Due to regulatory scrutiny, financial services firms have employed a conservative soft-dollar strategy for the past several years. But now that the SEC has defined a less-restrictive set of rules under section 28(e) of the Securities Exchange Act of 1934 for the use of soft dollars, the soft-dollar business has stabilized in terms of both the percentage of U.S. institutions involved and total dollar volume, according to results from a recent Greenwich Associates Equities Investor study. "Almost 70 percent of institutions use soft dollars to pay for third-party research produced by independent brokers," reports John Feng, a consultant with Greenwich Associates.
While 28(e) reaffirms that soft dollars -- a means of paying brokerage firms for their services through commission revenue rather than direct payments, or hard dollars -- can be used for independent research, it also is leading some to question the validity of the commission recapture model. The practice of commission recapture involves brokers giving back portions of the commissions they get from money managers to the investment plan sponsors. By directing their investment managers to use commission recapture service providers, plan sponsors recoup some of the cost of trading. But traders argue that directing order flow for commission recapture violates best execution requirements -- something the SEC has been focusing on lately.
Because 28(e) has defined a more-favorable set of standards for investment managers' use of soft dollar credits to buy research, many believe that commission recapture will lose out, as investment managers now have the validation they need to leverage soft-dollar arrangements. Further, some also argue that it would be simpler and more efficient for pension plans simply to negotiate lower commission rates up front, thus eliminating the need for commission recapture. The recent push to unbundle research fees from the trade execution commission seemingly would provide plans with the leverage they need to negotiate lower commissions. And finally, others believe that as the industry becomes more automated and commission rates -- and margins -- continue to decline, recapture services -- provided by brokers such as Russell Investment Corp. and The Bank of New York subsidiary Lynch, Jones & Ryan -- no longer will be needed.
While acknowledging that the playing field is changing, recapture providers say the game isn't over yet. "Years ago, when trades were being done at 6 or 8 cents a share, the part that paid for research in a soft-dollar trade or that was returned to the plan sponsor via commission recapture was substantial," says Todd W. Burns, president, LJR. "Today, even on rates as low as 1 to 2 cents per share, we still manage to make commission recapture work for clients."
Under a commission recapture arrangement, a broker writes a hard-dollar commission-rebate check back to the pension plan. Hence, the plan wins as it receives a cash injection. Soft-dollar arrangements, however, benefit the investment manager, as it can use the commission credits to buy research and other services that may or may not benefit a specific pension plan client. "Investment managers aren't fond of commission recapture because every commission recapture [transaction] takes away money they had been spending on soft dollars," explains Burns.
Since small pension plans typically aren't well funded by their sponsoring companies, commission recapture becomes especially important, as the soft dollar credits recaptured as hard dollars are used to run pension plan operations, relates Burns. "It's up to the client pension plan as to what they want to do with those [hard] dollars," he adds. "A lot of them use it to pay consultants, custodial fees or operations," or even for salaries.
But as commissions continue to dwindle, there is less to give back to the client, Burns concedes, and, eventually, the margin between what's paid and what's available to recapture ultimately may disappear. "There could come a time in the future when commission recapture doesn't really make sense anymore," he says.
Still, despite dwindling commissions, LJR has signed up through July 2006 144 pension plans interested in commission recapture, Burns points out. "Multiply that by all of the other recapture brokers -- like Frank Russell, State Street and Northern Trust -- and you can see that the pension plans still believe in commission recapture programs," he notes.
Transparency Through Technology
At agency execution firm Instinet, which develops advanced trading technologies that connect portfolio managers and traders directly to equity markets and also offers services around commission management, the entire trade process is electronic. As the client proceeds with a trade, the trade enters the Instinet clearing system, which divides the commission into an execution amount, which goes to Instinet, and the remainder, which goes into Broker Share, the company's in-house-built commission sharing agreement program. The next day, clients are able to access Broker Share to see how much credit is in their accounts.
"We don't have investment banking services so we will take out our piece for the execution, and anything above that the [pension plans] will have that money built up in a broker share account," says Michael Plunkett, president, North America, Instinet. "The money manager decides who provided good research and cuts checks to those people. Now there's an entire audit trail in place that says which research folks received the money and how much each got."
This type of transparency helps the smaller pension plans that depend on commission recapture for revenue, according to Plunkett, because it gives them more control over how -- and how much of -- commissions are allocated toward soft-dollar research. The FSA and SEC have encouraged commission sharing agreements, which promote unbundling, Plunkett continues. "You know exactly where your money is going on both sides of the equation, and you have a bit more control over how your commissions are spent," he says.
A Shrinking Market?
But with total unbundling, say experts, the commission recapture market would shrink substantially. Further, some argue, total transparency would challenge the necessity of commission recapture in the first place as pension plans simply could save money upfront by paying lower commissions as opposed to receiving a hard-dollar rebate after the fact.
Still, while the merits of commission recapture continue to be debated, the validation of soft-dollar spending is proving a boon to the commission recapture business, according to Dave Quinlan, president of Eze Castle Software, a provider of investment and commission management software. "The whole commission recapture arena is just exploding, and it's because of 28(e)," he contends.
Like Instinet's Broker Share tool, Eze Castle's Commission Optimizer sits behind the investment manager, aggregating all of the commission activity that occurs. According to Quinlan, with Commission Optimizer, investment managers are able to centralize and manage commissions and hard-dollar services, and create and manage budgets for directed broker relationships, soft dollars and proprietary research.
Quinlan adds that while many Eze Castle clients want a single point solution specifically to control and manage commissions, where a tool like Commission Optimizer comes into play, there also is a rising need to integrate soft-dollar allocation and commission recapture functionality with firms' broader operations in order to streamline IT systems. To address this need, he continues, The Bank of New York recently joined forces with Eze Castle and GTCR Golder Rauner, a private equity firm, to form BNY ConvergEx Group. The new company will bring together BNY Securities Group's trade execution, commission management, independent research and transition management businesses. Other BNY Securities Group businesses joining the BNY ConvergEx Group include BNY Brokerage, LJR, G-Port, Westminster Research and BNY Jaywalk. Each business will retain its respective brand name while taking advantage of the combined capabilities of BNY ConvergEx Group, according to The Bank of New York.
"BNY ConvergEx Group will provide integrated trade execution, independent research, commission management and trade order management services," said Joseph M. Velli, senior executive vice president of The Bank of New York and the future chairman and CEO of BNY ConvergEx Group, in a release. With the arrival of ConvergEx, both technology and financial services firms are sending a clear message to the industry that comprehensive functionality is an ongoing necessity to handle the complexities of soft-dollar and commission recapture arrangements. <<<