More clarity needed on soft dollars

Industry participants say more transparency and greater disclosure are required on soft dollar arrangements. Securities regulators recently released a brief report on comments received in response to a best execution and soft dollar concept paper, first published in February.

The comment period for the paper ended in May and 28 submissions were received.

The five regulators involved (Ontario, B.C., Alberta, Manitoba and Quebec) have divided the issues and comments into four areas: the definition of best execution and current requirements, the over-the-counter market, soft dollars arrangements, and directed brokerage and commission recapture.

Under typical soft-dollar arrangements, a portion of the brokerage commission goes to pay a third-party provider for certain goods or services, such as research.

Ontario Securities Commission policies on soft dollars outline allowable practices in the use of commissions for payment of goods or services other than order execution. These policies provide that commission dollars may not be used for payment of goods or services other than “order execution services” or “investment decision-making services.”

Most commenters felt there should be more clarity with respect to “investment decision-making services” and “order execution services” and that additional disclosure was needed, the regulators said. Almost all respondent also noted that disclosure requirements should be the same for third party and bundled arrangements. With respect to accounting treatment, the majority thought that commissions should not be treated as an operating expense on the financial statements.

Directed brokerage refers to the practice of advisors using commission payments as incentives for dealers to provide some type of preferential treatment. One type of directed brokerage — where transactions of a mutual fund are directed to a dealer as inducement or reward for the dealer selling securities of the mutual fund — is prohibited under National Instrument 81-105.

Commission recapture arrangements allow institutional investors to track the amount of commission dollars and, if available, receive back certain amounts. The paper asked whether these arrangements should be limited or prohibited and whether disclosure should be required. Some commenters raised concern with directed brokerage arrangements (that were not already prohibited) and commission recapture, but most believed that full disclosure was the most appropriate route.

On the question of best execution, many respondents to the concept paper stated that current requirements in National Instrument 23-101 and the Universal Market Integrity Rules are too narrow as they focus on “best price”, whereas best execution is a process that includes many other elements, such as speed and the total cost of the transaction.

On OTC trading, the paper asked whether lack of transparency generally makes it more difficult to assess execution quality and whether dealers and advisors should be required to obtain multiple quotes for a particular security in order to ensure that the best price is received.

Most respondents thought that, given the size of the OTC market in Canada, a requirement to obtain multiple quotes was not necessary. Issues specific to the fixed income market were also raised, such as the lack of clear best execution rules and the fact that the low level of transparency makes the measurement of best execution difficult.

The regulators noted that there have been developments on soft dollar arrangements in other jurisdictions, such as Britain, which has introduced new rules that will limit investment managers’ use of dealing commission for the purposes of execution and research service and will also require disclosure to customers of how commissions are spent.

The U.S. Securities and Exchange Commission has published for comment guidance on money managers’ use of client commissions to pay for brokerage and research services. The purpose of this initiative is to clarify the scope of “brokerage and research services”.

Based on the feedback received, the Canadian regulators are considering current requirements and deciding whether or not to make changes. They are aiming to publish proposed amendments dealing with the definition of best execution and new soft dollar requirements in the first quarter of 2006.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com

(12/19/05)