Softing Fixed Income Trades
Can an adviser soft fixed income trades?
The short answer: yes, but be careful.
That might come as a surprise, given that the Section 28(e) soft dollar safe harbor speaks in terms of "commissions." The SEC staff has long interpreted 28(e) not to apply to principal trades (with the recent notable exception of the SECís December 2001 interpretative release permitting the softing of riskless principal trades meeting certain disclosure standards).
Nonetheless, fixed income trades can be softed, under the right circumstances. "Itís done quite a bit," Pickard and Djinis LLP partner Lee Pickard told IM Insight. Hereís how: When a manager wants to buy certain bonds, he goes through a broker that buys the bonds on an agency basis and charges a commission on the trade. Like any other commission, explained Pickard, the commission on the agency bond trade is soft dollarable under 28(e).
Another investment management lawyer agreed that fixed income trades can be softable. "People do that," he said. But he cautioned advisers that soft fixed income trades to be sensitive to the interpositioning issue. Specifically, advisers need to make sure that the broker to whom they are paying the commission is adding value, he explained. The risk is that the SEC might conclude that the adviser has merely interpositioned the broker in order to generate soft dollar commissions.
Advisers, said the lawyer, need to be able to answer the question: "Why am I going to the broker when I can go directly to the dealer?" He noted that the broker may very well be adding value by "acting as a beard" in situations where the adviser doesnít want the market to know who is buying or selling the bonds. The broker also can provide value if the bonds are obscure or illiquid. But, he noted, the question is closer if the bonds are actively-traded. "And to do this in a Treasury? I donít how that passes muster."
In any case, said the lawyer, the adviser has to be "very careful" to justify the commission based on the value that the broker added. It should satisfy itself, and be prepared to satisfy regulators, that the commission is not just imposing an additional cost. And, he added, the net price on the trade should be "equal to or better than what you would have gotten had you gone directly to the market maker."
How else might an adviser soft fixed income trades? Pickard noted that the SECís December 2001 riskless principal transaction interpretative release left the door open to softing principal bond trades at some point in the future. In a footnote, the SEC noted that riskless principal transactions in the debt market "are not currently" subject to confirmation and reporting requirements that meet the conditions under the release. That very well could change, given the recent developments in the transparency of the debt market.
And, of course, 28(e)ís protections are not always needed. If an adviser has no investment company or ERISA clients, and if the applicable contractual and disclosure language governing the client relationship does not otherwise obligate the adviser to operate within 28(e), the adviser arguably is free to operate outside of 28(e) altogether. Seemingly, the adviser could use its clientsí fixed income trades to obtain soft dollar benefits, as well.
As the SEC staff itself explained in its 1998 soft dollar report: "Any type of transaction can be used to generate soft dollar benefits, provided that the broker-dealer is willing to provide credit on the transaction. Section 28(e), however, affords safe harbor protection only for research paid for with commissions on agency transactions in securities." Indeed, during the SEC sweep that lead up to that report, the agency found that 3.6 percent of the advisers examined received soft dollar credits on fixed income principal trades.
Advisers, however, should not take this approach lightly. An adviser that chooses to operate outside the 28(e) safe harbor does so at its peril. Such an adviser is well advised to consult with sophisticated counsel to ensure, among other things, that it is adequately disclosing the ways that it may use its clientsí commissions and that any additional markup/down that might be added to generate soft dollar credits squares with the adviserís duty to seek best execution (as well as the adviserís general fiduciary duties).