© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the May 2005 edition of BENEFITS CANADA magazine.
The issue of soft dollars is being closely looked at by regulators at home and abroad. Should sponsors follow suit?

ONE POSITIVE RESULT OF THE PENSION PLAN FUNDING crisis is the realization by regulators and plan sponsors of the need to ensure that pension plans have an effective governance system in place. Pension regulators have worked closely with the industry to develop governance guidelines and a self-assessment questionnaire to assist plan sponsors in applying them. The guidelines, which are principles-based, provide a framework for reviewing the adequacy of pension plan practices, procedures and arrangements.

One of the key areas sponsors will need to review is how portfolio transactions for their pension plans are handled. It will not take long before this raises the little-understood, but emotionally-charged issue of the use of “soft dollars,” along with related questions. These include whether the pension fund may be paying too much in commissions, whether the pension fund’s investment fund managers and brokers are benefiting themselves at the expense of the plan, and whether “best execution” obligations are being met.

The term “soft dollars” refers to the use by investment fund managers—and the brokers with whom they deal—of that portion of the commission payments that exceeds the cost of executing the trade to acquire goods and services that benefit their managed accounts. The term also extends to the commissions paid on portfolio transactions that investment fund managers direct to brokers to induce them to sell their managed funds and/or to refer clients to them: a practice that is prohibited in some jurisdictions.

Some people view “soft dollars” as the industry’s dirty little secret and feel they should be banned. Others believe there are benefits to be gained by client portfolios that permit commission dollars to be used to acquire certain goods and services (such as research and investment-decision making tools)that enhance the ability of the money manager and the broker to identify investment opportunities and improve the portfolio’s return.

The issue of the appropriate use of commission dollars has been around for years and has been the subject of extensive regulatory and industry review. As a result, a lot of questionable practices regarding this use were eliminated. However, in recent years, the need to revisit the subject has arisen and regulators in the United States, the United Kingdom and Canada are currently reviewing the matter.

The Canadian Securities Administrators have issued a concept paper on the subject and have invited comments on it until May 6, 2005. They have stated that based on the feedback they receive, they will consider their next steps.

In the United Kingdom, the Financial Services Authority has issued a consultation paper on bundled brokerage and soft commission arrangements along with proposed rules. These rules address the identified lack of transparency and accountability and contemplate an industry-led solution based on enhancing the disclosure regime and limiting the use of commissions to the purchase of “execution” and “research” services.

The U.S. Securities and Exchange Commission is expected to issue its proposals by mid-year. These too are expected to focus on increased transparency and accountability, a possible narrowing of the definition of soft dollars and unbundling commissions by placing separate values on proprietary research, execution and capital commitment.

Good governance requires plan sponsors to understand the issues relating to the use of commission dollars, the proposed regulatory approaches, and the impact on their portfolios and on the continuance of competitive capital markets. It is important that there be a meaningful, industry-led dialogue on this to ensure that the right framework is in place that will foster investment decision-making based on independent research—rather than a focus on lowest costs. Perhaps it’s time to re-convene the 1995 Roundtable of Institutional Investors whose deliberations eliminated much of the controversy which then surrounded soft dollar use.

Glorianne Stromberg is the author of three reports on regulatory strategies, a securities lawyer and a former commissioner of the Ontario Securities Commission. gstromberg@sympatico.ca.

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