Drilling Down

Drilling Down In the beginning of each year, usually late in the first quarter, institutional investment consulting firms report information about the prior year’s institutional brokerage commissions. The reported information is derived from advisors’ voluntary responses to “blind” questionnaires. The data from the questionnaires is collected, combined and then treated statistically; so industry wide conclusions can be derived from the questionnaires’ sample population. I’ve noticed one significant shortcoming in this reporting process. It seems that the consultants’ reporting on institutional advisors’ prior year soft dollar brokerage expenses only identify soft dollars generated from third-party brokerage and used to pay for independent research. And, therefore it seems this process and the reporting seems to have contributed to a very general misunderstanding about soft dollar arrangements. Soft dollars generated out of third party brokerage and used to purchase independently produced (i.e. non-broker sponsored) research are estimated to be only about ten percent of total soft dollars generated in institutional brokerage arrangements. The remaining ninety per cent of soft dollars are generated in full-service bundled undisclosed brokerage arrangements; these soft dollars are used to buy proprietary research and other services from full-service brokers. It seems that it might be helpful if investment consultants attempt to identify and quantify this other very significant use of soft dollars. Since the institutional investment consultants who use this questionnaire process are probably preparing their 2007 questionnaires now, I thought it might be helpful to propose a more comprehensive approach. My proposal for the brokerage commission section of the 2007 questionnaire follows a top-down and definitional approach to accounting for the total uses of institutional clients’ brokerage commissions. I suggest the 2007 questionnaire be structured something like the following:

Dear Respondent: To the best of your ability please estimate the dollar amount for each of the following questions. (To increase the precision of your estimates you may want review commission expense data from your firms’ trade and broker allocation documents, research committee documents, soft dollar budget documents, and data from your firm’s compliance department): (1) What was the firm’s total brokerage commissions paid during 2007? (2) What portion of these total commissions do you estimate was used to purchase execution related services from all of the broker dealers you use? (3) Using the SEC’s definition of soft dollars* please estimate the total of commissions generated out of third party brokerage arrangements and used to purchase independently produced research which qualifies for the safe harbor of Section 28(e). (4) Using the SEC’s definition of soft dollars please estimate the total commission expenses generated out of full-service brokerage arrangements and used to purchase affiliated (proprietary) broker research which qualifies for the safe harbor of Section 28(e). (5) Please provide the portion of total commission expanses which were client directed. (6) Please provide the portion of total commission expenses used for other purposes within your firm’s fiduciary discretion. * 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

Drilling Down by Bill George

11/8/2007