The End of “Soft Dollars”?

Over the past few decades, mutual fund shareholders have paid to brokerage and investment banking firms billions of dollars in so-called soft-dollar commissions that have far exceeded the costs of executing the transactions. Over the years, the U.S. SEC’s inconsistent interpretations of pertinent sections of the Securities Exchange Act of 1934 have generally allowed the continued use of soft dollars for the payment of not only brokerage commissions but also research products and services. This article discusses the history of the practice and suggests two approaches that may hasten the end of the era of soft dollars: client commission-sharing arrangements and paying for research directly in cash. See comments on this article.Over the past few decades, mutual fund shareholders have paid to brokerage and investment banking firms billions of dollars in commissions that have far exceeded the costs of executing the transactions. This expenditure of shareholder assets has been legally justified by a peculiar provision, Section 28(e), added to the Securities Exchange Act of 1934 shortly after fixed commission rates were abolished by the U.S. SEC on 1 May 1975. Section 28(e) provided a “safe harbor” for advisers who “paid up” to acquire research and other services. Although these commissions were paid by the mutual funds themselves, they were controlled and directed by fund managers, who were employees of legally separate management firms. Acquiring this array of services in return for soft dollars reduced the hard-dollar costs of research, administration, and marketing that the advisers would otherwise presumably have had to pay out of their own coffers.The protection afforded by Section 28(e) was apparently insufficient for fund advisers. In 1986, the SEC was persuaded to extend its interpretation of Section 28(e) to a wider range of permissible uses of soft dollars (in truth, excess brokerage commissions), including “mixed-use” products and services that covered both research and administrative costs (e.g., computer hardware, communications equipment, and publications) that the advisers would otherwise have had to pay with their own hard dollars. This additional flexibility further blurred the distinction between soft and hard dollars.Over the years, as the use of soft dollars for broker support has inevitably reemerged as a powerful force in fund marketing, the SEC’s inconsistent interpretations of pertinent sections of the Securities Exchange Act of 1934 have generally allowed the continued use of soft dollars for the payment of not only brokerage commissions but also research products and services. This practice—so harmful to clients of institutional managers—is virtually indefensible and must be ended.Two new approaches may hasten the end of the era of soft dollars: client commission-sharing arrangements (CCSAs) and paying for research directly in cash. CCSAs allow institutional managers and brokers to set aside a specified share of commissions for research services. CCSAs, which provide precise and measurable data that ought to be fully disclosed, are growing at a rapid rate. Nevertheless, CCSAs, although apparently more respectable than soft dollars because they are more transparent, are still “kissing cousins” of soft dollars. And because CCSAs do not get to the heart of the soft-dollar problem, they will probably prove to be only a bridge to a better approach.One such better approach is Fidelity Investments’ decision, following the SEC’s 2006 guidance, to separate research from trading commissions and to pay for research directly in cash. In time, pressure from regulators, public opinion, and even enlightened self-interest may force other major institutions to adopt Fidelity’s policy. Ultimately, the era of soft dollars, for marketing and research alike, must come to an end, simply because soft dollars ill serve fund investors. Note: The views expressed in this article are the author’s alone and do not necessarily reflect the views of Vanguard’s current management. The managers who supervise the funds under Vanguard’s direct management pay commissions solely for the execution of portfolio transactions and do not pay for distribution, research, or marketing services with soft dollars.