The central theme of both the Securities and Exchange Commission's and the Association for Investment Management Research's reports on soft-dollar practices is disclosure, disclosure, disclosure. Not only is the SEC requiring it, but an increasing number of pension-plan sponsors are requesting information on how their commission dollars are being used to benefit the performance of their plans.
The SEC report on soft-dollar practices found that "most broker dealers and advisers lacked comprehensive soft-dollar controls. This lack of comprehensive controls may have led to instances of incomplete disclosures to clients, using soft dollars for non-research purposes without disclosure, and inappropriate mixed-use allocations."
It's clear the SEC and plan sponsors will continue their probes in this area. To be compliant, most firms will need efficient methods for providing the details for these ongoing audits. The question is, Is there something more to be gained from keeping more accurate records of soft-dollar arrangements? We think the answer is yes.
Four Benefits
There are four benefits that can be derived from taking a systematic and comprehensive approach to managing commission expenditures. They are: better commission utilization; a disciplined assessment of compliance with regulatory requirements; more complete information for evaluating the value derived from each brokerage relationship; and improved relationships with plan-sponsor clients based on proactive disclosure.
The operative word here is systematic. More specifically, systems need to be developed that create a closed information loop on commission expenditures. The objective should be to provide management with a tool for allocating, tracking and reporting all expenditures for regulatory purposes, as well as for client relationship development and overall business management.
Better utilization of commissions has become a key determinant for the success of a money-management organization. The growth of commission-recapture programs, the increasing demand for independent research, and the importance of compensating key brokers to ensure ongoing access to a range of valuable services are all competing for the same commission dollars.
In order to manage these competing needs, a system must be developed that starts with a budgeting component. This would allow a firm to allocate commissions for client-directed programs as well as proprietary and third-party services. Knowing what resources are being used, by whom and for what purposes, would allow duplications and inappropriate services to be eliminated.
Compliance becomes increasingly complex as more research and other brokerage services are delivered electronically to advisers. Automating soft-dollar reporting practices is becoming more important because of the time spent on record keeping, and the other complexities involved.
Or as the SEC report aptly stated: "The use of electronically-provided research has increased. We found inconsistency in the way in which broker dealers and advisers classified various items used to send, receive and process research electronically. Industry participants are grappling with decisions involving whether the devices needed to obtain access to research and to analyze data constitute research or non-research."
Also, a systematized approach to record-keeping practices for soft-dollar arrangements would benefit advisers in their determination of what constitutes "mixed-use" items, products or services obtained by advisers that have both research and non-research uses. The SEC report found that many advisers "were either not allocating the purchase price of mixed-use items between hard and soft dollars, or could not justify how the hard-dollar to soft-dollar allocation was reached."
By taking a systematic approach, managers will have the information they need to evaluate the appropriateness of each broker's compensation in light of the value provided. In short, they are now in a position to gain the full value of each commission dollar spent.
Perhaps the biggest benefit to be gained from accurate record keeping is the opportunity for proactive client service. Armed with details, a money manager would be able to articulate the correlation between investment strategy and the use of commissions. This type of dialogue builds trust, the foundation of lasting client relationships.
