Directors Group Urges SEC Soft Dollar Rule Requiring Brokers to Unbundle Cost of Proprietary Research
In a move that is likely to add fuel to the soft dollar fire, the ICI’s Independent Directors Council has asked the SEC to adopt a rule requiring brokers to unbundle the cost of research and execution — including the cost of proprietary research. "It is entirely possible, and in the view of many desirable, that this will lead to the eventual elimination of the use of soft dollars in the mutual fund industry," said IDC chairman James Bodurtha in a letter to SEC Chairman William Donaldson transmitting the group’s "Statement of Policy Concerning Soft Dollars" late last month.
That sharp snapping sound you hear is the IDC breaking ranks with the NASD’s Mutual Fund Task Force. In its statement, the IDC called the Task Force’s recommendation that the SEC consider unbundling only third-party research "too narrow."
But the IDC didn’t stop there. The group also told the SEC that brokers, not advisers, should be required to do the heavy lifting. Specifically, the IDC asked the SEC to require, "through rule change," that all brokers executing a fund’s transaction separately state the costs charged to the fund for research and brokerage services. "The IDC does not believe that the investment adviser is in a position to provide ‘unbundled’ information without the assistance of the broker and, for this reason, the SEC should require the broker to supply it," said the group.
The IDC did not specify whether brokers should be required to provide a dollar or percentage breakdown of costs. Nor did it ask the SEC to provide a specific methodology that brokers must use when valuing their proprietary research.
The current system of bundled commission costs, said the group, "is potentially adverse to the interests of mutual fund shareholders and unnecessarily complicates the oversight responsibilities of fund directors." Fund directors that receive unbundled execution cost data will be better informed and will be able to make better decisions about the use of fund assets, "to the ultimate benefit of fund shareholders," they said.
The IDC acknowledged that some in the industry are concerned that the termination of all soft dollar practices may have an adverse impact on activities such as independent research. "Ultimately, however, we believe the best research quality will come about as a result of full and open competition for fund research dollars," said the group.
The IDC’s statement was framed in terms of providing better information to fund boards and shareholders. However, any SEC requirement that broker-dealers break out commission costs would seemingly affect information provided to all institutional managers (if not all advisers), regardless of whether they manage registered funds. Indeed, the IDC recognized that its request has "implications for the broader investment management industry."
The NASD’s Task Force, in its November 2004 report, explained that its unbundling recommendation wasn’t meant to disparage third-party research, but instead reflected the fact that the dollar amount of third-party research already is available to advisers and brokers. The group considered whether to unbundle proprietary research, but said that it was not able to reach a consensus on the issue. "The views of the Task Force members reflect a sharp disagreement on the value to fund boards, and ultimately to investors, of estimates of the amount of propriety research obtained with fund brokerage commissions." Interestingly, while "a substantial number" of Task Force members supported requiring an adviser to provide the fund board with a good faith estimate of the amount of proprietary research obtained with commissions, only a "minority" of the Task Force believed that it should be up to broker-dealers to provide advisers with such an estimate.
The IDC said that it supported the Task Force’s proposed narrowing of the research definition.
Of course, the IDC isn’t the first organization to call for broker-dealers to unbundle the cost of their proprietary research. Most notably, Fidelity Management and Research, in a March 2004 comment letter on the SEC’s transaction cost concept release, urged that broker-dealers be required to provide advisers with information on the value of their research, perhaps by means of an SEC rule requiring brokers to allocate salaries and other costs incurred in developing the research. Under Fidelity’s approach, however, the final determination of the value would be left to the fund (Fidelity also had suggested that the value of soft dollar research be disclosed in a fund’s prospectus).
Where does the ICAA stand on the issue? Executive director David Tittsworth said that his group has not taken an official position on unbundling, although he noted that it has addressed a number of related issues in comments on the U.K. Financial Service Authority’s CP176. The ICAA, he said, has generally stressed the importance of disclosure. And, he added, "while we’ve never got to the point where we said ‘Yes, unbundle,’ or ‘No, don’t unbundle,’ we’ve always said that if you’re going to go down that road, advisers shouldn’t have to value it." When considering the unbundling issue, said Tittsworth, regulators need to be mindful of the impact on smaller advisers and question whether recommendations like the IDC’s "favor large fund companies to the disadvantage of small advisers and their clients."