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Cox Calls For Repeal of Soft Dollars Safe Harbor Statute

SEC Chairman Christopher Cox referred to soft dollars as a "witches brew" of hidden fees and conflicts of interest, and has asked Congress to repeal or at least substantially revise the statutory safe harbor for soft dollars. In 1975, in order to facilitate the adjustment from fixed commissions to the new era of competition, Congress enacted section 28(e) of the 1934 Act to allow investment advisers to pay higher than market rates for brokerage commissions as a way to cover the cost of research. Cox said that the market considerations that gave rise to soft dollars are as out of date as the leisure suit. His remarks were delivered to the National Italian-American Foundation in New York City.

Regardless of what Congress ultimately does, Cox pledged that the SEC will continue to monitor abuses in order to bring hidden soft dollar expenditures to light and to ensure that, to the maximum extent possible, soft dollars are used only for research. The goal is to help investors get the information they need in a form they can readily use and understand.

In a soft dollar transaction, an investment adviser's customer pays one price that covers both the cost of the trade and other research products and services as well. While investors pay these costs, Cox said that most of them are not aware of these hidden fees. Soft dollars make life extremely difficult for investors of all kinds who are trying to understand where their money is going, he observed. Even large sophisticated customers of money managers have difficulty figuring out exactly what their money is buying.

Since soft dollars are hidden from view, their use is not subject to the same robust oversight that investors apply to the costs that they can see. The lack of transparency has led to abuses, such as money managers using their clients' soft dollars to pay for office rent, furniture and equipment, and lavish trips. According to Cox, the most common abuse of soft dollars appears to be advisers using their clients' money to pay others for referring new clients to the adviser, which is not the kind of research that will help investors' portfolios. This lack of transparency may also be contributing to higher costs, he said, which are borne directly by investors in mutual funds, pension funds and 401(k) plans.

There are also inherent conflicts of interest in the use of soft dollars that offer perverse incentives to investment advisers to use them in ways that do not benefit investors. Soft dollars offer the opportunity for money managers to use the client's money to pay for expenses they normally would pay themselves. Using the client's money may also remove the adviser's incentive to keep its own costs down. In order to generate soft dollars, the adviser has an incentive to trade even when it is not in the client's best interest.

In Cox's view, soft dollars can also create incentives to use one client's commissions to pay for another client's research. Beyond ill serving investors, he said, all of this is unfair to money managers, who should never be placed in a position where they have an incentive not to put their client first. 

Cox said the complexity of the soft dollars regime has given rise to a cottage industry of lawyers who give advice on what is "soft dollarable," and what is not. The legal tests are complicated, he added, and the SEC's staff spends a considerable amount of time answering questions about how to interpret Commission guidance.

As an example of the complexity, Cox noted that the SEC's soft dollar interpretation allows a particular product to be considered both research and not research at the same time. These mixed use products can be paid partially in soft dollars and partially in hard dollars. The money manager has to allocate the costs, and disclose them separately. Cox believes this is unnecessarily complex and leads to unnecessary costs for investors.