Dangerous LiaisonsMichael Schroeder
Last year, BMIG Inc. offered Twentieth Century Mutual Funds the Wall Street equivalent of frequent-flier miles. The Atlanta consultant told Twentieth Century that if it steered some of its stock trading business to an affiliated Wall Street broker, the $27 billion mutual-fund group could have their pick of some 400 services for free.
The services, which ranged from investment research to payment for a $3 million computer upgrade for the trading room, would be paid for by what the Street calls "soft dollars." Under this widespread practice, brokers effectively grant money managers rebates by allowing them to allocate a portion of the commissions they pay when they trade securities to purchase services from outside vendors. According to Greenwich Associates, at least one-third of the $2.4 billion in brokerage commissions spent annually by money managers is converted into soft dollars. Some money managers believe the total is more than $1 billion and expanding every year. "The services available have grown exponentially," says Theodore R. Aronson, a partner at the Philadelphia money manager Aronson & Fogler.
But as the practice--which goes back at least to the 1970s--has grown, so has the controversy surrounding it. Mutual-fund shareholders and pension participants are generally unaware that investment managers can reap big benefits at investors' expense.
A Securities & Exchange Commission rule permits fund managers to use soft dollars for anything that "assists them in the decision-making process," such as research reports which tend to benefit investors. The SEC also accepts use of soft dollars for such fund expenses as custodial services and recordkeeping. But over time, many managers have stretched those boundaries to such services as computers and cellular phones that don't directly benefit investors.
Even when fund managers use soft dollars to pay for legitimate fund expenses, the payments do not show up as an expense of the fund but are rather recorded as part of the price of the securities that the fund buys. As a result, the fund's expense ratio, a key consideration for many investors, will appear lower than it really is.
What's more, investors may be hurt if money managers choose a broker that offers the best catalog of goodies but not necessarily the lowest brokerage commissions or best executions on trades. "The practice is rife with conflicts of interest," says Harold S. Bradley, Twentieth Century's head trader.
DISCLOSURE RULES? That concern led Kansas City (Mo.)-based Twentieth Century to refuse all soft-dollar offers. Indeed, the fund has been fighting questionable soft-dollar practices for years, and it has been a lonely battle--until now. The appointment of Arthur Levitt Jr. as chairman of the SEC has vastly improved the prospects for regulatory changes in the soft-dollar system. "It doesn't feel right or smell right," says Levitt. A strong advocate for the individual investor, Levitt has even suggested banning soft dollars entirely. But the practice is so prevalent that no one believes that's feasible. At least for the near term, new disclosure requirements, which the agency proposed in August, are more likely.
Soft-dollar supporters say the benefits outweigh isolated problems. They argue that research obtained via soft dollars augments in-house research, which helps investors. Some material comes from small boutiques, which "only get paid through soft dollars and couldn't stay in business otherwise," says Howard J. Schwartz, president and CEO of Lynch, Jones & Ryan Inc., a soft-dollar broker.
In a typical soft-dollar arrangement, a money manager agrees to direct orders to designated brokers at a commission price of, say, the current average of 6 cents a share. Typically, the money manager or fund gets $1 of free services for every $1.60 in commissions.
Much of the soft-dollar money goes for investment research. Twentieth Century's Bradley received a list of 581 services, available through a Wall Street brokerage, which included investment research from Standard & Poor's, a unit of McGraw-Hill Inc., which also owns BUSINESS WEEK. Subscriptions to BUSINESS WEEK, The Wall Street Journal, and other publications are also available.
But other services on the list were questionable. Among the "research" providers whose services could be paid for with soft dollars: a Baltimore office-supply store and telephone companies including AT&T, New York Telephone, and Pacific Bell. There's even a lawyer and a doctor on the list whose bills could be paid through soft dollars.
Abuses are relatively rare, insists Lee A. Pickard, a former SEC official and a lawyer representing the soft-dollar lobbying group, Alliance in Support of Independent Research. As evidence, he notes that the SEC has gone after only a handful of firms in the past 20 years.
HARD LESSONS. One recent SEC audit resulted in an enforcement action last November against DeMarche Associates Inc., an Overland Park (Kan.) consultant to pension funds that accepted payment in cash or soft dollars. Regulators said DeMarche charged twice as much for soft-dollar clients as it did for cash customers. The firm settled allegations that it failed to disclose adequately its fees without admitting or denying guilt. DeMarche declined comment.
But many abuses likely go undetected. That's because the SEC doesn't have the staff to audit investment advisers regularly. While mutual funds are reviewed often, the SEC's examination of Twentieth Century's investment adviser unit last year was the first in 35 years, says general counsel William M. Lyons.
Yet if the DeMarche case is in any way typical, it means investors are getting hurt. And it's virtually impossible to ferret out how much, because commissions are not broken out. If a fund buys $1 million in stock and pays $2,500 in commissions, the fund's cost of the stock is listed in reports as $1,002,500. Current practices make it nearly impossible to detect if the fund is paying higher commissions or accepting a less favorable price to earn soft dollars.
Mutual funds aren't the only target of soft-dollar scrutiny. Now, pension plans are striking deals with brokers. Pension-fund managers can buy anything with soft dollars that aids a plan's beneficiaries, such as services of actuaries, trustees, and consultants. But plan sponsors are getting other freebies, including computers and even cash rebates. John Keane, administrator of the $500 million Jacksonville (Fla.) Police & Fire Pension Fund, says his fund gets a cash rebate through certain brokers, including Lynch, Jones & Ryan. Since 1987, more than $700,000 in rebates have been used to pay for the fund's administrative building and a big chunk of operating expenses. "There's nothing soft about getting a check each month," Keane gushes.
MORE SCRUTINY. Not all pension fund executives share Keane's enthusiasm. Cash expenditures are far easier to monitor. "Soft dollars are the dirty little secret in our industry," says M. Steve Yoakum, executive secretary of the Public School Retirement System of Missouri.
What worries investor watchdogs the most is that mutual funds and pension plans may receive inferior trade execution from firms that offer big soft dollars. "Funds may cut commissions to 3 cents, but pay 12.5 cents more for stock than they should have," says Paul G. Haaga Jr., senior vice-president of Los Angeles-based Capital Research & Management Co., which manages 26 mutual funds with $70 billion in assets in the American Funds Group.
Given rumblings in Washington these days, the industry is girding for more scrutiny of soft-dollar practices. Representative Edward J. Markey (D-Mass.) has been pushing for more regulatory control. And after receiving comments on its August proposal, the SEC is expected to require mutual funds to publish soft-dollar expenses in prospectuses. The Vanguard Group, for one, is beginning to disclose that information in shareholder reports. The comments will guide the agency in seeking broad new disclosure of soft-dollar practices of money managers and brokers.
Disclosure is only a mild first step in dealing with soft-dollar problems. Yet if investors start paying attention to the money involved, they might over time start demanding that they, not the managers, reap more of the benefits of the soft-dollar gravy train. If so, Wall Street would never be the same.
THE SOFT-DOLLAR CONTROVERSY
"Soft dollars" are rebates. When a money manager pays a broker commissions to buy or sell securities, the broker in return will often allow the manager to allocate a portion of those dollars to pay for a wide variety of services.
-- Soft-dollar research may enhance investment returns, which benefits mutual fund and pension investors
-- Soft-dollar payments have spawned independent research boutiques that provide innovative and unique research not provided by big brokerage firms
-- Money managers may be getting investors to pay expenses that should come out of their own pockets
-- Money managers may select brokers on the basis of who pays the largest soft-dollar rebates instead of who offers the cheapest brokerage rates or the most favorable trade execution
-- Shifting costs to soft dollars may distort the true cost of running a mutual fund and thus mislead investors