investigations of pension fraud, money management abuse, wrongdoing, securities brokerages, pension investment consultants, unethical business practices, benchmark alert, institutional investors, plan sponsors
investigations of pension fraud, money management abuse, wrongdoing, securities brokerages, pension investment consultants, unethical business practices, benchmark alert, institutional investors, plan sponsors
investigations of pension fraud, money management abuse, wrongdoing, securities brokerages, pension investment consultants, unethical business practices, benchmark alert, institutional investors, plan sponsors
(April 1, 1996) New SEC Action: More Brokerage Disclosure to Confuse Mutual Fund Investors

Money Matters

New SEC Action: More Brokerage Disclosure to Confuse Mutual Fund Investors

In 1995, the Securities and Exchange Commission took action on two important proposals that concerned use of brokerage commissions by money managers. There was a great deal of confusion about the two proposals and what they were intended to do. Many believed that these proposals focused on "soft dollaring" and that the SEC was cracking down on the practice. In fact, only one of the two proposals, proposed Rule 204 (4), included, but was not limited to, soft dollar arrangements. And as we previously reported, that proposal was abandoned by the Commission. In this article, we will examine the second proposal, which was adopted, and clarify what it is about.

The second proposal, adopted in June, 1995, involved amendments to Rule 6-07 of Regulations S-X and certain forms. These amendments apply only to mutual funds and concern how they report their expenses. The amendments require a mutual fund to include in its expenses certain liabilities paid by brokerage firms in exchange for directing fund brokerage commissions to the brokers. In addition, the amendments require a mutual fund that invests in equities to disclose the average commission rate it paid. The amendments are intended to enable investors to better assess and compare mutual fund expenses and yield information. Contrary to popular belief, the amendments do not apply to soft dollar arrangements; they only apply to "brokerage/service" arrangements.

As most of you are aware, in a soft dollar arrangement an investment advisor uses client commissions to obtain certain investment research services which benefit the advisor. The soft dollar arrangement is then a narrow exception to the general rule that a fiduciary, the money manager, cannot use client assets for its own benefit. An exception for these arrangements is justified because the research services an advisor may pay for with client commissions must be shown to ultimately benefit the client.

In a soft dollar arrangement, the receipt of a benefit by an advisor through the use of its clients' commission dollars raises conflict of interest concerns addressed by the "safe harbor" provisions of Section 28(e) of the Securities Exchange Act of 1934. The Rule 6-07 amendments have no impact upon and are in no way concerned with traditional soft dollar arrangements; managers, including mutual fund managers, may continue to enter such arrangements without any new disclosure obligation.

The amendments are concerned with what are referred to as "brokerage/service arrangements" A "brokerage/service arrangement" is where a brokerage firm agrees to pay the cost of certain products as services provided to a mutual fund in exchange for fund brokerage. Under a typical brokerage/service arrangement, a broker agrees to pay a fund's custody or transfer agent fees and, in exchange, the fund agrees to direct a minimum amount of brokerage to the broker. The fund usually negotiates the terms of the contract with the custodian or transfer agent, which is paid directly to the broker.

Since these arrangements are structurally similar to soft dollar arrangements, the confusion regarding the Rule 6-07 amendments is not surprising. However, brokerage/service arrangements involve use of fund's commission dollars to obtain services that directly and exclusively benefit the fund. The advisor is not deriving any benefit through the use of client commissions. So why would the SEC care about what amounts to "commission recapture" by mutual funds?

The answer is that by entering into a brokerage/service arrangement, a mutual fund can reduce expenses reported to shareholders in its statement of operations, fee table, and expense ratio and can increase its reported yield. A mutual fund is able to decrease expenses and increase yield under these arrangements because the costs paid on behalf of the fund by the broker come out of the brokerage commissions the fund pays. Note that brokerage commissions are reflected in the cost basis of the purchased securities or as a reduction of the proceeds from the sale of securities and not as an expense of the fund. The amendments require that mutual fund financial data reflect amounts the fund would have paid to its service providers, such as its custodian, transfer agent, law firm or printing firm, if a broker had not paid those providers on behalf of the fund.

Keep in mind, these are amendments to accounting rules. The objective of the Commission in adopting the amendments is to have fund financial data more accurately reflect the expenses of the fund. The amendments do not in any way prevent a fund from entering into brokerage/service arrangements and the Commission is not in any way suggesting such arrangements are not in the best interest of mutual fund shareholders.

The amendments to Rule 6-07 are really nothing new.

The staff of the SEC had already required mutual funds to disclose in footnotes to the fee table, financial highlights table and financial statements, their participation in such arrangements. The amendments merely eliminate the need for such footnote disclosure.

The amendments also treat similarly "expense offset arrangements." These are arrangements that, like brokerage/service arrangements, have the effect of reducing reported mutual fund expenses. In these arrangements, however, expenses are reduced by the mutual fund foregoing income it is entitled to, rather than by recharacterizing an expense, e.g., custody, as a capital item, i.e., brokerage. For example, a fund may have a securities lending agreement with its custodian which permits the custodian to loan fund securities in exchange for a reduction in custody fees. So the income the fund would be entitled to from securities lending is foregone in exchange for a lower custody fee expense. Any reduction in fees arising from these arrangements must now be included in the expenses of the fund if the arrangement provides for a reasonably ascertainable fee reduction. It does not apply to fee reductions that are implicit in the service provider's basic fee. Furthermore, the income foregone does not have to be reflected; footnote disclosure regarding the effect of the arrangement is sufficient.

Finally, despite the fact that the most industry commentators were opposed to the proposal, the new amendments require a mutual fund that invests more than 10 percent in equities to disclose the average commission rate paid by the fund. In our opinion, such disclosure is meaningless and confusing since it does not include mark-ups, mark-downs and spreads on shares traded on a principal basis. These amounts are often well in excess of stated commissions and are not generally disclosed to investors at this time. Furthermore, factors affecting commission rates, such as the size of the order, the market in which the security trades, and whether a capital commitment on the part of the broker is required, all undermine the utility of such a comparison, which focuses exclusively on price. Disclosure of average commission rates will only induce funds to place undue emphasis on lower stated commission rates rather than quality or execution and may encourage principal trading.

What about soft dollar arrangements? There is no requirement to gross-up fund expenses to include research services provided to the advisor in exchange for commissions. The SEC specifically excluded soft dollar arrangements from the requirement to adjust reported expenses to include amounts paid with commission dollars. Because research services are typically provided to the advisor, not the fund, the specific exception was unnecessary.

However, in order to avoid confusion, the Commission adopted a specific exception. Unfortunately, many people are still confused about the applicability of amendments to soft dollar arrangements because such arrangements are by far the most commonplace ongoing relationships established with brokerage firms.

What the Commission has been clearly saying, which is evidenced by the two proposals recently discussed in The Anvil Report, is that investors should be provided with more information about how their brokerage dollars are spent. The days when clients did not ask about their commissions or direct or recapture commission are gone. Brokerage is, after all, the single largest expense of most pension or mutual funds.

The good news is that the intense Congressional and SEC scrutiny of soft dollaring which began in 1993 is now over. The two proposals which the SEC considered which might have impacted on the practice were, in one case, abandoned and, in the other, the Commission specifically excluded research services provided to money managers. In both instances, the Commission indicated an unwillingness to pursue further regulation of the practice of soft dollaring. As a result, the road is clear for investment managers to use commissions to purchase high quality independent research to benefit their clients.

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