Critics slam limits on independent research

Nov 7, 2005 @ 12:01 am

By Gregory Crawford

NEW YORK - Money managers could be shortchanging their investors by limiting the amount of independent investment research they are willing to pay for, critics of such limitations charge.

"This is a case where the tail is wagging the dog," said Scott Cleland, founder and chief executive of Precursor Group Inc., a Washington-based independent-research firm. "Normally, research is supposed to be paid based on performance and based on need. A cap is an arbitrary non-performance, non-need-based restriction that's blatantly discriminatory."

New SEC guidance on using commissions to pay for research clearly puts independent research on par with brokerage house research. But Mr. Cleland said the practice of setting a cap, either formally or informally, is rampant.

"It's the nemesis of our business," added John D. Meserve, president of BNY Research, Commission and Payment Services LLC of New York, a unit of The Bank of New York Co. Inc. "There are deep-seated urban myths or a view that when the SEC does examinations, there's an acceptable level of what you pay for third-party research."

The use of independent research varies from manager to manager "depending on where on the spectrum you fall," said Michael R. Rosella, partner at the Los Angeles-based law firm of Paul Hastings Janofsky & Walker LLP and chairman of its investment management practice group.

'A competitive thing going on'

Mr. Rosella said he knows of some smaller money managers that view independent research as critical to their investment process.

"There's a competitive thing going on here, too," he said. "It is easier for the bigger firms to be more pristine about these issues. Some say they won't use soft dollars, others say they won't use third-party research."

Mr. Rosella added that smaller money managers have less flexibility in how they handle research, because they have fewer commission dollars to work with.

Joseph C. Gawronski, chief operating officer at pure agency broker Rosenblatt Securities Inc. of New York agreed.

"Larger firms already have more research on staff and have pricing power," he explained. "For instance, if they're already paying a broker $50 million a year for execution and research, and now say they're going to pay only $40 million for execution and $5 million more for research, is the broker really going to say no? How does a 10-person money management shop that pays $1 million a year pull that off?"

Industry executives said the main reason money managers limit the amount of independent research they use is because of how they pay for that research. Many independent-research firms do not have brokerage relationships; that makes it impossible for them to be paid with commission dollars, better known as soft dollars, which is the norm.

Typically, a money manager will receive execution services - stock-trading services - and research for a "bundled" commission rate. The brokerage firm will internally split that commission between trading and research.

For independent-research firms that have relationships with brokers, the broker handles execution and receives the bundled commission rate. The research firm provides the research and receives payment from the broker. Independent firms that do not have a relationship with a broker need to get paid with hard dollars.

"Theoretically there's no difference between bulge-bracket research and independent research. They should be treated by money managers the same way under section 28(e)'s safe harbor, but the fact is they're not," Mr. Gawronski said, referring to the section of the Securities Exchange Act of 1934 that governs soft-dollar practices, which the SEC clarified in its latest guidance.

The SEC on Oct. 19 issued official guidance on revised regulations of soft-dollar arrangements that seeks to tighten the definitions of what research and services can be paid for with commissions under the Section 28(e) safe harbor clause.

The guidance, which is open for public comment until Nov. 25, also makes clear that independent research and brokerage research should be treated the same. The SEC is considering issuing further guidance on disclosure and transparency of soft-dollar arrangements.

"It's much more difficult finding a way to get paid as an independent-research provider than it is as a bulge-bracket firm," Mr. Gawronski said. "No one wants to increase their use of soft dollars, and no one wants to write checks."

One broker, who asked not

to be identified, said the issue boiled down to something entirely different.

"No one wants to write a check for $100,000 ... that's $100,000 less they can spend on bonuses," he said. "If it comes out of commissions, the investors pay."

If research is not paid with commissions, investors still could end up footing the bill, said Jonathan Boersma, standards of practice director at the CFA Institute in Charlottesville, Va.

"Research is going to get paid for one way or another," he said. "If it's getting paid for with client commissions, OK, and if that doesn't happen, either the firm pays out of its own pocket and takes a hit to the bottom line, or it raises fees to investors.

"It's going to come from some place. We're in favor of transparency in where it's being paid," Mr. Boersma said.

Mr. Cleland of Precursor said better clarity of what soft dollars can be used for might go a long way toward ending the practice of caps on independent research.

Uncertainty lifted

"The guidance lifted a lot of the regulatory uncertainty, because the SEC roundly rejected calls to ban soft dollars or curb their use for research or third-party [independent] research," Mr. Cleland said. "These types of caps appeared in a period of regulatory uncertainty, and hopefully now that that uncertainty has been lifted, people will realize that caps can put them at a competitive disadvantage."

The other development that might lead to a change in managers' use of independent research is Boston-based Fidelity Investments' decision to pay for research from Lehman Brothers Inc. in New York with hard dollars rather than commission dollars.

"In this case we're going to pay for research [with hard dollars] and we're trying to work out similar agreements" with other brokers, said Anne Crowley, a Fidelity spokeswoman. "We might do that with brokers that supply us with third-party research. The intention would be that we still want to take advantage of that research."

But while Fidelity's move might help independent-research shops, it might hurt smaller money managers.

"Today, with bundled commissions, you're paying for research and execution, but if going forward you're going to have to pay for research out of operating expenses, that will obviously pressure margins," said Rosenblatt's Mr. Gawronski. "The margin contraction that asset managers experience should theoretically affect smaller money managers more than larger ones."

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