OCIE Chief Emphasizes Importance of Soft Dollar Documentation and Disclosure
The SECís new soft dollar interpretation centers around a three-step analysis.
But advisers would be well-advised to consider two additional steps: Documentation and disclosure.
Last week, IM Insight talked to OCIE director Lori Richards about the SECís new soft dollar interpretation. Richards strongly emphasized the importance of documenting and disclosing soft dollar practices. She also touched on several other topics of interest to advisers: forensic testing, valuation of proprietary research, and commission-sharing arrangements.
Documentation. Richards began by pointing out that historically, the SEC has never required advisers to keep any specific type of documents pertaining to their soft dollar practices. In the recent soft dollar release, as well as in earlier soft dollar interpretations, "thereís no mandated recordkeeping around soft dollars," she noted. Nonetheless, Richards suggested that advisers consider memorializing their soft dollar reviews, both as a good business practice as well as a good compliance practice. "Investment advisers will want to have documentation around their use of soft dollars because itís in their own interest," she said. Documentation allows a firm to "have some process in place for making sure that its policies and procedures are being complied with." And, she added, "as part of any investment adviserís compliance program, they ought to make sure that they are keeping documentation that supports the fact that they have complied with all of the various prongs of the soft dollar guidance."
Of course, it doesnít hurt to have records of your soft dollar practices ready to hand over to SEC examiners the next time they come to visit. Richards acknowledged that providing soft dollar records would smooth the exam process. "Certainly, itís going to ease the examination," she said. If a firm keeps "really good" documents of its soft dollar activities, "itís going to facilitate the examinerís review of the firmís compliance."
Even an adviser that softs only one or two discrete products should consider documenting its review of those products. Richards noted that unless some documentation was provided, from an examinerís perspective "there would be no evidence" that the adviser actually performed the good faith analysis required under the new interpretation.
She also pointed out that examiners typically look back over a period of time. "When we do an examination, we may be looking at a period of time months or even years prior," she said. "Itís kind of unrealistic to expect us to believe that the adviser can accurately keep all this information in his or her head over a course of many years." It also would be unrealistic, she added, to believe that "examiners would simply trust these recollections."
Richards cautioned that an adviser that does not produce any soft dollar documentation faces an examination "thatís going to dig quite deep," she warned. "Examiners are going to ask for a lot of information and documents, and try to verify what the adviser has said." In her view, advisers can "save themselves an awful lot of trouble by having this information ready to go for examiners when they arrive."
Despite that, Richards again emphasized her view that business and compliance considerations "are more important" than simply wanting to facilitating an exam. Given the conflicts of interest present when using clientsí commissions to obtain soft dollar benefits, she said, advisers should consider keeping track of their soft dollar activities "even aside from whether or not examiners ever come into the firm."
She noted that most advisers have lived under 28(e) for a long time and already have compliance, documentation, and oversight processes in place. "I hope that they will build on their existing process in order to document that they have gone through the analysis," said Richards. The end result, she said, should be documents that "facilitate examinersí coming to a quick conclusion that the adviser has met all of the criteria under the law and has a sound compliance program in this area."
What type of documentation should advisers consider? Richards endorsed the use of a matrix, calling it "a really good idea" and a "good practice." She noted that a matrix "provides some continuity of analysis" so that an adviser "doesnít have to think anew" each time it acquires a new product or service using soft dollars: "They donít have to go fishing for what the standards are. Itís right there on the matrix. And they can document their analysis in one place." Moreover, Richards added, a matrix demonstrates that the adviser "has a process, has gone through the analysis, and has documented it," which "shows us that the adviser is on the ball." Advisers "are always going to be better off if they can facilitate the examination in that way."
A soft dollar matrix doesnít have to be fancy. "It could be as easy as [creating] an Excel spreadsheet." And, she added, it need not list out every specific soft dollar product and service. "Under the law," she explained, "you have to make sure each product meets the test." However, if a firm lists out all of the individual products and services it receives on the matrix, "the list could be incredibly long." As a practical matter, "a firm may be acquiring products of all the same type" and "might find it more practical to bucket products," she said. "The important thing" is that compliance people fully identify all of the types of products and services that are being obtained with soft dollars. "Not just research," she added, "but also the brokerage products and services as well."
Richards cautioned advisers to be careful when dealing with mixed use products and services. Examiners, she said, scrutinize mixed use allocations "very hard because weíve found a lot of problems in that area," many of which were described in the SEC staffís 1998 soft dollar report. The key is to make a good-faith determination of the hard/soft split: "Mixed use definitely requires thought and analysis," she said. "This is another area where documentation is going to be important and where this matrix approach could be really useful."
Disclosure. Richards indicated that SEC examiners will be looking carefully at advisersí soft dollar disclosures to confirm that they match actual practices. In fact, she suggested that advisersí soft dollar matrices include not only the four columns covering the three-step analysis set out in the SECís soft dollar interpretive release, but a fifth column as well: Disclosure. (As noted in last weekís IM Insight, the four other columns could be: "Eligible," "Provides lawful and appropriate assistance in the performance of our investment decision-making responsibilities," "Mixed use," and "Commissions paid reasonable in light of value.")
Richards said that examiners "will be looking at advisersí disclosure and matching it up" against each soft dollar product or service. Adding a "disclosure" column to the matrix allows advisers to show that they "have drawn that connection" between what is being softed and what has been disclosed. "I donít mean to imply that you need product-by-product disclosure," she added. More detailed disclosure, however, may be required in instances where a firm is softing products outside of the safe harbor or has mixed-used products, she noted.
Testing. Preparing a matrix also will allow an adviser to go back and test its soft dollar practices. Richards gave some examples of forensic tests that could be done based on the information collected on the matrix:
An adviser could go back and test "whether or not the matrix includes all the soft dollar products and services." That, she said, is "probably a good test" for many firms, "because we often find that there are misunderstandings about the nature of what products are acquired with soft dollars." For example, she noted that in the past there has been a misconception that research provided by a full-service brokerage firm is not a soft dollar product. ("Of course it is.") Because of that and other misunderstandings, she said, "a compliance officer might want to do a forensic test that ensures that the compliance program is aware of all the soft dollar products." Such a test might include periodically sending a request to some of the key brokers that the adviser does business with, asking them for a list of the products that theyíve provided during the period. "And then maybe double check that against the adviserís list," she said. Richards noted that a firm might not want to simultaneously send a request to all brokers that the adviser does business with, which "would be a lot." Instead, she said, an adviser might test "just a sample."
Another forensic test might involve "periodically doing a survey of portfolio managers and other business-side people involved in the soft dollar process and asking them about which products and services theyíve acquired over the period, and then matching that against the matrix." This type of test also would help confirm that the matrix includes everything that it should include. "It would give the compliance officer a measure of confidence that he or she is capturing [all of the firmís soft dollar products and services]," she said.
"Obviously," added Richards, these forensic tests "are not mandated." But "they certainly are made more possible by doing this kind of matrix."
Valuation of proprietary research. An adviser that relies on Section 28(e) must determine that the amount of commissions paid are reasonable in relation to the value of the soft dollar products and services received. "The statute itself requires both an analysis of the cost and an analysis of the value," Richards noted. However, in the past, examiners have found that advisers were doing only one of those things: "They were looking at the value of the research. They would typically say to us ĎYes, itís enormously valuable research.í" But, she added, "they werenít analyzing the value in relation to the cost."
Richards pointed out that an adviserís obligation to analyze costs applies to proprietary research as well as third-party research. "Obviously, valuing third-party research is easier because there is a separate invoice," she said. "We realize that determining the effective cost [of proprietary research] is very difficult when the price of execution is bundled together with research and possibly brokerage and other services, but we would hope that advisers would attempt some analysis in that space." Richards noted that some firms determine what the research component of the commission is by extracting out what other brokers charge for pure execution. "If other brokersí execution-only rate is two cents a share," she explained, the adviser can "extract out from the full-service commission price the remainder and then use that as the cost," she said.
Thatís one approach. In any event, valuing proprietary research may become easier down the line. "Brokers and investment companies and investment advisers are doing a lot more in this area to communicate," said Richards. "I think over time that will facilitate a better analysis in this area. But we do expect advisers to be complying with the statute to make a good-faith determination that the cost is reasonable in relation to the value."
Commission-sharing. If you find the commission-sharing arrangement section of the SECís soft dollar release as clear as mud, hereís some good news: The SECís examination program is going to spend some time getting its arms around the new rubric.
"Because this guidance is so new," said Richards, "what we intend to do as examiners is to have a conversation with the investment adviser and ask them about commission-sharing arrangements and about what information they obtain about commission-sharing arrangements." The goal, she said, is to "get a sense of what practices exist in the industry and really get a better understanding of whatís happening." Examiners "are going to be very low-key at the outset Ö and really just have conversations with the advisers and find out what they are doing."