SEC’s Cox Urges Soft Dollar Repeal


New York, NY – According to an article published by Dow Jones Newswire last night, SEC Chairman Christopher Cox recently proposed to senior members of congress that they consider eliminating the legislative protection for “soft dollars”.

The Details

Apparently, in a letter sent last week to Senate Banking Committee Chairman Christopher Dodd, and House Financial Services Committee Chairman Barney Frank, Cox suggested that a “legislative fix” might be warranted with regards to the soft dollar issue.

Cox explained his views to a Dow Jones writer saying that he thought the commission was hindered in its ability to truly reform soft dollar practices given current laws that are in place. Consequently, Cox felt that an outright ban of soft dollars would be preferrable.

One of the concerns Cox has about soft dollars is that the arrangement might encourage money managers to trade excessively with client assets to generate soft dollar credits. In addition, Cox was concerned that some asset managers might direct trades to trading desks to pay for their research, despite the fact that they did not offer “best execution”. Lastly, Cox expressed concerns about money managers potentially using the soft dollar commissions generated from one client’s account to benefit other clients’ portfolios.

It must be noted that the views expressed by Christoper Cox were not those of the Commission, nor were they reflective of what the other four Commissioners might think on this topic. Cox is expected to elaborate on his views on the subject in a speech in New York today (Thursday).

What This Means

These comments by SEC Chairman Cox must be considered extremely important as the banning of soft dollars would have a significant impact on the financial services industry — both to the alternative research industry AND securities firms as ALL commissions above and beyond the cost of execution is technically (legally) considered “soft dollars”.

However, as we evaluate Cox’s current comments on soft dollars versus his recent statements on the same subject, it becomes clear to us that the SEC Chairman is frustrated with his inability to substantively reform these practices — particularly the issue of providing investors with commission disclosure.

In fact, a cynic might conclude that Cox’s statements are part of a strategy to reengage the industry on this topic and try to get both the securities industry and the mutual fund industry to seriously consider supporting a meaningful disclosure regime.

Historically, this was exactly what happened in the UK after the delivery of the Myners Report when Paul Myners recommended a mandatory unbundling of equity commissions. Of course, the industry saw this approach as the worst of all possible outcomes, thereby making commission disclosure a more palatable solution.

Consequently, we see Chairman Cox’s remarks as important as he is clearly indicating that he is not satisfied with leaving the soft dollar issue alone, but that he wants to address many of the various conflicts of interest associated with soft dollars by fostering greater commission transparency.

Ultimately, Cox is looking to fulfill his duty of SEC Chairman by helping investors make better investment decisions by providing them with clear information about how their assets are being managed and spent.

Comment by Bill George:
In a letter to Senator Christopher Dodd dated May 17, 2007 Chairman of the SEC Christopher Cox mentions that nearly one billion dollars of pension plan and mutual fund clients’ brokerage commissions were used to purchase third-party research in 2006 (see the page one third paragraph of cox safeharbor softdollar 5-17-07, attached). Many people who are not deeply familiar with soft dollars get the impression that this is the full-scope of the issue. In fact, the one billion dollars of identifiable third-party research purchased in compliance with Section 28(e) is not the problem.

The real problem is the use of institutional clients’ commission dollars spent by fiduciaries to buy unidentified proprietary brokerage ‘services’ in full-service brokerage arrangements. The email below outlines the true significance of the un-disclosed use of institutional clients’ commissions. When considering an unreported drain on investable assets in the magnitude of 6.5 billion dollars per year one must consider the compounding impact this drain will have on investments over several years.

Chairman Cox’s letter correctly identifies several issues relating to the lack of disclosure in full-service brokerage arrangements where brokerage commissions are used to purchase proprietary services. Many of the investigations of brokerage and advisor abuse, over the last half decade, and prosecutions of conflict of interests, late trading, mutual shelf-space and distribution arrangements for “order flow” and other brokerage abuses, have at their root the exchange of institutional clients’ brokerage commission dollars for undisclosed favors. It seems that these favors rarely accrue to the direct benefit of the mutual fund or the pension plan account owner.

Disclosure of soft dollar arrangements used to buy proprietary services in bundled commission arrangements from full-service brokerage firms would go a long way toward solving the problems Chairman Cox has identified in his letter to Senator Christopher Dodd.

Best Regards,

Bill George

—– Original Message —–
From: Bill George
To: Undisclosed Recipients
Sent: Thursday, September 28, 2006 6:55 AM
Subject: The Compliance Void

Based upon estimates extrapolated from information provided by Greenwich Associates, and published in Pensions & Investments, in the year 2005 institutional brokerage commissions were approximately an 11.3 billion dollars per year business. (See, Link)

Traditionally, Greenwich Associates’ questionnaires and Greenwich Associates’ press announcements use the term “soft dollars” (incorrectly) to describe brokerage commissions used to acquire third-party research only. Greenwich Associates’ surveys and press releases do not acknowledge that when institutions use brokerage commissions in excess of their “fully-negotiated execution only rate”, the excess commissions paid-up are also, in fact, “soft dollars”.*

Most reliable sources estimate that the current cost of executing and clearing an institutional trade is less than 1.75 cents per share. Most institutional buy side brokers pay commissions of 5 to 6 cents per share. This leads one to the conclusion that the excess commission paid, above the cost of execution and clearing, is in the range of 3.25 to 4 cents per share. It seems apparent, then, that institutional client’s commissions “paid-up” in undisclosed soft dollar arrangements with full-service brokers were, at a minimum, 6.5 billion dollars in 2005.

It would be interesting to know what services institutional investment advisors received for the excess commissions they paid. And it would be interesting to test the services received for compliance with Section 28(e), ERISA, and fiduciary duty. Unfortunately, the lack of disclosure in bundled full-service brokerage arrangements prevents compliance testing.

The math:
Institutional advisors report using 1.13 billion dollars of commissions to purchase third party research.
Institutional advisors report this was 10% of their 2005 brokerage commission expenditures.
So, it seems total institutional brokerage commissions were 11.30 billions in 2005.(1.13 X 10 = 11.30)

If institutional execution and clearing can be accomplished for 1.75 cents per share (high side of the estimate range) and most institutional brokers pay .05 cents per share (Low side of the range) it seems most institutional brokers “pay-up” an excess of 65% over their fully negotiated cost of execution and clearing (conservative estimate). (.05 – 1.75 = 3.25 per share commission premium, (0325 / .05 = 65%).

If the Greenwich studies don’t include these commission premiums “paid-up” in their studies, then the total of soft dollars is mis-reported by 6.56 billions of dollars.11.30 total commissions – 1.3 third party payments = 10.27 commissions net of third party x .65 calculated premium over execution and clearing = 6.56 billions of unreported soft dollars.

* Greenwich’s confusion over the definition of soft dollars is not unique, an article written by Sara Hansard and published in Crain’s Investment News on July 24, 2006 quotes a senior official at the SEC: “Many advisers do not take into account the research they receive from affiliated broker-dealers when asked to report on their use of soft dollars”, said Lori Richards, director of the SEC’s office of compliance inspections and examinations.”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.” Later, in the same article, David Tittsworth, Executive Director of the Investment Advisor’s Association in Washington D.C.confirms significant mis-reporting (or is it avoidance?) in the way investment advisors respond to questions about soft dollars.


About Author

Leave A Reply