I-1.13 Soft-Dollar Arrangements: Do they present Conflicts of Interest?

 

 

 

I.         INTRODUCTION

  

In May 2007, the former Chairman of the Securities and Exchange Commission (“SEC” or the “Commission”), Christopher Cox, urged the U.S. Senate and House of Representatives to consider legislation to repeal or at least revise soft-dollar regulation.^[4]  In a letter to the U.S. Senate Banking Committee Chairman Christopher Dodd, Mr. Cox said that “soft-dollar arrangements create a conflict between a money manager and its clients, compromise a money manager’s fiduciary responsibility by inducing the manager to direct trades to broker-dealers that offer research the manager wants, instead of to the broker-dealer that could best execute the client’s transactions, and encourage overtrading of client portfolios in an effort to generate soft-dollar credits.”^[5]  These “troubling”^[6] practices as the former SEC Chairman referred to them, known as soft-dollar arrangements or soft commission arrangements, generally arise when an asset manager receives goods and services (e.g., research) from a broker-dealer in exchange for placing securities transactions with that broker-dealer. “The “soft” label is used because the asset manager does not pay for the goods and services separately with cash, but obtains them with what have been termed ‘inflated brokerage commissions’”.^[7]  The soft-dollar arrangements can present a conflict of interest for the asset manager which obtains benefits for itself through the use of its clients’ assets. By doing that, the manager could be viewed as breaching its fiduciary duty or best execution obligations. The use of these arrangements to pay for goods and services other than execution lacks transparency. This makes it difficult for clients to establish whether the asset manager is acting in their best interests or obtaining sufficient value for money on their behalf, or just engaging in excessive trading of clients’ portfolios to obtain soft-dollar benefits, as Mr. Cox emphasized.

U.S. and E.U. securities regulators have been concerned about, and have debated, these controversial practices and the potential, some would say “inherent”, conflicts of interest for years. How have they reacted to the potential conflicts of interest create by soft-dollar arrangements? In the United States, Section 28(e) of the Securities Exchange Act of 1934 (the “Exchange Act”) provides a “safe harbor” to protect fund advisers and other asset managers from criminal actions and civil suits for breach of fiduciary duty when they use soft-dollar commissions. To adapt to market developments and respond to market participants’ concerns, the Commission has provided interpretative guidance to clarify the scope of application of Section 28(e). 

Facing similar challenges, E.U. regulators, with a view to harmonize soft-dollar practices^[8] across its Member States, included soft-dollar arrangements in the directive 2004/39/EC in Markets in Financial Instruments Directive (“MiFID”). The U.K. securities regulator, the U.K. Financial Services Authority (“U.K. FSA”), inspired the work of E.U regulators in connection with soft-dollar arrangements. 

The problem with soft-dollar arrangements is that they mix the cost of research with the costs of trading and then eclipse the transparency that is desirable to have in the markets and an accurate analysis of transaction costs. The potential conflicts of interest presented by soft-dollar arrangements require a permanent monitoring and reaction from regulators to advances in technology and evolution in market structure. As financial markets become more global, many U.S. market participants have a significant presence abroad and the soft-dollar regulations constitute also a challenge for market participants to comply with multiple regulatory regimes. 

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II.        U.S. Approach: Section 28(e) of the Securities Exchange Act of 1934 and     Interpretative Guidance

 

1.      Origins of Section 28(e) “Use of Client Commission Dollar”: Safe-Harbor

 

In late the 1960s and early 1970s, after several brokerage firms collapsed and went out of business, pressure grew at the SEC and the U.S. Congress to examine the then current practices of stock exchanges and brokerage firms. This led to an examination and subsequent abolition of fixed minimum commission rates, a form of public price fixing.^[9]  “In the era of fixed rates, when broker-dealers could not compete on the basis of services including non-execution services that they could charge for executing orders, they competed on the basis of services including non-execution services that they could offer.”^[10]  These non-execution services included research.

In 1975, the SEC adopted Rule 19b-3 under the Exchange Act and the U.S. Congress passed legislation, both abolishing fixed commission rates. The intention behind this regulatory change was to allow stock markets and brokerage firms to adapt to changing events. However, the elimination of fixed commission rates raised concerns on the asset managers and broker-dealers sides on how asset managers will allocate research services without breaching their fiduciary duty vis-à-vis their clients, and how broker-dealers providing brokerage and research services will compete with broker-dealers providing execution-only services. To address these concerns the U.S. Congress decided to allow asset managers to continue paying for research through commission dollars in a bundled manner and included a safe harbor in the Securities Acts Amendments of 1975, codified as Section 28(e) of the Exchange Act (“Section 28(e)”).  

Section 28(e) provides a “safe harbor” for asset managers who use a client’s commission dollars to obtain investment research and brokerage services from broker-dealers if certain conditions are met. “The safe harbor provides generally that a money manager does not breach his fiduciary duties under state or federal law solely on the basis that the money manager has paid brokerage commissions to a broker-dealer for effecting securities transactions in excess of the amount another broker-dealer would have charged, if the money manager determines in good faith that the amount of the commissions paid is reasonable in relation to the value of the brokerage and research services provided by such broker-dealer.”^[11]  The safe harbor allows asset managers to pay higher commissions on behalf of a client than otherwise are available to obtain brokerage and research services, if asset managers make their good faith determination regarding the reasonableness of commissions paid.^[12]  “In making this good faith determination, an adviser may consider not only the benefit to be derived by the account paying the commissions, but also the benefits derived by other accounts. Moreover, the SEC believes that an adviser’s burden of substantiating its good faith determination is greater where the adviser enters into a soft-dollar arrangement with an affiliated broker-dealer as opposed to an independent broker-dealer.”^[13]  Conduct that is not protected by Section 28(e) may constitute a breach of fiduciary duty as well as a violation of the federal securities laws and the Employee Retirement Income Security Act of 1974. Since the passage of Section 28(e), to react to market developments and market participants’ concerns, such as what type of goods and services are within the protection of Section 28(e), the SEC has issued interpretative releases. 

 

2.      Market Developments and Controversies: How the SEC Has Reacted to them? SEC SEC’s Interpretative Guidance

 

·         1976 Release: no protection for “products and services which are readily and customarily available and offered to the general public on a commercial basis”^[14]

 

In March 1976, soon after the enactment of Section 28(e), the SEC issued a release to provide guidance on what type of products and services were within the safe harbor provided by Section 28(e). The 1976 Release provided that “products and services which are readily and customarily available and offered to the general public on a commercial basis”, such as newspapers, government publications and office equipment, were not within the safe harbor.   The Commission also admonished asset managers not to direct broker-dealers to make “give-up”^[15] payments and stated that to be within the definition of brokerage and research services under Section 28(e), “it was intended [...] that a research paid for in commissions by accounts under management be provided by the particular broker who executed the transactions for those accounts.”^[16]

 

·         1980 Report and 1986 Release: extensive interpretative guidance^[17]

 

In the 1980s, after an examination of commission practices conducted by the Commission, the Commission concluded that the standard set up by the 1976 Release was “difficult to apply and unduly restrictive in some circumstances”,^[18] “particularly as the types of research products and their method of delivery had proliferated and become more complex.”^[19]  The Commission withdrew the 1976 Release’s standard and interpreted the safe harbor to be available to research services that satisfy the definition of “brokerage and research services” under Section 28(e)(3) and provide “lawful and appropriate assistance to the money manager in the performance of his investment decision-making responsibilities.”^[20]  In the 1986 Release, the Commission also concluded that a product or service that was “readily and customarily available and offered to the general public on a commercial basis” nevertheless could constitute research. The 1986 Release also re-affirmed that, under appropriate circumstances, asset managers may use client commissions to obtain third-party research (i.e., research produced by someone other than the executing broker).^[21]  The Commission also emphasized the importance of disclosure requirements (written disclosure of client commission arrangements) and asset managers’ best execution duty.^[22]  The 1986 Release introduced the concept of “mixed use” and the Commission indicated that where a product has a mixed use, an investment manager should make a reasonable allocation of the cost of the product according its use, and should keep adequate books and records concerning the allocations.^[23]  The Commission, to control the inherent conflicts of interest of this allocation, noted that an asset manager may use client commissions pursuant to Section 28(e) to pay for the portion of a service or specific component that assist him/her in the investment decision-making process only and not for the portion of a service that provides him/her administrative assistance.

 

·         2001 Release: agents v. principals

 

The 2001 Release ended with the Commission’s interpretation that Section 28(e) was available only for research and brokerage services obtained in relation to commissions paid to a broker-dealer acting in an “agency capacity”.^[24]  In practice, that meant that asset managers could not rely on the Section 28(e) safe harbor for research and brokerage services obtained in relation to fees charged by market makers when they executed transactions in a “principal” capacity. The analysis behind that interpretation was that the fees on principal transactions were not quantifiable and fully disclosed in a way that would allow asset managers to determine that the fees were reasonable in relation to the value of the research and brokerage services received.^[25]   

Between 2001 and 2005, critics to the interpretation of the safe harbor rose and the Commission was urged to provide further clarification,^[26] and also take into account the developments in the United Kingdom. Many U.S. market participants have a significant presence abroad, in particular in the United Kingdom, and they were concerned about costs of compliance with multiple regulatory regimes and incompatibilities among them. On July 22, 2005, the U.K. FSA adopted final client commission rules. The U.K. FSA final rules describe “execution” and “research” services and products eligible to be paid for by commissions, and specify a number of “non-permitted” services that must be paid in hard dollars, such as custody not incidental to execution, computer hardware, telephone lines, and portfolio performance measurement and valuation services.^[27]  This was the context of the Commission’s proposed interpretative release that led to the issuance of the 2006 Release.

 

·         2005 Interpretative Release and 2006 Release: contours of the Section 28(e) safe harbor

 

On October 19, 2005, the Commission issued a proposed interpretative release (“2005 Proposal”) providing guidance and requesting comments on the scope of the brokerage-allocation safe harbor in Section 28(e). The 2005 Proposal focused on the scope of the Section 28(e) safe harbor and it did not address soft-dollar arrangements that do not fall within the safe harbor.^[28]   On July 18, 2006, despite the expressed antipathy for Section 28(e), the SEC published an interpretation clarifying the range of products and services that are eligible for safe harbor protection under Section 28(e), with a goal of providing “maximum flexibility” for asset managers to use client commissions to seek best execution of trades while obtaining valuable research.[29]  The 2006 Release significantly expands upon the 2005 Proposal, and contains important interpretive statements on research, brokerage, third-party services, and other aspects of the Section 28(e) safe harbor. The Commission substantially altered the approach to “commission sharing arrangements”^[30] for providing third-party research as described in the 2005 Proposal. The new interpretation calls them “client commission arrangements” and permits them to operate in a more flexible manner than the 2005 Proposal would have allowed.^[31]

An asset manager’s role as a fiduciary includes the duty to use reasonable efforts to obtain best execution in connection with clients’ transactions. Best execution requires the manager to seek to “execute securities transactions for clients in such manner that the client’s total cost or proceeds in each transaction are the most favorable under the circumstances.”^[32]  Section 28(e) provides a safe harbor from liability under any federal or state law that existed at the time the 1975 Amendments were enacted when the manager causes a client to pay more than the lowest available commission for effecting a securities transaction. In connection with third-party research, the Commission reiterated its long-standing position that independent research providers are accorded equal treatment with proprietary research providers, and that the Section 28(e) safe harbor encompasses third-party research and proprietary research on equal terms. While the Commission reiterated that Section 28(e) provides that a broker-dealer in a client commission arrangement must be involved in the process of “effecting” trades for the asset manager and must “provide” the research products and services, the 2006 Release broadens the scope of what would be permitted under the 2005 Proposal in order to provide greater flexibility in using client commissions to seek best execution for trades and obtain research. In part in response to comments on the 2005 Proposal that introducing brokers, who do not execute trades, would perhaps be precluded from providing valuable third-party research, the 2006 Release provides that a broker will be deemed to have effected a trade, and thus be eligible to share in commissions protected under Section 28(e), if it performs at least one of seven functions and has taken steps to see that the other functions have been reasonably allocated to one or another broker-dealer in the arrangement in a manner that is fully consistent with the obligations under self-regulatory organization (SRO) and SEC rules.[33]

In issuing the 2006 Release, the Commission intended to clarify the scope of “brokerage and research services” for purposes of Section 28(e), in light of evolving technologies and industry practices. The 2006 Release sets out a three-step analysis that an asset manager should employ when determining whether a product or service falls within the statutory scope of Section 28(e) safe harbor.^[34]  The Commission also concluded that “research services” are restricted to advice, analyses, and reports relating to the subject matter areas in Section 28(e)(3). The Commission attempted to draw a line between products and services that have substantive content (i.e., the expression of reasoning or knowledge), which are eligible as research (e.g., pre-trade and post-trade analytics available through an order management system, conferences and seminars (but not meals or transportation)) and those that have “inherently tangible” characteristics, which are not eligible (e.g., operational overhead, computer hardware). A research service or product is covered by the Section 28(e) safe harbor only to the extent that the service or product constitutes advice, an analysis or a report and provides lawful and appropriate assistance in the investment decision-making process (as opposed to, for example, the use of account performance analyses for marketing purposes). The 2006 Release provides that the form of the research (e.g., electronic, paper or oral) does not affect the availability of the safe harbor. The Commission determined that the non-eligible products and services do not reflect the expression of reasoning or knowledge relating to the subject matter identified in Section 28(e).

The 2006 Release reiterated the Commission’s guidance on mixed-use items provided in the 1986 Release and emphasizes that an adviser should keep adequate records to support allocation determinations.^[35]  The 2006 Release highlights certain areas in which an asset manager must make reasonable mixed-use allocations —such as trade analytical software, account performance analyses, proxy voting services, and order management systems— to the extent that the manager uses those items for purposes other than investment decision-making.                                       

Regarding market participants’ concerns about compliance with multiple regulatory regimes, the Commission indicated that the guidance provided by the 2006 Release was intended to be generally consistent with the guidance provided by the U.K. FSA. The 2006 Release, however, highlights certain differences between the Commission’s and the U.K. FSA’s guidance, such as the eligibility under the 2006 Release (but not under the U.K. FSA’s guidance) of seminars, publications targeted to a narrow audience, and raw data provided for research purposes. 

Through these interpretive releases, the Commission has reiterated its intention to avoid conflicts of interest and improve transparency of soft-dollar arrangements.^[36]  Indeed, in the SEC Open Meeting on July 12, 2006, the Commissioner Roel C. Campos said “I am glad to see that some industry participants have taken a piece of the puzzle into their own hands with the unbundling of commissions (such as Fidelity’s and Lehman Brothers’ $7 million October 2005 unbundling deal), which requires the sell side to affix a value to each of its research products. The likely outcome of this conduct is to reduce the types of goods and services managers considered legitimate under the safe harbor. Again, the power of transparency and disclosure can be enormous.”^[37]  A concern is still the misuse that market participants give to soft dollars -some firms will use soft dollars to buy office equipment or to pay other expenses not eligible for the Section 28(e) safe harbor and will fail to make appropriate allocations of mixed-use items, between soft dollars and their own expenses. “The Commission has warned asset managers in the past about ‘extending the outer boundaries’ of the safe harbor, and cautioned broker-dealer that they need to be alert to situations where an asset manager may be breaching its fiduciary duties and the securities laws.”^[38]  As presented in this part, the Commission has debated these issues for several years and has released guidance for managers and advisers and even appealed to Congress directly for help. 

 

II.        U.K. AND E.U. APPROACHES: UK FSA’s Guidance and MiFID

 

1.      U.K. FSA’s Guidance: Origins of Soft Commission Arrangements and Current Rules

 

Soft commission arrangements grew up in the United Kingdom in the 1970s, in response to the minimum commission regime operated by the London Stock Exchange. Brokers competed by offering additional services to asset managers, to discount the cost to them of having to pay hard commission at a fixed minimum rate. The United Kingdom was following the example of the U.S. market, where soft-dollar arrangements had also arisen in response to a fixed commission regime. By the time fixed commissions were abolished in 1986, “softing” had become a common practice in the market place. Under the soft commission arrangements that were typical in the United Kingdom, a broker agreed to pay for certain goods and services that were supplied directly to the asset manager – usually by a third-party rather than the broker or one of its associated companies. The total amount the broker will pay was agreed between the parties, and was dependent on the asset manager sending a specific volume of business to the broker.[39]  Soft commission arrangements therefore imply a commitment on the part of the asset manager to direct a certain level of business to the broker.[40]

In 2000, the Chancellor of the Exchequer appointed Paul Myners, then chairman of Gartmore Investment Management, to carry out a review of institutional investment in the United Kingdom. Mr. Myners published his final report in March 2001 (“Myners Report”).[41]  This centered on the efficiency of investment decision making and the responsibilities of those involved, particularly pension fund trustees and their investment managers. The Myners Report also examined the way in which dealing commission were charged to a fund, when the fund manager buys and sells securities for the fund’s portfolio. Here, the report focused on the disparity in the way that the main costs of managing a pension fund – management fees and dealing commissions – were treated.[42]  Mr. Myners noted that management fees were transparent to the customer; and indeed pension scheme trustees and their advisers subject them to considerable scrutiny and negotiation when appointing a fund manager. Dealing commissions, on the other hand, were not transparent, since they are invariably charged directly to the fund itself on a transaction by transaction basis. As a result, customers were less likely to know how much commission was charged to their funds in total, or how much of that commission was being used to buy services in addition to trade execution. Mr. Myners was concerned that the lack of customer focus on commission costs provided an “artificial bias” for fund managers to acquire additional services paid for through commission. This enabled a fund manager to reduce his own operating expenses even after the management fee was been negotiated and agreed, and so increase the profit element of the management fee.[43]  Mr. Myners concluded that there was an incentive for fund managers to direct business to brokers to obtain additional services, rather than the most favorable trade execution terms for their customers, and that this represented an unacceptable market distortion. Concerned by the issues raised in the Myners Reports, and the consequences of the lack of transparency and the potential conflicts of interest of dealing commissions on consumer protection and market confidence, in July 2001, the U.K. FSA and the HM Treasury agreed to review the U.K. regulatory regime. They started analyzing how well the U.K. regulatory regime addressed the conflicts of interest and market distortions arising from bundled brokerage and soft commission arrangements. The U.K. FSA and the HM Treasury carried out this work in parallel with their work on best execution and investment research, as they thought the subjects were interrelated. In April 2003, the U.K. FSA issued a Consultation Paper identifying four areas of concern. Similarly to the SEC’s concerns, the U.K. regulators were worried about the opacity in the transaction costs, the potential conflicts of interests[44] and the disclosure of the managers’ soft commission arrangements to their clients.[45]  The U.K. FSA and the HM Treasury concluded that the U.K. regulatory regime[46] did not address the issues mentioned below satisfactorily, and that further action was necessary. The U.K. FSA proposed two main amendments to the existing regulatory regime which it believed would realign the interests of asset managers and their clients and create greater transparency for clients. The U.K. FSA proposed to limit the range of services which a broker may offer under a soft or bundled arrangement. They believed that will reduce incentives for asset managers to deal with brokers against the interests of their clients. Accordingly, the first proposal was that certain goods and services should be excluded from those that can be provided under soft or bundled arrangements. After extensive consultation and studies,[47] on July 22, 2005, the U.K. FSA adopted final client commission rules, which came into effect on July 1, 2006.[48]

The U.K. FSA introduced a new section into the U.K. FSA’s Conduct of Business Sourcebook (“COB”) and deleted the section formerly entitled “Inducements and Soft Commissions,” which dealt with the requirements of, and allowable benefits under, soft commission agreements, as well as prior and periodic disclosure requirements, in relation to soft commission agreements. The new title reads “Inducements.”[49]  In the July 2005 Policy Statement, the U.K. FSA summarized the effect of its rules, together with the introduction of “an enhanced industry disclosure regime to tackle the identified lack of transparency and accountability.” The intended result was to:

 

·         “Limit investment managers’ use of dealing commissions to the purchase of execution and research services;

 

·         Require investment managers to disclose to their customers details of how commission payments have been spent and what services have been acquired with them; 

 

·         Embed in the commercial relationship between investment managers and brokers incentives to secure value for clients for execution and research spend; and

 

·         Promote competition between those who produce investment research by removing the regulatory distinction between research services provided by brokers along with execution (i.e., bundled services) and research services provided by third parties (i.e., softed services).” 

 

The U.K. FSA established a set of principles governing soft commissions. Principle 1 (Integrity) requires a firm to conduct its business with integrity. Principle 6 (Customers’ Interests) requires a firm to pay due regard to the interests of its customers and treat them fairly. Principle 8 (Conflicts of Interest) requires a firm to manage conflicts of interest fairly, both between itself and its customers and between one customer and another. 

The U.K. FSA allows the use of dealing commissions to purchase good or services only where the investment manager (an investment manager that executes customer orders through a broker and passes on the broker’s charges (whether commission or otherwise) to its customers; and in return for those charges receives goods or services in addition to the execution of its customer orders) “(a) has reasonable grounds to be satisfied that the goods or services […] (i) are related to the execution of trades on behalf of the investment manager’s customers; or (ii) comprise the provision of research; and (b) will reasonably assist the investment manager in the provision of its services to its customers on whose behalf the orders are being executed and do not, and are not likely to, impair compliance with the duty of the investment manager to act in the best interests of its customers.” The COB explains the circumstances in which an investment manager will have such reasonable grounds to be satisfied in relation respectively to execution and research. The execution requirement will be met (COB 7.18.4(1)E) “if the goods or services are: (a) linked to the arranging and conclusion of a specific investment transaction (or series of related transactions); and (b) provided between the point at which the investment manager makes an investment or trading decision and the point at which the investment transaction (or series of related transactions) is concluded.” In relation to research, the requirement will be met if the research (COB 7.18.5(1)E): “(a) is capable of adding value to the investment or trading decisions by providing new insights that inform the investment manager when making such decisions about its customers’ portfolios; (b) whatever form its output takes, represents original thought, in the critical and careful consideration and assessment of new and existing facts, and does not merely repeat or repackage what has been presented before; (c) has intellectual rigour and does not merely state what is commonplace or self-evident; and (d) involves analysis or manipulation of data to reach meaningful conclusions.” The COB also listed the goods and services which the U.K. FSA states will not meet the above requirements and which, therefore, a manager cannot purchase with commission (e.g., computer hardware, seminar fees, portfolio valuation services).[50]  

 

Recognizing the importance of monitoring the effects of the new rules, the U.K. FSA developed performance indicators (the U.K. FSA charged OXERA with developing these indicators) to determine whether its proposals are achieving the desire outcome, among others intended results, provide greater transparency regarding the use of dealing commissions. On April 7, 2009, the U.K. FSA published its post-implementation review of the use of dealing commission regime. The U.K. FSA concludes that the evidence it has gathered indicates that as a result of the new regime, the market appears to be delivering the outcomes it sought; in particular: overall, the performance indicators found that the expected changes were occurring and that the market was moving towards delivering the intended outcomes. The report also found that the new regime has clearly delivered benefits to the market. Commission rates have fallen and the new regime has limited the use of dealing commission to the purchase of “execution and research”, encouraged greater separation in the purchase of execution and research and improved the provision of information. On the retail side, the evidence indicates that the benefits accruing on the wholesale side are being delivered to retail consumers since retail funds are treated in the same way as wholesale funds. When the U.K. FSA implemented the rules, it anticipated some adverse effects, such as the risk that the new regime might lead to lower liquidity. While disclosures were being provided, there was limited evidence that they were being used. However, if the use of disclosures were to increase, this might deliver further benefits, stated the U.K. FSA.[51]  

 

2.      MiFID[52] and CESR’s work: an Intent to Harmonize E.U. Soft Commission Practices

MiFID was enacted on April 21, 2004 and came into effect in November 1, 2007. This directive gave investment firms (this term includes broker-dealers and asset managers) an effective “single passport”, allowing them to operate throughout the European Union on the basis of authorization in their home Member State. It is a very far-reaching piece of legislation. It sets out a comprehensive regulatory regime covering investment services and financial markets in Europe. It contains measures which changed and improved the organization and functioning of investment firms, facilitate cross-border trading and thereby encourage the integration of E.U. capital markets. MiFID was also intended to ensure strong investor protection, inter alia with a comprehensive set of rules governing the relationship which investment firms have with their clients. This directive provides the framework legislation, voted on by the European Council and Parliament, also known as Level 1.[53]  

A successful application of MiFID depends upon an intensification of supervisory convergence through its Members States. Following the implementation of MiFID Level 1, the emphasis at European Level was shifted to Level 3. The DG Competition of the European Commission published an issues paper on May 24, 2006 entitled “Competition in EU securities trading and post-trading”. Section 4.2.2 of the paper focused on inducements. In its discussion of the appropriate regulation of soft commissions, DG Competition singles out the U.K. FSA soft commission regime as a model approach. Since then, the Committee of European Securities Regulators (“CESR”), in charge of implementing Level 3 to facilitate the convergence of regulatory outcomes, has issued recommendations further tightening the regulations around inducements. MiFID Level 1 extends best execution to all traded products and prohibited inducements-note that a safe harbor is provided under certain conditions. 

The purpose of the provisions on inducements under MiFID and its implementing regulations (referred hereinto as “MiFID”) is to ensure that firms comply with its “duties” to act honestly, fairly and professionally in accordance with the best interests of their clients.[54]  Under MiFID, fees, commissions or non-monetary benefits paid or provided to or by the client or a person acting on behalf of the client are authorized inducements. Proper fees are defined as fees which enable or are necessary for the provision of investment services, and which, by their nature, cannot give rise to conflicts with the firms’ “duties”. Fees, commissions or non-monetary benefits paid or provided to or by a third-party or a person acting on behalf of a third party are prohibited, except if, the inducements are disclosed to the client before the provision of the services, are designed to enhance the quality of the relevant service or the inducements do not impair the firm’s “duty” to act in the best interest of the client.[55]  CESR has provided guidance in how to assess if the inducement enhances the quality of the service and comply with the firm’s duty and has stresses that both criteria should be met.[56]  Note that these criteria have been qualified as vague and ambiguous by market participants.[57]

E.U. regulators and CESR have emphasized the importance of disclosure. One of the questions raised by market participants was how to disclose. Pre-MiFID a mere reference to the fact that an inducement was paid by a third-party was sufficient and post-MiFID, that is no longer sufficient, the inducement must be clearly disclosed to the client-the disclosure must include its existence, nature and amount of the inducement received or paid, prior to the provision of the relevant service. The disclosure must include the “essential terms” to allow the investor to relate the information to the service render and the firm must be able to provide further details ate the request of the client. Through MiFID and CESR’s recommendations, E.U. regulators propose to enhance fee transparency, obliging investment firms to give their clients, as pre-contractual information, an itemized breakdown of the fees charged for each trade executed. It is hoped that this additional transparency will help asset managers to become more cost sensitive, and further competition would hereby be encouraged in the brokerage market. 

Despite the meritorious effort to reach a common approach across the European Union to supervise soft commissions, they are still a subject where Member States have the power to impose further or different standards. In its paper entitled CESR’s Level 3 Feedback Statement (para. 27-28),[58] CESR noted that softing and bundling arrangements were regulated differently by different Member States. Many respondents mentioned the U.K. arrangements as a precedent for the European Union and recommended that they continue. The majority of respondents suggested that regulation on softing and bundling reflects the particularities of specific markets and that national regulators may be best placed to effect appropriate supervision. In addition, it was suggested that softing and bundling arrangements should be led by an industry driven approach and that any common approach be developed only after full consultation and research to discover the exact nature of practices in the various Member States.           

The European Commission has accepted in principle the U.K. FSA’s Article 4 notification[59] of the U.K.’s use of dealing commissions regime, i.e., that the U.K. soft dealing commissions regime can remain intact under MiFID. This suggests a jurisdictional approach may be allowed in this area going forward. The U.K. FSA has taken a more restrictive approach to soft commissions requiring evidence that the service(s) provided constitute research and/or execution in order to be exempt from regulation; whereas, CESR (and regulators in the European Union outside of the United Kingdom) do not have this requirement. Under the U.K. FSA use of dealing commission rules, services that are related to the execution of orders and investment research are considered as enhancing the quality of investment management services to a client. 

The European Union is still struggling with the notion of soft commissions. The jurisdictional approach and the vagueness and ambiguity contouring soft commissions under MiFID and CESR’s recommendations make it difficult for firms to comply with a variety of standards and for regulators to monitor firms’ practices. 

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IV.      Concluding Remarks

Bundling and softing enable asset managers to finance some of their management expenses by charging their clients in a way that lacks transparency. This makes it difficult for clients to identify which additional services are being bought with their money, or how much they are paying for them. Consequently, clients do not have enough information to judge whether they are getting good value for their money and to assess how well their asset manager has performed its “good faith” or best execution obligation.^[60]  The former SEC Chairman, Mr. Cox claimed the elimination of soft-dollars complaining that some soft-dollar arrangements were being used to pay for membership dues, office rent, carpeting, “and even entertainment and travel expenses.”[61]  In my opinion, there is little doubt soft-dollar arrangements engender conflicts of interest, and that most asset managers’ clients lack actual knowledge of these conflicts or the wherewithal to directly monitor their managers and brokers. To prevent this type of conflicts of interest, we have seeing that securities regulators in the United States and the European Union have established standards so clients are able to asses whether their asset managers comply with their duties, and to ensure best execution requirements. Regulators are challenged to articulate the benchmark for determining the appropriateness of the research and brokerage services received and whether such services enhance the investment decision making process or order execution quality for the benefit of investors. An enforceable and thereby effective best execution regime is the best safeguard against conflicts of interest. Disclosure of transaction costs (as pre-contractual information) is the keystone of client protection. This should result in an environment in which the costs of managing and dealing of assets are more visible and clients are better placed to understand and assess them, and asset managers are more costs sensitive.[62]  Clients should receive reports explaining how much of their commissions were spent on what services, with assessments of the value asset managers place on the research they purchase. This would in turn place downward pressure on the over-consumption of services, as clients include this among other issues they would consider in the selection of asset managers.

Two main economic benefits have been claimed for softing. It can:

·         ease market entry by smaller fund managers and brokers, increasing competition and choice; and

·         facilitate market entry for third-party research providers, enabling them to compete with broker research (mitigating some of the negative effects of bundling).[63] The availability of third-party research made it possible for smaller asset managers to compete with the large investment managers since they could cover considerable portions of what would otherwise have been their overheads by paying for research from all sources—not just traditional in-house, Street research—through their clients’ commissions.

It has been said that research would be undersupplied if soft-dollar commissions were abolished entirely. It would be a mistake to prohibit innovative business practices in the interest of investor protection simply because they give rise to conflicts of interest. Regulators are confronted to create an environment in which technologies can flourish and investors are protected. In the soft-dollars world, a balance can be established in restricting the range of services and products for which soft-dollars could be used and increasing transparency through disclosure of transaction costs. 

Properly balancing conflicts of interest is a task best left to regulators with the participation of market participants-professional associations and self-regulatory organizations should be key players.

Maria-Leticia Ossa Daza

 

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