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News August 20 & 27, 2012 Issue

What Can Your Soft Dollars Buy?

Soft dollars have long been used by advisers to avoid the direct payment of certain expenses. Direct payment in hard dollars not only requires cash on hand, but also can affect mutual fund fee disclosures when such payments would increase the adviser’s annual fee. Shareholders bear the cost either way, but in soft dollar arrangements the hit is hidden in increased commission payments on securities transactions.

Provided the excess commission dollars are used only to purchase appropriate "research" services that contribute to the investment decision-making process, advisers may rely on the Section 28(e) safe harbor in the Securities Exchange Act to use such "soft" dollars.

"Probably the most sensitive area within conflicts of interest is the use of soft dollars," said ClearBridge Advisors general counsel and CCO Barbara Brooke Manning. Manning made her remarks during the ALI CLE Mutual Funds Conference last month in Washington DC.

What you can buy with soft dollars has long been the subject of ongoing discussion, she said.

For example, last year when the Form ADV amendments imposed a Part 2 brochure requirement, the SEC said that if you use soft dollars, the adviser must make a ‘flat out’ statement in brochure disclosures that the use of soft dollars presents conflicts of interest.

The safe harbor allowing the use of soft dollars turns on the provision of "research" services, those services that contribute to the adviser’s investment decision-making process. As a result, much time and energy has been devoted to determining what "research" is.

The adviser must also make a good faith determination that the services it receives are valuable to the client.

Generally speaking, "research" can include services such as:

  • Bloomberg;
  • Pricing services;
  • Attendance at conferences and seminars (but no travel or meal expenses);
  • Meetings (often arranged by the sell side); and
  • Publications targeted to a narrow audience (not, for example, the Wall Street Journal).

"Research" does NOT include:

  • Auditing or legal services;
  • Recordkeeping services;
  • The salaries of research staff;
  • Internet service;
  • Membership dues;
  • Proxy voting services, unless for certain narrow research-related purposes; or
  • Compliance models.

In circumstances where categorization of the service is unclear – the firm’s order management system, for example – Manning takes the conservative position that the service must be paid for with hard dollars. "It is an area where the SEC is really going to dig into your allocations," she said.

It used to be with client commission arrangements that the executing broker had to be legally obligated to pay for the product or you couldn’t use it.

However, in 2006 the SEC issued its Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934. That guidance clarified the scope of brokerage and research services in light of evolving technologies and industry practices.

As a result, now advisers can unbundle the cost of execution from the cost of research, and her firm does. This allows us to execute with the right broker-dealer for the transaction, while maintaining preferred sources of research, said Manning.

Her firm does not allocate soft dollars by fund because of the difficulty in tracking. Credits are used "across the board," with appropriate disclosures that credits might secure services that are not used by a particular fund.

The CFA Institute has developed its own voluntary Soft Dollar Standards: Guidance for Ethical Practices Involving Client Brokerage, to assist advisers with a practice it says has become increasingly "complex."

The guidance is based on three principles:

  • Soft dollars belong to the client;
  • Advisers may only use soft dollars in the investment management process and not for firm management purposes; and
  • Advisers must disclosure all relevant benefits they receive through client brokerage.

"Formulating what is allowable research is not subject to hard and fast rules," says the guidance. The determining factors focus on the actual usage of the product or service.

Appendix B, Permissible Research Guidance, recommends a three-level analysis, in which the product or service is first defined, then actual usage is determined. "In evaluating a practice, the substance of actual usage will prevail over the form of some possible usage," it said.

Where a product or service is less than 100 percent devoted to investment management decision-making processes, it is considered to be in mixed use.

In the third level of analysis, advisers determine what percentage of the product or service is devoted to decision-making on behalf of clients and therefore may be paid for with client brokerage.

The guidance also includes appendices offering case studies and analysis of various proposed transactions under the applicable laws in both the U.S. and Canada.