Soft Dollar Brokerage

Soft dollar brokerage, or simply soft dollars, is an arrangement in which brokerage firms offer institutional investors products and services other than the execution of trades. Institutional investors, such as mutual funds and pension funds, pay a commission to brokerage firms to execute trades of securities. In addition to executing trades, brokerage firms offer some institutional investors credits for other products and services, most commonly proprietary research. These products and services, which are typically provided by a third party, such as research firms, are paid for by the brokerage firm. The credits for these products and service are called soft dollars.

This arrangement began in the 1950s with the growth of institutional investors during a period of fixed commissions for securities traded on the New York Stock Exchange. Barred from competing for volume customers by offering lower commissions, brokerage firms offered various nonprice benefits, including research services, in lieu of lower commission rates. After the system of fixed commissions was abolished in May 1975, the practice of soft dollars continued. Although commission rates declined after that date and customers could pay for only the execution of trades, soft dollar arrangements continued to [Page 1980]be an important form of competition among brokerage firms and a significant source of resources for institutional investment funds.

The legislation ending fixed commissions, the Securities Act Amendments of 1975, reiterated that fund managers have a fiduciary duty to secure the best execution of trades, which includes paying low commissions. However, Section 28(e) created a safe harbor that allows soft dollar arrangements as long as the managers believe in good faith that a higher-than-market commission is reasonable in relation to the value of the brokerage and research services provided.

For such a little-known practice, soft dollars has received a surprising amount of moral concern, with some observers claiming that it did not pass “the smell test.” Soft dollars was the subject of a 1998 report by the Securities and Exchange Commission, and in the same year, the Association for Investment Management Research issued extensive guidelines for soft dollar arrangements.

Moral criticism of soft dollars has two sources. First, soft dollars is a virtually invisible process that appears to depart from the ideal of arm's-length economic transactions. In soft dollar arrangements, the managers of institutional investment funds seem to be paying brokers more than necessary for executing trades and receiving other benefits in return. The costs of execution and research are bundled together in ways that other parties (e.g., mutual fund investors) may not be aware of and cannot easily evaluate. Expressed in the terms of agency theory, investors (the principals) have the task of monitoring fund managers (their agents). The lack of transparency and market forces makes the monitoring of fund managers by investors more difficult. As a result, investors either suffer the agency costs of inadequate monitoring or else are forced to incur additional monitoring costs. That transactions should be unbundled and made transparent are key elements not only of sound financial practice but also of effective monitoring.

Second, investment fund managers, as fiduciaries, have a fiduciary duty to act in the best interests of a fund's investors. This includes obtaining “best execution” and using any soft dollars solely for the benefit of a fund's investors. However, soft dollars appears to create incentives for fund managers to advance their own interests or the interests of a fund's adviser to the detriment of investors. This would be not only a violation of fiduciary duty but also an unacceptable conflict of interest. Fund managers might unjustly enrich themselves through soft dollar arrangements by engaging in excessive trading or “churning” designed merely to generate more soft dollars. They might also use soft dollars for purposes other than research that benefits a fund's investors, and finally, the benefit from soft dollars may make managers more careless about monitoring the quality of a brokerage firm's execution. All these possibilities would violate the safe harbor provision of Section 28(e), but critics of soft dollars complain that the vagueness of this law leaves investors with inadequate protection.

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