New York, NY – According to a recent article posted on the Wall Street & Technology website (http://www.wallstreetandtech.com/featured/showArticle.jhtml?articleID=210602231) some buy-side participants are questioning the risk of having Commission Sharing Agreements or Client Commission Arrangements with bulge bracket brokers – particularly given the high likelihood that many of these firms could go bankrupt or be sold. In fact, some even suggest that “agency only” venues might be safer CSA brokers.
The concern is based on the uncertainty surrounding unpaid commission balances in a Commission Sharing Agreement or Client Commission Arrangement (CSA or CCA). In this article, we will use an example of a money manager who has a balance of $1.0 million in commissions in a CSA or CCA with “Broker A” and Broker A goes bankrupt or is sold.
Can You Get Access to the Funds?
Of course, the first question that is likely to go through the head of a buy-side client when they hear that Broker A, their CSA or CCA broker, is filing for bankruptcy or is being sold is will they be able to get access to their unpaid balances.
Justin Kane, Director of Equity Trading at Rainier Investment Management, explained this concern in the WS&T article. “Those commission dollars may not be recoverable or they may be wrapped up in litigation for a while. It could be a pretty high risk to client commission dollars.”
Whose Money is It Anyway?
The second question that must be addressed is, “Whose Money Is It Anyway?” After informal conversations with several experts in this area, it became clear that there is no consensus on this issue. Apparently, the Securities and Exchange Commission has not clarified this topic.
Consequently, some brokers believe the $1.0 million in unpaid commission balances is actually theirs not the money managers. Others, however, think the $1.0 million in unpaid CSA or CCA commissions belongs to the asset manager. As you might imagine, these radically different views would result in very different responses from the brokers if they went bankrupt or were sold to another party.
While we have not spoken to many buy-side accounts on this topic, we suspect that most money managers assume that the unpaid CSA or CCA balances are theirs, and not the broker’s.
Can CSA Commissions be Transferred?
The third, and probably the trickiest question is, “Can CSA Commissions be Transferred to Other CSA Brokers?” Let’s say, that Broker A believes the $1.0 million in unpaid CSA or CCA balances actually belongs to the asset manager, but Broker A goes bankrupt or is sold. Can the asset manager maintain the use of these funds to pay for third-party broker or independent research by transferring these funds to another CSA or CCA broker?
Interestingly, not all CSA or CCA brokers agree that they can or should accept transfers of unpaid CSA or CCA balances from Broker A on behalf of specific buy-side clients. We spoke with a few brokers who expressed grave concerns that they would not be meeting the requirements outlined in the July 2006 Interpretive Guidance for “effecting the trade” on any of the transferred CSA commissions.
In the July 2006 Interpretive Guidance, the SEC explained that a broker-dealer will be deemed to have satisfied the “effecting” requirement if it performs at least one of four “minimum functions.” These functions are (i) taking financial responsibility for the trades until the clearing broker has received funds or securities; (ii) making or maintaining records relating to customer trades, including blotters and memoranda of orders; (iii) monitoring and responding to customer comments concerning the trading process; or (iv) generally monitoring trades and settlements. In addition, the SEC notes that a broker-dealer will be deemed to be effecting securities transactions if it executes, clears or settles the trades.
These brokers acknowledge that they did not execute, clear or settle the trades which generated the $1.0 million in unpaid CSA balances. However, they also note that they did not meet any of the four minimum functions which satisfy the “effecting” requirement.
As a result, these brokers felt that the $1.0 million in CSA or CCA commissions transferred from Broker A to pay for proprietary or third-party research would not be protected by the 28(e) safe harbor. In fact, a few brokers noted that if they accepted transferred CSA balances, they would probably issue a warning to customers explaining they were not sure that these transferred funds would actually be covered under the 28(e) safe harbor.
Are Agency Brokers a Better Bet?
Of course, none of this addresses the fundamental contention expressed by Mr. Kane in the WS&T article. He commented, “I think this should cause firms to take a look at the value proposition that the agency-only brokers that have CSAs to offer. You’re not going to be at risk of losing your kitty – the money you’ve put into the CSA pool.”
While we understand Mr. Kane’s conclusion, we disagree that agency-only brokers are the best solution. In fact, we think that one of the factors that asset managers need to consider when selecting a potential CSA or CCA brokers is counter-party risk. Unfortunately, this was traditionally not one of the criteria used by most asset managers when deciding who to select as their CSA or CCA broker.
And while it is true that in today’s market environment, the default risk of many bulge bracket investment banks is quite high, there are numerous financial services firms whose risk profile is much lower and who could be safer options as a CSA or CCA broker. This includes regional broker-dealers, banks with large consumer deposit bases, and agency brokers.