What Guidance on Guidance?


New York – The Investorside Research Association, the U.S. trade association for independent research, is formulating its position on the SEC’s recently proposed soft dollar disclosure guidance to mutual fund directors.  Last week, the trade association sponsored a briefing on the SEC’s proposed regulation by William Edick of Pickard & Djinis.   Will Edick’s opinion is that the guidance should not have a negative impact on third party soft dollar use.  We agree, but perhaps with different logic.  The more interesting question is what should Investorside’s position be on the proposed regulation.

Guiding Fund Directors

Two years after its interpretive release on soft dollars, the SEC has completed the task it set itself a decade earlier, providing more clarity on the practice of using brokerage commissions to pay for investment research.  The interpretive guidance released in July 2006 spelled out what was permitted to be paid through commissions, but did not address disclosure requirements.  The SEC included some soft dollar disclosure in the amendments to Form ADV proposed in March of this year [see Integrity’s comments].  On July 30th, the commission proposed guidance to mutual fund directors on what they should seek in soft dollar disclosure.  [See our comments on the open meeting at which the rules were announced.]

Will Edick of Pickard provided a summary of the proposed rules.  The guidance reiterates the duties of fund directors as fiduciaries and under the Investment Advisor Act of 1940, which governs mutual funds.  The rules primarily apply to mutual fund directors, and will not impact hedge funds (which don’t register as 40 Act funds) or pension funds (which are governed by ERISA.)

The rules provide guidance on evaluating the adviser’s best execution policies, then turns to oversight of the adviser’s use of brokerage commissions.   The guidance makes it clear that “proprietary” research (research provided by investment banks) is typically paid by soft dollars.  It continually astounds us how widely misunderstood this is.  In the minds of most (including SEC Chairman Cox based on his public comments), soft dollars = payment for ‘third party’ (aka, alterative or independent) research.    We’ll come back to this point later.

The guidance outlines the SEC’s view of potential conflicts associated with soft dollars and summarizes section 28(e) of Securities Exchange Act of 1934, which created the safe harbor for soft dollars in 1975.  The proposed rules then launch into a list of questions the board should be asking the adviser about soft dollars [see pages 29 & 30 of the proposed guidance.]  Directors should also inquire how the adviser’s soft dollar compliance procedures are determined and monitored.

The proposed rules include a section linking the directors’ soft dollar duties to the fund board’s review of the adviser’s compensation under section 15(c) of the 40 Act.  As part of this process, directors are encouraged seek additional information beyond what the SEC requires disclosed under Form ADV.  Directors should seek “information regarding the adviser’s brokerage policies, and how a fund’s brokerage commissions, and, in particular, the adviser’s use of soft dollar commissions, were allocated, at least on an annual basis.”

Finally, the rules request that boards review the adviser’s Form ADV disclosures to ensure not only that they are accurate, but also that that they are complete and understandable.

Impact on Soft Dollars

One of Investorside’s concerns is whether the new guidance will put a chill on soft dollar usage by mutual funds.  This is not an academic concern.   A significant portion of the alternative research industry’s revenues are paid through commissions.   In December 2003, during the height of the mutual fund market timing scandals, the U.S. trade group for mutual funds, the Investment Company Institute (ICI), called on the SEC to ban the use of soft dollars for third party research.   (Oddly, it did not call for a ban of soft dollars for proprietary research.)    Prominent mutual fund groups like MFS, Capital Research, and American Century implemented bans of soft dollars for third party research.

In theory, mutual fund groups were paying cash for services they previously paid through commissions, but in practice third party research firms found that spending on their services declined when advisers no longer paid through commissions.  Then recently founded Investorside sprang into action and membership surged from 20 in mid-2003 to 76 by mid-2004.  Investorside and others convinced SEC commissioners that banning soft dollars for third party research was not good policy, but the chill in mutual fund spending on third party research continued for another few years.  The SEC’s July 2006 guidance on soft dollars helped to clear the air.   Now the trade group is concerned whether the current guidance will be a step forward or a step back.

Will Edick is sanguine.  The guidance is intended to impose no new requirements on fund directors, merely to clarify their obligations and give assistance.  The proposed rules state this very clearly, and, during the open meeting when the guidance was discussed, Buddy Donahue, Director of the Division of Investment Management, reiterated this point.  But things may not be that simple.  Chairman Cox has a different agenda, as his remarks made clear, even though his influence seems to be on the wane.

As a practical matter, thirty-eight pages of new rules for fund trustees will have an impact.  For most boards, the new rules will translate into more focus on soft dollars.  Especially if the analysis gets linked to their 15(c) reviews, which receive the most intense scrutiny by board members.  The SEC’s attempt to tie soft dollar analysis to the renewal of the adviser’s contract, however tenuous, signals that the SEC believes boards should focus on soft dollars as a top priority.

Further, the guidance itself underlines in more than one place that just because soft dollars are given safe harbor status doesn’t mean that a board has to approve them.   After listing the conflicts inherent in soft dollars, the guidance concludes, “When evaluating an adviser’s use of fund brokerage commissions in light of these conflicts, a fund board may determine that such use is in the best interests of the fund.”  In other words, the default should be not to approve.  Guilty until proven innocent.   This is accompanied by a footnote which begins: “Fund boards are not required to approve brokerage and research services simply because they fall within the section 28(e) safe harbor.”  For those directors with attention deficit, the guidance reiterates this point again later, with another reference to the same footnote.

Is Less More?

Before charging off to Washington, however, Investorside should consider whether greater scrutiny of soft dollars by fund boards is a bad thing or not.   And exactly what its policy goals are regarding soft dollars should be.

The question is what the fund boards will be scrutinizing.  The major difference between now and 2003 is that soft dollars explicitly include proprietary investment banking research.  Third party research is not being singled out.  Quite the opposite:  boards that permit soft dollars are already scrutinizing third party research because until recently soft dollars = third party research.   The likely recipient of additional scrutiny will be proprietary research.

Ask yourself, given proprietary research is included, how like will it be that boards ban soft dollars?  There are few mutual funds in a position to totally cut themselves off from external research.   The more interesting question will be how the fund groups that have cut themselves off from third party research deal with proposed guidance.  There are quite a few fund groups who have trumpeted the fact that they do not use soft dollars.   Most of them use proprietary research.  So will they cut off proprietary research, or quietly back away from their soft dollar bans?

Currently, the Securities Industry and Finanical Markets Association (SIFMA, the trade association of the US securities industry) and ICI positions on soft dollars are relatively similar.  Soft dollars are generally a good thing, but should be kept below the radar.  Less soft dollar disclosure is good.  Less scrutiny by fund boards is good.   Transparency on research pricing, costs and commissions allocated to research is bad.

Before Investorside jumps on the SIFMA and ICI bandwagons, it should consider what its view of soft dollars policy should be.  How important is a level playing field between proprietary research and third party research?  Is more transparency on research pricing good or bad for third party research?  Is more disclosure on soft dollars good or bad?  Are soft dollars ultimately a good thing or a bad thing?

It is a good sign that the new Investorside Chairman, Richard Leggett, and Excecutive Director Pat Shea are focusing on the SEC’s proposed rules.  The proposed SEC guidance is the last regulatory action on soft dollars planned for the immediate future, and it represents an opportunity for Investorside and its members to make its views known.  The comment period ends October 1st.

Disclaimers:  Integrity Research is a member of Investorside, and Mike Mayhew (who it should be stressed had no hand in writing this article, being blissfully on vacation) is a member of the Investorside board of directors.   


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  1. For those who would like to read the original text of Section 28(e) I’ve copied and pasted it below:

    28(e)(1) No person using the mails, or any means or instrumentality
    of interstate commerce, in the exercise of investment discretion
    with respect to an account shall be deemed to have acted unlawfully
    or to have breached a fiduciary duty under State or Federal
    law unless expressly provided to the contrary by a law enacted
    by the Congress or any State subsequent to the date of enactment
    of the Securities Acts Amendments of 1975 solely by reason of his
    having caused the account to pay a member of an exchange, broker,
    or dealer an amount of commission for effecting a securities transaction
    in excess of the amount of commission another member of
    an exchange, broker, or dealer would have charged for effecting
    that transaction, if such person determined in good faith that such
    amount of commission was reasonable in relation to the value of
    the brokerage and research services provided by such member,
    broker, or dealer, viewed in terms of either that particular transaction
    or his overall responsibilities with respect to the accounts as
    to which he exercises investment discretion. This subsection is
    exclusive and plenary insofar as conduct is covered by the foregoing,
    unless otherwise expressly provided by contract: Provided,
    however, That nothing in this subsection shall be construed to impair
    or limit the power of the Commission under any other provision
    of this title or otherwise.

    (Copied and pasted from The Securities and Exchange Act of 1934
    pg. 235 as published on the SEC Website at:
    http://www.sec.gov/about/laws/sea34.pdf )

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