CSA rules tackle soft dollar practices, Pt. 2

Money managers direct business, or order flow, on behalf of client portfolios to brokers and dealers who effect the transactions in the appropriate marketplaces.

And the fees or brokerage commissions charged often exceed what’s needed to cover the cost of straight execution. This excess can be used by money managers to obtain goods and services for client accounts, which are provided by the sell side. These goods and services are purchased using soft dollars and both formal and informal agreements between buy-side players (pension funds and money managers) and broker-dealers are called soft dollar arrangements. In Canada, key rules governing these activities are now set out in National Instrument 23-102, Use of Client Brokerage Commissions.

If you start with the assumption that money managers are fiduciaries and order flow belongs to the money manager’s clients, then it’s easy to see that any benefits generated by the order flow must accrue to benefit client accounts, not money managers. And, as much as possible, this should be transparent to the client. That said, it’s inconsistent with those principles to use client order flow to pay for the day-to-day operating costs or overhead of the money manager. In my business, a law firm, we charge clients for expenses (disbursements) such as printing, courier fees, and filing fees. But clients don’t expect to pay for things like the cost of the flowers in the reception area, or for the computers used by lawyers and staff.

Nor do they expect to pay for lawyers to travel to and attend professional conferences, even where attendance my directly benefit the client. Such costs are expected to be covered by the legal fees. Similarly, in the securities world, it’s improper for client order flow to be used to pay for a money manager’s salary costs, or for a portfolio manager’s attendance at a conference.

Hard guidance on soft dollars So, what things are money managers allowed to use soft dollars to buy? And what stuff can’t they use soft dollars to pay for?

Under NI 23-102, client commissions may be used to pay for “order execution goods and services” and “research goods and services.” The Companion Policy, 23-102 CP and its related commentary, allows for a fair degree of latitude in what can count as an “order execution good or service,” and especially what can count as a “research good or service.”

The former can include goods or services that are directly related to order execution, which according to the Companion Policy means they’re “integral to the arranging and conclusion of the transactions that generated the commissions.” The Companion Policy also recommends application of a time standard to determine if a good or service is eligible under the Instrument. That means market participants must consider the point in time within an order’s lifecycle that the good or service was used. If it’s used between the time a portfolio manager makes the investment or trading decision and the time the trade settles, then the good or service in question will fall into the “order execution goods and services” category. So, for example, order management systems used for transmitting orders, algorithmic trading software and market data services can be soft dollared under the Instrument.

Research is similarly given a more liberal interpretation. For example, the commentary specifically states “post-trade analytics from prior transactions” can count as a research good or service under the Instrument. In fact, the commentary points out that although post-trade analytics software and services will not fall under “order execution goods and services” when the temporal standard analysis is applied, it will nevertheless fall under research and thus be eligible.

Further guidance says that, to be eligible, the goods or services must be used to assist with investment or trading decisions, or with effecting transactions, on behalf of client accounts. Advisors must make a good faith determination that clients are receiving a reasonable benefit.

Sell-side requirements The CSA went to some trouble to be consistent with guidelines and policies of other major regulators such as the SEC and FSA, recognizing the increasingly global nature of money management. A global manager with operations and clients in Canada, the U.S., the Far East and Europe would find it cumbersome to manage very similar mandates while adhering to widely divergent rules for broker selection and soft dollar usage.

The sell side does not escape obligations under the Instrument. Dealers are not permitted to pay for, or arrange payment for, goods and services that appear to be ineligible and can’t simply pay invoices forwarded to them by the buy side client without first asking questions. Specifically, the regulators state that “when it is not clear as to whether the good or service meets one of the definitions, or when the description on the invoice is insufficient, an inquiry should be made with the advisor before accepting payment or agreeing to pay.”

In addition to restricting the scope of goods and services that can be purchased with soft dollars, the Instrument adds a second level of investor protection: disclosure. Advisors must provide clients, prior to account opening, with a description of its broker selection and soft dollar practices and policies, including an explanation of the advisor’s method for determining the client account has received reasonable benefit in connection with soft dollar arrangements.

Similar information must be furnished to the client at least annually. And, if the transactions were effected through a related entity, more details are required, including identity of the related entity and the types of goods and services provided.

The CSA carefully considered whether or not any attempt should be made to assign and then disclose some sort of hard (quantitative) value to the goods and services obtained using soft dollars. The problem is determining who is best placed to determine value: the provider (sell side) or the recipient (buy side)? What’s the best way to un-bundle the execution from other value-added components? And since there is no agreed on method of determining value, what purpose would such disclosure serve, since each transaction is unique?

Recognizing these difficulties, regulators have temporarily dispensed with requirements for quantitative disclosure — however investment funds must still disclose in notes to their financial statements, the amounts of brokerage commissions that are soft dollar amounts (to the extent that such amounts are ascertainable).

Soft dollar arrangements are one of the more peculiar features of the investment management industry. If we could start over with a blank slate, we might collectively decide there are better ways for advisors and dealers to purchase and sell services. But regulation is partly about being pragmatic and dealing with the facts as they are. And NI 23-102 is a balanced, pragmatic rule for dealing with a complicated area of investing. The new rules will come into force June 30, 2010.

Susan Han is a lawyer at Miller Thomson LLP in Toronto

(02/08/10)