The United States often sets the standards for the business world, defining rules, best practices and ethical guidelines that other countries seem happy to follow. However, the U.S. may find itself following England's example in the handling of soft dollar arrangements among broker-dealers, investment managers and third-party research providers.
In July, the U.K.'s Financial Services Authority (FSA) - the country's equivalent of the U.S. Securities and Exchange Commission - issued its long-anticipated soft dollar guidelines (see sidebars). In issuing the guidelines, the FSA revealingly noted that it has not been working alone. "We continue to have discussion with the SEC staff on issues connected with dealing commissions and continue to believe they are looking at outcomes not dissimilar to our own," the Authority stated.
Soft dollars cover services beyond execution provided to investment managers by broker-dealers. The extra services - research, technology and market data, for example - are paid for by the broker-dealers, which then are compensated by the investment manager in the form of inflated commissions and guaranteed order flow. Such arrangements are allowed under what is known as the safe harbor rule - Rule 28(e) of the Securities and Exchange Act of 1934.
Since investment managers' clients (e.g., pension funds, corporations, etc.) often foot the bill for services acquired with soft dollars in the form of higher fees, questions have arisen as to whether clients are benefiting from the services. Further confusing the issue is the fact that the commissions usually are bundled - meaning the portions of the commissions for execution, research and technology are not itemized.
John Meserve, president of Bank of New York subsidiaries BNY Jaywalk (which offers third-party research) and introducing broker Westminster Research Associates, says he hopes any SEC regulation will create a more equal playing field by forcing broker-dealers to unbundle, or break out, the costs of execution and research in their commissions - common practice today for third-party research providers. "We are hopeful that the SEC will take a page out of what the FSA has done," he says.
However, others doubt that the SEC will take the unbundling step. "I don't think we are going to see the unbundling of executions from proprietary research that the large bulge-bracket firms offer," says Randy Grossman, research manager with the institutional trading and investment management division of Framingham, Mass.-based Financial Insights. "I don't see any way to do that at this point in time, and I don't think people are expecting that."
Mike Udoff, VP and associate general counsel with the Securities Industry Association, says the soft dollar concerns - safe harbor-allowable issues and unbundling - will be handled separately. "Nothing will happen, or at least nothing will happen in the near term, from the SEC on the unbundling issue for a lot of reasons. There certainly isn't the kind of general agreement on that issue that you have on the safe harbor issue," he says. "We have a number of problems with unbundling - the question is whether there is a credible way to do it."
Whether the SEC seeks unbundling or not, comments from the SEC indicate that something is in the works. In addition, some large money managers - Fidelity and MFS Investment Management included - are eliminating the use of soft dollars. Add it all together and observers say that the Street appears ready for some regulatory action.
According to Benjamin Ho, vice president with New York-based Bank of American Securities, his firm will continue to service established clients that currently pay for services with soft dollars, "But we are not actively out there selling soft dollar [services] right now." Ho notes that BOA Securities is using software from Marlboro, N.J.-based Vipss to help track its soft dollar business, though the firm is considering building its own solution.
The Soft Dollar Trail
Solutions on Wall Street almost always involve technology, and the situation is no different with tracking soft dollars - both on the buy and sell sides. Soft dollar arrangements for a single large investment manager can involve dozens of brokers and hundreds of service contracts - all of which have to be continuously monitored in conjunction with the firm's trading to ensure that obligations for order flow are met.
In addition, investment management firms often poll their portfolio managers and traders about which broker-dealers have provided the best services in the past year, and then budget their order flow for the coming year accordingly. All these activities need technology to be managed properly.
Commission management software can go a long way to clarify that picture. "Who you are paying commissions to and how much is becoming a bigger issue as you have the whole pressure on bundling and soft dollars," says David Quinlan, president of Boston-based Eze Castle Software. The vendor's Commission Optimizer - a small company it purchased from Bank of New York - takes feeds from any OMS, runs that information against soft dollar budgets and produces reports.
According to Financial Insights' Grossman, "There are not that many [vendors] doing this right now, which is amazing to me because new rules will affect all money managers." Other providers of soft dollar commission management software include London-based Rontech, New York-based Financial Sockets and Summit, N.J.-based Cogent Consulting.
Soft Tech Spending?
No matter what happens, both buy- and sell-side firms likely will be more accountable from an audit standpoint for their soft dollar business. But, rather than spur spending on commission management systems to help follow the soft dollar trail, the elimination or curtailment of soft dollar spending could impede technology spending.
Buy-side firms, cut off from soft dollar resources, might be more reluctant to write a check for the ancillary systems that support their businesses, causing a revenue stream for broker-dealers and third-party vendors to dry up, according to a report by Rob Hegarty, vice president of Needham, Mass.-based TowerGroup. "We still see a decline in soft dollars and people getting rid of soft dollars practices because they don't want the perception problems with the uncertainty around soft dollar regulation, so they figure let's just play it safe," Hegarty says. "Even if there are no regulations, I still see that having a negative impact on soft dollar IT spending." At the very least, he explains, a rash of contract renegotiations would surely follow, as invoices would have to be redirected to the investment manager.
The exclusion of some technologies from soft dollar's safe harbor has some investment managers worried about footing the bill, but Celent analyst Denise Valentine says crying poverty is an overreaction. "Most people use a Bloomberg terminal, and many say they can't run money without one - almost like working without a desk and a chair," she says. "But if you can't afford to pay for your own Bloomberg terminal, then maybe you shouldn't be in business anyway."
Regs on the Way?
Any forthcoming SEC guidelines regarding soft dollars may have been delayed by the organization's leadership transition, which took place in early August when former chairman William Donaldson was replaced by Representative Christopher Cox. Still, no one thinks the issue will be tabled indefinitely.
"The SEC is saying the right things," asserts BNY's Meserve. "I am hopeful that as soon as the new commissioner gets in place, he will address this issue."
BOA's Ho asserts that most firms aren't guilty of any improprieties, but he acknowledges that there are exceptions. "I don't see any problem, but I guess there are people taking advantage of the way funds are managed, and I guess it wouldn't hurt to have something put in place."
Whatever ultimately is put into place, few think that new responsibilities will be borne by the buy side alone, especially since buy-side scrutiny of its sell-side partners has been on the rise, according to Sang Lee, a managing partner with Boston-based Aite Group. "As buy-side spending has increased, they are trying to analyze their relationship with brokers and asking, 'What kind of brokers do we need to work with?' That puts pressure on the sell side to provide services at a cost-effective level or they can't compete in this market," he says. "But, in the end, whatever pressure the buy side is under will pass onto the sell side. That has always been the case."
The FSA's New Soft Dollar Guidelines Call for:
- A limit of investment mangers use of dealing commissions going to the purchase of execution and research services.
- A requirement that investment mangers disclose to customers details of how commission payments have been spent and what services have been acquired with them.
- The existence of incentives in the commercial relationship between broker-dealers and investment managers to secure value for clients for execution and research spend.
- The promotion of competition between those that produce research by removing the regulatory distinction between research services provided by brokers along with execution (i.e. bundled services) and research services provided by third parties.
FSA Says Only Hard Cash For the Following:
- Services relating to the valuation of performance measurement of portfolios.
- Computer hardware.
- Dedicated telephone lines.
- Seminar fees.
- Subscriptions for publications.
- Travel, accommodation or entertainment costs.
- Office administrative computer software, such as word processing or accounting programs.
- Membership fees to professional associations.
- Purchase or rental of standard office equipment or ancillary facilities.
- Employees' salaries.
- Direct money payments.
- Publicly available information.
- Custody services relating to designated investments belonging to, or managed for, customers, other than those services that are incidental to the execution of trades.
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