WASHINGTON — The debate over abolishing or reforming the practice of soft dollars to curb perceived conflicts of interest was reopened recently, and some industry experts are considering the potential effect on hedge funds should the discussion reach Congress.
In a recent letter to the chairmen of two congressional committees, Securities and Exchange Commission Chairman Christopher Cox said that soft-dollar arrangements “hurt investors.” They compromise a money manager’s fiduciary obligation “by inducing it to direct trades to broker-dealers offering research that the money manager wants,” rather than executing trades in the client’s best interests, he said.
Mr. Cox added that the desire to build up soft-dollar credits can lead to overtrading in clients’ portfolios and that managers use one client’s commissions to buy research useful for other clients.
However, not everyone agrees that soft dollars harm investors.
David Friedland, president of the Washington-based Hedge Fund Association, said soft dollars “benefit investors in hedge funds.”
The practice allows
hedge fund managers to receive services “at lower cost, as opposed to charging the fund an extra managing, servicing or consulting fee,” he said. Further, brokerage firms that provide the services are heavily regulated, which protects against abuse, added Mr. Friedland, a principal of Magnum U.S. Investments Inc., an Aventura, Fla.,
hedge fund company with $500 million under
management.
Currently, hedge funds, which are not required to be registered with the SEC, do not have to comply with regulations strictly limiting soft-dollar use for research and requiring disclosures.
Spokesmen for the House Financial Services Committee and the Senate Banking Committee said they are reviewing Mr. Cox’s letter.
Personal mission
“Primarily, this is motivated by a desire to bring hedge funds under regulation,” said Bill George, president of Blue Sky Research Services, a consulting firm in Encino, Calif.
He has made soft dollars something of a personal mission, writing frequently to the SEC and other groups about the issue.
Independent-research providers have argued vehemently against disbanding the soft-dollar system. They fear they will be put out of business if investment advisory firms no longer can get their research using commissions.
The primary problem with soft dollars is the lack of SEC enforcement of clear disclosure about them, Mr. George said. “You’ve got full-service brokers trading all kinds of favors for order flow. They’ve been selling crappy mutual funds, because they make money from commission dollars,” Mr. George said. “The third-party [-research] business has been wrongly blamed. They disclose soft dollars.”
Last week, when asked about soft dollars, Mr. Cox told InvestmentNews that he doesn’t want to harm investment research. “Our aim is to encourage the provision of more research and to ensure that more dollars, not less, will get to that area,” he said. “Research is important. Investors want it and will pay for it,” Mr. Cox added.
Not everyone agrees that attention from Congress will lead to regulation of hedge funds’ use of soft dollars. If Congress prohibits use of soft dollars, “hedge funds would have a greater ability to obtain research for soft dollars than any of their competitors,” including mutual funds, said Lee Pickard, a partner with Washington law firm Pickard & Djinis LLP, which represents hedge funds, mutual funds and brokerage firms.
A hearing tentatively is planned by the House Financial Services Committee June 26, at which Chairman Barney Frank, D-Mass., will be questioning Mr. Cox about whether the SEC is doing enough to protect investors.
“It is clear that Cox wants to either reset the agency or he wants to reposition the SEC as a friend of the investor,” said Michael Mayhew, chairman and co-chief executive of soft-dollar consulting firm Integrity Research Associates LLC in New York.
“The fact that there will be hearings and a lot of focus on this may create more urgency for the [Investment Company Institute in Washington] and the [Securities Industry and Financial Markets Association in Washington and New York] to come up with a more appropriate disclosure regime,” Mr. Mayhew said.
“The time is ripe for a comprehensive review of soft dollars,” said ICI spokesman Ed Giltenan. “In its examination, Congress and the SEC should ensure that all investment advisers, not just advisers to mutual funds and [Employee Retirement Income Security Act] pension plans, are subject to the same rules regarding the use of soft dollars. A level playing field will help ensure that all investors receive the same level of benefits and service from broker-dealers.”
“All advisers, regardless of whether they are registered or not, should be subject to the same rules,” said Henry Hopkins, chief legal counsel of Baltimore-based mutual fund company
T. Rowe Price Group Inc.
About 60% of the more than 10,000 investment advisory firms regulated by the SEC use soft dollars, including advisory firms that work primarily with individuals, as well as firms that manage mutual funds, according to the Investment Adviser Association in Washington.
