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Nazareth Urges Better Assessment of Fund Fees by Directors

In remarks earlier this month to the Mutual Fund Directors Forum in Chicago, Commissioner Annette Nazareth said that fund boards could better assess the appropriateness of soft dollar arrangements if the SEC mandated better disclosure of the research and brokerage services provided to advisers for the bundled commission rate they charge. She said it would also be useful for directors to review brokers' execution-only commission rates to compare the costs the fund would have been charged without the additional research and brokerage services. The staff is currently considering comments on the SEC's proposed interpretive release on soft dollars and should soon make a recommendation to the Commission, according to Nazareth. Her prepared remarks were posted on the SEC's Web site.

The SEC's proposed interpretation of the 1934 Act section 28(e) safe harbor is an important first step, in Nazareth's view, to guide the industry in assessing the eligibility of research and brokerage services. However, it does not address a number of questions relating to soft dollars and best execution such as the documentation of services an adviser receives with soft dollars from full-service brokers.

Nazareth pointed to a trend in which broker-dealers are pricing their proprietary research separate from execution and said she is encouraged by the improvement in transparency and accountability. The SEC must address whether and how to improve disclosure by the adviser to the fund board about its use of soft dollars and to improve the adviser's accountability through increased recordkeeping. She urged funds to ask for better disclosure from their advisers with respect to soft dollar practices.

Independent directors should inquire about the portfolio execution process, she added, and should receive full explanations about the adviser's broker selection process. She suggested that funds request regular reports from the adviser on the execution of portfolio transactions and an analysis of execution quality.

Nazareth noted that a fund board could require the adviser to develop written policies on the execution of portfolio transactions to address how order routing decisions are made, how trades are allocated and how best execution is sought on all brokerage transactions. She said the policies should address situations where research or another benefit, such as a rebate, is considered when routing orders. The policy could also describe how the adviser monitors execution quality, she said, including the use of analytical tools, the periodic assessments of broker execution quality and reports to the board. The board should review the adviser's policies and practices annually, she added.

Nazareth said that directors should consider the impact of commission rates on best execution and request from the fund advisers summary reports on the commission rates paid to brokers. They should ask for explanations if the rates exceed the customary rate paid and review the adviser's use of alternative execution strategies such as program trading, direct access and electronic communication networks that can obtain quality executions at reduced costs. If trades are executed by an affiliate of the adviser, Nazareth said directors should require that the adviser receive the most favorable rate that is given to the affiliate's comparable clients. The affiliate should also provide the best execution reasonably available under the circumstances, she said.

Nazareth believes the biggest contribution independent directors can make to the bottom line relates to fees and expenses. Directors should review the contract and the fees and demand detailed disclosure about any conflicts of interest, she said. Nazareth is puzzled that fund fees continue to rise without evidence of a commensurate rise in operating costs or fund performance. Some funds may not compete on the basis of price or fees for the delivery of professional management advice, she said. Further, advisers may not pass cost savings on to investors that result from economies of scale. She urged directors to be more vigilant about fund fees.

Nazareth said that boards should determine the actual expenses of the adviser to determine if the fees are appropriate. Boards must assess whether the manager is fulfilling its fiduciary duties and is providing value to fund shareholders, she said. Nazareth also encouraged directors to further examine arrangements such as revenue sharing and rule 12b-1 fees. With respect to 12b-1 fees, Nazareth said the SEC should review the rule, but directors should determine whether shareholders are benefiting from the sales fees that are paid and the services that are provided.