Advisers misreport use of soft dollars

Jul 24, 2006 @ 12:01 am

By Sara Hansard

WASHINGTON - One week after the Securities and Exchange Commission approved new guidelines governing the use of so-called soft dollars, the commission's top inspections official said that many investment advisers underestimate the benefit they receive from such commission-sharing arrangements.

Many advisers do not take into account the research they receive from affiliated broker-dealers when asked to report on their use of soft dollars, said Lori Richards, director of the SEC's office of compliance inspections and examinations.

"One very common misperception among investment advisers is that when they obtain research from a proprietary broker-dealer, they don't consider that to be a soft-dollar transaction," she said. "That's a misunderstanding. If they are acquiring research with client commission dollars, they're engaged in a soft-dollar transaction."

Although the SEC isn't planning to take action as a result of that "misunderstanding," Ms. Richards hopes the new guidelines on soft dollars will correct the problem, she said.

In fact, 39% of advisers maintain they do not use soft dollars, according to a soon-to-be-released report. A sponsor of that report, based on SEC filings, says the finding suggests that many advisers are confused about what constitutes the use of soft dollars.

"What a lot of investment advisers have thought, and probably still think, is, if I'm not asking for it or if I'm not using it, I don't have to mark yes here," said David Tittsworth, executive director of the Investment Adviser Association in Washington, which is sponsoring the report along with National Regulatory

Services Inc., a Lakeville, Conn., firm that sells materials to help advisers evaluate their soft-dollar compliance.

To come up with their findings, the IAA and NRS reviewed the "ADV" disclosure forms filed by the approximately 10,000 SEC-registered advisory firms.

Although the percentage of advisory firms disclosing soft-dollar use in 2006 - 61% of a total of 6,232 firms - is up from the 58% of firms reporting soft-dollar use in 2005, the increase "may be more the result of the new hedge fund adviser registrations rather than a change by previously registered advisers," Mr. Tittsworth said.

The SEC instructs advisory firms to check "yes" to Item 8E on the ADV form if they receive research or products and services other than execution from broker-dealers or third parties in connection with client securities transactions, which is how the SEC defines "soft dollars."

"Fewer investment advisers mark 'yes' on [Item 8E ] than what we would think" should be answering 'yes' to the question, Mr. Tittsworth said.

SEC officials, he noted, have made it clear that if an adviser uses a full-service broker and pays full commissions for trades, they are "undoubtedly getting something other than execution," he said.

Some advisers who oppose continuation of the soft-dollar system agree that it leads to confusion.

"Are people on the adviser's side aware of whether they're using soft dollars or not?" asked Christopher Van Slyke, a certified financial planner who is managing director of Capital Financial Advisors LLC of La Jolla, Calif. "They probably think they aren't when they use the broker's research."

On Tuesday, the SEC issued restrictions that were approved a week earlier on the use of soft dollars.

Those restrictions are intended to clarify how advisory firms can have liability protection, or a "safe harbor" in regulatory parlance, while using client commissions in brokerage transactions to pay for research.

The biggest change resulting from the new restrictions involves the use of computer systems.

The SEC likely will demand more record keeping and justification by advisers who rely on brokerage trade order management systems that include research as well as administrative and compliance functions, said Lee Pickard, a partner with Pickard and Djinis LLP, a securities regulation law firm in Washington.

"On the compliance side, the use of commissions to obtain that element of the service would not be permissible" as a soft-dollar expense, Mr. Pickard said. "The fiduciary would have to use his own cash to pay for the compliance element of the system," he said.

In addition, "mass marketed" news publications can no longer be included in soft-dollar expenses under the new guidance.

For mutual fund companies and brokerage firms, the guidance should make it easier to follow the rules, several officials said.

"It should be a lot easier to engage in commission-sharing arrangements along the lines of what [U.K.] asset managers are doing right now," said Ethan Corey, senior vice president and associate general counsel of MFS Investment Management in Boston.

Previously, brokers providing soft-dollar research to money managers had to pay for the research, he said. Under the new guidance, money managers can instruct brokers to pay for research out of their soft-dollar credits, which will result in the costs' being more apparent, Mr. Corey said.

Brokers now will "know exactly what they need to do" to follow soft-dollar rules, said Stephen Schardin, president of Charles River Brokerage LLC in Burlington, Mass., a subsidiary of Charles River Development that sells soft-dollar order management systems.

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