Secrets of the NASD Task Force

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New York-There is a rumor making the rounds that the SEC is revisiting the recommendations of the NASD’s 2004 Mutual Fund Task Force as part of its deliberations on what sort of soft dollar disclosures to mandate.  This prompted us to dust off our copy of the Task Force’s report to see what clues this might offer on what the SEC will propose.

Soft Dollar Disclosure

In the U.S., current soft dollar disclosure is sparse and well hidden.  SEC Form ADV requires advisors currently to disclose whether they use soft dollars, and if so, whether the research is used for all accounts or just those paying for it.  Mutual funds disclose in their Statements of Additional Information (SAI) how the fund selects brokers for transactions and, if a fund considers the receipt of research services in selecting brokers, the fund must identify the nature of the services.  If a fund advisor directed transactions to a broker because of research services provided, the fund is required to state the amount of the transactions and related commissions.  In practice, this disclosure is boilerplate and contains no specific information.

In contrast, other regulators have developed frameworks for explicit disclosure of soft dollar usage.  The Financial Services Authority (FSA) in the UK implemented a regime at the beginning of 2006 which requires fund managers to provide clear information about the respective costs of execution and research–including third party research and proprietary brokerage research-as well as the overall expenditure on these services.  The Canadian Securities Administrators (CSA) is about to implement regulation requiring detailed disclosure of the research component of commissions on a client by client basis (to see our article on this,  click here.) Even the Department of Labor has gotten into the act, proposing that pension funds be required to disclose the research portion of commissions on a client basis (to see our article, click here.)

The marketplace is also evolving pretty rapidly.  The UK has embraced Commission Sharing Arrangements (CSAs) which effectively unbundle commissions between execution and research.  A U.S. variant of the CSAs, Client Commission Arrangements (CCAs), are being actively promoted by bulge bracket investment banks and agency brokers.  CCAs also divide commissions into execution and research portions.

The NASD’s 2004 Task Force

The NASD formed a Task Force to consider the topic of soft dollars and soft dollar disclosure in 2004.  The Task Force was comprised of nine mutual fund executives, nine securities firm executives, one academic and one lawyer.  The mutual fund representatives were all from large fund complexes with assets over $100 billion, and many of the individuals involved are active in the industry trade group, the Investment Company Institute (ICI).  The securities industry representatives were slightly more diverse, ranging from medium to large firms.

Given the composition of the task force, it is not surprising that its recommendations echoed the stated positions of the ICI and the securities industry trade group (now the Securities Industry and Financial Markets Association.)  And, yes, the recommended disclosures are pretty lame, especially in the context of all that has transpired in the last few years.  The task force recommended that mutual funds disclose in their prospectuses whether they obtain proprietary research through soft dollars and whether they obtain third party research through soft dollars.  Full stop.

Assume for a moment that the SEC is being lobbied by the securities industry and the mutual fund industry to keep soft dollar disclosure to a minimum which may explain why it is taking so long for the SEC to come up with guidelines.  Should we also assume that a fresh reading of the 2004 NASD Task Force report is a sign of SEC capitulation to industry pressure?

The Fine Print

Let’s look more closely at the report.  The first thing that jumps out is that the Task Force was very careful to broaden the analysis of soft dollars to include the proprietary research provided by a broker.  This is not a trivial change, especially when you consider that industry practice is to equate soft dollars only with third party research.  Although this approach was not one of the official recommendations of the Task Force, the SEC adopted it in its updated Soft Dollar guidelines issued last July.  Hmmm.  Maybe there is more here than meets the eye.

If we turn to the discussion of soft dollar disclosure, a few more tidbits emerge.  As we re-read the report, what is striking is that there is more discussion about what the Task Force didn’t recommend that what it recommended.   Many paragraphs are spent describing requirements for the advisor to provide estimates of the amount of proprietary research obtained with brokerage commissions, which “a substantial number of Task Force members” believed the SEC should require.

Specific points of view are documented. “At least one Task Force member feels strongly that advisers, with input from broker-dealers, could provide fund boards with the actual dollar amount of proprietary research obtained with fund Commissions.”  “Two members of the Task Force would go further, and would support a requirement that such estimates be provided to fund investors, such as disclosing the estimates in the fund prospectus.”

The report also discusses at some length the then-pending FSA guidelines.  The majority view, that such disclosure is subjective, expensive and would be of no practical use to fund boards or investors, is handled in a single paragraph.

You get the impression of a pesky minority-perhaps the sole academic on the panel and/or the lawyer– tying up the task force members’ valuable time before being squashed by the industry consensus.

Conclusion

At first glance, we assumed that, if true, the rumor of the SEC revisiting the NASD Task Force report was a signal it was leaning toward the industry viewpoint.  Now we’re not so sure.   The Task Force’s position on soft dollar disclosure wasn’t so easily derived, even in 2004.  Probably this is a microcosm for what the SEC is going through in its deliberations.  And then there is one more small detail about the 2004 Task Force: the lone academic on the panel was Erik R. Sirri, who was appointed Director of the SEC’s Division of Market Regulation in September 2006.

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