Changing Attitudes

Changing Attitudes The Investment Company Institute (ICI), which is the lobbying group for the mutual fund industry, has a long and well documented history of opposing soft dollars(1) generated in third party brokerage arrangements. At the same time the Investment Company Institute and many individual executives from the mutual fund industry, speaking on their own, have made comments and statements suggesting that the regulation and enforcement approach for soft dollars generated in bundled undisclosed institutional brokerage arrangements should not be changed from the current (benign) approach.(2) (3) (4) It may seem incongruous that an organization or individuals from an industry could, for very long, sustain an argument that a procedure that is disclosed, documented and identifiable is riskier to the welfare of institutional investors than a procedure which is not disclosed, lacks transparency, and (from all claims) seems not to be auditable; but, so far, this position appears to have been successful. Recently, however, there have been a couple of indications that the ICI and the mutual fund industry may be moving away from the idea that better disclosure of institutional clients’ commissions would be a bad thing. It seems the explosive growth of hedge funds and the ability of hedge funds to use clients’ brokerage commissions to buy undisclosed services and favors from full service broker dealers appears to have caused a change of philosophy at the ICI and in the mutual fund industry. For me, the first evidence of this potential change in philosophy came on what was supposed to be the last day of the “Comment Period” on “Commission Guidance Regarding Client Commission Practices Under Section 28(e) Of The Securities Exchange Act of 1934”.(5) On September 7, 2006 two comment letters from highly placed individuals in ICI and in the mutual fund industry requested that the SEC ‘level the competitive playing field’ by mandating compliance with Section 28(e) for all types of advisors.(6) From these two letters it’s obvious that the authors’ main concern is competitive encroachment, by hedge funds, into a process that, until recently, mutual funds had dominated (i.e. quid pro quos in exchange for client commissions / order flow). I’ve copied and pasted the relevant portions of these letters below. (1) Excerpt from “Comment Letter” Dated September 7, 2006 from Elizabeth Krentzman, General Counsel to the Investment Company Institute (now a partner at Deloitte Consulting, Securities Regulation):

“Level Playing Field for All Investment Advisers While the interpretive guidance helps ensure a strong regulatory framework for soft dollar practices of investment advisers and accounts subject to Section 28(e), we continue to believe that the Commission should prohibit the use of client commissions outside the safe harbor by all investment advisers, regardless of the type of client account involved. As we noted in our comment letter on the proposed interpretive guidance, advisers to investment companies and advisers to pension funds under ERISA may be prohibited from using commissions outside the safe harbor, whereas advisers to other types of accounts are free to do so (registered advisers must provide appropriate disclosure in Form ADV).4 This regulatory disparity, especially when combined with other forces exerting downward pressure on overall commissions, may create strong incentives for broker-dealers to favor hedge fund and other advisers who have greater freedom to use soft dollars to make payments outside of the Section 28(e) safe harbor.5

Changing Attitudes

by Bill George

11/7/2007

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We urge the Commission to adopt a rule under Section 206(4) of the Investment Advisers Act that will prohibit an investment adviser from using client commissions to pay for any products or services that fall outside the safe harbor. The Commission also should pursue the recommendation of the NASD Mutual Fund Task Force that the SEC urge the Department of Labor (with respect to non-ERISA retirement accounts) and the federal banking agencies to require all discretionary investment advisers not subject to the SEC’s jurisdiction to comply with the standards of the safe harbor. This approach will ensure that all advisers treat investors equitably in connection with the adviser’s use of brokerage, and that broker-dealers do not have an incentive to favor advisers who are permitted to use client commissions outside the safe harbor.” (2) Excerpt from “Comment Letter” Dated September 7, 2006 signed by several members of the legal department at T. Rowe Price:

“Need to Level the Playing Field. The interpretive guidance has effectively clarified the regulatory framework for soft dollar practices under Section 28(e). Unfortunately not all advisers are subject to this Section 28(e). Accordingly, we urge the Commission to take steps to level the playing field by prohibiting the use of client commissions outside the safe harbor by all investment advisers, including hedge funds, regardless of the type of client account involved. This change would ensure that all advisers treat investors equitably in connection with their use of brokerage, and that broker-dealers do not have an incentive to favor advisers who are permitted to use client commissions outside the safe harbor. Without such regulatory parity, all advisory clients would not be afforded the same protections relating to their adviser’s use of brokerage. Mutual funds and certain advisory accounts could also be subject to regulatory and competitive disadvantages compared to other types of accounts.” Of course these calls for “a level playing field” have been complicated by the current legal interpretation that hedge funds are not subject securities regulators’ jurisdiction. But if anything changes in that regard it would then seem necessary to force sufficient commission disclosure and transparency to audit all advisors compliance with Section 28(e) and to test for the appropriate use of institutional clients’ brokerage commissions. If hedge funds become regulated entities, it will then be very interesting to see the suggestions for disclosure and transparency coming from the ICI and the mutual fund industry. Footnotes: (1) Soft dollar brokerage is defined in the SEC Office of Compliance Inspections and Examinations “Inspection Report” released on September 22, 1998: “I. Soft Dollars Defined: The Commission has defined soft dollar practices as arrangements under which products or services other than execution of securities transactions are obtained by an adviser from or through a broker-dealer in exchange for the direction by the adviser of client brokerage transactions to the broker-dealer. An individual or firm must exercise "investment discretion" over an account, as defined in Section 3(a)(35) of the Exchange Act, in order to use client commissions to obtain research under Section 28(e) of the Exchange Act ("Section 28(e)").” See the Inspection Report Section II item A, Soft Dollars Defined: http://www.sec.gov/news/studies/softdolr.htm

(2) Investment Company Institute - Request for Rulemaking Concerning Soft Dollars and Directed Brokerage filed with the SEC on December 16, 2003: http://www.sec.gov/rules/petitions/petn4-492.htm

Changing Attitudes

by Bill George

11/7/2007

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(3) January 27, 2004 testimony by President Paul Schott Stevens, On Behalf of the Investment Company Institute before the U.S. Senate Subcommittee Financial Management, the Budget and International Security, Committee on Governmental Affairs. Hearing titled, Oversight Hearing on Mutual Funds: Hidden Fees, Misgovernance, and other Practices that Harm Mutual Fund Investors. See, Section V. a. Soft Dollar Arrangements Should Be Significantly Restricted: http://www.ici.org/statements/tmny/04_sen_stevens_tmny.html#P86_28814 (4) March 31, 2004 Statement of ICI Chairman, Paul Haaga before the U.S. Senate Committee on Banking Housing and Urban Affairs hearing titled, Review of Current Investigations of and Regulatory Actions Regarding Mutual Fund Industry: Fund Costs and Distribution Practices. See, http://www.ici.org/statements/tmny/04_sen_haaga_tmny.html#TopOfPage It should also be interesting to note that at the same time Mr. Haaga gave this testimony he was also an Executive Vice President and Managing Director at Capital Research and Management, The American Funds. And less than a year after this testimony was given, this investment management and mutual fund complex was being investigated by several regulatory agencies, and was settling prosecutions and paying fines and penalties for engaging in some of the abuses outlined in Mr. Haaga’s testimony. See, New York Times article published February 17, 2005 titled, NASD Says Fund Family Paid Improper Fees by Riva Atlas, see: http://www.nytimes.com/2005/02/17/business/17fund.html?n=Top/Reference/Times%20Topics/Organizations/N/N. A.S.D.&_r=1&adxnnl=1&oref=slogin&adxnnlx=1194447630-eRAKYE/u1BndQTHHK7+qSA and, NASD (now FINRA) February 16, 2005 News Release: http://www.finra.org/PressRoom/NewsReleases/2005NewsReleases/p013358 (5) See, the U.S. Securities and Exchange Commission website at: http://www.sec.gov/rules/interp/interparchive/interparch2006.shtml (6) See Comment Letters on Commission Guidance dated September 7, 2006 from Elizabeth Krentzman, General Counsel - Investment Company Institute, and from Darrell Braman, Associate Legal Counsel, et. al. T. Rowe Price at: http://www.sec.gov/comments/s7-13-06/s71306.shtml

Changing Attitudes

by Bill George

11/7/2007

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