WASHINGTON -- A Labor Department panel has given its blessing to soft-dollar, directed brokerage and commission recapture practices.
But the report comes down hard on cozy relationships between investment consultants and brokerage firms. It suggests pension plan sponsors "avoid soft-dollar conflicts of interests by hiring only consultants with no financial arrangements with brokerage firms."
"That will probably lead to consulting firms separating their brokerage businesses if they want to continue in the business," said Howard J. Schwartz, chief executive officer of Lynch, Jones & Ryan Inc., a large New York-based soft-dollar brokerage firm.
An industry source who did not want to be identified said consulting firms with brokerage affiliations doubt the Labor Department will take that recommendation seriously.
The report, by the ERISA Advisory Council's working group on soft dollars and commission recapture, also endorses a provision in securities law permitting money managers to pay higher than the prevailing rate for commissions to brokers if they receive investment research services and products in exchange.
Tighter definition requested
But the report recommends the Labor Department ask the Securities and Exchange Commission to tighten the definition of research under Section 28(e) of the Securities Exchange Act of 1934, "to better determine what can justifiably be purchased with soft dollars."
The report notes that soft-dollar and directed brokerage arrangements have "fostered competition in (the) brokerage industry," and suggests pension plans that do not take advantage of such arrangements "may be subsidizing every other pension plan's research."
The practice of brokerage firms providing research to money managers in return for securities trades "encourages more and better research," the report noted. It cited testimony by Tina Byles Poitevien, president of FIS Funds Management Inc., that about 90% of U.S. money managers receive investment research through soft dollars.
A repeal of the Section 28(e) safe harbor, therefore, could "have widespread negative effects throughout the investment management industry," the report states.
"A properly structured commission recapture program can assist investment managers, reduce plan commission costs, and help plan sponsors fulfill their fiduciary responsibilities," the report noted.
Some praise, some criticize
The report has drawn a mixed reaction from supporters and critics of soft dollar and directed brokerage arrangements.
The report "effectively ratifies what current practices are," Lynch, Jones & Ryan's Mr. Schwartz said. "This report is very favorable to our business and further supports the trend toward commission recapture."
Theodore R. Aronson, head of Aronson + Partners, a Philadelphia-based money management firm, is a vocal critic of soft-dollar arrangements. He also applauded the report.
"Disclosure and the light of day in the hands of owners and fiduciaries will go a long way toward sorting this out," Mr. Aronson said.
Even if the Labor Department and the SEC fail to implement the report's recommendations, "this report alone will up the bar," he said. "It draws attention in a very honest, articulate way to the issue, and the side I'm on wins because we have disclosure."
But some others picked it apart.
A recommendation that the SEC prepare a "list of which brokerage and research services are acceptable purchases with soft dollars" drew fire from Lee A. Pickard, a partner in the Washington law firm of Pickard and Djinis, who represents an alliance of soft-dollar independent research firms.
The recommendation "demonstrates a profound lack of understanding of how the SEC works," Mr. Pickard, a former director of the SEC's market regulation division, said at a recent conference.
Said Douglas Scarff, associate regional director of the SEC in New York, who spoke at the same conference: "There will be no 'UnAmerican Activities' list."
But other recommendations jibe with what the SEC already is doing, said Douglas J. Scheidt, chief counsel in the SEC's division of investment management.
He noted the SEC is already looking at ways to clarify the definition of research, and may consider issuing guidance on the subject.
Some recommendations 'naive'
Another industry observer -- an outspoken critic of soft dollars who declined to be identified -- called some of the recommendations of the report "naive."
He cited the report's recommendation that pension plan sponsors certify they are complying with the Labor Department's 1986 guidance in using directed brokerage programs.
That guidance "has done more to hurt pension plans than anything the Labor Department has ever put out," he said.
The Labor Department's technical release 86-1 allows plan sponsors to use commission dollars to purchase goods and services other than research, as long as the purchases are made on "behalf of the pension plan; total compensation paid to the broker is reasonable; best execution of trades is obtained; and plan sponsors monitor brokers for best execution."
That release "spawned a whole cottage industry of measuring transaction (costs) that have done nothing for the plan sponsor," he said.
(In a typical soft-dollar arrangement, brokerage firms provide money managers with investment research products or services instead of commission rebates, in exchange for buying or selling stocks and bonds through the brokerage firms.
(In contrast, in directed brokerage arrangements, pension plan sponsors "direct" their money managers to conduct a portion of their trades through selected brokerage firms, which then pass on the commission rebates to the pension fund, generally by picking up the tab for some of their administrative expenses.
(Commission recapture is a process in which pension plans receive a discount on brokerage commissions on trades executed by their managers.)
A host of recommendations
Other recommendations in the report:
* The Labor Department should change Form 5500, the annual form all pension plans must file, to list all fees in excess of $5,000 paid with directed brokerage.
* Investment managers should give clients full disclosure of all trades involving soft dollars and the benefits investment managers receive from those soft dollars. In addition, investment managers should be required to provide a description of their policies involving soft dollars.
* Investment managers should summarize -- on periodic disclosures to the SEC -- all outside research they receive.
* Independent accountants should audit soft-dollar disclosures by investment managers and consultants to plan sponsors, so long as the benefits of those audits outweigh their costs.
* Plan sponsors should obtain copies of brokers' and investment managers' projected budgets for directed brokerage and soft dollars.
* Only those with no vested interests should monitor soft-dollar brokerage.
* Plan sponsors should require investment managers and consultants to disclose in writing all potential conflicts of interest.
* Plan sponsors should require consultants to disclose in their contracts all compensation they receive from investment managers either through the sale of services or through directed brokerage arrangements.
* Plan sponsors should require money managers to disclose, in their contracts, how they paid for research, and how the pension plan benefited from that research.
* Plan sponsors should have consultants and money managers acknowledge their fiduciary status in writing.
* Plan sponsors should obtain written confirmations from consultants and money managers about their brokerage arrangements.
* Plan sponsors should create specific guidelines for responsible soft-dollar and directed brokerage programs.
Report's future uncertain
A small unit of the working group also recommended repealing the safe harbor provision in securities law for research for pension plans, and doing away with soft dollars.
But the citizens' group of employers, money managers and consultants advising the Labor Department's Pension and Welfare Administration does not have any legal standing.
Labor Secretary Alexis Herman, who received the report Dec. 5, may or may not sign off on its recommendations.
She is expected to forward the report soon to Congress, as required by law.
The House Finance and Hazardous Materials subcommittee, which has asked the SEC to submit an upcoming report on soft dollars, also may examine the ERISA Advisory Council's report in hearings next year, said Jeff Duncan, legislative counsel to Rep. Edward J. Markey, D-Mass., the ranking minority member on the subcommittee.
He held hearings on soft dollars in July 1993.