Tooled By Semantics

‘Tooled’ by Semantics, And A Whole Lot of Powerful Lobbying In 1975, after Congress mandated that the U.S. brokerage industry end fixed-price brokerage commissions(1) and institute fully-negotiated commissions, the U.S, Congress passed an amendment to the Securities Exchange Act of 1934. This amendment is known as Section 28(e). Section 28(e) provides a safe harbor for investment advisors acting as fiduciaries to ‘payup’ from their fully-negotiated brokerage commission rate and use the excess commissions ‘paid-up’ to pay for qualifying investment research. This use of client commissions, by fiduciaries, is subject to the fiduciary’s good faith judgment that the value of commissions paid is reasonable in relation to the value of research and brokerage services provided. After Section 28(e) was passed a new type of institutional brokerage business model began to evolve. This new brokerage business model provided trade execution and third-party investment research invoice payment in compliance with the U.S. Security and Exchange Commission’s interpretations of the safe harbor provided by Section 28(e). Because the brokerage firms adopting this new business model facilitated soft dollar payments to third-party research producers, these brokerage firms soon became known as soft dollar “converters”. Later “soft dollar brokers” became the conventional term used to describe these brokers. Over time the term “soft dollars” became inexorably and exclusively linked to the third-party brokerage business-model which had evolved in direct response to Section 28(e). Institutional fiduciaries, regulators and the investing public seemed to ignore the fact that significant soft dollars are also generated in full-service bundled brokerage arrangements. They also seem to ignore that third-party brokerage provides a documented and fully-disclosed audit trail of brokerage commission uses, while no comparable audit trail, and no comparable disclosure is available in bundled full-service soft dollar brokerage commission arrangements. In the late 1980’s the full-service brokerage and investment advisory industries began a public relations and lobbying campaign designed to hobble competition from the third-party brokerage and independent research producers. The full-service brokerage and investment advisory industry began to make allegations against and impugn what had erroneously, and without regard to proper definition, become known as “soft dollar brokerage”. I recall this lobbying campaign very well; however, retrospectively the first documented reference to this campaign that I can now find is a speech that actually came out of The U.S. Securities and Exchange Commission. The speech was delivered to the D.C. Bar Corporation, Securities Law and Finance Section by Richard G. Ketchum who at that time was Director, Division of Market Regulation of The SEC.(2) (Prior to joining the SEC Mr. Ketchum was Head of Bond Trading at Salomon Brothers Brokerage, now part of Citigroup). The next documented instance of this campaign came in Congressional testimony in 1993 when Goldman Sachs and Morgan Stanley strongly criticized “the soft dollar industry”.(3) At about the same time Byron Wien, then Chief Investment Strategist at Morgan Stanley, issued a report to his clients stating, “one of the most sinister aspects of commerce on Wall Street is the concept of soft dollars”.(4)

‘Tooled’ By Semantics, And A Whole Lot of Powerful Lobbying by Bill George 11/10/2007

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It’s widely understood, within the institutional brokerage business, that this lobbying effort by fullservice brokerage firms was the major stimulus that motivated the “inspection sweep” conducted by the SEC Office of Compliance, Inspections and Examinations. This sweep was conducted between November of 1996 and April of 1997. On September 22, 1998 the SEC Office of Compliance, Inspections and Examinations (OCIE) released its Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisors, and Mutual Funds.(5) As part of the Inspection Report the OCIE included the definition of soft-dollars. I’ve copied and pasted that definition (below) directly from the OCIE Inspection Report, it reads: “ 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)").” Further, in the OCIE’s Inspection Report, Section III. Examination Sweep: Objectives Methodology and Universe, the report states “We commenced the sweep with examinations of seventy-five broker dealers believed to be actively engaged in third-party soft dollar arrangements.” (6) So by its own admission, during the sweep, the SEC Office of Compliance, Examinations and Inspections focused its attention on examining and auditing third-party brokers; not on a broader examination of all brokerage industry soft dollar practices, as defined by the SEC OCIE’s interpretation of Section 28(e). Taking above history into account it seems that, until very recently, the lobbying efforts the fullservice brokerage industry and the enforcement focus of the U.S. Securities and Exchange Commission have quite effectively distracted attention from the abuses and conflicts-of-interest in undisclosed full-service bundled brokerage arrangements. Furthermore, it seems the constant parsing of terms and the misrepresentation about what are soft dollars, and what brokers and advisors infer are not soft dollars, contributes to significant confusion about the term “soft dollars”. Considering this history of soft dollars it’s sad and ironic that so many of the brokerage abuses discovered by Eliot Spitzer(7) and the New York State Attorney General’s Office in investigations and prosecutions in the early 2000’s and which are mentioned in the Global Analyst Research Settlement(8) were actually motivated by advisors’ and brokers’ collusive uses of institutional clients’ brokerage commissions in bundled undisclosed brokerage arrangements. Some examples of the kinds of conflicted behavior that were fueled by the undisclosed uses of institutional clients’ brokerage commissions are: mutual fund and high net-worth ‘wrap account’ directed commissions in exchange for brokerage distribution assistance – commonly known as shelf-space arrangements; mutual fund, and other trusteed retirement and savings plan ‘directed brokerage’ in exchange of allocations of new issues (IPO’s), corporate executives’ promises to direct investment banking engagements and have internally sponsored savings and retirement plans ‘direct’ trades to broker dealer’s in exchange for analysts’ positive coverage and in exchange for IPO allocation to company executives, and brokerage order-flow ‘directed’ to brokers in exchange of mutual fund late trading ‘privileges’.

* Directed brokerage occurs when a client, an investment advisor, a mutual fund director or other executive successfully designates which broker will receive the opportunity to execute trades.

‘Tooled’ By Semantics, And A Whole Lot of Powerful Lobbying by Bill George 11/10/2007

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In consideration of this history, it seems odd that there is any debate or any reason to delay a regulatory mandate for full disclosure and transparency in all institutional brokerage arrangements.

Footnotes: (1) See, The New Breadth of Competition speech to Seminar on The Analysis of Security Prices, The University of Chicago by A.A. Sommer, Jr. SEC Commissioner May 15, 1975. http://www.sec.gov/news/speech/speecharchive/1975speech.shtml (2) Remarks of SEC Director Richard G. Ketchum* Division of Market Regulation Before The D.C. Bar Corporation and Securities Law Section delivered March 22, 1989 begin reading at the last paragraph on page 7 - beginning with the words: With or without. http://www.sec.gov/news/speech/1989/032289ketchum.pdf (3) Benchmark Alert article titled, Pensions and Brokerage published October 2000, see the second paragraph above the “Press Release” at the bottom of the page: http://www.benchmarkalert.com/newsletters/newsletter/2956736/25479.htm (4) See top of page 27 of U.S. Senate testimony given to the Committee on Banking, Housing and Urban Affairs by Harold Bradley on March 31, 2004, for quote from U.S. Congressional testimony given to the House Telecommunications and Finance Committee, on July 12, 1993, by David Selfin, partner, Goldman Sachs & Co. http://banking.senate.gov/_files/bradley.pdf (5) The SEC Office of Compliance, Inspections and Examinations (OCIE) released its Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisors, and Mutual Funds. http://www.sec.gov/news/studies/softdolr.htm (6) On September 22, 1998 The SEC Office of Compliance, Inspections and Examinations (OCIE) released its sweep Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisors, and Mutual Funds. See, Section III. Examination Sweep: Objective Methodology and Universe - second paragraph. http://www.sec.gov/news/studies/softdolr.htm (7) See, Wikipedia entry for Eliot Spitzer Securities sect 3.2.1.2 at http://en.wikipedia.org/wiki/Eliot_Spitzer#Securities (8) See Wikipedia entry for Global Analyst Research Settlement http://en.wikipedia.org/wiki/Global_settlement and Blood on The Street by Charles Gasparino http://www.amazon.com/Blood-Street-Sensational-GenerationInvestors/dp/0743250230/ref=pd_bbs_sr_2?ie=UTF8&s=books&qid=1194621970&sr=1-2

‘Tooled’ By Semantics, And A Whole Lot of Powerful Lobbying by Bill George 11/10/2007

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