Regulators turn a skeptical eye to soft dollars

(July 19, 2004) They’ve been castigated as the brokerage industry’s dirty little secret and praised as an important funding source for independent research. Whatever your opinion on soft-dollar arrangements, regulators are taking notice and there seems little doubt they will soon be subjected to increased disclosure, according to one industry expert. That new transparency could spell the end of soft dollars.

Soft-dollar arrangements, an often misunderstood element of the brokerage industry, are essentially a component of brokerages commissions rebated by institutional brokers, in the form of credits, to professional money managers, typically pension and mutual fund managers. Those credits are used to purchase goods and services managers need to run their business, such as research reports and other investment-related services, everything from Bloomberg terminals to industry publication subscriptions.

In Canada, it’s estimated that institutional investors spend $70 million a year on soft-dollar arrangements.

Soft dollars sprang up in the U.S. in the 1970s when brokerage commission rates were fixed, says Susan Han, senior vice-president and general counsel at AIM Trimark Investments in Toronto. Institutional investors demanded a volume discount because of the amount of trading they conducted. Because of fixed rates that wasn’t possible, so a new system evolved where brokers would provide credit notes, which Han compares to frequent flyer points, used to pay for things like research, software and market intelligence.

However, a number of problems with soft dollars came to light in the 1980s. Although the credits were supposed to pay only for research, some firms took a broader view and it wasn’t uncommon for brokerages to pay for trips and office furniture for money managers, says Han.

“Investment managers would be using those soft-dollar credits to benefit themselves, when they’re supposed to be used to benefit the portfolios they are managing,” she explains.

And there’s a perception that the value of soft dollars is on the rise, as improved technology has driven down the cost of order execution — the actual trading of shares — to fractions of pennies.

For regulators, the hidden nature of soft-dollar arrangements in the new post-Elliot Spitzer world of increased transparency and disclosure is an even bigger concern. “For funds, they’re mixed in with the brokerage commissions, so you don’t really see them,” Han says. “So you can’t figure out from a financial statement what percentage of commissions are soft dollars.”

Still, soft dollars do have their supporters, who make a “powerful and interesting argument,” says Han: Accounting discrepancies at firms like Enron and Tyco were not uncovered by broker-dealers and their analysts, but by independent researchers.

“The fear is that if the [soft-dollar] mechanism is abolished, independent research firms would lose business and all you’d have is sell-side research, which we all know is tainted.”

Despite that argument, there’s likely no stopping the forces of increased disclosure. “The Ontario Securities Commission (OSC) has identified soft dollars as a priority, something they are going to look at and decide if more regulation is needed,” says Han.

“I think the trend will be toward more disclosure at the very least, because that’s what everyone is calling for, including the OSC, Britain’s Financial Services Authority and the U.S. Securities and Exchange Commission. They have all said we need better disclosure and it’s pretty difficult to argue against that.”

Of the two options, complete prohibition or better disclosure, disclosure would be less disruptive to the industry, Han believes.

But what will increased transparency mean for soft dollars? If the practice comes under increased scrutiny, money managers may decide it’s simply not worth the headache and decide to scrap the practice altogether. “I’m suggesting that disclosure could lead to the end of soft dollars,” says Han.

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