New York, NY – A few weeks ago, Securities and Exchange Commission Chairman Christopher Cox stunned the financial services industry by sending letter to Senate Banking Committee Chairman Christopher Dodd, and House Financial Services Committee Chairman Barney Frank requesting that the legislature eliminate soft dollars completely.
In his letter, and a subsequent speech before the National Italian American Foundation, Chairman Cox noted a variety of concerns he had about soft dollars – ultimately expressing his view that soft dollars “hurts investors and the US capital markets”. However, we believe that Chairman Cox seriously underestimated the consequences that banning soft dollars could have on the very investors he is trying to protect.
When do soft dollars make sense?
We want to make it clear that the team at Integrity Research Associates agrees that soft dollars do not make much sense in a free market environment, and we would not recommend their use if we were building our financial markets again.
However, it is clear to us that the significant costs associated with eliminating them at this stage are too high for all involved – including retail investors. As a result, we now feel strongly that the commission needs to focus its attention on trying to help investors clearly understand how their commission assets are being spent, thereby enabling investors to make well informed investment decisions.
The Chairman Slips Up
Before we discuss the various negative consequences of banning soft dollars, we need to make it clear that Chairman Cox was seriously mistaken in his speech before the National Italian American Foundation when he explained that close to $1.0 billion dollars were currently being spent on soft dollars.
The reality (at least according to the SEC’s own definition) is that institutional investors are currently spending almost $6.5 billion in soft dollars. This includes close to $1.0 billion in soft dollars for third-party independent research and almost $5.5 billion in soft dollars for proprietary sell-side research.
In fact, the SEC’s interpretive guidance released in July of 2006 made it abundantly clear that the commission saw no difference between sell-side and independent research when it came to soft dollars. Unfortunately many journalists, money managers, and (apparently) even the SEC commissioner sees it differently.
However, it is extremely important that we have an accurate understanding of what comprises soft dollars so we can clearly understand what the negative consequences would be of banning them altogether.
Some Will Lose Access to Research
The first consequence of banning $6.5 billion in soft dollars would be to drastically reduce the amount of research from both independent research providers and from sell-side broker-dealers and investment banks. Now some would not see this as a dire consequence as they argue that too much research is currently being produced.
However, we need to understand that the loss of investment research would hurt a number of parties – many of whom cannot afford to produce this research on their own, including retail investors, micro and small cap companies, and mid and small money managers.
This could not be a good outcome as the investment playing field would become unlevel as the largest investors would be able to afford the best research, while the small players would have little or no research.
In fact, this outcome would be in direct conflict with past regulatory efforts to create a “level playing field” for investors, including Sarbanes Oxley, Regulation Fair Disclosure, and the Global Research Analyst Settlement.
Investors Will Lose Investment Options
The loss of sell-side and independent research will have a substantial impact on small and mid-sized money managers as most of these firms do not have the assets under management to be able to afford to build their own internal research departments, nor will they be able to pay enough for access to the limited research produced by Wall Street’s remaining research departments.
Consequently, small and mid-sized money managers will probably either close up shop, or they will merge with larger firms in order to create the economies of scale necessary to be able to compete in the marketplace.
Not only will this reduce the number of options for investors, but it is also likely to reduce the performance of remaining investment options. Numerous studies have shown that very few money managers generate performance in excess of the market in general.
However, studies also show that the best performing money managers year after year are the small to mid sized funds. We suspect that the consolidation that is likely to occur as a result of eliminating soft dollars will not just reduce the number of money managers, but it will paradoxically eliminate the very managers that were generating the best returns.
Investors Could Actually Pay More
One of the arguments that Chairman Cox makes for banning soft dollars is that investors might be able to pay less if the practice were abolished. And at first glance, this argument makes sense as commissions could fall if all money managers were only paying for execution with client commissions.
However, this ignores the fact that many mutual funds and money managers will be faced with the prospect of having to pay for research (either internal or external) out of their own pockets if soft dollars were banned. As a result, we suspect that money managers will have an incentive to raise their management fees to cover these higher costs of operations.
US Will Lose Its Competitive Edge
Another cost of banning soft dollars in the US is the fact that we will inevitably become less competitive in the global financial markets. This is not terribly dissimilar to the trend currently taking place with small cap companies, who are taking their companies public overseas to eliminate the regulatory and financial burden of Sarbanes Oxley. Similarly, we would not be surprised if smaller money managers, broker-dealers, and independent research firms were to move their operations to the UK, Europe, and other regions where soft dollar regulations are less onerous.
A related cost associated with banning soft dollars in the US would be the creation of significantly varied regulatory regimes between various countries. This would result in increased costs of doing business for multinational firms as they would have to establish different compliance procedures for different regulatory regimes. This could contribute to companies’ desire to do business in the US.
Who Might Win with No Soft Dollars
Besides the negative consequences of banning soft dollars, Chairman Cox has also missed the political ramifications of who benefits from eliminating the practice. It is clear to us that the three segments that actually benefits from banning soft dollars are the largest asset managers, the largest broker-dealers, and most hedge funds.
As was shown in the 4th Quarter of 2005, when Fidelity struck deals with Lehman Brothers and Deutsche Bank to pay for their research in hard dollars, some firms could actually win if soft dollars were banned. This is due to the fact that the largest money managers have sufficient assets under management to be able to afford to pay for internal or external research out of their management fees. Smaller players, however, don’t have the scale to be able to compete.
In addition, the largest investment banks can also afford to maintain their research departments even if soft dollars are banned. These firms can, if they decide to, subsidize their research departments with the profits generated from investment banking, proprietary trading, and prime brokerage. In addition, reduced competition in the investment research business will increase the value of the research produced by the firms that are able to remain standing after soft dollars are eliminated.
Lastly, most hedge funds can, if they want to, circumvent the 28(e) safe harbor thereby reducing their need to use soft dollars. For example, hedge funds can include language in their Offering Documents enabling them to use client commissions to pay for research or any other fund expenses that management wants to. Consequently, hedge funds could legally continue using client commissions to pay for research even if soft dollars were banned.
In Summary
As we mentioned earlier, Integrity agrees with Chairman Cox’s sentiment that the practice of using client commissions (soft dollars) to pay for research services creates many conflicts of interest that may not be in the best interests of the investor. However, it is also clear to us that the consequences of eliminating soft dollars are much too high to warrant such a precipitous move. In addition, we wholeheartedly believe that the SEC could address most of Chairman Cox’s concerns and conflicts by mandating a commission disclosure regime in the US like the one adopted in the UK by the FSA. The big question is why hasn’t he moved in this direction?
Comment by Bill George:
On Saturday morning, June 9, 2007, I submitted the letter below to Senator Christopher Dodd via his Senate website “comment submission” web form. I felt it important to communicate directly with Senator Dodd because after the Stock Market Crash of 2000, from late 2000 until approximately 2004, the banking committees of the The U.S. Senate and The U.S. House of Representatives held several hearings and received a significant amount of testimony relating to brokerage practices, and mutual fund and investment advisory practices. If these legislative bodies decide to consider Chairman Cox’s recent request it seems important that these legislators receive more in-put from sources other than the industry groups representing the very largest broker dealers and the largest advisory complexes (both pension plan advisors and mutual fund advisors) and these groups’ industry lobbyists.
I believe an individual letter writing campaign might serve to assure that all sides of the issue might be considered. My letter to Senator Dodd:
June 9, 2007
The Honorable Christopher Dodd
Chairman, Sent Via Web Form
Committee on Banking, Housing, and Urban Affairs
United States Senate
634 Dirksen Senate Office Building
Washington, D.C. 20510
Subject: Request for repeal or revision of Section 28(e).
Dear Senator Dodd:
You received a letter, dated May 17, 2007, from SEC Chairman, Christopher Cox requesting the Senate Banking Committee repeal or substantially revise Section 28(e) of the Securities Exchange Act of 1934.
As you consider Chairman Cox’s request I hope you will also consider the following:
Section 28(e) outlines fiduciaries’ appropriate use of their clients’ brokerage commissions paid in excess of the fully-negotiated costs of securities transaction execution. Section 28(e) provides a safe harbor for fiduciaries to use client commissions (paid in excess of the fully negotiated costs of execution) to purchase qualifying research. Clients’ brokerage commission expenses outside the safe harbor of Section 28(e) are subject to the fiduciaries’ investment discretion and to the tests of fiduciary responsibility.
In 1975, when Congress passed Section 28(e) institutional third-party brokerage did not exist, so it seems Congress’ intention, at that time, was to force full negotiation of the costs of securities execution on the traditional investment industry and, at the same time, provide a transition from the historic industry marketing practice of providing investment research along with execution in exchange for brokerage commissions.
Since 1975 institutional third-party brokerage and independent research have flourished and become vital to investment decision making (and market efficiency) by conforming to the requirements of Section 28(e). The component costs of institutional third-party brokerage arrangements are completely disclosed and highly transparent. The books and records of institutional third-party brokers provide a detailed record of these transactions, and regulators, fiduciaries, and institutional clients can review this accounting.
In contrast, the traditional full-service brokerage industry, and many investment advisors have very strenuously resisted all attempts to force disclosure of the elements of the costs obscured within institutional bundled brokerage arrangements. In spite of this industry-wide resistance to disclosure, external studies of execution quality and execution costs substantiate Chairman Cox’s statement that institutional execution costs range from one-to-two cents per share. And using total institutional commission statistics, confirmed by several institutional investment consulting firms, one can estimate that last year the full-service brokerage industry received at least six and a half billion dollars of institutional clients’ brokerage commissions in excess of the costs of full-service brokers’ transaction execution.
It seems irrefutable that such excess undisclosed institutional brokerage commission payments have been a substantial motivation for several of the conflicts of interest and other institutional investment industry abuses, practiced over several years, which gained public attention after the Stock Market Crash of 2000. Institutional clients’ brokerage commissions have been used to purchase IPO allocation and IPO flipping favors, mutual fund and wrap account shelf-space and fund distribution favors, late trading accommodations, access to non-public information, and other more sophisticated abusive schemes.
Obviously, when compared to third-party brokerage, traditional full-service brokerage has many synergistic advantages that can be used in ways that create conflicts of interest and tempt advisors to abuse institutional clients’ brokerage commissions – particularly in an environment that does not mandate the disclosure of the components of institutional brokerage commissions.
The process leading up to the Global Research Analyst Settlement offered significant substantiation of the value of independently produced research; so much so that the final settlement included a major provision for the funding and distribution of independently produced investment research.
Objective, independently produced investment research has great value and can only thrive if it has a funding mechanism which is competitive with, and separate from, the mechanism for funding the proprietary research and ‘other services’ provided by the traditional (full-service) brokerage industry. To that end I hope whatever is done to address Chairman Cox’s request will include a mandate that all U.S. brokerage firms identify and price the services they provide within institutional brokerage arrangements. And that, in the future, all regulated investment advisors and fiduciaries are held accountable for specific disclosure of the uses of their clients’ brokerage commissions.
In this context, I believe the quote from Chief Justice Louis Brandeis is appropriate, “Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.” – Louis D. Brandeis, Other People’s Money and How the Bankers Use It 92 (1914)
Respectfully submitted by,
William T. George