Fixing Soft Dollars Is Not That Hard: A Consent and Reporting Framework for Regulating Client Commission Arrangements

By Biffany, Brendan | Duke Law Journal, October 2018 | Go to article overview

Fixing Soft Dollars Is Not That Hard: A Consent and Reporting Framework for Regulating Client Commission Arrangements


Biffany, Brendan, Duke Law Journal


ABSTRACT

Under soft dollar arrangements, investment advisers promise portfolio trades to participating brokers in exchange for investment research or other benefits. Recently, some academics, financial regulators, and practitioners have scrutinized such arrangements, arguing that they provide an avenue for advisers to unjustly enrich themselves at the expense of their clients. However, others defend so ft dollar arrangements, seeing them as a mechanism for binding advisers to clients and increasing client returns.

A safe harbor currently protects advisers' use of soft dollars, so long as certain minimum requirements are met. Critics argue that soft dollars should be banned outright, contending that advisers should be required to pay for all investment research and advisory benefits out of their own pocket rather than by using clients' commissions. Supporters recommend maintaining the status quo, arguing that the safe harbor promotes access to diverse research that, ultimately, benefits clients.

This Note analyzes the benefits and drawbacks of soft dollar arrangements, the original rationales for the development of the soft dollar safe harbor, and the agency costs and conflicts of interest inherent in maintaining the sa fe harbor. This Note advocates a middle ground between maintaining the status quo and banning soft dollars outright: a consent and reporting framework for the use of soft dollars that is consistent with general principles of agency and the fiduciary duties that advisers owe their clients.

INTRODUCTION

Through soft dollar brokerage arrangements, investment advisers can use their clients' trading commissions to pay for research and brokerage services. Although the use of such arrangements is "virtually invisible" to individual clients, (1) soft dollars constitute a billion-dollar industry (2) in the United States that touches more than ninety-five million people. (3) Almost all investment advisers have soft dollar arrangements with the broker-dealers (4) that carry out their clients' transactions. (5)

To understand how soft dollar arrangements work, consider the following scenario: A parent gives a babysitter ten dollars to buy his kids some ice cream. Although ice cream usually costs five dollars per pint, the babysitter finds a great deal: four pints for ten dollars. She uses the full ten dollars to buy four pints, gives two to the children, and keeps the other two without telling the family, using them when she watches another family's kids or keeping them for herself.

Real soft dollar arrangements are not so different. Clients hire investment advisers to research, identify, and execute portfolio transactions. When an adviser identifies a trade, he contracts with a broker-dealer to execute the trade for the client on the most advantageous terms possible. The adviser has a choice in selecting a broker-dealer: route the trade through a discount broker that charges a commission rate of approximately two cents per share, or, as happens more often, route the trade through a premium broker at a rate of about six cents per share. (6) While either kind of broker can execute the transaction, premium brokers provide advisers with additional research or brokerage services that advisers can use in managing their clients' accounts--soft dollar benefits. Although these benefits accrue to the adviser, the broker's commission cost comes directly out of the client's holdings. (7)

Investment advisers must abide by fiduciary duties in managing their clients' accounts. (8) These include the general common-law duties of care and loyalty, which require the adviser to seek "the most favorable terms" for the execution of client transactions that are "reasonably available under the circumstances." (9) However, federal law contains a safe harbor provision that protects investment advisers when they receive soft dollar benefits: Advisers are allowed to use research and brokerage services paid for by one client for the benefit of any of their clients without breaching their fiduciary duties, so long as the commission paid is "reasonable" compared to the services received. …

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