June 12, 2000
Mr. Jonathan G. Katz
Office of the Secretary
Securities Exchange Commission
450 Fifth Street, NW
Washington, DC 20549
Re: File No. S7-10-00
Dear Mr. Katz:
We appreciate the opportunity to comment on the Commission's proposed new Form ADV disclosure guidelines for investment advisers regarding their brokerage practices and soft dollar arrangements. Specifically, we would like to address the sections concerning Directed Brokerage and Commission Recapture.
The proposed disclosure requirements would require an investment adviser to disclose specific information about directed brokerage and commission recapture arrangements. Item 11 of Form ADV as proposed would require an investment adviser that "permits" its clients to direct brokerage to state that the adviser may be unable to obtain best execution, and that directing brokerage may cost clients more money.
We would like to point out that pension funds direct commissions to commission recapture brokers in order to satisfy their fiduciary duty to lower operating expenses and to insure the receipt of best execution. Contrary to the implication in the proposed disclosure, we are of the opinion that clients who direct trades do receive best execution.
Transaction costs include explicit costs (commissions and taxes) and implicit costs (bid/offer spread, market impact, and operating costs). I have had conversations with senior managers of the two leading providers of transaction cost analyses, Elkins/McSherry (a subsidiary of State Street) and Abel Noser. These providers have concluded that directed trades are of equal quality to trades that are not directed. We are aware of only one study, conducted by the Plexus Group and paid for by its investment manager clients, that concluded that directing trades resulted in inferior execution quality. We note, however, that the Plexus Group's study results were influenced by an old practice known as sequencing. Sequencing, the practice of segregating directed trades from the block and transacting the directed trades after the block, is rarely practiced today. Today, most pension funds choosing to enter into directed brokerage arrangements do so using the execution facilities of the major broker-dealers. Their trades generally are executed as part of the investment adviser's block order and allocated afterward. In practice, the client who participates in a directed trade today receives the exact same average price as the client who does not direct its trades.
As stated above, there is no difference in execution quality between directed and non-directed trades. At most, the Commission's proposed disclosure might be appropriate where a client chooses to direct trades for no tangible benefit in return. Where, however, the client has entered into a commission recapture arrangement, the client receives the same quality of execution and the added benefit of a lower commission cost. Therefore, one can conclude that clients who do not direct a portion of their trades receive the higher all-in transaction cost and are at a disadvantage.
We applaud the suggestion that investment managers help their clients to establish commission recapture programs. As noted above, clients who direct trades are more likely to receive a lower transaction cost and would benefit if they established a well-conceived program. Furthermore, the commission recapture program is likely to be consistent with the managers' own broker selection criteria if they give input at the time that the program is established.
Accordingly, we respectfully request that the Commission decline to adopt the proposal to require investment advisers who "permit" their clients to direct trades to disclose that the adviser may be unable to get best execution, and that directing brokerage may cost clients more money. Under the circumstances, we believe the proposed disclosure would be misleading and a disservice to the advisers' clients, particularly those clients who themselves have fiduciary obligations to reduce transaction costs.
We would be happy to provide further comment as well as transaction cost data or any other information that would be helpful to the Commission.
Kenneth L. Kahn