Some Urge Cox To Reconsider Request to Ban Soft Dollars


New York, NY – A few weeks ago, Securities and Exchange Commission Chairman, Christopher Cox wrote a surprising letter to senior legislators, suggesting that Congress consider repealing the Section 28(e) safe harbor for the use of client commissions to purchase research services.

As mentioned on Friday, rumors are swirling in the marketplace that Chairman Cox and his staff are currently working on draft legislation that congressional staff might use as a starting place to consider such a request.

A Letter from the Alliance

However, some in the industry are not content to sit idly by and hope that Chairman Cox’s appeal fails to gather support on Capitol Hill.  Last week, The Alliance in Support of Independent Research, a consortium of agency brokerage firms, submitted a letter to Chairman Cox, urging him to reconsider his request that Congress repeal or substantially modify Section 28(e).

Following is a summary of the major points from the Alliance’s letter to Chairman Cox.

  • The repeal of Section 28(e) would reduce the flow of research to the marketplace, to the detriment of all investors.
  • The repeal of Section 28(e) would significantly harm the ability of independent research firms to provide their innovative research to the securities markets.  Client commission arrangements allow independent research providers to obtain assistance from broker-dealers to market and provide their research.  The loss of this efficient marketing mechanism would make it extremely difficult for independent research providers to compete with their better financed and more recognizable Wall Street peers.
  • Small investment managers would be especially harmed by the repeal of Section 28(e).  While large investment managers could spread the cost of research over their larger client base, smaller managers would be required to either raise their management fees or to limit their use of research.  The resulting consolidation in the investment management industry would lead to less choice and competition, which in turn would lead to higher asset management fees.
  • The repeal of Section 28(e) would have a disproportionately negative effect on smaller investors.  Mutual fund and pension fund managers require the protection of Section 28(e) to receive research through the use of client commissions.  Hedge fund managers, however, do not need the protection of Section 28(e) to access research through the use of commissions, as this practice can be authorized through disclosure to, and consent of, hedge fund investors.  The ability of hedge funds to use a payment mechanism not available to investment vehicles serving smaller investors would give wealthier hedge fund investors preferred access to the best investment ideas.
  • The repeal of Section 28(e) would expose U.S. broker-dealers and money managers with an international presence to conflicting regulatory regimes, and harm the ability of U.S. entities to compete in the global market of brokerage and investment advisory services.
  • In 2004 the SEC formed a Task Force on Soft Dollars to consider, among other issues, whether to request the repeal Section 28(e).  The Task Force did not recommend the repeal of Section 28(e), but rather recommended several steps the Commission could take to improve the efficacy of Section 28(e) arrangements.  The Commission has begun, but not completed, the implementation of the Task Force’s recommendations.  The Commission should focus its efforts on the remaining issues it has not addressed, namely whether additional transparency is needed in respect of client commission arrangements under Section 28(e).
  • There have been virtually no abuses of the Section 28(e) safe harbor in recent years.  A review by the Alliance of SEC enforcement actions involving conduct occurring since the issuance of the SEC’s Soft Dollar Inspection Report nearly nine years ago revealed only three actions involving the impermissible use of client commissions for services.  None of these actions involved fiduciaries who purported to rely on the Section 28(e) safe harbor to justify their behavior.

Unintended Consequences

As we have mentioned in the past, the Chairman’s desire to eliminate soft dollars, while philosophically understandable, is likely to have substantial unintended consequences — particularly for the individual investor that Chairman Cox wishes to protect.

This will come in the form of reduced competition in the asset management industry as some small and mid-sized firms go out of business due to the increased costs of research.  In addition, other asset management firms will raise their fees to make up for the cost of paying for research in hard dollars.  Lastly, investors will be disadvantaged because the firms that will suffer most from the elimination of 28(e) — the small and mid-sized money manager — are the very firms that have traditionally generated the best investment returns for small investors.

An Issue That Won’t Go Away

It is clear from the letter sent by The Alliance in Support of Independent Research, and the recent rumors that Cox’s staff is working to draft potential legislation for Congressional staffers to consider, that Chairman Cox’s unexpected call to abolish soft dollars is not likely to quietly disappear.

In fact, we suspect that various groups, including SIFMA, the ICI, The Alliance in Support of Independent Research, and Investorside, will start an extensive lobbying campaign to garner support to maintain the 28(e) safe harbor.

It must be noted, however, that the ICI is currently embroiled in another important battle for the industry with the SEC — the potential elimination of 12-b1 fees.  This factor could have am impact on how aggressive the ICI wants to be on soft dollars.

Ultimately, we do not think that Chairman Cox will be able to garner the political support to ban soft dollars, particularly if those that want to maintain 28(e) point out the various ways that eliminating the safe harbor will disadvantange indivual investors.

One such influential member of Congress, Senator Charles Schumer, has come out consistently in favor of maintaining the 28(e) safe harbor, and of addressing any concerns with the practice through the establishment of better transparency.
Try To Head Him Off At The Pass

Despite this, we do believe that one of the most meaningful ways to head off Chairman Cox’s efforts to ban soft dollars, would be for the industry (SIFMA and the ICI) to propose a meaningful set of guidelines to promote commission transparency, thereby enabling investors to clearly understand how their commission dollars are being spent to purchase proprietary sell-side and independent research.

In our mind, this would require disclosure like what is currently taking place in the UK where asset managers are telling pension fund clients how much of their commissions are being spent on execution and how much commissions are being spent on research.

This disclosure, in combination with the use of CSAs and CCAs, would encourage buy-side investors to move from the traditional opaque sell-side / buy-side relationship to one where they can make two separate decisions — the first choosing execution providers purely for their ability to provide “best execution”, and the second to select and pay for research providers who provide “best in class” research.

Comment by Bill George:
Subject: Financial Services Committee Hearing

Representative Barney Frank’s Financial Services Committee is holding a Congressional hearing Tuesday June 26, 2007 (2:00 PM EDT) . I have heard that one of the subjects under consideration at this hearing is Christopher Cox’s request to repeal or revise Section 28(e). The hearing announcement mentions testimony will be requested from the five commissioners of the SEC.

I am hoping that someone testifying at this hearing will mention that regulators seem to have acknowledged the significant importance of independent research when they structured the Global Analyst Research Settlement.

And I’m hoping that testimony brings attention to the significant effort regulators expended to devise protected systems for the distribution of the independent research mandated in the Global Analysts Research Settlement. At the regulators seemed very aware that a trusteed research distribution plan was very necessary to prevent the independent research from becoming biased by the firms submitting to Global Analyst Research Settlement.

To me it seems highly contradictory that only two years after implementing the Global Analyst Research Settlement regulators and legislators would consider jeopardizing the market’s solution to ensuring the independence of third-party (independent) research providers.

P.S. To access the live web cast of this hearing you can go here. >


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