On February 17th, the Securities and Exchange Commission released its long-awaited proposal that, if adopted, will require money managers to disclose substantial additional information regarding their use of client brokerage commissions. This proposed rule is intended to provide "investment advisory clients with important information about the brokerage commissions they pay and their advisors' receipt of "soft dollar" benefits from those commissions." This information is supposed to help a client better understand if the investment advisor is directing trades according to the client's best interests. The added disclosure should also help the client determine if the advisory fee is appropriate, in light of the services provided and costs incurred by the advisor.
As a former attorney and advisor to the Division of Investment Management of the SEC, the Division which is proposing this new rule, and as the owner of a soft dollar brokerage firm, I'm surprised by the SEC's lack of both knowledge and direction in this important matter. Rather than providing meaningful information, the SEC's proposal will result in clients receiving a confusing and misleading analysis of their advisor's use of brokerage commissions. This proposal is especially surprising considering the strong sentiment currently in Washington against additional government regulation. While soft dollars may not seem to be a burning national issue, it has always generated heated debate on Wall Street. After all, there are vast amounts of money involved.
Soft dollars are so named because the practice does not involve the actual exchange of funds. "Soft Dollars" are the percentage of brokerage commissions a money manager uses to purchase identifiable investment research and related material that assists the money manager in investing client funds. Soft dollaring has become commonplace, accounting for 40% of all stock trades, according to some industry estimates. Yet, some contend that despite existing guidelines and extremely few cases of abuse, soft dollaring lends itself to the appearance of impropriety.
So, was a mere appearance of impropriety enough to prompt the SEC to take action, or are there real dangers here to the investing public? Or, what seems more likely, was the SEC pressured by certain large investment firms that heavily lobbied Congress and the SEC on this "sinister" soft dollar practice?
To understand this proposed rule, you must let go of your rational mind, travel back in time and willingly enter the "Twilight Zone." In this Twilight Zone, large Wall Street firms, specifically Morgan Stanley Group, Inc., and Goldman, Sachs & Co., Inc., have been transformed into public interest advocates championing the rights of investors.
We enter the Twilight Zone in 1993 when Goldman, Sachs and Morgan Stanley, in their testimony before Congress, strongly criticize the effectiveness of soft dollar disclosure requirements. Byron Wein, chief investment strategist of Morgan Stanley, around this time issues a report to Morgan Stanley clients in which he claims that, "one of the sinister aspects of the commerce of Wall Street is the concept of soft dollars."
He suggests that soft dollaring could be viewed as a "bending of ethical or legal principles." The potentially compromising dangers of the practice of soft dollaring have been viewed with benign neglect for too long, he says. So, Morgan and Goldman work Congress to push the SEC, that sleepy watchdog agency, to put an end of this plundering of investors.
Morgan and Goldman propose to the SEC that money managers who receive independent third party research from brokers in exchange for client brokerage should have to disclose the nature and value of this third party research. Presumably this will show clients that money managers reap huge benefits from these brokers at the clients' expense.
However, they say disclosure is not necessary when internally produced research is provided to money managers. This is because these firms never really put a price on the research they produce internally -- they just sort of give it away. Or maybe the theory is that since these firms usually own positions in or perform investment banking services for the companies they research, it's not really a "benefit" that managers "reap", it's part of the cost of selling the stocks they keep in inventory.
Well, welcome back to reality. What's really going on here? Morgan and Goldman are, of course, two large Wall Street firms known for their focus on principal transactions, program and proprietary trading and investment banking-practices which can involve taking the opposite side of any transaction and essentially betting their highly leveraged capital against that of their clients. Why would they take the position that money managers who receive independent investment research in connection with trading client accounts are sinisterly stealing from their clients? You would think that these firms would be looking to cater to these big ticket money manager clients, not blow the whistle on them.
Fortunately, it's never difficult to figure out why Wall Street firms periodically become champions of investor protection. Hidden in the SEC discussion regarding the proposed rule lies the statement that goes to the heart of Morgan and Goldman's public spiritedness: "Comment is also requested whether disclosure requirements that apply primarily to agency transactions would cause more transactions to be executed on a principal basis."
The problem that Morgan and Goldman are having, according to Byron Wein's 1993 report, is that money managers are increasingly trading with brokerage firms that give them independent research. They are only coming to firms like Morgan and Goldman, says Wein, with really "difficult trades" which may require these firms to put up their own capital.
Wein believes that all this soft dollar trading is bad; when money managers give trades to agency trading soft dollar firms in exchange for research, he thinks the managers end up being charged more. If anything, he says, brokerage firms which commit their own money, like Morgan, should charge more because "they are risking real money, as well as providing in-house research."
Wein apparently is unaware that agency trading soft dollar firms which purchase independent research and provide it to money managers in exchange for brokerage are "risking real money" too. In such cases, the broker is contractually responsible to pay for the research, but the money manager is not contractually obligated to pay the broker. If you don't think that's risking real money, try to get a lender to extend funds to you to finance soft dollar commitments. The only difference between principal trading and agency trading firms is how they use their capital. Soft dollar firms trade on an agency basis and use their capital to purchase research for their clients. Principal trading firms commit capital to make a trading profit.
And do brokers who trade on a principal basis really charge less? We will never know because clients never know how much the broker trading as principal paid for the stock-that disclosure is not required. So the principal broker is getting not only the stated commission but any profit related to his proprietary trading. A good argument could be made that a principal trader should charge a lower stated commission than an agency trader because he frequently is already making money on the trade.
Wein notes with regret that, "whatever drawbacks there may be to soft dollars, clients seem to like them." He goes on to speculate that if money managers would give principal trading firms, like his employer, more of their "trouble free" transactions, these firms might be able to give better prices to their clients. Again, he sadly notes that as long as money managers and their clients believe no one is hurt by soft dollaring, they are not likely to steer more business to principal firms, and hence we won't find out if their clients would get better service.
Well, one thing we know for sure. When money managers have the freedom to choose between independent research provided by agency traders versus proprietary research provided by principal trading firms. Money managers simply don't like research that is really a selling tool and they don't like their brokers betting against them. The SEC, to its credit, did not fall for the poorly reasoned arguments of the principal trading firms which sought to focus disclosure and investor attention on third party independent research only.
However, the SEC's new proposed rule generally applies only to agency transactions and will, as a result, give clients incomplete and misleading information. Transaction costs related to principal trades vastly in excess of the commissions generated on agency trades will never show up in the annual report given to clients.
The rule, if adopted, will certainly make some managers less willing to purchase clearly priced independent research with brokerage dollars. The fact that the Commission has singled this trading out for additional disclosure will suggest to many managers and investors that there is something fishy going on here. The end result will be that more transactions will be executed on a principal basis.
This is clearly an area where market forces should continue to be allowed to operate freely. Money managers choose independent research because it helps them invest client funds better. Being able to choose which trading desk to use to pay for that independent research gives more discretion to the money manager and ultimately benefits the investor. And there has been no public outcry for additional disclosure regarding soft dollars. In fact, clients rarely request information about the soft dollar benefits that the advisor receives and those that are interested may obtain the information on request. Rather, the outcry for additional disclosure has come from certain brokerage firms which are losing business to soft dollar brokers.
However, if there is to be additional disclosure in the name of investor protection -- let it be comprehensive and fair-handed. Let us examine what additional disclosure is appropriate for all trading, not just agency or soft dollar trading. The true beneficiaries of this proposed rule will be the firms which trade primarily on a principal basis. They will have the highly confidential information they have always wanted -- exactly how much business a money manager gives to he brokers he does business with. If you don't think that firms which commit capital to trading and underwritings, including "hot issues," will use this previously confidential information to demand a greater share of the business from their money manager clients -- think again.
Setting Standards For The Investment Management Industry
