Campaign-finance laws have banned the use of "soft-money" donations in political elections -- but an equally slippery form of currency continues to circulate on Wall Street. Under so-called soft-dollar arrangements, money managers overpay on commissions to their brokers, who then use the excess to provide the managers with everything from research reports to Bloomberg terminals. Critics have railed against these thinly disguised kickbacks for decades, and now Congress and the Securities & Exchange Commission are taking a hard look.
The SEC is considering limits on what money managers may buy with soft dollars. A bill sponsored by House Capital Markets Subcomittee Chairman Richard H. Baker (R-La.) would force mutual-fund managers to disclose more about their use of soft dollars and direct the SEC to consider banning the practice.
Here's how soft dollars work, and why many experts think they create conflicts of interest that cost investors billions:
What are soft dollars?
Soft dollars are created when investment managers who buy or sell stocks for a pension, insurance, or mutual fund pay more than the lowest available brokerage commission. Most of them do: Financial experts say that fund managers pay their brokers an average of 5 cents a share in commissions, of which no more than 2 cents represents the actual cost of trading. The managers are supposed to use the excess, the soft dollars, to buy research that the brokers supply from their firm's analysts or from independent shops. Managers can also use soft dollar credits to obtain data feeds, news services, and financial information terminals.
Why do mutual funds overpay so much?
Because of how they report their expenses. Brokerage commissions are subtracted from fund returns, and remain largely invisible to investors. If managers bought their own research, they would have to recover the cost by jacking up their reported fees. Investors compare fees when they're shopping for funds, so hiding the cost of research and other services makes funds look cheaper.
How much money are we talking about?
A lot. A 1998 SEC survey of 280 investment advisers and 75 brokers found that for every $1.70 in commissions paid to a broker, advisers received $1 worth of soft-dollar products and services. By some estimates, soft dollars accounted for nearly three-quarters of the $8.4 billion in total U.S. equity commissions paid in 2002.
This sounds like a kickback. Is it legal?
Soft dollars are an outgrowth of the SEC's ban on fixed commissions in 1975. Before then, research came free as part of the deal. But after the ban, investment advisers feared they could be held in breach of their fiduciary duty if they paid more than rock-bottom commissions. So the SEC created a "safe harbor" to let advisers pay more if they got research in return. Advisers still have to make sure that what they pay is reasonable.
What's the rationale for soft dollars?
Proponents say that investors benefit because soft dollars give advisers access to extensive research that can enhance a fund's performance. "Investors are getting an enormous bargain," says Lee A. Pickard, a lawyer at Pickard & Dijinis LLP in Washington who represents brokers and mutual funds. Others argue that soft dollars support independent research shops that otherwise would have trouble competing against big investment banks such as Goldman, Sachs & Co. and Morgan Stanley.
So what's the problem?
Fund managers have an incentive to overpay, increasing investors' costs. "Advisers might choose broker-dealers on the basis of soft-dollar products and services, not trade execution quality," the General Accounting Office noted in a June report. Also, managers might overtrade to generate soft dollars. "It's an inherent conflict of interest," says ex-Treasury Dept. official Gary Gensler.
Because soft dollars are largely hidden from investors and lightly regulated, they're easily abused. In a June 9 report, Paul F. Roye, director of the SEC's Investment Management Div., said a number of hedge-fund advisers "often use soft dollars to pay for services that are clearly outside the safe harbor, including payment for office operations." The SEC's 1998 study found that 35% of brokers paid for items that had nothing to do with research -- such as cable TV, travel expenses, postage, and even parking fees -- with soft dollars.
Should soft dollars be banned?
Vanguard Group founder John C. Bogle and other investor advocates say yes. But Congress is in no hurry to eliminate a freebie that money managers hold dear. While House Capital Markets Subcomittee Chairman Richard H. Baker (R-La.) has introduced a bill to curb soft dollars, even he stops short of a ban: His bill would give the SEC 18 months to study outlawing soft dollars.
Political reality aside, a ban could decrease competition. Eliminating soft dollars would squeeze many independent research firms at a time when conflicts of interest between analysts and their investment banking brethren have put a premium on untainted research.
Are there other ways to clean up soft-dollar practices?
The SEC is considering banning their use to pay for data terminals and other overhead. Greater disclosure would help, too. "Investors should be able to know what their soft dollars are being spent on and whether they're being spent in their interest," says Scott C. Cleland, CEO of Precursor Group, an independent researcher that derives its revenue from soft dollars. Baker's bill would require mutual-fund advisers to detail soft-dollar purchases in an annual report to fund directors. A spotlight on costs could deter managers from spending more than they need to for investors' sake.
By Amy Borrus in Washington