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Commentary: Wall Street's Soft Dollars: Only A Ban Will Do



In almost every industry, a person who accepts payment in return for steering business to a company is deemed to have received a kickback and risks prosecution. Except in the investment-advisory business, where the practice is almost universal and where it costs investors billions of dollars. A recent report by the Securities & Exchange Commission staff found a wide variety of abuses involving legal kickbacks, or what the investment advisory industry calls "soft dollars."

Here's how soft dollars work: A money manager executes a trade and pays a brokerage commission. In many cases, the brokerage commission paid by the money manager is higher than the actual cost of the trade plus a reasonable fee. The spread is soft dollars. The fund manager is supposed to use soft dollars to get research services, such as company reports, news services, or technical charts.

Who pays for the soft dollars? The investors in the fund, who pick up the tab for brokerage commissions. Instead of going to a cut-rate broker, the fund manager patronizes a high-cost firm in order to generate soft-dollar rebates. But if a rebate isn't spent on research--or the research doesn't directly benefit the investors who paid the commission--the higher commission is cash taken out of the investors' pocket.

These relationships are allowed under the 1934 Securities Exchange Act, as long as they are disclosed to investors. But the SEC report found that disclosure is flimsy at best and often nonexistent. The Commission is now considering new rules that would require more complete disclosure and better bookkeeping by both the brokers who refund soft dollars and the investment advisers who receive them. But the focus on cleaning up soft-dollar practices is misplaced. Disclosure is fine, but that's not enough. Congress needs to step in. It's time for the SEC to seek congressional authority to ban soft dollars outright.

An entire industry of soft-dollar-dependent brokers and research suppliers has grown up around this practice. It's so universal that the money-management industry last year recaptured more than $1 billion in commissions. Says Craig S. Tyle, general counsel at the mutual fund trade group Investment Company Institute: "My guess is everybody uses soft dollars to some extent. It's hard to be 100% free from it."

Richmond T. Fisher, chief executive of S&P Securities Inc., derives 100% of his business from soft dollars. But Fisher, whose company, like BUSINESS WEEK, is a unit of the McGraw-Hill Companies, says there's nothing wrong with that. When used properly to acquire research, he argues, soft dollars benefit investors. "Educated investment advice comes from research," he says.

Indeed, most money managers strongly defend soft dollars as their lifeblood. Typically, $1 of credits accrues for every $1.60 worth of brokerage commissions paid. Tyle, however, argues that it would be difficult to separate out the portion of commissions that goes for execution and the portion for research.

The SEC report, though, documents numerous abuses. In an inspection sweep of 280 investment advisers and 75 brokers in the six months ended in April, 1997, 35% of brokers provided, and 28% of advisers received, nonresearch products and services. Soft dollars were used to pay salaries, office rent, telephone services, legal expenses, and entertainment. Virtually all advisers who used their refunds for something other than research failed to adequately disclose it.CLEAN SWEEP? Even among the advisers who stayed within SEC guidelines--and spent their rebates on research-related products--half poorly disclosed their soft-dollar expenses. Says Lori A. Richards, director of the SEC's Office of Compliance, Inspections & Examination, about 20 firms "engaged in egregious fraud" and have been referred to the Enforcement Div. for possible legal action. While Richards will not name any of the companies, she says none were mutual funds.

While the SEC is expected to move quickly to clean up the practice, the agency is partly to blame, says former SEC chief litigator Richard A. Levan, for failing to enforce its own rules. "The less scrutiny, the more opportunity to manipulate the system," says Levan.

There are many ways to make the system more transparent. Wall Street firms could start by unbundling the cost of services that commission fees are supposed to cover. Money managers could be more selective and pay only for those products and services they need to improve their fund's bottom line. And investors could start demanding more information on the hidden costs behind soft-dollar rebating. But only Congress can give the industry a clean sweep overnight by banning soft dollars altogether.By Paula Dwyer

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