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News August 2, 2004 Issue

Mutual Fund Advisers Urged to Abandon Soft Dollars

Yet another group has added its voice to the call for soft dollar reform.

Last week, the Mutual Fund Directors Forum officially recommended that mutual fund independent directors prohibit their fundsí advisers from participating in soft dollar arrangements in trades for the funds. The position was announced in the groupís "Best Practices and Practical Guidance for Mutual Fund Directors."

"Ideally," said the Forum, the prohibition "should extend to both formal and informal soft dollar arrangements and to both proprietary research and third-party research." The group acknowledged that the prohibition would "likely have an economic effect on fund advisers and on trading practices" and that "long-established patterns in brokerage practices may come under pressure." It also noted that advisers that follow the recommendation and "eschew" soft dollar arrangements may be placed at a competitive disadvantage to advisers that continue to use soft dollars. "The reform contemplated by this recommended best practice would be more equitably instituted if achieved through a change in applicable law," noted the group.

Forum president Allan Mostoff told IM Insight that the soft dollar position "was the subject of spirited discussion by the members of the Working Group" that formulated the recommendation.

Thatís not surprising.

Taken to its logical conclusion, a flat prohibition on all fund soft dollar trades would mean that mutual funds could not trade through any full-service broker. Since ECNs offer commissions somewhere around 1 or 2 cents per share, the 5 or 6 cents typically charged by full-service brokerage firms requires an adviser to, technically speaking, pay up.

The soft dollar product or service? Wirehouse research.

A blanket prohibition on all soft dollar trades would mean that an adviser that ran fund trades through a full-service broker would have to return any research provided (or promptly toss it in the trash, as some have quipped) and generally refuse to avail itself of the non-execution "goodies" that the broker offers, such as access to analysts. That, of course, would be antithetical to many advisers, who might view it as a breach of their fiduciary duty to "leave money lying on the table" by not taking advantage of the full-service brokerís resources (already paid for by shareholder commissions).

Even if a fund adviser was bound and determined to shun all soft dollars, ECNs and alternative trading venues would seem to offer only a partial solution, since many large or complex trades require the skills of a full-service brokerage firm.

Of course, as some advocates of soft dollar reform might argue, a uniform imposition of a soft dollar ban by the mutual fund industry, spearheaded by independent directors, could put pressure on full-service brokerage firms to lower their commission rates from 5 or 6 cents a share down to the "true" cost of execution.

Or it might not. No one knows what type of market and structural effect a ban on soft dollars could have. Thatís why most policy makers are moving cautiously in the soft dollar area.

The Forum noted that some advisers have "instituted affirmative measures to pay low commissions," an apparent reference to negotiated execution-only rates. But unless you are Fidelity, you shouldnít expect your full-service broker to offer you a 2 cents per share execution only rate. IM Insight has heard that some of the very largest advisers have attempted to negotiate execution-only rates with full-service brokers. They didnít get very far.

Interestingly, the Forum isnít the first group of directors that has called for an overhaul of soft dollars. Back in December, the Investment Company Instituteís Directors Committee, in a letter to SEC Chairman William Donaldson, said it would "support a legislative effort to repeal in its entirety Section 28(e)" (see document, below).

Other recommendations in the Forumís Best Practices of particular interest to advisers:

  • Independent directors should instruct the fundís adviser that it may not consider research as a factor in determining best execution. "Research received by an adviser should not influence the selection of a broker-dealer for allocation of trades," said the group.
  • Independent directors should require fund advisers to disclose revenue sharing arrangements to the board. The board should review those arrangements annually and consider them during the contract renewal process, as applicable. "The Forumís recommendation should not be taken as suggesting that revenue sharing arrangements are inappropriate," said the group, "but rather that transparency is important for revenue sharing arrangements." The group recommended that at a minimum, the independent directors receive information about: the types of entities to which revenue sharing payments are made; the structure of the payments made under each type of arrangement; the services received for the payments; and the total amount paid, both in dollars and basis points.
  • Independent directors should use an expanded definition of independence that provides that no independent director may have been affiliated with the fundís adviser or the adviserís affiliates in the past five years. A five-year "cooling offí period," said the group, is appropriate "before a former affiliated person should be deemed no longer potentially influenced by his or her relationship to the adviser."
  • The group deferred consideration of Rule 12b-1 issues, noting that the rule has "become the focus of potentially far-reaching regulatory changes." The Forum said it plans to provide recommendations about 12b-1 payments "later this year."

The Forum described its recommendations as "aspirational" and noted that independent directors should tailor them to their particular funds. The recommendations were issued in response to a request by Chairman Donaldson that the group develop practical, written guidance for independent directors. Donaldson encouraged all fund directors "to review and consider carefully the Report's recommendations."