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News September 11, 2006 Issue

Department of Labor Changes Would Require Advisers to Unbundle Soft Dollar Information for ERISA Clients

The Department of Labor has embarked on a project that would effectively require all investment advisers that manage ERISA money to unbundle the cost of full service brokerage and report the estimated value of soft dollared proprietary research to their ERISA clients.

On July 21, DOL proposed a package of amendments to Form 5500, the annual reporting form filed by nearly all ERISA plans. The rulemaking was overshadowed by the pending passage of the Pension Protection Act and attracted little attention. However, tucked away among the amendments is a package of changes designed to address DOLís concerns, first highlighted by the joint DOL-SEC pension consultant study, about direct and indirect compensation received by advisers and other plan service providers. These amendments, known as the "Schedule C amendments," would require plans to disclose detailed information about how their service providers are compensated ó both directly by the plan and plan sponsor as well as indirectly by third parties.

Specifically, the proposed amendments would require plans to provide information about each service provider that received, directly or indirectly, $5,000 or more of compensation in connection with rendering services to the plan during each year. That, of course, would pick up things such as the amount of management fees paid to the planís investment managers.

Controversially, however, the form goes on to require plans to provide additional detail about compensation provided to each service provider indirectly by third parties, such as findersí fees, shareholder servicing fees, 12b-1 fees, and soft dollar payments, in connection with services provided to the plan.

The upshot: If the amendments are adopted, the form would require virtually all ERISA plans to disclose the amount of soft dollar benefits provided to the planís investment manager as a result of the commissions generated by the planís trading. To get that information, of course, the plan would have to ask the adviser.

Letís assume, for the moment, that as a client service matter your firm would be willing to do whatever it takes to help your ERISA clients meet their regulatory obligations and complete the form. First, youíd need to place a value on the aggregate amount of soft dollar products and services you receive. While thatís an easy matter for third-party, independent research, placing a value on bundled proprietary research is an entirely different matter.

Is it the brokerís cost? Your value? Do you simply deduct the amount of comparable ECN commissions to net out the research component?

Unbundling, of course, is quite a tricky business. Thatís why the U.K. Financial Services Authority dedicated over five years of study and industry consultation before requiring unbundling. When it finally did so, the FSA only required institutional firms to unbundle. Itís why the NASD mutual fund task force has come out against it. And itís why the SEC is moving extremely cautiously before making policy in this area.

But we digress. Letís get back to DOL and its form amendments.

Assuming you are able to value proprietary research, youíll need to determine the portion of soft dollar benefits that is attributable to each ERISA clientís trading commissions. "DOL has said that you can use a reasonable allocation to estimate the amount attributable to each plan," said Andrťe St. Martin of the Groom Law Group. She noted, however, that allocating aggregated client information "is very difficult, because records are not maintained currently in such as way to permit that without some huge systems change." Itís one thing "if you had four clients." But for a firm that has hundreds of clients, and multiple payors, itís another. "Itís the scale of it that is really problematic," she said. "In theory, it doesnít look so bad, having to allocate lots of payments among lots of clients based on lots of transactions." In reality, however, "it is going to be very, very challenging."

St. Martin also pointed out that if compensation is due to services provided to more than one plan, the total amount of the compensation would have to be reported on each planís Form 5500. The proposed form instructions contain the following example: "[I]f an investment adviser working for multiple pension plans and other non-plan clients receives a gift valued in excess of $1,000 from a securities broker in whole or in part because of the investment adviserís relationship with plans as potential brokerage clients, the full dollar value of the gift would be reported [on the Form 5500] of all plans for which the adviser performed services."

In other words, explained St. Martin, "you have to report the entire amount of that thing as if you got it for each plan client."

Thatís one scenario. Now letís assume your firm would not want to provide your clients with such information.

The short answer is, tough luck. While DOL does not have direct jurisdiction over investment advisers, it has devised a few sticks to ensure that advisers get with the program. (Apparently, there are no carrots.)

First, the proposed amendments would require plans to disclose the names of any service providers "who failed or refused to provide the information necessary" to complete those items. "They are trying to do indirectly what they cannot do directly" by using the "embarrassment factor," said Investment Adviser Association general counsel Karen Barr.

Barr also noted that DOL could potentially use that part of the form as a basis for telling plan fiduciaries that one of the factors they should consider when maintaining a relationship with a service provider is whether the service provider has cooperated in providing the fiduciary with the requested information. Morgan Lewis associate Dan Kleinman agreed that this was a possibility. "Think about a fiduciary who needs this information and doesnít get it," he said.

Second, DOL is believed to be working on amendments that would condition the availability of the service provider exemption ó used by virtually all investment managers ó on the managerís providing the requested Form 5500 information. "This is all part of their service provider disclosure project," explained St. Martin. DOL has long taken the position that plan fiduciaries need to know what their service providers are receiving from mutual funds and other third parties, she said. "What DOL is likely to be doing as we speak" is revising the service provider exemption regulations to make clear that the exemption is not available "unless the service provider discloses what it is getting." Those changes havenít been proposed yet. But, she said, "it is all part of the same package."

Meanwhile, the IAA is putting final touches on a comment letter on the Form 5500 proposal. "Basically, we are concerned with the soft dollar piece," said Barr. "Even though it does not impose any direct requirements on our members, their clients certainly will have to ask [them] about soft dollar payments in order to respond to the form. We are concerned that, in effect, it may require unbundling of bundled brokerage, because the execution portion certainly is not Ďcompensation.í"

Barr added that another concern stems from the fact that the proposed amendments would require plans to obtain information about brokerage commissions. "If it is not a commission recapture or directed brokerage arrangement negotiated by the plan and the investment adviser is the one selecting the broker and executing the trades, it is possible that the brokers and the clients will expect the advisers to provide that commission information," said Barr. Such an expectation, she said, would create an "additional burden" on advisers.

DOLís interest in providing greater soft dollar information to plan fiduciaries was foreshadowed in its March 13 comment letter on the SECís proposed soft dollar interpretive release. Plan fiduciaries that appoint an investment manager for a plan have an "ongoing duty to monitor the investment manager to assure that the manager has secured best execution of the planís brokerage transactions and that the commissions paid are reasonable in relation to the value of the brokerage and other services recieved by the plan," said the letter. The SEC should require advisers to disclose "with greater specificity" the amount of client commissions paid for soft dollar products and services. "We would suggest a standard form of such disclosure," said DOL.