Soft dollar
Encyclopedia
Soft dollars is a term used in finance
to describe the commission
generated from a trade
or other financial transaction between a client and an investment manager
. A soft dollar arrangement is one in which the investment manager directs the commission generated by the transaction towards a third party or in-house party in exchange for services that are for the benefit of the client but are not client directed. Soft dollars, in contrast to hard dollars (actual cash), which have to be reported, are incorporated into brokerage fees and paid expenses, which may not be reported directly. Registered Investment Companies generally comply with the limitations detailed in Section 28(e) of the Securities Exchange Act of 1934
but hedge fund
s, which are generally not registered, are not subject to the limitations of Section 28(e) and thus the client commissions are not necessarily used for the direct benefit of the client.
; the schedule was 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 were required to charge a fixed commission and 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 1970s, 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.” and created the Discount Brokerage segment of the industry. 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 Section 28 of The Securities Exchange Act of 1934. Section 28(e) provides a "safe harbor
" for any fiduciary that “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, but Section 28(e) is not a rule it is just a "safe harbor". 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 be able to 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 ERISA have confirmed that institutional brokerage commissions are an asset of the client / beneficiary / principal.
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 1.65 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 difficult to apply Section 28(e) tests and measure Section 28(e) compliance.
An example of illegal use of undisclosed soft dollars might be when a mutual fund manager pays excess commissions and as a quid pro quo
receives an allocation of a hot IPO from his broker (so he 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 have been criticized by securities regulators. Full-service brokerage 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 interest
and motivate fraud. The lack of transparency in these full-service brokerage arrangements may shield abuses from immediate detection.
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 institutional funds can trade a significant number of shares every 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 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 deteriorate if the benefits of the services are not allocated back to the accounts that paid the extra commissions for the services.
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. In Australia soft dollars are not illegal although they are discouraged and must be disclosed in plain language terms to clients.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
to describe the commission
Commission (remuneration)
The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...
generated from a trade
Trade (financial instrument)
In finance, a trade is an exchange of a security for "cash", typically a short-dated promise to pay in the currency of the country where the 'exchange' is located...
or other financial transaction between a client and an investment manager
Investment management
Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
. A soft dollar arrangement is one in which the investment manager directs the commission generated by the transaction towards a third party or in-house party in exchange for services that are for the benefit of the client but are not client directed. Soft dollars, in contrast to hard dollars (actual cash), which have to be reported, are incorporated into brokerage fees and paid expenses, which may not be reported directly. Registered Investment Companies generally comply with the limitations detailed in Section 28(e) of the Securities Exchange Act of 1934
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 , , codified at et seq., is a law governing the secondary trading of securities in the United States of America. It was a sweeping piece of legislation...
but hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s, which are generally not registered, are not subject to the limitations of Section 28(e) and thus the client commissions are not necessarily used for the direct benefit of the client.
Background and history
In the brokerage business, soft dollars have been in use for many years. Prior to May 1, 1975, all brokerage firms used a fixed price commission schedule published by the New York Stock ExchangeNew York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
; the schedule was 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 were required to charge a fixed commission and 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 1970s, 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.” and created the Discount Brokerage segment of the industry. 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 Section 28 of The Securities Exchange Act of 1934. Section 28(e) provides a "safe harbor
Safe harbor
The term safe harbor has several special usages, in an analogy with its literal meaning, that of a harbor or haven which provides safety from weather or attack.-Legal definition:...
" for any fiduciary that “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, but Section 28(e) is not a rule it is just a "safe harbor". 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 be able to 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 ERISA have confirmed that institutional brokerage commissions are an asset of the client / beneficiary / principal.
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 1.65 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 difficult to apply Section 28(e) tests and measure Section 28(e) compliance.
Examples
As an 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.The costs of research services are generally not disclosed to the funds' investors. Fully disclosed third-party brokerage facilitates the provision of independently produced research, which may have fewer potential conflicts of interest.An example of illegal use of undisclosed soft dollars might be when a mutual fund manager pays excess commissions and as a quid pro quo
Quid pro quo
Quid pro quo most often means a more-or-less equal exchange or substitution of goods or services. English speakers often use the term to mean "a favour for a favour" and the phrases with almost identical meaning include: "give and take", "tit for tat", "this for that", and "you scratch my back,...
receives an allocation of a hot IPO from his broker (so he 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 have been criticized by securities regulators. Full-service brokerage 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 interest
Conflicts of Interest
"Conflicts of Interest" is an episode from the fourth season of the science fiction television series Babylon 5.-Arc significance:* Garibaldi begins to work for William Edgars. In the process Garibaldi is reintroduced to his ex-girlfriend, Lise, who is currently married to Edgars.* The "Voice of...
and motivate fraud. The lack of transparency in these full-service brokerage arrangements may shield abuses from immediate detection.
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 institutional funds can trade a significant number of shares every 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 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 deteriorate if the benefits of the services are not allocated back to the accounts that paid the extra commissions for the services.
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. In Australia soft dollars are not illegal although they are discouraged and must be disclosed in plain language terms to clients.