New CSA rules aim to tackle soft dollar practices

In the world of money, hard is generally superior to the alternative.

Hard currency can be relied upon to retain its value. Hard loans, including sovereign debt, are payable in hard currency, like US dollars or Euros. Hard stands for reliability, widely agreed-upon value and effortless convertibility. Soft, on the other hand connotes less predictability and subjectivity in determining value.

So it’s little surprise that soft dollars, and their proper place in investment management, have been a source of regulatory consternation for some time. The latest effort to regulate how money managers and the broker dealers with whom they do business use soft dollars is the final version of National Instrument 23-102 Use of Client Brokerage Commissions, which takes effect on June 30 of next year.

There’s always been some degree of unease surrounding soft dollars, or the use of brokerage commissions by money managers to obtain goods and services other than straight execution. Some purists have called for abolition of the practice, but soft commission is an absolutely entrenched part of the way we do business in investment management. By the time regulators, observers and market participants had thoroughly studied the issue, soft dollars had become an integral part of the industry.

Any understanding of how they work requires some background. The story goes back to the era of fixed commissions — which were the norm for more than 200 years. Without them, there would be no soft dollars.

Until 1975, brokerage commission rates were fixed by both custom and regulation. Stockbrokers were not able to differentiate themselves on the basis of price, so they looked for other ways to compete. They offered research reports, and called up clients with investment ideas.

Over time, brokerage firms earned order flow by offering to pay for things that the buy side needed to conduct business. For trades by institutional clients especially, the minimum commissions far exceeded the actual execution costs, even in an era that we’d consider technologically primitive. Brokers were able to “give up” some of the fees and apply the excess, like a form of rebate, to the purchase of goods and services used by money managers.

But, when the fixed commission structure went away and dealers could compete on price, money managers were in a quandary. As fiduciaries, they had an obligation to obtain best execution for their clients, but it was questioned whether that obligation was solely linked to getting the best available price. If broker selection was solely based on price, then did the money manager risk losing access to research and other services provided by dealers who charged higher commissions to take these into account?

Dealers were only too eager to furnish all manner of goods and services to their best buy-side clients, including things supplied by third parties. Some of those are necessary tools of the trade (Bloomberg terminals for example) and, to the extent the goods and services can be purchased with soft dollars, the money manager doesn’t have to dip into the firm’s own hard dollars (which the money manager would find difficult to charge to its own clients).

The problem is this creates an incentive among money managers to pay up, and even to increase portfolio turnover in order to generate more brokerage commission with an eye towards getting more stuff. Plus, the costs are largely hidden: brokerage commissions are included in the cost of securities for purposes of calculating the value of the portfolio. It takes a fair amount of effort to accurately break out and track transaction costs.

Rules concerning what’s eligible to be purchased with soft dollar credits were ambiguous and practices diverged widely across the industry. U.S. money managers fretted that sending brokerage to anyone other than the lowest-cost provider could expose them to a charge of breach of fiduciary duty. Legislators responded with a set of rules protecting them from liability and regulatory action, so long as certain conditions were met. These provisions were enacted as Section 28(e) of The Securities Exchange Act of 1934, and have come to be known ever since as the “Section 28(e) safe harbour”.

In the mid-1980s, regulators in Canada and the U.S. felt the need to remind the industry of the fundamental principle that the order flow which generates commission revenue to the brokers is the client’s. The assets belong to the clients and anything those assets generate accrues to them. Therefore, the client and not the money manager should reap all of the benefits of the order flow. Otherwise, there is, in effect a non-negotiated, non-transparent transfer of value from the client to the money manager.

Rules were established or clarified that provided soft commission was only to be used to pay for goods and services related to the management of the client’s portfolio, namely goods and services classified as aiding either research (investment decision-making) or order execution.

In 1986 the SEC replaced the original safe harbour rules in response to concerns that the narrow standard impeded money managers from obtaining goods and services which were important to the decision-making process. The 1986 release liberalized the definitions of brokerage and research services that could be paid with client commissions. Through the next decade, during which the fund industry enjoyed unprecedented growth, there was corresponding growth in soft dollar usage. Concerned that it did not have a good handle on the extent of the practice, the SEC conducted a sweep of 75 broker-dealers and 280 investment advisers and fund companies in 1996.

What the SEC found did not reassure the regulator. The SEC dryly notes in its Inspection Report on Soft Dollar Practices, published in 1998, that “we identified investment advisers that may have received products or services that appeared to be outside of the safe harbour.” The report went on to list some of these, including salaries for research staff, IT used for purposes other than research and the travel, air fare, hotel and other expenses of research consultants.

In the wake of the various scandals involving mutual funds and improper behaviour in 2003 and 2004, then New York Attorney General Eliot Spitzer decided to tackle soft dollar practices at mutual fund companies. And in February, 2005, Canadian regulators released Concept Paper 23-402, Best Execution and Soft Dollar Arrangements, which made explicit reference to the developments and regulatory responses in the U.S. and in other jurisdictions around the world.

The Concept Paper tackled a broad set of issues, including market structure and fragmentation and the best execution responsibilities of broker dealers. The CSA wisely decided that the narrower problem of soft dollars could be dealt with apart from the market structure matters. And so, after several more rounds of consultation, in October of 2009, the CSA published the final version of National Instrument 23-102 Use of Client Brokerage Commissions.

This column is part one of a two-part series. The next column will look into specifics of those new requirements.

Susan Han is a lawyer at Miller Thomson LLP in Toronto.

(12/09/09)