Magazine article Government Finance Review

Soft Dollars: Management Required

Magazine article Government Finance Review

Soft Dollars: Management Required

Article excerpt

The dollar amounts associated with brokerage commissions on securities transactions tend to pale in comparison to the total dollar amounts involved in those transactions and, by virtue of their relative size, easily may be overlooked. Small percentages of very large amounts, however, can add up to large dollars. Such is the case with brokerage commissions paid by institutional investors, like public employee retirement systems, which collectively pay tens of millions of dollars annually in commissions.

The purpose of this article is to examine the evolution of brokerage business as it relates to institutional investors, explore its impact on accounting results and give pension-plan sponsors some food for thought regarding how they may wish to direct their money managers to conduct business.

Fixed vs. Negotiated Rates

During the past 20 years, fully negotiated brokerage commission rates on securities transactions have been allowed by the Securities and Exchange Commission (SEC). Prior to the establishment of the current free-market environment, a fixed-rate schedule for brokerage commissions was in effect. During those fixed-rate days, being competitive from a cost-of-doing-business standpoint was not allowed other than to allege ability to produce best execution. To gain a competitive edge, brokerage firms began making proprietary research available to money managers in exchange for their business.

When a regulated industry moves into the free market, there is usually a period of chaos followed by stabilization. Such was the case in the brokerage industry when fully negotiated rates were made available in May 1975. Highly competitive commission rates emerged and then stabilized at rates lower than the previous fixed-rate amounts. Once again, firms had to find alternatives to the price of services to remain competitive. Providing proprietary research was a practice with which brokerage firms were familiar so it seemed natural that they would continue and expand services in that area.

Directed Brokerage and Soft Dollars

When research alone was not enough to attract large-volume institutional clients, some brokerage firms offered to purchase other services in exchange for business. This resulted in the directed brokerage concept. Directed brokerage means that for the promise to direct a certain amount of brokerage business to a firm, the firm will agree to pay for something for the client (with the client being the retirement fund rather than the money manager). Initially, the most common service provided was investment performance measurement.

A frequent arrangement was for approximately one-half of the commission dollars generated to be made available to purchase investment performance measurement services, either from the brokerage firm or some other vendor. Amounts available to clients through directed brokerage picked up the label "soft dollars," probably because the client was not making payments directly with "hard cash." Through directed brokerage, soft dollars now are employed to purchase a range of services and/or equipment, all with the blessing of the SEC under Rule 28(e).

Accounting Flaws

In spite of the expanded use of soft dollars in purchasing services and/or equipment, neither the Financial Accounting Standards Board nor the Governmental Accounting Standards Board has provided any guidance on accounting for soft dollar usage. This is somewhat surprising in that a by-product of soft-dollar purchases is some rather odd accounting results, relative to traditional standards of financial accounting and reporting. An example of nontraditional accounting outcomes can be seen in the following example. Assume that a client pays $100,000 in commissions to a brokerage firm for executing a number of trades - an amount twice the price the firm might charge just for conducting the trade. This provides the client a credit of $50,000, which may be directed to another service provider. …

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