Industry Develops New Commission-Sharing Arrangements, While SEC Watches and Waits
As a direct result of the SECís relaxed approach to commission sharing in the final soft dollar release, a number of full-service brokerage firms have begun offering new research pooling arrangements to their institutional customers. Under the arrangements, the execution and research components of the commission are unbundled, and the research component is put into a pool to be spent as the adviser directs. The arrangements, which most often are piggy-backed on the brokerage firmís electronic trading platform, typically require the adviser to pay up a penny per share. That additional penny is used to fund the research pool.
According to Jon Giblin, senior vice president of Lehman Brothers, the arrangements have become increasingly popular in the last couple months. Speaking at the September 28 Investment Company Institute equity markets conference, he described the arrangements as involving a "discussion" between the broker and adviser about what portion of the commission is for execution and what portion is for research. The execution portion remains with the executing broker to pay for trading services rendered. The research portion, however, goes into a "research kitty," where it is used to pay various research providers, such as the executing broker (assuming it provides proprietary research), other brokers that provide research, as well as independent, third-party research providers. Giblin reported that his firm has been approached by managers seeking such arrangements. "Thereís been a lot more interest in the last couple months in this type of a model," he said.
Giblin cited research by Greenwich Associates, saying the "average split" between execution and research "seems to be coming down the middle." So, for example, if a manager pays $100 in commissions, $50 of that would go to execution and $50 would go to research. That $50 to the research may then be "split up," he said, with a portion retained by executing broker, if it provided proprietary research. Another portion may be paid out to independent research shops or other brokers that provide research. "Thatís really the way it seems to be grabbing hold in the United States over the past couple of months," he said. "It is certainly a work in progress." The success of the new model, he added, "will center around what disclosure rules we get out of the SEC." If the SEC does not promulgate disclosure rules, "perhaps we stay in the status quo world," he said. "If we do get new disclosure rules, I think we are going to see a lot more of this UK-similar model around the United States."
The Division of Investment Management is "actively looking" at the whole issue of unbundling, according to associate director Robert Plaze, who also was speaking at the ICI conference. However, he added, the agency is taking a wait-and-see approach. Plaze said that the SEC is watching developments in the United Kingdom "very closely" to see whether the new soft dollar disclosure regime will have its intended effect. So far, he noted, the reviews of the U.K. disclosure regime have been mixed, "depending on who you talk to." Some people, he said, praise the new regime as the "best thing thatís happened." Others, he said, say it is the "worst," complaining that the data has "no integrity and therefore cannot be trusted."
Plaze said that the SEC also is watching how U.S. markets are responding to the new SEC soft dollar interpretative release. It also is seeking additional input from U.S. market participants, he added.
Plaze noted that in the U.S., unbundling is being driven "by the economics and by the participants." In contrast, in the United Kingdom, "itís been driven by the regulator." He said it would be preferable from the SEC staffís point of view "that if unbundling occurs, it occurs in reaction to market events." That, he said, is why the SEC has been watching the developments, rather than taking action. If the SEC were to create unbundling rules, he said, those rules might not anticipate future market developments. As a regulator, said Plaze, "Iím watching this market. Itís very interesting and Iím not sure I want to get out ahead of it for fear of lousing things up." In fact, one of the reasons he said he attended the ICI conference was to "listen" and learn about market developments. "When this is all said and done five years from now Ö we might all be glad the Commission waited to deal with the disclosure issue and waited for developments to occur, rather than stepping in and then having to go through two or three iterations with respect to our policies."
So, does this mean we will still see a soft dollar disclosure rulemaking by the end of the year? "You will see something by the end of the year," said Plaze. "What I donít think you will see by the end of the year is us dealing with the unbundling question."
However, he indicated that unbundling, U.K.-style, is still an option here in the States. The SECís final interpretive release, said Plaze, could possibly establish a basis "for the Commission at some point in the future from now mandating something like what the [U.K. Financial Services Authority] has done."
Timothy Mahoney, managing director and head of equity trading at Merrill Lynch Investment Managers, seemed to agree that commission-sharing arrangements with research pools are the trend of the future. "I think weíre going to get relatively quickly to some sort of an unbundled world," he said. However, he cautioned that any disclosure rules adopted by the SEC should be realistic. "The perfect is the enemy of the good," he said. When it comes to unbundling on paper, "itís an essay question, not a multiple choice question."
The "trick," Mahoney noted, is valuing research. In his view, brokers and advisers should engage in a "thoughtful process" of determining the components of brokerage that are attributable to execution and research. "As long as we all accept the principle that this will never be perfect, and that if you had five asset managers Ö with the same broker, there would be five different valuations of the exact same research they reviewed, the discipline around trying to understand what you paid for and what you got and how are you using it" is to the benefit of investors, he said. "I think it is good to do something, but you have to accept that it will never be perfect."
Gerald Lins, general counsel of ING Investment Management Americas, agreed that valuation is a significant issue. Disclosing the actual costs of execution and research can be case of a "garbage in, garbage out," he warned. "Donít over-estimate how granular or accurate you can be," he said. Lins noted that a manager can give a great deal of information to a mutual fund board, which in turn can sit down and "walk through the data" with a trader. However, he questioned whether the average fund shareholder would have the same level of knowledge. "I would err on the side of shorter, more general discussion," he said. "Overkill is not good in this area."
Giblin noted that sell-side has struggled with research valuation issues, as well. He noted that there are a number of different valuation models as well as a number of different ways that the buy-side uses research.
On that note, Plaze said that the staff has "spent hours in meetings" talking about valuation. "Do you look at the cost? Do you look at the value?" he asked. The point of the disclosure, he said, is to help clients understand the extent of the money managerís conflict, which is tied to the value that the adviser places on the research. "It doesnít have anything to do with the cost to the broker," he said. He noted that the FSA adopted a "brilliant" approach in which they decided it would "force a negotiation" by which brokers and advisers would agree upon a market price. "The argument against that," he added, "is that itís a wholly discretionary price, depending on the relative market power of the two parties rather than the inherent value [or] inherent cost of the good."
In any event, he noted that regardless of the valuation methodology, the process will establish a baseline value of the research. "Whatís going to be very interesting is how clients react the second, third, or fourth year when they see changes in the amount of research," said Plaze. Such changes may empower institutional clients to impose budgets or limits on their money manager, "even if the numbers arenít pristine."