By now, the institutional brokerage community, its adviser clients and plan sponsors have digested thoroughly the top-line findings of the SEC's Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, released Sept. 22 by the SEC's Office of Compliance, Inspections and Examinations.
Plan sponsors do not, of course, fall directly within the Securities and Exchange Commission's jurisdiction. But they can take away from the report a helpful distinction between "soft dollars" and "directed brokerage."
Plan sponsors also are likely to derive enhanced comfort from working with brokers and advisers who follow "best practices" for soft-dollar relationships as suggested by the SEC's report.
For their part, brokers and advisers alike are moving beyond the report's immediate findings and seeking to discern its longer-term implications and lessons. Some are likely to see an opportunity -- provoked, ironically, by regulatory scrutiny -- to enhance their soft-dollar practices and differentiate themselves from their peers.
Best practices opportunity
While the SEC found general improvements are needed in the area of disclosure and compliance procedures, most products and services obtained by advisers fall within the definition of bona fide research as defined by Section 28(e) of the Securities and Exchange Act of 1934.
The enhanced compliance measures recommended by the SEC should not be terribly burdensome for institutions that already have "best practices" statements and procedures in place. Indeed, advisers should use the report's findings as an opportunity to assess their procedures and improve their practices. The fact is "best practice" management of soft-dollar relationships can be used by plan sponsors to differentiate advisers.
Similar but different
The SEC report clarified that while directed brokerage is "structurally similar" to a soft-dollar relationship, it does not raise the same potential conflicts of interests. The safe harbor of Section 28(e) of the 1934 Act does not apply.
This distinction is of more than passing interest because plan sponsors often confuse the two. Surveys by our firm have found nearly two-thirds of both corporate plans and public funds incorrectly consider directed brokerage to be a soft-dollar arrangement.
Directed brokerage -- in which the plan sponsor directs trades for its account to be executed through specific brokers to achieve cost control or other goals -- requires the fund's commission dollars to be used for the exclusive benefit of the fund. While the adviser makes the investment decisions for the client, the adviser does not receive services or cash rebates under this arrangement.
The SEC report was yet another confirmation that the assets of the plan do, in fact, belong to the plan and, with the caveat of best execution, plan sponsors may direct a portion of their commissions to broker-dealers.
The SEC report also confirmed SEC Rule 10b-10 as applied to commission recapture relationships. Such a relationship occurs when a broker-dealer enters into an agreement with a plan sponsor to rebate a portion of the commission paid for brokerage transactions back to the beneficial owners of the assets. This arrangement requires disclosure on the customer confirmation.
Disclosure, record keeping
From November 1996 through April 1997, the SEC conducted inspections of the soft-dollar activities of 280 investment advisers and investment companies as well as 75 broker-dealers. According to the SEC, while most of the products acquired with soft dollars are research, 35% of broker-dealers and 28% of advisers provided and received non-research products and services in soft-dollar arrangements.
Clearly, receipt of non-research (or non-brokerage) products for soft dollars can be lawful with adequate disclosure and informed consent of the client. However, the SEC maintained virtually all of the advisers that obtained non-research products and services had not disclosed such practices to their clients.
The SEC also said that, even with respect to permissible research and brokerage products and services, many advisers' disclosure of their soft-dollar practices didn't provide sufficient information to enable a client or potential client to understand the adviser's policy.
It makes sense to be familiar with current guidance regarding adviser disclosure.
When an adviser receives research services as a result of allocating brokerage on behalf of clients' accounts, disclosure of soft-dollar arrangements is required even if an arrangement is within the safe harbor of Section 28(e) of the Securities and Exchange Act of 1934.
Compliance checklist
The following checklist was generated by Lee Pickard of the law firm Pickard & Djinis, Washington.
* Criteria for selecting brokers or dealers and for determining the reasonableness of commissions; also, whether in return for products or services from brokers, the adviser pays higher commissions than those paid to other brokers.
* Brokerage and research services received in consideration of commissions on portfolio transactions. (While an adviser need not list each product or service acquired, they must identify types of products or services specifically enough that clients understand what is being obtained; mere disclosure that various research products are obtained is not enough.)
* Receipt of special services falling under the brokerage and research definition found in Section 28(e), such as trading systems, order routing facilities and custodial services.
* Use of client commissions to obtain services with a mixed use -- that is, a service that assists the adviser both in the investment decision process and administratively -- including the method used to determine allocations.
* If research is used to service all of the adviser's clients or just the clients paying for the research, as well as situations in which commissions are used to obtain research for clients other than those generating the commissions (e.g., equity client commissions used to pay for research benefiting fixed-income clients).
* If the receipt of products or services other than brokerage or research services is a factor in broker selection.
* If the adviser obligates itself formally to generate a specific amount of commissions in consideration of receipt of research services (and the amount of the commissions to be generated is material to the adviser's business).
* If the adviser directs client transactions to a particular broker in return for products or research services received -- for example, "step-outs" used to compensate non-executing brokers for services rendered to an adviser and practices such as "paying-up" or formal obligations to generate a specific amount of commissions.
* If the adviser uses an affiliated broker for the execution of portfolio transactions and the factors for compensating such broker. (If commissions are paid by ERISA accounts to an affiliated broker, the adviser would need to comply with disclosure provisions found in Department of Labor Prohibited Transaction Exemption 86-128.)
* If the adviser receives research services in consideration of payment to a broker-dealer of selling concessions and discounts in fixed-price offerings of securities.
* If the adviser directs portfolio transactions to a broker-dealer in consideration of services to be furnished to the adviser's account or in consideration of expenses of the account being paid by the broker-dealer (sometimes referred to as a directed brokerage agreement). Also consider disclosing the extent to which client direction may disadvantage the execution of orders of those accounts that have given direction of those accounts that have not directed orders.
* The adviser's role in arrangements in which a portion of the commissions generated on portfolio trades for a managed account are rebated by the broker to the account.
* Any verbal or written arrangements in which the adviser or an affiliated person is paid cash or receives some economic benefit such as commissions, equipment or non-research services from a third party (a non-client) in connection with rendering advice to clients.
* Considerations involved in the selection of a broker-dealer for the execution of portfolio transactions in recognition of the broker-dealer's past referral of accounts or in anticipation of possible future referrals.
'Mixed-use' products
Another likely implication of the report is increased scrutiny of "mixed-use" products and greater pressure on advisers to ensure appropriate allocation of costs.
Under Section 28(e), appropriate products/services must assist the money manager in the investment decision-making process.
Services such as computer hardware/software or portfolio management systems with a "mixed use" (providing both assistance to the money manager in the investment decision-making process and also administrative or other functions) call for an appropriate allocation of costs between these uses.
In the SEC's view, many advisers either were not allocating the purchase price of mixed-use items between hard and soft dollars or could not justify how they reached the hard dollar/soft dollar allocation.
Who's responsible?
Ultimately, the money manager must evaluate carefully the service and determine the proper research allocation.
The logic used by a money manager in determining a research allocation should be documented and filed at the time the service is required -- not at a later date.
Challenge the brokers
Clearly, advisers need to implement their own best practices and should legitimately challenge their brokers to follow their own high standards.
It is in the best interest of plan sponsors, as well, to know the fine points of the "best practices" standards to which advisers and brokers should be held.
Look at disciplinary history and reputation. Look also for the broker's willingness to maintain constant contact with customers and the regulatory community, to keep clients fully apprised of relevant, critical recommendations and regulatory changes.
Other points to look for are:
* Does the broker support broker-dealer practices as defined by the Alliance in Support of Independent Research and the Securities Industry Association?
* Is the broker committed -- even though current law does not impose direct obligations on broker-dealers concerning Section 28(e) -- to recognizing and responding correctly to the possibility of conduct that might violate fiduciary duty or anti-fraud provisions of federal securities laws?
* Is the broker ready to make reasonable inquiries to determine that services being paid in soft-dollar arrangements fall within Section 28(e)'s definition of brokerage and research?
* Does the broker maintain records of services provided for each client, with full disclosure of the services paid?
* For mixed-use items, is the broker ready to advise the fiduciary when an allocation may be needed, and does the broker urge fiduciaries to periodically review the brokerage allocation.
* Is the broker ready, when appropriate, to remind the fiduciary that a disclosure obligation exists for commission arrangements and brokerage allocation practices?
* Does the broker offer customers regulatory assistance in dealing with third-party research payments?
* Does the broker have written procedures concerning soft-dollar arrangements and systems in place to ensure compliance with legal and regulatory standards?
* Above all -- is the broker committed to best practices, the highest ethical standards, and the most favorable execution to customers?
Kristi Potts is director of compliance, assistant to the president for Capital Institutional Services Inc., Dallas
