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News March 7, 2005 Issue

Soft Dollar Reform: What Advisers Should Do Right Now

Like the Boy Scouts, advisers should be prepared for changes to the soft dollar landscape. Whether stemming from regulatory action, industry practices, or changed client expectations, industry experts agree that changes in soft dollar usage are likely to affect smaller advisersí bottom lines.

Budget now for more hard dollar expenditures. Legg Mason general counsel Thomas Lemke advised smaller firms to start planning their budgeting now. "Computers are going to be gone, direct lines, special T-1 lines, anything that looks like computer or overheard . . . whether it's 2005 or 2006, youíre going to have to start budgeting for hard dollar expenditures to pay for those items." That, he said, can represent a significant expenditure for small advisers. While he noted that the details wonít be known until the SEC issues its rules, "a safe point for your budgeting process is to assume that all of that equipment is going away," he said.

Educate clients about the benefits of soft dollars. Following the Investment Company Instituteís December 2003 call for the end of softing third-party research, and attendant press coverage, some advisory clients have forced their managers to eliminate third-party research. That, said Lemke, "seems illogical." He surmised that the clients that have made this request, which include mutual fund boards and pensions plans, simply donít understand the role of third-party research and how soft dollars work.

Lemke encouraged advisers to educate their clients about what soft dollars are, how the adviser uses them, and how it benefits the client. "I think when you step back, managers havenít educated their clients enough about soft dollars," he said. If you spend time explaining why third-party research is beneficial "you might be able to head off some of these situations where clients are going to dictate to you what you can do."

If you trade through a full-service broker, make sure your ADV indicates that you get soft dollars. This seemed to come as a surprise to some conference attendees. However, as Nancy Morris of the SECís Division of Investment Management noted, an adviser that trades through a full-service brokerage firm and receives that firmís proprietary research is receiving soft dollar benefits, even if the adviser did not request the research and does not allow the receipt of research to influence the firmís brokerage allocation decisions. "Proprietary research is soft dollars," said Morris. "People need to understand that."

Lemke noted that some firms have taken the position that in such a situation, they arenít receiving soft dollars because the full-service firm will charge them four and half cents per share regardless of whether the adviser utilizes their research. These firms, said Lemke, take the view that they are not "paying up" for research. "You can make the argument," said Lemke, "but you have to understand that you are out of the norm." He cautioned that historically, the SEC staff has disagreed with that position, and that most firms acknowledge that in trading through a full-service brokerage firm, they are paying up.

Morris also warned advisers to be careful before taking that position. "Iíd be cautious about saying Ď[The firm] never pays upí in an ADV."

Document your portfolio managersí involvement in evaluating research. To make the SEC happy, said Lemke, you have to show them that you have a rigorous process for making brokerage allocation decisions. Portfolio managers should have some involvement in that process, and their involvement should be documented, he said. "You want to show that they have been consulted and they are making judgments about what you are doing with your soft dollar budget."

Industry trends. Lemke noted that as a result of the focus on soft dollars, a number of third party research providers have "morphed" so that their services look more like proprietary research. One way they have done this is registering as a broker-dealer and acting as introducing brokers, he said. Panelists also discussed the increased emphasis clients are putting on commission recapture programs.

Whatís in? Whatís out?

Lastly, Lemke provided a partial list of whatís currently in and out of the Section 28(e) definition of brokerage and research services.


  • Stock price quotation services
  • Subscriptions to magazines, newspapers or journals that give advisers information that they use when managing client accounts
  • Credit rating services
  • Brokerage analystsí estimates


  • Tax, accounting, and recordkeeping software
  • Business entertainment
  • Rent, office furniture, and other overhead or administrative expenses
  • Salaries of research personnel
  • Travel, airfare, meals, and hotel expenses of people that you might get research from.