The term soft dollars is used to describe certain payments made by institutional investment funds to their service providers. In contrast to "hard dollars" (actual cash), which have to be reported on the fund's books, soft dollars are incorporated into
brokerage feesand the expenses they pay for may not be reported directly.
For example, let's assume fund ABC Capital purchases computer equipment from XYZ Computers. Rather than paying XYZ for the computers, ABC adds a few cents to the brokerage fees it pays for executing transactions through its broker, LMN Brokers. LMN then sends payment to XYZ. (Of course, in this arrangement where third-party services have been acquired, there would be invoices and statements which would be documented in the broker's books and records and would serve as documentation of the expense.) If ABC had paid XYZ directly, the transaction would have been designated as a "hard dollar" cost.
Another example of soft dollars might be when a mutual fund manager pays excess commissions and as a
quid pro quoreceives an allocation of a hot IPO from her broker (so she can flip the IPO, generally before the end of the stabilization period, for a fast profit). Or, a situation where a fund manager wants to reward a wire-house for providing "shelf space" and marketing favoritism for her family of funds, or perhaps where an investment manager wants to earn favoritism for late trading consideration by paying-up in commissions. Such brokerage arrangements, where favors are traded in exchange for institutional clients' excess commissions usually occur in full-service brokerage bundled commission arrangements. Bundled commission arrangements involving the exchange of brokerage firms' undisclosed proprietary services provided for institutional clients' brokerage commissions (paid in excess of a fully negotiated execution only commission rate) can create conflicts of interestand motivate fraud. The lack of transparency in these full-service brokerage arrangements shields abuses from detection.
In contrast to fully disclosed third-party brokerage, which facilitates the provision of independently produced research, the costs of proprietary services bundled in full-service brokerage arrangements are not disclosed to the funds'
In soft dollar arrangements, the brokerage commissions are higher than they would be for an "execution only" trading relationship, and over time investment performance may suffer by that higher commission cost. Because instituional funds can trade a significant number of
sharesevery day, the soft dollars add-up quickly. The amount of soft dollars institutional funds use is quite high (estimated in 2007 to be in excess of 11 billion dollars). (Note that soft dollar amounts do not have to be disclosed to anyone, not even the agencies responsible for oversight, so only estimates are available.) Because hard dollars eventually end up being reported as part of the management fee the fund charges its investors, soft dollar transactions are also a way for funds to lower their apparent fees (even though in the end investors pay for the expense). But, over time, investment performance will deteriorate if the soft dollars are not used to purchase research that enhances performance. And the performance of individual investment accounts will deterriorate if the benefits of the services are not allocated back to the accounts that paid the extra commissions for the services. It appears this practice has little or no point.
Although soft dollar transactions have incurred a lot of scrutiny lately, the practice is still allowed Under Section 28(e)of The Securities Exchange Act of 1934, soft dollars are regulated by the U.S.
Securities and Exchange Commission.
Background and History
In the brokerage business soft dollars are an old tradition. In the very early days of public investing all brokerage firms used a fixed price commission schedule; the schedule was published as a matrix listing the number of shares in the trade on one axis, the stock's price per share on the other axis, and the corresponding commission charge in the cells of the matrix. Because broker / dealers traditionally could not compete by lowering the commission for a trade, they soon began to compete by providing additional services to their institutional clients. In the industry this became known as “bundling” services with commissions.
In the early 1970’s the U.S. government investigated the brokerage industry’s pricing practices. They concluded the industry was engaged in price fixing. The government told the brokerage industry that, as of May 1, 1975 it would be required to “fully negotiate” brokerage commissions with each client for each trade.
As the May 1, 1975 deadline approached the brokerage industry went through several changes in an attempt to restructure itself so it could offer services and negotiate the price of each service separately. In the industry this process was known as “unbundling”. At the same time the brokerage industry lobbied Congress to allow it to continue to include the cost of investment research given to institutional clients as part of the fully negotiated commission. Shortly after May 1, 1975 Congress passed an amendment to The Securities Exchange Act of 1934, this amendment is Section 28(e). Section 28(e) provides a "safe harbor" for any
fiduciarythat “pays-up” from its fully negotiated commission rate to receive qualifying research from its broker(s).
The Securities and Exchange Commission is responsible for interpreting and enforcing Section 28(e). In Section 28(e) the definition of qualifying services is detailed and explicit. The use of client commissions to pay for services which are not within the safe harbor of Section 28(e) is not defensible under the safe harbor. A fiduciary who “pays-up” in client commissions to receive non-qualifying services must defend the use of the excess brokerage commissions (and the allocation of services received) on the basis of fiduciary law. Under fiduciary law it is the fiduciary's responsibility to use its client's assets for the "exclusive benefit" of the client / beneficiary /principal. Fiduciary law and
ERISAhave confirmed that institutional brokerage commissions are an asset of the client / beneficiary / principal.
Maybe the best solution to controlling abuses in the use of client brokerage commissions is for account owners and their fiduciaries to mandate constructive disclosure of the elements of brokerage commissions from their investment advisors and the brokers that serve them. Brokers and investment advisors should be able to and identify and account for their pricing of execution and clearing, research services that qualify under Section 28(e), and "other bundled services" requiring further explanation. Such a mandate seems basic to the fiduciary responsibility for oversight of the principal's assets; such commission oversight is an appropriate responsibility of investment advisors, retirement plan trustees, plan sponsors, personal trust officers and mutual fund directors. These professional fiduciaries should be demanding and receiving disclosure of commission detail from their brokers and co-fiduciaries.
Statistical studies over several recent years and large populations of institutional trade data have revealed that the cost of executing and clearing institutional trades is between 1.25 and 1.75 cents per share. Most institutional advisors pay 5 to 6 cents per share commissions to their brokers. Many of these institutional fiduciaries provide no disclosure of what "services" they are receiving for the excess over their fully negotiated commission rate. In bundled full service brokerage arrangements this lack of disclosure is particularly problematic because it makes it impossible to apply Section 28(e) tests and measure Section 28(e) compliance.
* [http://www.sec.gov/rules/interp/2006/34-54165.pdf Section 28(e) Interpretive Guidance ]
* [http://majestic.typepad.com/seth/2004/03/transparent_bun.html The Big Picture: How it works]
* [http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/wcom/92memo.html Follow The Money ]
* [http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/interviews/spitzer.html The environment]
* [http://www.sec.gov/rules/interp/s70905/wtgeorge9607.pdf The evolution of two distinctly different institutional brokerage business models.]
* [http://www.sec.gov/news/speech/spch420.htm Remarks of Chairman Arthur Levitt] at the Annual Meeting of The Securities Industry Association, Boca Raton, Fla. - November 9, 2000 - see topic headings: “ ‘Sticky’ Brokerage Commissions”, and “Order Flow and IPO’s”.
* [http://www.sec.gov/news/studies/softdolr.htm SEC Report The SEC's Soft Dollar Brokerage "Inspection Report" published in 1998]
* [http://www.hewittinvest.com/pdf/SpotlightOn_Jul04.pdf Hewitt Investment Consulting Spotlight On: "Making Sense of Soft Dollars" - July 2004]
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