No soft-dollar shocker now — but just wait

WASHINGTON — The Securities and Exchange Commission dished up few surprises in its first guidance in years on soft-dollar arrangements, but hinted at tougher regulations yet to come for Wall Street brokerage firms.

The SEC's clarification of the definition of research available through soft-dollar arrangements was uncontroversial. But Meyer Eisenberg, acting director of the SEC's investment management division, suggested the regulator will propose a rule requiring money managers to break out the cost of research products and services they receive from full-service brokerage firms and disclose that cost to mutual fund directors and other clients.

Nancy M. Morris, an attorney-fellow in the SEC's investment management division, had announced at a conference that the SEC was working on that proposed rule (Pensions & Investments, March 21, 2005). For years, Wall Street brokerage firms have resisted efforts by regulators and law firms to disclose the cost of soft-dollar research they give money managers.

The SEC's proposed rule might be along the lines of that adopted by Britain's Financial Services Authority, sources said. U.S. investment advisers must ask brokerage firms to estimate the cost of the research they provide through soft-dollar arrangements.

These arrangements, in which brokerage firms give money managers investment research instead of cash discounts on trades, have been controversial for years despite the few high-visibility enforcement actions by the SEC against money managers. Section 28(e), a 1975 amendment to the Securities Exchange Act, permits money managers to pay more than the prevailing rate of commissions to brokerage firms as long as they receive research that helps them with investing their clients' money.

The controversy has been over just what exactly that research is. In 1976, the SEC interpreted the law narrowly to exclude off-the-shelf publications and services, but in 1986 it 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."

Late last month, Christopher Cox, the new SEC chairman, acknowledged "almost breathtaking audacity" by money managers using soft dollars for everything from entertainment to college tuition and membership dues to office expenses. Mr. Cox said investors have a right to know how money managers are spending their commission dollars.

The SEC's proposed guidance, which is open to a 30-day public comment period, defines the kind of research money managers may receive through soft-dollar arrangements as limited to "advice, analysis and reports that have intellectual content."

"It's very much in line with what we were expecting. This makes it clear that unless (the research) is really adding value to the investment decision-making process, it's out of bounds," said Jonathan Boersma, director of the standards of practice at the CFA Institute, Charlottesville, Va.

Computers would fall outside the definition of research, but market data services such as those provided by Bloomberg LP as well as services that analyze trades would be permitted.

Officials also left intact the existing interpretation that investment conferences may be treated as research but not the cost of conference travel and hotel expenses.

Robert Colby, acting director of the SEC's division of market regulation, said the guidance is an effort to curb the use of research of "dubious" value to money managers.

Brokerage services protected under the law would be those from the time a trade is executed to delivery of the securities to the money managers. But Lee Pickard, partner in the Washington law firm of Pickard and Djinis LLP, worried the SEC might be excluding from its definition of research trade-order systems that permit money managers to keep track of orders, and confirm their execution.

Mr. Pickard — a former director of the SEC's division of market regulation who represents independent research firms — also worried the SEC might exclude brokerage arrangements that involve "introducing brokers" that pass trades to larger firms but receive a share of soft dollars generated by those trades.

"That is a sleeping giant issue," he said.

The guidance reiterated that money managers must determine if the research is valuable enough to warrant paying higher commissions on trades.