THE ALLIANCE IN SUPPORT OF INDEPENDENT RESEARCH
c/o Pickard and Djinis LLP
1990 M Street, N.W.
Washington, D.C. 20036
June 13, 2000
Mr. Jonathan G. Katz
Office of the Secretary
Mail Stop 0609 - - Room 6507
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-10-00
Dear Mr. Katz:
The Alliance in Support of Independent Research is pleased to have this opportunity to comment on File No. S7-10-00, a proposal by the Securities and Exchange Commission ("SEC" or "Commission") and state securities authorities to, among other things, establish an electronic filing system for investment advisers and expand substantially certain required investment adviser disclosures on SEC Form ADV. As a group of broker-dealers furnishing research and other support services to advisers and their clients we focus our comments on the proposed disclosures regarding brokerage practices.
The leading members of the Alliance in Support of Independent Research ("Alliance") include the following broker-dealers:
Boston Institutional Services, Inc.
John W. Gomez, President
Capital Institutional Services, Inc.
Don C. Potts, President and Chief Executive Officer
Fidelity Investments, Institutional Brokerage Group
Richard W. Collett, Vice President
The Interstate Group,
A Division of Wachovia Securities, Inc.
Grady G. Thomas, Jr., President
Westminster Research Associates, Inc.
Richard G. Macris, Managing Director
We believe our members are involved in a significant portion of the arrangements under which fiduciaries such as mutual funds, investment advisers, banks and other money managers are provided with research services and products for the benefit of their managed accounts.
Members of the Alliance share a common interest in fostering a favorable regulatory environment in which research services and products may be furnished to the money management community, and in preserving the umbrella of protection Section 28(e) of the Securities Exchange Act of 1934 provides to fiduciaries who receive all forms of investment research. A primary goal of the Alliance is to promote observance of proper standards under the securities laws for disseminating research and achieving best execution of portfolio transactions for managed accounts. In accordance with this objective, the Alliance is committed to the principle of full and fair disclosure of advisory practices. The Alliance applauds the SEC's efforts to improve the quality of disclosures to advisory clients and provides its comments in hopes of assisting in those efforts.
As noted, this comment letter focuses principally on the SEC's proposed Form ADV disclosure requirements concerning brokerage practices. As set forth below, the Alliance supports some of the proposed requirements, and it also suggests further disclosure in some areas. The Alliance believes, however, that in some instances the SEC's proposed disclosures on these matters unfairly cast aspersions on the practice of advisers obtaining research services for commissions and may have the unintended consequence of discouraging advisory clients from participating in such arrangements. The proposed disclosures are based in part on perceptions (which are embedded in the disclosure instructions) about conflicts of interest between advisers and clients that, in some cases, may be mistaken. Moreover, the proposed disclosures are unnecessarily detailed and rigid as they relate to execution practices. Because the premises of many of the proposed disclosures do not reflect actual industry practice, we believe it helpful to the Commission to first set forth the current standards for the provision of research and other services under directed brokerage arrangements, as well as the manner in which they are provided. Following this, we provide specific comment on the proposed disclosures.
A. The Provision Of Research And Other Services And Their Benefits To Investors
History of Soft Dollar Arrangements and Section 28(e)
The term "soft dollars" encompasses a broad array of brokerage practices. Generally, the term denotes the provision of research and other types of services to managed accounts by broker-dealers in consideration of compensation on portfolio transactions. The term also is used to describe commission recapture arrangements underwhich large institutional accounts contract with brokers to pay the accounts' expenses in consideration of commissions, thereby reducing the accounts' trading costs. The term "soft dollars" is relatively new, but the practice of broker-dealers furnishing research to institutional and retail accounts in conjunction with execution services has a long history in the financial community. Indeed, the practice of providing both trade execution and investment research in exchange for commissions may go all the way back to the opening of the New York Stock Exchange in 1792.
Because broker-dealers are deeply involved in the investment decision-making process through their execution, trading and investment banking activities, it follows that they would also provide research and other advisory service to investors. Several large broker-dealers have annual budgets of $100 million or more devoted to research analysts and evaluation of investment opportunities. Other firms service their institutional accounts by providing research services and analytical tools developed or authored by organiza tions that are independent of the broker-dealer furnishing the service. The value of such "third-party" research purchased with soft dollars is estimated to exceed $1 billion annually. The vast preponderance of research and financial services available to investors has been disseminated by the Street as part of the portfolio execution process.
During 1996-97, the SEC staff conducted a wide ranging examination of advisers' soft dollar practices and disclosure.1 The staff conducted on-site inspections of the softdollar activities of 75 broker-dealers and 280 investment advisers, covering $274 million in soft dollar payments for third-party research, estimated to represent between 32% and 41% of all soft dollar commissions paid for third-party research by advisers from January through October 1996. The staff concluded that almost all advisers examined by it obtain products and services (both proprietary and third-party) other than pure execution from broker-dealers and use client commission to pay for those products and services. The staff also concluded that most products and services obtained by advisers fall within the definition of research -- that is, that they provide lawful and appropriate assistance to the adviser in the performance of its investment decision-making responsibilities and therefore fall within the Section 28(e) safe harbor.
Payment for Research Services and the Origins of Soft Dollars
Fiduciaries such as investment advisers and portfolio managers, as well as investors acting on their own behalf, are inclined to give a portion of their order flow to broker-dealers who can assist in the investment decision-making process by providing valuable investment ideas or tools. Brokers receive commissions or other forms of compensation on securities transactions, instead of cash, as payment for the execution and research services they furnish to investors. For some time, investors have almost universally preferred this bundled approach for acquiring investment research. Like manyother types of businesses, securities market participants have elected for reasons of economic efficiency and competitive pressures to transact business for combined services (i.e., executions and research) for one charge.
Legal Underpinnings of Soft Dollar Arrangements
Federal law, regulations and interpretations of the SEC and other governmental bodies, as well as private contractual agreements, are the foundation for soft dollar arrangements, which generally take one of two forms: "Section 28(e)" arrangements and "directed brokerage" arrangements.
Provision of Research Under Section 28(e) Of The Securities Exchange Act of 1934
The principal form of soft dollar arrangement is one in which a broker-dealer provides research services to a fiduciary, such as an investment adviser or bank, who manages other people's money. In such an arrangement, the fiduciary seeks and uses the research to assist in the investment decision-making process on behalf of account beneficiaries. The beneficiary pays for the research indirectly with commissions on portfolio transactions that the broker-dealer effects for his or her account.
Commission rates on exchanges have been competitive only since 1975. Before that time, commission rates on portfolio transactions generally were fixed by law and had been throughout the history of the New York Stock Exchange. Under the old fixed rate system, money managers were able to obtain research through expenditure of theiraccounts' commissions without incurring additional costs to the accounts, since commission rates were the same regardless of whether the broker-dealer provided research. Because commission rates were fixed by law, the practice of providing research services to fiduciary accounts eventually became very prevalent, since brokers recognized the need to compete for orders on the basis of services rendered. In this way, brokers came to provide necessary support for the professional fiduciaries' internally-developed advisory functions. The business relationships and expectations that evolved between fiduciaries and their accounts continue today in the era of competitive commission rates.2
When commission rates on exchanges were made competitive in 1975, a large segment of the investment community was concerned that the flow of research would be restricted. Money managers feared that fiduciary principles would or could require fiduciaries to operate under the principle that "cheapest is best" and that only the lowest cost execution would avert a lawsuit for failure to obtain best execution. In response to these concerns, Congress passed Section 28(e) of the Securities Exchange Act of 1934, a safe harbor for fiduciaries who receive research services in consideration of portfolio commissions, to ensure the continued availability and quality of research in the competitivecommission rate environment. The Congressional hearings on this provision reflect the notion that without Section 28(e) protection, the flow of research previously furnished to institutions under a fixed commission rate structure could be cut off to the detriment of investors.3
Both Congress and the SEC have taken steps to ensure that the legal standards under which brokers provide research to fiduciaries protect the interests of investors. Section 28(e) itself limits the definition of "research" that can be obtained for commissions, and requires the fiduciary to determine that the commissions paid are reasonable in relation to the research and brokerage services provided. The SEC also has placed limits on the manner in which broker-dealers may provide research under Section 28(e) by, for example, prohibiting the use of compensation on principal transactions to pay for research. In addition, the law requires investment advisers and mutual funds to disclose their brokerage arrangements to investors.
Directed Brokerage Arrangements
Another common form of soft dollar arrangement is frequently referred to as a "directed brokerage" arrangement, or sometimes as "commission recapture." These terms denote an arrangement in which an account such as an employee benefit plan or mutual fund directs portfolio transactions (either directly or through a money manager) to a particular broker-dealer who has agreed to provide services to the account. In thesearrangements, the service is provided not to the fiduciary but to the account itself. For a variety of reasons, this type of arrangement does not fall within the safe harbor of Section 28(e). The terms of a directed brokerage arrangement are reflected in contracts between the participants to the arrangement.
Directed brokerage arrangements also are beneficial to investors. An account may enter into a directed brokerage relationship with a broker-dealer based on the belief that it can effectively reduce its costs through the portfolio execution process. Directed brokerage arrangements also have had the positive effect of putting downward pressure on execution costs. The value of services that broker-dealers furnish to accounts is an indirect form of commission discounting, which benefits the investor directly.
Because Section 28(e) coverage is unnecessary for a directed brokerage arrangement, the range of services that a broker-dealer provides under such an arrangement may go beyond research to include consulting, custodial or accounting fees, or even administrative expenses of the account such as rent, salaries, or telephone expenses.4 The latter type of expenses (e.g., rent, telephone, etc.) sometimes is cited incorrectly in financial publications or public statements as an example of abuse in the soft dollar area. In fact, use of directed brokerage for these expenses amounts to nothing morethan an investor seeking to reduce the ongoing expenses of the fund or plan by negotiating with a broker for additional services in exchange for brokerage commissions.
Benefits To Investors From Soft Dollar Arrangements
Investors reap a number of benefits from the kinds of soft dollar arrangements described above:
One of Congress's principal objectives in adopting Section 28(e) was to ensure "the future availability and quality of research and other services" to the investment community.5 Congress adopted Section 28(e) to address the concern that investors would suffer if competitive commission rates were to impede the flow of research services to money managers. Events over the past 25 years demonstrate that Section 28(e) has indeed facilitated the flow of research to investment managers.
Broker-dealers now provide literally hundreds of research services to money managers to assist in the investment decision-making process. The vast majority of these research services have only become available to money managers since Congress adopted Section 28(e) in 1975. These services include not only investment informationbut fundamental databases, portfolio modeling, and strategy software. Equally significant, the technology for the delivery, formatting, and use of information has made research more accessible to the investor and has added greatly to market efficiencies. Technology decisions relating to the investment process have become extremely important as money managers today face growing market complexities and information needs.
By becoming major competitors for institutional order flow, research brokers have exerted downward pressure on commission rates. Since commission rates became unfixed in 1975, execution costs have declined significantly, running on average, according to the SEC staff's 1998 Inspection Report on the Soft Dollar Practices, of Broker-Dealers, Investment Advisers and Mutual Funds (the "1998 Inspection Report"), at about 6¢ per share for those institutional accounts examined by the SEC staff.
In its deliberations on Section 28(e), Congress recognized that without highly developed internal research departments, smaller money management firms might be required to rely entirely on "Street" research. According to the Congressional record on Section 28(e), by gaining access to research that broker-dealers provide, small investmentmanagers could serve their clients without feeling pressure to charge higher fees than a large money manager would charge.6
What was true in 1975 is true today. Many startup investment advisers cannot establish their businesses and compete against larger money managers (who command large fee bases from which they can sustain in-house research) without access to the research services that broker-dealers provide for portfolio commissions. Section 28(e) has facilitated small firms' entry into the investment advisory business. Included in this category are firms that may not have significant capital resources but have been able to obtain the technology-oriented research and other investment services with which to compete with larger fiduciaries for access to ideas and strategies. These observations were confirmed by the SEC staff's 1998 Inspection Report. Smaller advisers generating less than $100,000 in commissions used over 50% of their commissions for soft dollar research, contrasted with larger money managers generating more than $100 million in commissions, which used only 8% of their commissions for soft dollar research.
How Investors Are Assisted In Soft Dollar Arrangements
A money manager's receipt of research services from a broker-dealer for commissions occurs under the statutory guidelines of Section 28(e). The conditions of Section 28(e) coverage were fashioned so as to protect investor assets and insure the use of research obtained with client commissions for the benefit of the investor.
Under a proper Section 28(e) arrangement, a fiduciary may use commissions only to acquire services that are useful in the investment decision-making process. A fiduciary may not, for example, use commissions for administrative expenses without being exposed to liability under various laws. If a research service to be obtained for portfolio commis sions has the potential to provide administrative or non-research assistance to the money manager, Section 28(e) guidelines require the money manager to allocate the cost of the service according to its use. Where a research service has a "mixed-use," only that percentage of the service attributable to the investment decision-making process may be paid for with commission dollars. The fiduciary must use its own resources to pay for that portion of the service that provides non-research assistance to the fiduciary. Further, a fiduciary may not use commissions to acquire research unless it has investment authority over the account.
A fiduciary who uses commissions to obtain research must determine in good faith that the commissions are reasonable in relation to the brokerage and research services received. In this way, Section 28(e) provides protection only where the beneficiary receives fair value for its commissions. Moreover, the SEC has determined that only commissions on agency securities transactions support a proper arrangement under Section 28(e). A money manager may not obtain research with principal trades, where thecompensation a broker-dealer earns is not as readily identifiable as a commission payment.
Current SEC disclosure requirements for advisers have also worked to protect investors' assets in soft dollar arrangements. Even where a soft dollar arrangement falls within Section 28(e), the SEC requires a registered investment adviser to disclose its brokerage allocation practices on its Form ADV. Registered investment companies are required to make similar disclosures in their registration statements.
An investment adviser has a fiduciary duty to act in the best interest of its clients. As a fiduciary, an adviser has a duty to disclose to his investor clients all potential or actual conflicts of interest that might influence him, consciously or unconsciously, to render advice that is not disinterested. The potential conflict of interest that arises when an adviser receives research as a result of allocating brokerage on behalf of investors led to the SEC's requirement that an adviser disclose all basic information about the provision of research to investors. Through these disclosures, the investor is given sufficient information to judge whether the use of his commissions for research is in his best interest and whether he is being properly served by his adviser.
Another important disclosure requirement is found in Rule 10b-10 under the Securities Exchange Act of 1934, which requires brokers to indicate the capacity in which they act when executing a transaction for an investor. When a broker acts as agent, Rule10b-10 requires disclosure of the amount of commission. When the broker acts in a principal capacity, the rule in some cases requires disclosure of the markup. Through these disclosures on confirmations, money managers and clients are given the opportunity to monitor the reasonableness of their commissions.
In addition to required disclosures, competitive pressures and business practices have led broker-dealers who provide research services to produce customer statements indicating the value of the research provided to the customer and the aggregate commissions used to pay for the research. This type of accountability has made the research dissemination process more efficient and has benefitted the fiduciary and its accounts by bringing them accurate cost and benefit information.
In short, there currently is a great deal of information available to fiduciaries and investors regarding brokerage commission arrangements and research services. In its 1998 Inspection Report, the SEC staff found that many advisers' disclosure of their soft dollar practices was inadequate in that it did not appear to provide sufficient information to enable a client or potential client to understand the adviser's soft dollar policies and practices, as required by law. Accordingly, the staff recommended that the SEC modify Form ADV to require more meaningful disclosure by advisers, particularly regarding non-research products received for commissions. In evaluating the sufficiency of adviser disclosures, however, it is important to recognize that soft dollar arrangements involve the institutional portion of the securities business in which highly informed investors have theexperience and sophistication to assess the information and weigh the advantages and disadvantages of a specific arrangement.
While directed brokerage arrangements do not fall within Section 28(e), the parties to these arrangements have a contractual understanding of the responsibilities of each side. For example, a pension plan or mutual fund might agree to send a specific amount of commissions to a broker in exchange for consulting or other administrative services. Both the broker and the investor may trace commission payments and the cost of the services to ensure that the other party has performed in accordance with its contractual obligations.
In addition, where an account or plan has directed a money manager to execute portfolio transactions through a particular broker in exchange for services, the money manager (particularly if it is an investment adviser), would be required to make the type of disclosures discussed above. A mutual fund that "recaptures" part of its portfolio costs in the form of services (e.g., custody or transfer agency fees) from a broker is obligated under SEC rules to report the cost of the services as an expense in its statement of operations and other financial statements.
The Department of Labor has issued a clarification of the responsibilities of a pension plan governed by ERISA where the plan elects to have a broker pay some of its expenses. ERISA plans using directed brokerage arrangements must determine initiallythat the broker-dealer is capable of providing best execution; monitor the plan's portfolio transactions on an ongoing basis for best execution; and determine that the amount paid for portfolio execution and other service is reasonable in light of the total services the plan has received. In addition, the services obtained with commissions should be of the type for which the plan otherwise would be obligated to pay, as well as necessary for the operation of the plan. Moreover, under ERISA, all services procured pursuant to such a directed brokerage arrangement must be used for the exclusive benefit of the plan and its beneficiaries. Managers of accounts or plans involved in directed brokerage arrange ments for the provision of non-research services may not use portfolio commissions of one account to pay for services or expenses of another account.7
In summary, parties to directed brokerage arrangements may ensure that each participant receives that to which it is entitled by contract and under government regulations.
B. The SEC's Investment Adviser Disclosure Proposals
In the process of creating an electronic filing system for investment advisers, which will require an adviser to make more disclosures generally about its business practices, fees and potential conflicts of interest with clients, the SEC has taken the opportunity to call for substantial new disclosure requirements concerning advisers' selection of brokers,payment of commissions and other compensation to broker-dealers, the provision of research services, and the direction of portfolio trades for client services.8
The SEC proposes to revise extensively the format of advisers' disclosure requirements. Under the proposed rules, each adviser will be required to give clients a narrative brochure written in plain English. The new proposed rules under the Advisers Act specify the disclosure required in the brochure, but advisers generally would be free to structure the disclosure and order the topics in a manner that best coveys the required information. The new adviser brochures would be organized in two parts, consisting of a firm brochure and a brochure supplement for each individual who provides advisory services to clients on the adviser's behalf. Advisers would be required to deliver a brochure to each client, and would be required to deliver an individual's supplement only to those clients to whom that individual will provide advisory services. The SEC proposes to require that updates to the brochure be delivered to clients whenever information in the brochure becomes materially inaccurate.
The new brochure must address 19 separate items, each of which elicits required disclosure on a distinct topic. The items include background information about the advisory firm, fees and compensation charged, types of clients, method of analysis and investment strategies, disciplinary information, affiliations, participation or interest in client transactions, brokerage practices, soft dollar practices, client referrals, transaction costs,directed brokerage, payment for client referrals, custody of client assets and other types of information. Of significance, a number of these brochure topics will have an important bearing on the execution and soft dollar practices of investment advisers.
Brokerage Practices (Item 11 Of The New Disclosure)
Under the proposed revised disclosure standards, an investment adviser would be obligated to tell clients a great deal more about its brokerage placement and soft dollar practices than under current standards. Specifically, an investment adviser would be required to describe in expanded fashion its practices regarding transaction-based compensation, execution procedures, soft dollar arrangements and conflicts of interest that might arise in the context of these practices.
SEC's Position On Soft Dollars As Stated In The Release
The SEC maintains that when, in connection with client brokerage, an adviser receives products or services that it would otherwise have to produce itself (or pay for), the adviser's interest may conflict with those of its clients. The SEC maintains, for example, that soft dollar arrangements may cause an adviser to violate its best execution obligations by directing client transactions to brokers who are not able to execute the transactions adequately, or may give the adviser an incentive to trade client securities more often than it would absent the benefits it receives. Because of these perceived conflicts, the SEC proposes to require advisers to disclose their policies and practices onthe use of client brokerage to obtain soft dollar benefits. These disclosures are detailed in Item 11 of Part 2 of Form ADV to be incorporated into the brochure delivered to clients.9
Comment On Specific Proposed Disclosures Regarding Brokerage Practices
The SEC's proposal would require an adviser to disclose the following specific brokerage practices:
Directed Brokerage And Commission Recapture
Form ADV disclosure requirements, if modified as proposed, would obligate an investment adviser to disclose specific information about directed brokerage and commission recapture arrangements:
Negotiation of Brokerage Commissions
* * * *
We hope these comments assist the Commission and its staff in formulating meaningful disclosure by advisers concerning their portfolio execution practices. Members of the Alliance would appreciate the opportunity to meet with the staff to assist in formulating appropriate disclosure provisions. Please call Lee A. Pickard or Laura Walker at 202-223-4418 if you have any questions.
The Alliance In Support Of Independent Research
By: Lee A. Pickard, Esq.
Pickard and Djinis LLP
Counsel to The Alliance
In Support Of Independent Research
cc: Hon. Arthur Levitt
Ms. Annette L. Nazareth
Director, Division of Market Regulation
Mr. Robert L.D. Colby
Deputy Director, Division of Market Regulation
Ms. Catherine McGuire
Associate Director/Chief Counsel
Division of Market Regulation
Mr. Paul F. Roye
Director, Division of Investment Management
Mr. Robert E. Plaze
Associate Director, Division of Investment Management
|1||Inspection Report on the Soft Dollar Practices of Broker-Dealers, InvestmentAdvisers and Mutual Funds, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission (September 22, 1998).|
|2||According to the Senate Committee Report accompanying the Securities Act Amendments of 1975, which included Section 28(e), existing investment management relationships, including the size of the management fee, were based, in part, on an environment that enabled the manager to obtain research and other services from broker-dealers, which services were paid out of portfolio brokerage and were not an expense of management. In addition, certain state laws, regulations, and customs regulated the maximum administrative expenses chargeable to a trust estate, mutual fund, or other managed portfolio in contemplation of the fixed rate environment.|
|3||Securities Act Amendments of 1975, Report of the Comm. on Banking, Housing and Urban Affairs, S. Rep. No. 75, 94th Cong., 1st Session 71 (1975).|
|4||Any service that the account could properly pay itself generally may be furnished by a broker for compensation on account transactions under a directed brokerage arrangement.|
|5||Report of the Comm. On Banking, Housing and Urban Affairs, S. Rep. 94-75 (1975).|
|6||Report of the Comm. On Banking, Housing and Urban Affairs, S. Rep. 94-75 (1975).|
|7||This contrasts with soft dollar arrangements under Section 28(e), which permits commissions on agency transactions for one account to be used for research that also benefits other accounts.|
|8||See SEC Release No. IA-18602 (April 5, 2000).|
|9||The SEC states in the Release that the proposed description in the brochure regarding soft dollar practices must be specific enough for clients to understand the types of products or services the adviser is acquiring and to permit them to evaluate conflicts. Disclosure must be more detailed for products or services not used in the adviser's investment decision-making process. This would appear to be the standard under which advisers currently operate with respect to the disclosure of services obtained for portfolio compensation.|
|10||Commission recapture is defined in the disclosure proposals to mean a program that permits a client, rather than the adviser, to receive benefits (including cash rebates, products, services, and expense payments or reimbursements) from broker-dealers in connection with that client's securities transactions.|