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News September 27, 2004 Issue

Unbundling the SEC’s Soft Dollar Task Force

Research: 3.1 cents.

Execution: 2.4 cents.

Knowing what the SECís soft dollar task force is up to: Priceless.

Letís not keep you waiting: The SECís soft dollar task force delivered its written recommendations to SEC Chairman William Donaldson last week (forget that "end of the year" stuff).

And yes, Virginia, the task force wants advisers to unbundle their transaction costs, at least on paper. Based on what IM Insight is hearing, it sounds as though the task force has recommended that the Commission require advisers to disclose the breakdown of their clientsí transaction costs between execution and research.

An informed source said it is "likely" that the recommendations include "some kind of requirement to identify the soft dollars and whatís happening to them." The source noted that advisers already are obligated under Section 28(e) to be aware of what portion of their transaction costs are for execution and what portion are for research. Moreover, he noted, under new Rule 12b-1(h), fund advisers and directors need to know the breakdown of their transaction costs to ensure that their funds donít have a brokerage-for-distribution arrangement. "If they look [at 28(e) and 12b-1(h)] now, itís there," said the source, "and if they look in a couple of months, itíll be even clearer."

Unlike Dan Rather, IM Insight hasnít seen the actual report, much less verified its authenticity. But itís a safe bet that the report also discusses whether advisers should be required to pay hard dollars for a la carte execution and research. The staff clearly is thinking about that approach: as IM Insight reported earlier this month, SEC staffers meeting with representatives of the Investorside Research Association poked and prodded at whether advisers might be willing to pay hard dollars for research. However, itís also a safe bet that the report doesnít endorse that approach. Moving in that direction, as one lawyer put it, would have the effect of repealing soft dollars altogether. And there have been no signals from the staff to date that the SEC is inclined to do that.

Of course, the ball is now in Donaldsonís court. And as weíve certainly seen, he hasnít been shy about suggesting radical change in the face of steep industry opposition.

Assuming that the SEC plans to require advisers to disclose the breakdown of transaction costs on paper, the big question becomes who will have to figure out the allocation. Thatís a question thatís got both the buy-side and the sell-side nervous.

Consider the following: Last spring, the FSA announced that following its controversial Consultation Paper 176 on unbundling, it would informally consult with participants in the U.K. investment management industry on how to define research and how to quantify execution costs, which the FSA plans to require firms to separately disclose.

At last weekís ICI Equity Markets Conference, T. Rowe Price Associates associate legal counsel David Oestreicher reported that he recently had attended a meeting sponsored by the Investment Management Association, the U.K. equivalent of the ICI. During the meeting, said Oestreicher, there were eighteen firms in the room trying to decide how to quantify execution costs. "There was chaos," he said. Some firms took the view that the FSA should "put it on the broker" to decide what the true costs of execution and research were. Others said "the advisers should decide what it is." The Brits, according to Oestreicher, are "having a very difficult time." The FSA has said it plans to issue a proposed unbundling rule by the end of this year.

ICAA executive director David Tittsworth already knows how he feels about the issue. If the SEC requires advisers to disclose the portion of transaction costs that represent execution and research, he said, it should be up to the brokers to provide advisers with the breakdown. "Thatís a really hard thing for [advisers] to figure out, because itís the broker that is providing it," said Tittsworth. "They know what execution costs, how do we know what it costs?" To require advisers to make that cut, he said, would be "really difficult and unfair."

Turning back to the SEC task forceís report: The task force undoubtedly has recommended that the SEC go back to pre-1986 standards and more narrowly define research to eliminate the ability of advisers to soft items such as Bloomberg terminals and other execution-related products and services, as SEC associate director Larry Bergmann announced at the SIAís June 2004 soft dollar conference.

SEC associate director Gene Gohlke, Oestreicherís co-panelist, said that while it is "somewhat premature" to predict the outcome of the soft dollar task forceís work, he said that at a minimum, we can expect to see a "better definition" of what research is. It will be "stuff that includes intellectual content." On "perhaps the other extreme," he said, the SEC might decide that "advisers have to pay all trading costs."

And, of course, the SEC staff has made clear six ways to Sunday that it has no intention of distinguishing between proprietary and third-party research (you may have seen the September 17 Bank of New York Westminster Research memo going around in which Chairman Donaldson is quoted as stating that "In approaching soft dollar issues, the task force has not distinguished between Ďproprietaryí research produced internally by a broker-dealer, and independent Ďthird-partyí research.")

Interestingly, the SEC itself has publicly grappled with the issue of how to quantify transaction costs. Remember the December 2003 transaction cost concept release, questioning how spreads, market impact, and opportunity costs can be quantified?

But, you may ask, donít transaction measurement services, such as Abel/Noser or Plexus, have the whole "true cost of execution" puzzle figured out?

Not according to Oestreicherís co-panelist, Susan Sidd, an equities lawyer at Goldman Sachs. While she didnít mention any particular service by name, she said that the services "donít do a good job" of evaluating opportunity costs. She pointed out that there are a number of difficulties involved in measuring execution. She acknowledged, however, that the services are making strides towards improving their measurement techniques.

Consider this: according to data provided by Oestreicherís co-panelist, American Century Investments CIO Harold Bradley, the median commission in NYSE trades is currently around 4.5 cents per share, whereas consulting firm Greenwich Associates has concluded that the true "execution-only rate" is 2.2 cents per share. Bradley reported that 42 percent of American Centuryís trading is done at commission rates of under a penny. The buy-side "is increasingly having to put a value on what the sell-side provides," said Bradley.

Sidd agreed that "there is a trend in the market" towards unbundling of execution. But she noted that the buy-side is provided with a "array of services" that comes at "an array of costs," from full-service brokerage firms to the low-cost, low-touch ECNs. Advisers, she noted, "can buy research from a research-only shop, they can buy execution from an execution-only shop." Buy-side firms have a choice, she said.

Sidd expressed concern that the SEC is "focusing the debate" on commissions. Commission costs, she said, are only 11 percent of trading costs. The "lionís share" of execution costs are indirect, she said, such as slow or missed executions. "Low-cost executions may not be the right tool for the bigger, chunkier trades," she said.

Bradley pounced on Siddís 11 percent remark. How do you know what percentage of transaction costs commissions represent if no one does a good job measuring the costs? he asked, somewhat rhetorically.

Sidd also noted that "market solutions tend to work better than government solutions" and that regulatory solutions can have real business impact. If advisers have to pay hard dollars for research, she said, there will be less research. Moreover, bigger advisers will have an advantage over small advisers. And, added Sidd, "if you want a disclosure-based solution, you have to think of what is useful disclosure." If the SEC focuses on commissions, it will be ignoring "this big elephant in the room of indirect trading costs."