Once again, the Securities and Exchange Commission is examining the issue of soft-dollar payments for investment research.
The new examination would not be necessary if the SEC would simply closely monitor money manager compliance with its existing rules, and enforce those rules.
In fact, that should be the No. 1 recommendation of the task force examining the current soft-dollar situation.
Soft dollars are a way of paying for investment research services by directing brokerage to certain brokers, who then pay the research provider.
The use of soft dollars has spawned a number of panels and reports over the last three decades but little effective action in stopping the abuses and conflicts of interest, or even in providing for adequate disclosure.
For example, in 1998 an SEC examination found nearly one-third of the money managers examined "used soft dollars to pay for routine business expenses rather than research and they failed to tell their clients about them," according to a Pensions & Investments story. But the SEC failed to act.
Part of the problem is that the definition of "research" has proven remarkably elastic. Despite the SEC's attempts to narrow the definition over the years, abuses still occur. Understanding those abusive practices is one key to unraveling any pay-to-play schemes between consulting firms and managers.
An audit of the Metropolitan Government of Nashville and Davidson County Benefit Board in 2000 found the then-$1.6 billion fund "established an investment consulting arrangement with inherent conflicts of interest … resulting in board decisions that generated higher commissions. … The root cause of this problem": paying the consultant in soft dollars. UBS PaineWebber Inc, which had acquired the consultant, settled with the Nashville system for $10.3 million in 2002.
Beyond the potential for abuses, the use of soft dollars creates disincentives to reduce costs for research, and affects investment performance. That alone should limit the practice.
Soft dollars can add 50% to the cost of investment management, while providing little incentive for money managers to restrain the cost of obtaining research, most of which is wasted, according to a 2002 study by Ennis Knupp + Associates Inc., Chicago.
The practice of money managers "paying up" for investment research with excess brokerage commissions reduces pension funds' investment performance, the study noted. Each additional penny paid per share in brokerage commissions lowers a typical equity portfolio's annual rate of return by about six basis points, it estimated.
Neeraj Baxi, who wrote the study, suggested at the time investment managers should pay for research out of the investment management fees. "While this arrangement could conceivably result in higher management fees, it should not have a negative effect on the net wealth of investors," the study noted. "If an investment manager pays for research himself, he will make sure he spends it wisely. But when a manager is using pension assets to pay those costs, there is a tendency not to monitor and control these costs."
The SEC task force examining soft dollars is expected to issue a report in October.
Its recommendations should include, at the very least, a requirement for complete disclosure to clients of soft-dollar brokerage arrangements and the volume of transactions involved. This disclosure should address another tricky issue: A quid pro quo for winning business from a consultant may come indirectly; a manager may direct trades from other clients, rather than the client it won to avoid appearances of a deal.
The recommendations also should require managers to place a value on the research they receive. That's a tough issue, too, as the P&I story noted: a brokerage firm may put a value on research provided to money managers that the same managers consider worthless.
Pension funds also should police soft-dollar arrangements. The abuses would certainly be fewer if pension sponsors had done so all along.