Speech by SEC Chairman:
Statement at the Commission Open Meeting Regarding the Proposed Soft Dollar Interpretive Release
Chairman Christopher Cox
U.S. Securities and Exchange Commission
September 21, 2005
The third item on our agenda is a recommendation from the Division of Market Regulation. It is proposed that the Commission publish an interpretive release to provide guidance to money managers who pay "soft dollar" commissions. The release will help money managers understand exactly when it is legal to use their customers' brokerage commissions to pay for "something else" besides brokerage, without violating their fiduciary duty to their customers.
In many ways, soft dollars are an anachronism. They are a throwback to the time of fixed commission rates on securities transactions, which Congress abolished in 1975 - 30 years ago. In the old days, under the high price umbrella of fixed commissions, price competition could occur only in the form of extra services, such as the provision of research. Of course, research is a good thing. So when Congress abolished fixed commissions, it also added a statutory safe harbor, in Section 28(e) of the Exchange Act. The purpose was to clarify that money managers could continue using commissions to pay for research in this new environment of competitive commission rates. The safe harbor provides that a money manager will not violate her fiduciary duty if she uses client commissions to pay for research. But the amount of the commissions still has to be reasonable in relation to the value of the research services received.
The safe harbor's useful purpose is to allow brokers to compete on the basis of research as well as execution services. At the same time, the use of soft dollars, and the lack of transparency in how those soft dollars are spent - and for whose benefit - can present money managers with conflicts of interest, when it comes to choosing what's best for them versus what's best for their investor clients. In implementing Section 28(e), therefore, the Commission has to take great care. Soft dollars can distort the market for brokerage services. They can also distort the market for advisory services. Investors have an interest in knowing actual brokerage and other management costs, and in being able to evaluate those costs, and compare them from fund to fund. Soft dollars can get in the way of that. The Commission's challenge is to minimize these risks to investors, while at the same time preserving the safe harbor's intended benefit of an active market in competitive research.
Over the last 30 years, since the adoption of Section 28(e), the Commission has issued two interpretive releases regarding the scope of permissible research services. The first release was issued in 1976, just one year after the law was enacted. It stated that the safe harbor did not protect "products and services which are readily and customarily available and offered to the general public on a commercial basis." This release was clearly aimed at soft dollar abuses that had nothing to do with research. Among the products excluded from the safe harbor were office supplies, off-the-shelf software, and airline tickets. The second release, issued ten years later in 1986, went the other way: it construed the safe harbor more broadly, to cover research services that provide "lawful and appropriate assistance to the money manager in the performance of his investment decision-making responsibilities." The good news was that this standard provided the industry with greater flexibility to make judgments about how to treat new products and services. But the bad news was that it also opened the door to potentially overbroad readings of the safe harbor, and renewed opportunities for abuses that heightened the conflicts of interest between money managers and investors.
The Commission has continued to study the question of soft dollars in recent years. The world has changed a great deal since our last interpretive guidance. The internet has been invented. Industry practices and technologies have evolved in dramatic ways. The products and services available to money managers have grown far more varied and complex. We now find that in the 21st century money managers are often applying the Commission's 20-year old guidance inconsistently and, at times, in overly aggressive ways. There is a sometimes breathtaking audacity in private determinations of what services qualify for the safe harbor. For example, we have seen soft dollars used to pay for membership dues, professional licensing fees, office rent, carpeting, and even entertainment and travel expenses. The Commission has brought enforcement actions in some of the most egregious cases. But clearly going after these abuses one at a time is not enough. We have got to provide great clarity in our own guidance, and insure that there can be no mistake about how this 30-year old law applies in today's world.
In developing this kind of crystal-clear guidance, we have benefited greatly from the views of other regulators. Last year, the NASD Mutual Fund Task Force published a report recommending that the scope of research services be narrowed, to include only services that principally benefit the adviser's clients, rather than the adviser. And this summer, the Financial Services Authority of the United Kingdom adopted new rules that restrict the use of soft dollars for any purpose unrelated to research and trade execution.
The release we are considering today clarifies that permissible research is restricted to advice, analyses and reports that have intellectual and informational content, and that it does not include operational overhead expenses, such as computer hardware or the salaries of research staff. Permissible research would include market data and other financial and economic data.
With respect to brokerage, the release introduces a temporal limitation - so that permissible brokerage would include only those services relating to trade execution from the point at which the money manager places the order, through the point at which the order is executed and settled. The release also provides guidance with regard to mixed-use items, third-party research, and commission-sharing arrangements. Importantly, the release reiterates the statutory requirement that money managers must make a good faith determination that commissions paid are reasonable in relation to the value of the products and services received.
We are issuing today's release as a proposed interpretation and soliciting comment on whether there are industry practices, technologies or other market developments that the Commission should consider before issuing a final interpretation. I encourage interested parties to send us your views, and I very much look forward to reading the comments on this proposal.
Going forward, the Commission will continue to examine a variety of policy questions surrounding the use of soft dollars, in order to ensure that money managers are acting in the best interests of their investor clients, and that investors are fully and effectively informed of the purposes for which their commission dollars are being spent. In the coming months, the Commission will be considering whether to propose requirements for disclosure and recordkeeping of client commission arrangements, as well as seeking to take final action on the interpretive release before us today.
I would like to thank the staff in the Division of Market Regulation for their hard work on this proposal, particularly Bob Colby, Larry Bergmann, Jo Anne Swindler, Patrick Joyce, Stanley Macel, and Marlon Paz.