The SEC will shortly issue its long-awaited final “interpretive release” on a brokerage industry practice that would make Tony Soprano blush. Known as “soft dollars,” the practice involves a broker charging a fund manager commission fees five to 10 times the market rate for a trade execution, in return for which the broker kicks back a substantial portion in the form of “investment-related services” to the manager. Magazines, online services, accounting services, proxy services, office administration, computers, monitors, printers, cables, software, network support, maintenance agreements, entrance fees for resort conferences—all these things are bought through brokers with soft dollars. And in one of the industry’s loveliest ironies, fund managers even pay inflated commissions in return for trading cost measurement services which invariably tell them that their brokers cost too much.
Why do the fund managers do it? Why don’t they buy items directly from their suppliers, and then choose brokers on the basis of lowest trading cost? The reason is clear. If the fund manager buys items directly from the suppliers, he pays with his firm’s cash. If he buys them through brokers when executing trades, however, the law, or the SEC, lets him use his clients’ cash.
How widespread is the practice? Some 95% of institutional brokers receive soft dollars, about a third of which were found by the SEC in the late 1990s to be providing illegal services to fund managers, well outside the scope of “investment-related.” Surveys find that fund managers routinely choose brokers based on criteria having nothing to do with trade execution.
How much does this practice cost investors? My own analysis suggests that the cost in bad trading alone amounts to about 70 basis points a year, or about 14 times the estimated cost of the market timing abuses that dominated headlines in 2004.
The Senate Banking Committee held hearings on soft dollars in March 2004. Chairman Richard Shelby indicated at the time that the SEC would “get more than a nudge” to eliminate clear abuses, defined as services which could not reasonably be held to constitute “research.” So what has our champion of investor rights decided to do for us? Punt the ball back to Congress. In its initial guidance last October, expected to be substantially reiterated in the forthcoming final verdict, the commission’s long-awaited crack down amounted to little more than a memorandum to fund managers instructing them to read the law, cut out a few egregious abuses (office furniture is a no-no, though resort conferences are still fine), and pay only “reasonable” commissions.
How does the “reasonable” commission regime work in practice? Put simply, the higher the price tag on the soft-dollar goodies, the more trading the fund manager does with the broker to acquire them, which is clearly antithetical to investor protection. To his credit, freshman SEC Chairman Christopher Cox issued a thoughtful statement in advance of last October’s guidance, diplomatically describing soft dollars as an “anachronism”—referring to the politics of unfixing fixed commissions 30 years ago, and Congress’s insertion of the Section 28(e) safe harbor into the Exchange Act, allowing client trading commissions to pay for research. But it was under the SEC’s watch that the safe harbor ballooned into a safe coastal resort, in which client-financed commission payments have become so generous that a broker for one of the nation’s largest fund management companies made the headlines in 2003 by thanking the funds’ traders with a lavish dwarf-chucking bachelor party. It is therefore time for Congress and the SEC to stop punting the ball back and forth, and for Congress finally to abolish the “anachronism.”
As a Wall Street Journal reader in good standing, I’m not calling for more rules and market intervention. Quite the opposite. It is in the nature of a government-sanctioned kickback scheme that serial interventions by regulators will be required to pacify the fleeced. This is a simple property rights issue, and treating it sensibly as such would require less government intervention in the future.
The solution is simple. If a fund manager wants to buy $10,000 worth of research, let him write a check to the provider. That's how you and I would buy it—we wouldn’t expect to get it by making a thousand phone calls through Verizon at 10 times the normal price. There is a legitimate debate over whether the cost of research should be charged to the fund manager, which would then recoup it transparently through the management fee, or deducted directly from the clients’ assets.
The first option was recommended by former Gartmore chairman Paul Myners in his famous 2001 report to the U.K. Treasury. The second would, in any case, be a dramatic improvement on the status quo. If the government did not force funds to buy research through brokers in order to pass the cost on to clients, the SEC’s “best execution” requirements, meaningless in a soft-dollar environment, would actually become part of a fund manager’s DNA. No longer forced to choose between soft dollars for his firm or good trades for his client, he will finally have an incentive to seek out value-for-money in both research and trading, as it will benefit both his firm and his client.
What do mutual fund traders think? At a November conference, I surveyed 35 of them anonymously. 46% said that they should pay with “hard dollars,” out of their own assets rather than the investors’. 37% backed option two above, paying the providers directly rather than through commissions, but recouping the cost from investors’ assets. A mere 17% supported the status quo, soft dollars. The problem is that fund managers have no incentive to move away from soft dollars while their competitors are legally using them to inflate profits.
So who actually loses from Congress correcting its mistake? Brokers. But shed no tears for them. Middlemen always lose when kickback schemes are ended.
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