Where has Commission Disclosure Gone?


New York, NY – When the Securities and Exchange Commission announced its interpretive guidance on the use of client commissions (a.k.a. soft dollars) in July of last year, commission staffers indicated they would have a proposal on commission disclosure presented for comment by the end of 2006.

Unfortunately, the SEC was unable to meet this deadline, prompting many in the financial services industry to wonder if the SEC actually plans to issue any disclosure rules.  It is clear from current evidence that the SEC would rather not weigh in on this topic.  However, we believe that various developments will force the commission to mandate some level of disclosure around how money managers are spending their customers’ equity commissions.

Impossible to Understand

In the past, many investment bank and money management executives have tried to make the spurious argument that providing disclosure of how client’s commissions are being spent would not be very helpful, and in fact, it could be dangerous as clients could not easily understand this information.  They argue that the only disclosure that makes sense would be provided to the board of trustees of the mutual fund or money management company.
In many ways the argument that clients “cannot understand” the information that might be provided under commission disclosure sounds like the financial services industry is trying to hide something from their clients.  In fact, this argument is a little reminiscent of how some in the United States felt about giving women the vote, putting nutritional labels on food, or establishing a level playing with the creation of Regulation Fair Disclosure – all developments that have put the power of information in the hands of the people.

The Impact of CSAs and CCAs
Some experts have noted that the SEC is secretly hoping that the growing popularity of Commission Sharing Agreements and Client Commission Arrangements would make the topic of “commission disclosure” superfluous.  They explain that CSAs and CCAs, by their very nature, would enable money managers to pay for execution and research separately, thereby enabling them, over time, to learn about how much they were spending on research and execution.
However, the fact that money managers know how much they are spending on execution and research really doesn’t enable their pension fund and plan sponsor clients to evaluate and assess whether their managers are spending their commission assets wisely.

International Developments
One obvious factor that should encourage the SEC to come out in favor of some form or meaningful commission disclosure is the fact that it would not be leading in this regard, but it would actually be following an established global trend.  A few years ago, the Financial Services Authority in the United Kingdom mandated that asset managers disclose how much of client commissions they were spending on execution and research.

In July of last year the Canadian Securities Administrators (CSA) published proposed new rules dealing with acceptable soft dollar practices. This rule, National Instrument 23-102, proposed that money managers disclose how their client’s commissions were being spent.  It is interesting to note that the ICI (the US money management trade association) commented on this proposed legislature using the same argument that this information would not be useful to clients.

Pressure from the DOL

In July, 2006 the Department of Labor Employee Benefits Security Administration (EBSA), the regulator of ERISA plans in the United States, approved regulation which proposed new reporting requirements of brokerage fees and commissions, soft dollars, 12b-1 fees, float income, etc.
In fact, EBSA went so far as to state that plan sponsors needed to pay attention to the soft dollars being spent by investment managers on the plan’s behalf:  “The Department believes that an annual review of such expenses is part of a plan fiduciary’s on-going obligation to monitor service provider arrangements with the plan. Requiring the reporting of such information should emphasize that monitoring obligation.”

Again, representatives of both the money management and securities industries, the ICI and SIFMA, weighed in with protests, arguing that the EBSA should defer to the SEC on soft dollar issues.  They also argued that the disclosure requirements recommended by the EBSA were over the top: “[EBSA’s] proposed revision goes way beyond Section 28(e) by purporting to require the manager to ‘unbundle’ and separately value…’brokerage and research services’ provided to the manager.”  They argued that this would be difficult, time consuming, and extremely costly – and that any resulting allocation of commissions between brokerage and research would be “inherently subjective and arbitrary”.
Of course, this is a strange argument as countless money managers in the United Kingdom, and a growing number in Europe, have already moved to such a disclosure regime.

Request For SEC Rulemaking

The most recent development in this saga came on February 10, 2007 when Mr. William George of Blue Sky Research Services filed a Request for Rulemaking on Disclosure and Transparency in Client Commission Arrangements with the SEC (see file 4-531 at http://www.sec.gov/rules/petitions.shtml).

Under the rules of the SEC, any person may request that the Commission issue, amend or repeal a rule of general application. Petitions must contain the text or substance of any proposed rule or amendment or specify the rule or portion of a rule requested to be repealed. Persons submitting petitions must also include a statement of their interest and/or reasons for requesting Commission action.

In his request, Mr. George argues the following:

“Sophisticated transaction cost analysis of large samples of institutional brokerage executions indicate that institutional trades can be executed, on average, at a cost ranging between 1.25 and 1.65 cents per share.  Full service brokers typically charge 5 cents per share for their brokerage services without explaining how the 320 to 400 percent “paid up” above the costs of execution is used.  Is the excess commission “paid up” used to buy proprietary research which qualifies for the safe harbor of Section 28(e)?  How does one know?  The lack of transparency and disclosure in bundled brokerage arrangements seems intended to inhibit regulators and fiduciaries   from discharging their duties.  The opacity of bundled brokerage arrangements can camouflage the abuse of fiduciary clients’ commissions.

For the above cited reasons, I feel it’s in the best interests of the investing public, the independent research community, the viability of third-party brokerage, and for market efficiency; that the SEC to work rapidly to introduce a mandate for commission unbundling and disclosure.  The identification and pricing of the services brokers provide, and for which fiduciaries may “pay up” with their clients’ commissions, will simplify fiduciary and regulatory oversight and reduce opportunities for abuse.”
The Result of These Pressures

Consequently, we believe that the Securities and Exchange Commission will find it extremely difficult to continue ducking the issue of establishing some form of reasonable commission disclosure regime for much longer.

In fact, given the mounting pressure, we would not be surprised if a few investment banks and mutual fund companies were to reverse their previous stances towards commission transparency and start lobbying the SEC to roll out an FSA like disclosure proposal.   The reason for this startling conclusion is because we suspect that a conservative proposal from the SEC would probably be more acceptable to the industry than the more aggressive proposal that has already been announced by the Department of Labor.

And despite the rather inane arguments put forth by many in the financial services industry, we also think it will be difficult for the commission to ignore the growing international consensus that disclosure and transparency will be good for investors.  As former U.S. Supreme Court Justice Louis Brandeis argued when discussing the benefits of openness and transparency, “sunlight is the best disinfectant.”


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