The term "soft dollars" is used to describe the provision of research and brokerage services by broker-dealers to fiduciaries such as investment advisers, banks, and portfolio managers in exchange for commissions on securities transactions. This is referred to as "soft dollars" because the broker receives a commission on portfolio transactions and in turn uses a portion of it to pay for investment research and brokerage services that are provided to the fiduciary.
What is the history of soft dollars?
What is the history of soft dollars?
Prior to 1975, commission rates were fixed and research was the basis upon which brokers would differentiate themselves and attract business. When fixed rates were eliminated, the investment community was fearful that the flow of quality research would be restricted and brokers would be selected based on price alone. Congress agreed, and passed Section 28(e) of the Securities Exchange Act of 1934 specifically to allow fiduciaries to use commissions on portfolio transactions to acquire research and investment services.
What are some examples of products that qualify as research under Section 28(e)?
What are some examples of products that qualify as research under Section 28(e)?
Commission-purchased research can include market and economic data, financial and political analysis, fundamental and technical analysis, databases, portfolio modeling and strategy software, and a variety of commercially available economic, market data and market tracking services used in making investment decisions.
How is this research provided?
How is this research provided?
There are two forms of research provided to money managers under Section 28(e). The first is proprietary research, where, for example, research is produced by research analysts employed by broker-dealers and acquired by fiduciaries for commission dollars. This is the case with many large Wall Street firms. The second form of research provided to money managers under Section 28(e), and one of increasing importance particularly in view of the recent disclosures of serious conflicts of interest by some in-house research analysts, is independent (or third party) research. Independent research is produced by firms that are independent of the broker and then provided by the broker to the fiduciary for commissions.
Why use commissions to pay for research rather than cash?
Why use commissions to pay for research rather than cash?
Nearly all institutional investors participate in commission-purchased research and brokerage services arrangements. Money managers choose this one-charge payment for reasons of economic efficiency, to obtain as much value as possible for their clients with their clients' commission dollars, and to acquire additional research tools. They obtain brokerage services and proprietary research directly from brokers selling their own research products, or brokerage services and independent research from brokers providing the research products of third parties. With regard to the provision of independent research services, institutional investors are allowed to specifically select the independent research services that will add value to their investment decision-making process and are informed of the specific costs of these services.
How do investors benefit from soft dollar arrangements?
How do investors benefit from soft dollar arrangements?
First, a wider variety of research may be acquired, which contributes to better information and performance. Current SEC regulation allows money managers who represent investors a wide choice of investment ideas, types of investment information, and sources of research and investment services.
Second, lower costs due to increased competition. Having access to independent research through soft dollar arrangements allows small money managers to compete with larger institutions for investor clients. Soft dollar arrangements provide an economic base for smaller, independent research providers to compete with Wall Street's biggest proprietary research firms for commission dollars. And soft dollar arrangements enable smaller securities firms to compete with the biggest brokerage houses for commission dollars. The result is better research, lower trading commissions and lower costs for research services.
Third, soft dollar arrangements have fostered the expansion of independent research. Independent research firms typically have no investment banking connections and are therefore free of the conflicts recently exposed by regulators and investor lawsuits. They are compensated through the portfolio execution process (i.e., soft dollars) and do not rely upon investment banking fees to support their research efforts. Independent research firms are often start-up or small firms with limited marketing budgets to promote their research. Soft dollar arrangements expose money managers to conflict-free independent research they would not otherwise see.
In summary, soft dollar arrangements allow money mangers to use the broker of their choice, trade at the lowest price they can negotiate and obtain the research that will most benefit their clients from a wide variety of sources, including independent research firms.
What does it mean when money managers say they don't use soft dollars?
What does it mean when money managers say they don't use soft dollars?
Any arrangement where a money manager receives research in exchange for commission dollars involves the use of soft dollars. Nearly all institutional investors participate in commission-purchased research and brokerage services arrangements. If money managers say they do not use soft dollars, in the correct meaning of the term, it would mean that they do not use research and investment services unless they pay with cash. It is important to remember that full service Wall Street firms do not sell proprietary research for cash. Therefore, if an adviser accepts research or one phone call from a Wall Street broker's financial analyst and then trades with the broker, the adviser is using a soft dollar arrangement. To be completely free from the use of soft dollars for research and investment services, an adviser would have to trade with execution-only brokers, perhaps at the expense of best price/execution and performance.
How do soft dollar arrangements increase competition?
How do soft dollar arrangements increase competition?
Three ways. First, the many sources and types of research paid for by soft dollars give both small and large money managers access to investment ideas and data and lower barriers to competition. Many small managers don't have the same degree of access to Wall Street proprietary research because they don't generate sufficient commissions to pay for it.
Second, small brokerage firms, by being able to offer money managers an independent research product, can compete with Wall Street's largest firms for commission dollars.
Third, independent research firms, by being able to sell their product to money managers through brokerage firms, can compete with the largest securities firms selling their in-house research. Many of the most innovative and effective research tools and information systems used by professional money managers today are available from independent research firms. Moreover, brokerage firms selling independently generated research, rather than their own proprietary research, are making available truly independent viewpoints sold on the basis of performance.
How does the law governing soft dollar use by money managers protect investors?
How does the law governing soft dollar use by money managers protect investors?
Research expenditures as part of commission payments must be for products or services used in the investment decision-making process. Research can be purchased through commissions only for accounts over which the money manager has investment authority. Money managers must disclose in filings with the SEC brokerage arrangements where research is provided. All commissions must be reasonable in relation to the transaction and research services provided, and are subject to best-execution requirements. In other words, the Section 28(e) safe harbor dictates that money mangers use client commissions for the benefit of clients.
Has the SEC studied soft dollar arrangements?
Has the SEC studied soft dollar arrangements?
Soft dollar arrangements have been studied extensively by the SEC and its staff. As discussed above, the SEC issued a comprehensive Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds in 1998. In December 2001, the SEC effectively expanded the permissible use of soft dollars by issuing an interpretation extending the coverage of Section 28(e) to certain principal transactions. In July 2006, the SEC issued comprehensive guidance on Section 28(e) that modified the definition of acceptable brokerage and research services available under the safe harbor and defined acceptable parameters for client commission arrangements. In addition, reviews of soft dollar arrangements are standard in SEC examinations of investment advisers and mutual fund complexes.
Are non-research products or services purchased with commission dollars?
Are non-research products or services purchased with commission dollars?
Section 28(e) of the Securities and Exchange Act is clear in excluding non-research related expenses from its coverage. There are, however, several situations where an account may receive non-research related products or services with commission dollars through a broker-dealer. However, the beneficial owner of the account being traded (i.e., a pension plan or mutual fund) may directly receive cash or services from the broker under a client directed or commission recapture arrangement. These commission discounting arrangements, sometimes referred to as "directed brokerage arrangements," are fairly common and occur when a plan sponsor, or other fiduciary, determines that it is in the plan's best interest to use commissions to defray plan costs, or have cash directly paid to the plan to reduce costs for the benefit of investors. These practices are not "soft dollar" arrangements governed by Section 28(e) but are acceptable contractual arrangements between the beneficial owner and the broker.
Are hedge funds permitted to operate outside of safe harbor?
Are hedge funds permitted to operate outside of safe harbor?
Hedge funds and certain other types of accounts (but not mutual funds or pension funds) may receive products and services outside the Section 28(e) safe harbor if they disclose such use to, and receive the consent of, their investors (partnership papers).
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