breached their fiduciary duty if they used the soft dollar commissions of their advised accounts to obtain legitimate research and brokerage services.

This means that if an asset manager pays more than the cost of execution (say 1.5 cents per share) and they receive research from the executing broker-dealer, investment bank, or third-party independent firm, then they are deemed to have paid for this research with “soft dollars”.  Of course, this use of client commissions is completely acceptable, being protected by Section 28(e).

Unfortunately, most investment advisers still don’t get it.  They continue to report that they are spending much less in soft dollars than they actually are.  And while it is unclear whether asset managers are doing this on purpose to mislead investors or not, it is clear that investors are not seeing the complete picture – and that is just how much of their money is being spent by their investment managers on external research.

Below we have included an excerpt from a recent copy of the SEC’s ComplianceAlert newsletter that reveals the extent of the problem.  In this newsletter, the SEC discusses the results of a number of registered investment advisers use of soft dollars. 

What is shocking is that the average percentage of soft dollars to overall commission dollars spent was reported as just 20% (with a range of 3% to 100%).  The reason this is so surprising is that these advisers also reported that the average commission rate they paid was $0.05 per share (with a range of $0.01 to $0.08 per share).  In my book, these advisers either overpaid for execution (which is highly unlikely), or else they paid close to 70% of their commissions as “soft dollars” to pay for investment bank, brokerage, and independent research (this was determined using the following formula ($0.05 – $0.015)  / $0.05).

Of course, the reason the advisers reported 20% of their commissions was spent in soft dollars is probably because they mistakenly don’t consider the amount paid for proprietary sell-side research as “soft dollars”.  However, the SEC examiners should understand this subtlety and have corrected the advisers they examined.  Unfortunately, this did not take place.

So, while we are anxious to see if on Wednesday the SEC will issue guidance to Mutual Fund Directors on the use of soft dollars, we are not terribly confident that any guidance provided will actually help investors understand how their investment advisers are spending their commission dollars.


Soft Dollar Practices of Investment Advisers

Examiners recently reviewed the soft dollar arrangements maintained by a number of registered investment advisers. The focus of these examinations was to gain a better understanding of: the extent to which advisers to institutional clients, including hedge funds, use soft dollar arrangements to obtain third-party and/or proprietary services or products; the disclosures advisers provide to their clients regarding soft dollar practices; and the policies and procedures that advisers who receive soft dollar benefits use to meet their fiduciary duty to seek best execution.

In reviewing soft dollar transactions, examiners generally review arrangements that an adviser may have with both third-party and proprietary providers. Generally, examiners will review documents and information regarding the adviser’s policies and procedures related to brokerage, trading, and soft dollar arrangements. In addition, examiners will consider the identity of broker-dealers and service providers used and the products and services received from them, as well as trade journals, commission runs, disclosure documents, investment advisory contracts, any written agreements relating to soft dollar arrangements (including commission sharing arrangements), and any documentation of the adviser’s periodic evaluation of execution quality.

In our recent review, examiners observed the following:

  • Products and services. The advisers examined generally received both proprietary and third-party products and services through soft dollar arrangements with broker-dealers. Research and trade execution assistance products and services were the most common. Many advisers received “mixed-use” products or services and a few advisers received products and services outside those that are defined in the safe harbor under Section 28(e) of the Securities Exchange Act of 1934.
  • Total commissions directed. All of the advisers examined who had soft dollar arrangements told examiners that they had informal commission “targets” with the broker-dealers who provide them with third-party or proprietary research services. Advisers stated that these commission targets were intended as guides and did not obligate the advisers to firm commitments. On average, 20% of these advisers’ total client commissions were directed to broker-dealers through which the advisers earned soft dollar credits, though the percentage among all of the advisers ranged from about 3% to 100%. Commissions on transactions that earned soft dollar credits ranged from $0.01 to $0.08 per share, with an unweighted average commission rate on soft dollar trades of $0.05 per share.
  • Best execution analyses. Most advisers documented their efforts to seek best execution, as required. Advisers typically conducted “periodic” execution quality reviews on an annual, semi-annual, or quarterly basis. To ensure consistency with regulations and internal compliance policies and procedures, many advisers chose to assign the responsibility for such reviews to brokerage or compliance committees. Examiners evaluated the quality of firms’ best execution reviews, which varied – some were more detailed and comprehensive than others.

Most of the advisers examined who were relying on the Section 28(e) safe harbor made determinations that commissions were reasonable in light of the brokerage and research services received, as required. Some advisers, in making such determinations, elected to regularly compare the amount they might have been “paying up” against the actual value of the research. In situations where advisers have not evaluated the value of the research received through the use of soft dollar credits and the commissions are higher than examiners would expect for the instruments traded, examiners may question whether the advisers have overpaid for such research.

A few advisers accumulated large soft dollar credit balances at broker-dealers, up to millions of dollars in value. As a result, examiners analyzed further whether the commissions paid may not have been reasonable, especially when some advisers were paying higher commission rates and were not receiving products or research. For example, examiners evaluated whether an adviser had the opportunity to misappropriate client assets, such as if an adviser accepted cash rebates offered by broker-dealers for the outstanding soft dollar credit balances maintained with the broker-dealers.

  • Disclosures. Most of the advisers disclosed the types of products, research and services received in exchange for soft dollars, as required. Advisers also generally complied with regulatory guidance by disclosing: that clients may pay commissions higher than those obtainable from other broker-dealers in return for the research, products and services; that research is used to service all accounts and not just those accounts paying for it; and, the procedures they follow when they direct client transactions to particular broker-dealers in return for products, research and services received.

Most advisers complied with their obligation to disclose the existence of conflicts of interest from their receipt of research obtained with soft dollars, including the adviser’s incentive to use client brokerage commissions to purchase research that the adviser might otherwise have to purchase with its own money. They also, as required, disclosed that certain products and services may have a mixed-use and the extent of the allocation between hard and soft dollars. However, examiners commented when an adviser does not disclose conflicts of interest, such as when an adviser has acquired research with soft dollar payments from a research company in which affiliated persons have an ownership interest.

Examiners also commented when advisers that acquired products and services outside the Section 28(e) safe harbor, such as internet domain fees, wireless services for a Blackberry, and telecommunications and computer equipment, did not disclose this practice to clients. Examiners also may comment if an adviser expressly represented to clients that it would only engage in soft dollar arrangements within the Section 28(e) safe harbor, but nonetheless earned soft dollar credits by trading in accounts for which the adviser does not have brokerage or investment discretion.

  • Compliance policies, procedures, and/or controls. Most advisers examined had policies and procedures related to soft dollar practices. While these policies and procedures varied per firm, examiners noted that effective practices required the adviser to maintain reports of soft dollar arrangements and transactions, reconcile commissions on a periodic basis, review mixed-use product allocation, and ensure that its chief compliance officer or a committee approve, in advance, specific products and services acquired with soft dollars.

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  1. Bill George on

    The portion of the webcast that deals with the proposed interpretive guidance, for fund directors, on soft dollar commissions begins at 1 hour and 15 minutes of the webcast. You can drag the “slider” on your computer’s video player to that point if you are only interested in this subject.

  2. Bill George on

    From: Bill George
    Sent: Wednesday, July 30, 2008 1:07 PM
    Subject: Dear Chairman Cox

    Dear Chairman Cox: I’ve copied and pasted an email (below) which I sent this afternoon to several members of the press, several third-party research providers, several third-party broker dealers and some securities lawyers. In the context of soft dollars and today’s Proposed Guidance for institutional investment fund board members, I believe it’s very important that the true size and financial impact of soft dollar brokerage be acknowledged and emphasized. Furthermore, during the July 12, 2006 Sunshine Meeting at which the “Commission Guidance Regarding The Appropriate Use of Client Commissions Under Section 28(e) of the Securities Exchange Act of 1934” was approved and released, it was stated that soft dollars used to purchase third-party services would no longer be treated differently than soft dollars used to purchase proprietary research (and other services) from brokerage firms. And, at that July 12, 2006 Sunshine Meeting several commissioners and staff members mentioned that a “second wing” of interpretive guidance would soon be released to provide guidance to the industry on the disclosure and transparency of brokerage commissions and services in all institutional brokerage arrangements. In July of 2007, U.S. Senator Charles Schumer reminded you that you had agreed to that the second wing of guidance on disclosure and transparency and that “fund boards and trustees were eager to receive such guidance so they could discharge their fiduciary obligations”. The verbal description of the Proposed Guidance which I watched this morning did not seem to provide any guidance on disclosure, transparency or the identification of proprietary services offered in bundled undisclosed brokerage arrangements. It seems to me that absent specific disclosure and identification of such services it’s difficult, if not impossible, for regulators, fund board members or institutional investors to discern if brokerage commissions are being used in compliance with Section 28(e) and or fiduciary propriety. It also should cause one to wonder how soft dollars used to acquire brokerage firms’ proprietary research and services can possibly be treated with equal scrutiny as compared to third-party fully disclosed investment research.

    From: Bill George
    Sent: Wednesday, July 30, 2008 1:11 PM
    To: Recipients, Undisclosed
    Subject: Soft Dollars and Sunshine

    During today’s SEC “Sunshine Meeting” Chairman of the SEC Christopher Cox stated, in his opening comments (prior to the presentation of the Proposed Guidance to fund directors regarding fund advisors’ uses of fund investors brokerage commissions) that the use of soft dollars by institutional investment advisors now totals approximately “one billion dollar per year”.* This is a misstatement.

    Section 28(e) of the Securities Exchange Act of 1934 describes soft dollars as any brokerage commissions paid-up above the fully-negotiated costs of brokerage execution. An analysis of the annual average of all tangible institutional brokerage execution related costs, as compared to the annual brokerage commissions paid by institutional advisors puts the true annual cost of soft dollar brokerage (in recent years) at something over ten billion dollars per year.

    For years investment consulting organizations and investment advisors have been misrepresenting and misreporting the institutional investment advisory industry’s use of soft dollars. They have only reported soft dollars spent for fully-disclosed (transparent) third-party investment research. They make no attempt to account for soft dollar commissions used to purchase brokerage firms’ proprietary research and other proprietary services which are not disclosed or transparent, and which may not qualify for the safe harbor of Section 28(e) and which may even be outside an advisors’ fiduciary authority. Without disclosure it’s impossible to determine if these commissions paid-up above the costs of fully-negotiated brokerage commissions are appropriate, or if they are used as monetary inducements contributing to conflicts of interest which do not accrue to the direct benefit of the advised funds’ investors.

    The archive of this SEC Sunshine Meeting will soon be posted at >

    The section of the meeting at which the above proposed guidance was submitted and discussed begins at around 1 hour 15 minutes (you can drag your media player “slider” to that point in the meeting).

    Best regards,

    Bill George

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