Soft Dollar Zone: A Sensitive Area Published in The Journal of the Institute for Investment Management Consultants
Institutional investors and brokerage firms, which provide research, apparently have a difficult time understanding that the soft dollar business is legally defined. Principles of fiduciary duty generally prohibit money managers from deriving any benefit in connection with a client brokerage transaction if the manager could have undertaken it without the research service at a lower cost. Congress, sympathetic to the importance of investment research to money managers and recognizing that such research services ultimately benefit the investor, enacted Section 28(e) of the Securities and Exchange Act of 1934 in order to provide a "safe harbor" for money managers who wished to receive investment research, known as "soft dollar" services, as part of their clients' brokerage costs. Since Section 28(e) is a safe harbor, failure to comply with its terms does not automatically result in a violation of law. However, arrangements outside the safe harbor are subject to greater scrutiny than those within it.
Virtually all of the major brokerage firms offer soft dollar services: in addition, there are numerous soft dollar specialty firms. Brokerage firms which operate within this regulatory niche of the brokerage business, offering soft dollar services, routinely and informally advise clients as to whether proposed soft dollar arrangements are legally permissible. While the legal, regulatory and compliance aspects of the soft dollar business have assumed greater prominence in recent years and the penalties for non-compliance by money managers can be severe, most soft dollar firms are not owned or managed by individuals with significantly-relevant legal, regulatory or compliance backgrounds. At best, these firms retain outside legal counsel to assist their salesmen and clients (indirectly) regarding regulatory developments and the advisability of proposed soft dollar and commission recapture arrangements. However, in most cases, salesmen at these firms advise clients without contacting competent outside counsel.
Money managers routinely have questions regarding their soft dollar brokerage programs. These soft dollar practices must be properly disclosed by managers to their clients and are reviewed by Securities and Exchange Commission examiners periodically. The Securities and Exchange Commission has over the years, issued many interpretations of what is required in order for a money manager's soft dollar brokerage program to be afforded the protection of Section 28(e). These interpretations are not always clear and frequently do not always clear and frequently do not address the specific program contemplated.
It is not surprising then, that controversial soft dollar practices are commonplace. As the owner of a soft dollar brokerage firm who is a former SEC attorney, as well as a legal counsel for one of the largest money managers, I frequently encounter soft dollar abuses. Generally, it is the soft dollar broker who has misinformed the pension fund or money manager regarding the propriety of a proposed soft dollar arrangement. While the securities bar has long recognized the possibility that a soft dollar brokerage firm could be subject to aiding and abetting liability for a money manager's breach of fiduciary duty, rarely does the SEC even disclose the names of brokerage firms involved in soft dollar abuse cases, and even less often, if ever, have these firms been held accountable. In some cases, it is the money manager who conceives of the improper soft dollar arrangement; however, even in these cases, the brokerage firm offering soft dollar services should be prepared to inform the money manager of the abuse and walk away from the business. The current regulatory state of affairs permits brokerage firms that do not have a real soft dollar expertise to prosper by facilitating abusive arrangements. In those rare cases where blatant and widespread soft dollar abuses are brought to the attention of the SEC, the Commission has been reluctant to take action.
Rather, the Commission has often taken the position that such abuses are insignificant compliance oversights. We welcome the new, enhanced Commission scrutiny of soft dollar practices.
Setting Standards For The Investment Management Industry
