Whose Money Is It Anyway?

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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.

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  1. It might be appropriate to require “pooled” client commissions awaiting distribution to research providers to be put in an escrow account and paid interest at the broker loan rate. The escrow account could be identifed as the property of the firm paying the brokerage commissions.

    I’ve been critical of the concept of CCA’s since its creation, I even submitted a Request For Rule to the SEC on February 10, 2007 on CCA’s (see, http://www.sec.gov/rules/petitions/2007/petn4-531.pdf ).

    More Concerns over Client Commission Agreements

    I’ve been thinking about Michael Mayhew’s article, “CSA Agreements Pose Problems For Some” which was posted on the Integrity Research web log on December 10, 2006 and which included a re-publication of a Wall Street Journal article titled, “Funds Consider New Way to Pay For Research” by Tom Lauricella, originally published in the WSJ on December 8, 2006; page C1.(1) I’ve also been thinking about Ivy Schmerken’s article, “Buy Side Dilemma: Research vs. Execution” which was published in the December issue of Advanced Trading.(2) And I’ve been thinking about the public comments [some of which touched on Commission Sharing Agreements] that were posted on the SEC website in the sections relating to the recent “Commission Guidance Regarding The Appropriate Use of Client Commissions Under Section 28(e) of the Securities Exchange Act of 1934.”(3)

    In my opinion – in the present environment – there are two very important concerns about the effects of the implementation of Client Commission Agreements (CCA’s) that haven’t been sufficiently discussed. These two very important concerns are disclosure and regulation.

    Disclosure:
    In many discussions about CCA’s comparisons are made to the soft dollar regulations recently implemented by the Financial Services Authority (FSA) in Great Britain. Some say that CSA’s seem to be working well in Great Britain, so it should be possible to implement them in the U.S. without any problems. To me, this is alarming reasoning, the soft dollar regulations implemented by the FSA are substantially different than those implemented by the SEC in at least one significant respect. That is, The FSA mandated guidelines for commission disclosure, the SEC has not mandated such guidelines or issued interpretive guidance on disclosure.(4)

    I believe it’s reasonable to assume, that without a mandate for disclosure full service brokerage firms and institutional investment advisors will continue to be tempted to use client commissions to buy goods and services that do not accrue to the direct benefit of the institutional investor whose commissions are paying for those goods and services. In the Integrity Research web log article, “Marginal Values”(5) in the section titled, Disclosure and Transparency I summarize how bundled undisclosed commission arrangements have been used to obscure the quid-pro-quos that motivate conflicts of interest and tempt brokerage employees and fiduciary investment advisors.

    It should be obvious that many of the conflicts of interest and abuses of the past were facilitated by the exchange of institutional client’s brokerage commissions for favors (IPO allocation, late trading consideration, mutual fund distribution & shelf space arrangements, etc.). If CCA’s have the expected result of concentrating order execution and the allocation of brokerage commissions at a few of the very largest brokerage firms, is it reasonable to assume that commissions in excess of the cost of execution (aka soft dollars) will be used exclusively for the direct benefit of the investor(s) whose account paid the commission? I believe true disclosure of institutional commissions is the best way to reduce the temptation for commission abuse.

    Regulation:
    No commenter seems to question that CCA’s will concentrate more order flow, trading activity and commission revenue in a very few, extremely powerful brokerage firms. This conclusion raises a serious concern, is it beneficial to strengthen what already seems oligopoly domination of the brokerage industry?

    For anybody who followed the news leading up to The Global Analyst Research Settlement (6) it should come as no surprise that The Settlement was actually a compromise between New York State Attorney General Eliot Spitzer and The U.S. Securities and Exchange Commission. Mr. Spitzer was in favor of more severe punishment for the perpetrators and overseers of fraud and abuse. The SEC argued in favor of less severe less far reaching penalties – out of fear of severely damaging the nation’s financial infrastructure. These two regulatory forces met somewhere in the middle.

    It seems that allowing the proliferation of loosely defined CcA’s which would predictably fuel more consolidation and increase oligopoly power in an industry that’s already known to be difficult to regulate is a prescription for further emboldening abusers, while at the same time increasing risk to the nation’s financial infrastructure.

    Conclusion:
    It seems that without constructive commission disclosure and without a more formal definition of the mechanics of CCA’s, their immediate implementation is fraught with risk. Also, it seems that trading venues (exchanges) are evolving toward a natural solution to the fragmentation of order flow, and that, in the near future this evolution may provide increased liquidity. This evolution might make best execution a more evenly distributed characteristic. I believe Lisa Shallet’s suggestion for third-party oversight of Commission Sharing Arrangements (by a clearing-house operation like DTC) has a great deal of merit and should be explored.

    Footnotes:
    (1) CSA Agreements Pose Problems for Some by Michael Mayhew Integrity Research web log
    http://integrityresearch.blogdrive.com/archive/cm-12_cy-2006_m-12_d-12_y-2006_o-1.html

    (2) Advanced Trading Magazine “The Buy Side Dilemma: Research vs Execution” by Ivy Schmerken, Senior Editor December 2006 issue.
    http://www.advancedtrading.com/issues/200612/showArticle.jhtml;jsessionid=3O4JVBETWIJ4UQSNDLOSKH0CJUNN2JVN?articleID=196513715

    (3) See, comment letters to The SEC on ‘final’ version of Commission Guidance
    http://www.sec.gov/comments/s7-13-06/s71306.shtml
    And, see comment letters to The SEC on The Proposed Interpretive Guidance
    http://www.sec.gov/rules/interp/s70905.shtml

    (4) The FSA has adopted Great Britain’s Investment Management Association’s “Pension Disclosure Code” as its working model for brokerage commission disclosure.
    http://www.investmentuk.org/news/standards/pfdc2.pdf

    (5) “Marginal Values” by Bill George published on The Integrity Research web log.
    http://integrityresearch.blogdrive.com/archive/cm-12_cy-2006_m-12_d-12_y-2006_o-3.html

    (6) SEC Fact Sheet: The Global Analyst Research Settlement
    http://www.sec.gov/news/speech/factsheet.htm

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