Mutual fund investment advisers could face harsh sanctions for using commission rebates on securities trades to pay for day-to-day business expenses instead of for research.
And money managers that have used the stock market's ride in the past two years to exaggerate their historical performance records could end up paying stiff penalties to the securities watchdog.
Both would come as a result of the Securities and Exchange Commission's extensive new examinations of the areas.
The SEC has asked for reams of records from soft-dollar brokerage houses that give money managers commission rebates in kind - instead of cash discounts - in return for buying and selling stocks through them.
SEC "Chairman (Arthur) Levitt, who doesn't like the concept of soft dollars, asked that we take a rather tough look," said Gene Gohlke, associate director of the SEC's office of compliance inspections and examinations, who is overseeing the current series of examinations.
The scrutiny comes as the booming U.S. stock market and record trading volume on the stock exchanges have generated millions of dollars more in brokerage commissions and, consequently, soft-dollar rebates for money managers.
Greenwich Associates, a consulting firm in Greenwich, Conn., estimates about one-fourth of all listed commissions are paid in soft-dollar goods and services. Soft dollars, estimated to be a $940 million business at the beginning of the year, might have crossed the $1 billion mark this year, up from $770 million at the beginning of 1995, according to Greenwich Associates.
"All the results seem to point that commissions have gone up sharply and soft dollars have at least maintained their proportion," said John Webster, partner at Greenwich.
Securities laws permit investment advisers to pay higher commissions for trading securities than they otherwise would, so long as they receive research in return that can help them improve their investment performance.
The problem is, after the SEC loosened the definition of research in 1986 to include anything considered a "lawful and appropriate assistance to the money manager," money managers began using these rebates for all kinds of expenses they would normally incur in running a business.
SEC may 'clarify' definition
Consequently, the SEC is considering clarifying the definition of "research" goods and services money managers can pay for with soft dollars, to prevent the rumored use of soft dollars for accounting software, travel costs and marketing expenses.
"Utility bills, secretaries' salaries, and rent have been paid for in the past using soft dollars," Mr. Gohlke said.
"If we find very problematic situations, the exam staff may consider making a recommendation to the enforcement division that some action be taken," he noted.
John Heine, an SEC spokesman, confirmed the objective of the examinations is to ferret out violators: "We don't examine people because we think everything is fine."
At the same time, the regulatory agency is asking money managers to show how they calculate their performance numbers, Mr. Gohlke said. "We see information on money managers which show firms having superior performance going back many years. Is it possible?" he said. As a result of the exams, the SEC may develop a standardized method for money managers to calculate their performance, he said.
"Its possible the investment management (division) and the SEC might feel investment advisers need more guidance on calculating their performance numbers," he explained.
Examination records obtained by Pensions & Investments reveal the SEC is asking broker-dealers to provide a list of all money managers with which they have soft-dollar arrangements; details of goods and services they have paid for with the rebates; the cost to the brokerage firms of providing those services; as well as procedures maintained by the broker-dealers to show those goods and services are considered legitimate research expenses under Section 28(e) of the Securities Exchange Act of 1934.
Brokerage firms also are being asked to give the SEC examiners invoices, canceled checks and bank statements for all soft-dollar research provided.
What's more, SEC examiners are asking soft-dollar brokers to share names of any money managers with which they refused to do business because their expenses could not be considered legitimate research. Some 60 to 80 firms could be examined by next spring.
Broker-dealer exams rare
What is unusual about these exams is that the SEC's investment management staff, which typically examines money managers, is now examining registered broker-dealers to figure out their role in abusive soft-dollar practices.Broker-dealers traditionally are regulated by the stock exchanges to which they belong.
"I will tell a money manager that they cannot use soft dollars to pay for anything related to marketing, and they will then go to a competitor," who signs off on such uses, said Edward A.H. Seidle, president of Anvil Institutional Services Inc., a New York soft-dollar brokerage firm. He declined to identify the managers.
Because of the number of soft-dollar abuses he says can be traced back to the broker, Mr. Seidle, a former SEC lawyer, has been pestering the SEC to investigate broker-dealers in addition to money managers, who ultimately benefit from the soft dollars.
"I think the commission has not been doing enough to ferret out soft-dollar abuses. Hopefully this new SEC action signals the end of a prolonged period of regulatory indifference," said Mr. Seidle, whose firm was among the dozens the SEC has examined recently.
R. William Lee, president of Paragon Financial Group, a soft-dollar brokerage firm in Atlanta, concurs. "Let me go on record as being in favor of the SEC policing this business," said Mr. Lee, who said his firm went through a "very polite, very quick and painless" exam by the SEC.
Donaldson & Co. Inc., another Atlanta-based soft dollar brokerage firm, keeps tabs on every commission dollar and research services paid for through soft dollars, said John Donaldson, president. His firm, which expects to do about $20 million in commissions this year, also was among those examined recently by the SEC.
And Harold S. Bradley, head trader at the Twentieth Century Investors Research in Kansas City, Mo., agrees brokers often are to blame for encouraging managers to use soft dollars for ineligible expenses. He recently received software from The Citation Group, a subsidiary of Merrill Lynch & Co., that showed how he could use soft dollars to cut his company's overhead and improve the mutual fund group's expense ratios.
His firm could have added $9.4 million to its bottom line if it used soft dollars.
Herb Wortmann, director of sales and marketing at Citation, Merrill Lynch's soft-dollar business in New York, said the CD-ROM is sent to existing customers as no more than a listing of the possible services they may obtain with soft dollars. "There are no secrets or sales in there, this is an informational tool," he said. The list is not a legal document, he said. "It does not tell them what they can or cannot do. Money managers should know what they can and cannot do," he said.
Mr. Wortmann said he had no idea how Mr. Bradley might have received the CD because Mr. Bradley's abhorrence of soft dollars is legendary in the industry.
Hoenig & Co., Inc., a large Ryebrook, N.Y., soft-dollar brokerage house, that raked in $45 million in commissions for the first nine months of 1996, for example, provides all new clients with a laundry list of things the money managers can not pay for with soft-dollar credits. These include consulting services for marketing the money manager, rent, furniture, office support staff, conferences and seminars for marketing the firm's services, and travel and entertainment, according to a copy of the list provided by Kathryn L. Hoenig, general counsel.
Will managers find loopholes?
Even if the SEC examinations of broker-dealers prompt the SEC to return to the pre-1986 definition of research, which excluded "products or services which are readily and customarily available to the public on a commercial basis," some experts argue money managers will find loopholes.
"There is no way you can redefine Section 28(e) that puts a fence around it that cannot be breached," said Junius "Jay" Peake, a professor of finance at the University of Northern Colorado in Greeley, and a former vice chairman of the National Association of Securities Dealers.
And Theodore R. Aronson, a long-term critic of soft dollars who runs Aronson + Partners, a Philadelphia money management firm, said the only way to stamp out abuses is for the SEC to insist money managers disclose to clients every soft-dollar arrangement.
"Very few firms regularly report the stuff. I don't think most money managers cheat, I just think they are sloppy because there is no disclosure," he noted.
Under current SEC rules, mutual funds must disclose in their expense ratios the cost of custodial services, printing and other expenses brokerage houses routinely pick up for business given to them. But investment advisers to mutual funds are not required to disclose their soft-dollar arrangements with brokerage firms.
The SEC proposed a rule in 1993 that would have required money managers to lay out the details of soft-dollar arrangements with brokerage firms, but abandoned the proposal after being bombarded with negative comments.
There are no plans now to revive that moribund proposal, said Robert E. Plaze, associate director of the SEC's investment management division. "The concern we have here is compliance with the current law," he explained.
