SEC proposes soft-dollar breakout

WASHINGTON — Wall Street brokerage firms will have to break out the cost of investment research they provide to money managers trading securities through them, under a proposed rule the SEC is expected to issue by the end of June.

Money managers also will have to classify the products and services they receive from full-service brokerage firms through soft-dollar arrangements, and disclose the costs to pension and mutual fund clients, regardless of whether the clients use the research.

Executives at brokerage giants such as Goldman Sachs & Co., Morgan Stanley and Merrill Lynch have argued for years that it's difficult to estimate the value of the "research" products and services they routinely provide to institutional clients.

"A lot of firms say they don't use soft dollars, but they use full-service brokerage firms and receive proprietary research. Even if you don't read (the research) you're still getting soft dollars," said Nancy M. Morris, an attorney-fellow in the Securities and Exchange Commission's investment management division. She announced the proposed rule at a compliance conference sponsored by IA Week and the Investment Counsel Association of America in Washington last week.

Under such arrangements, brokerage firms typically give money managers an array of "free" research services and products in exchange for trading with them.

Regulators are concerned money managers might be using their clients' commission dollars to pay for computers, office equipment, salaries, marketing and other routine costs of doing business, instead of research that could result in better investment performance. Regulators also fear that money managers might use soft dollars to benefit other clients whose trades do not generate the commissions.

The SEC's proposed rule would clarify the definition of research under Section 28(e) of the Securities Exchange Act. That section allows money managers to trade through brokerage firms that charge higher than the lowest available commissions if those brokers provide research and brokerage services that help managers make better investment decisions. In 1986, the SEC broadened the definition of research to virtually anything that "provides lawful and appropriate assistance to the money manager in carrying out investment decision-making responsibilities."

Ms. Morris said the proposal will require that allowable research provide "some intangible, intellectual content." That would exclude some common uses of soft dollars, such as publications generally available to the public as well as computers, software, high-speed Internet connections and stock-quotation systems such as Bloomberg terminals.

But the SEC's soft-dollar task force is struggling with the question of "when is data just numbers, and when does it become research?" she said. The answer would determine, for example, if Bloomberg terminals that provide customized data could be considered research permitted under soft-dollar arrangements.

The SEC also is examining "mixed-use" arrangements, where money managers receive some permitted research and brokerage services as well as some other services outside the scope of the securities rule. "This is an area where we've seen tremendous abuse, and it's something under serious scrutiny," Ms. Morris said.

Also expected as part of the proposal is a requirement that brokers give investment advisory clients — including mutual fund directors — details of trading costs, including commissions and other transaction costs.

The SEC ultimately wants to open discussions between mutual fund directors and investment advisers "to drive down transaction costs," Ms. Morris said.

Money managers, for the first time, would have to disclose details of their soft-dollar arrangements in their annual Form ADV filings with the SEC.

"We're looking to clarify the books and records investment advisers and broker-dealers have to keep," Ms. Morris said, noting that inspections have found a "lackadaisical approach" to the record-keeping requirement.

The proposed rule is a huge victory for smaller, no-frills brokerage firms — also known as execution-only firms — that lack the resources for internal research. Those firms typically charge lower commissions on trades than full-service brokerage firms

Some money managers — including MFS Investment Management and Putnam Investments, both implicated in the mutual fund trading scandals — have stopped using soft dollars in an effort to refurbish their reputations.

"It would be more intellectually honest to say, ‘Let's just get rid of all soft dollars,' than target what is just the best part of soft dollars because it's the most transparent … and it's more independent than conflicting research from the sell-side brokerage firms," said David G. Tittsworth, executive director of the Washington-based Investment Counsel Association.

The SEC proposal is expected to be heavily influenced by the United Kingdom's expanded, voluntary disclosure code, expected to be published later this month by the Investment Management Association, London,

Under the U.K. code, money managers will give to pension fund clients early next year their data on trading volumes, commissions and soft-dollar usage for the second half of 2005, said Gordon Midgley, director of research at the IMA. In the future, managers will be required to give that information to all institutional clients.

The expanded code asks money managers to break out, by asset class for each client, total trading volume conducted during a specified period by the top 10 brokerage firms and electronic crossing networks. It also requires managers to give the percentage of trades on which no commissions, full commissions or other rates of commissions were paid.

Money managers also must describe how the commission dollars were allocated between execution and research products and services, Mr. Midgley said. The SEC's proposed rule, by contrast, would not include this breakdown, Ms. Morris said.