December 1, 2010

Soft Dollars and Investor Relations

A note on trading today: The dollar dropped out of the gate this morning, buoying stocks. Talk about soft dollars. The price of shares is a construct of the Fed at present.

Anyway, after sharing the Hyatt in downtown Seattle with the Kansas City Chiefs (convincing victors Sunday), we returned to Denver Monday, body-scanned once but otherwise briskly processed through airport security. So we’re a day late with The Map.

Speaking of body scans, the SEC’s current insider-trading probe is poking at the squishy Wall Street practice of rebating trading costs with “soft dollars.” We should know about soft dollars in the IR profession. Chances are, the last sizeable institutional position taken in your stock involved them.

The soft-dollar tale is twisted and winding. It’s another lesson on the foibles of policies predicated on exceptions to rules. Our story begins in 1975, when regulators and congresspersons decided that cash on the barrelhead was a quaint, anachronistic notion unfit for a society increasingly enamored with convolutions. Better if the exchange of valuable services involved paperwork, puts and takes, and accounting gimmicks.

Obtuse? Only in part. From the late 1700s, the Buttonwood Agreement governed cash on the barrelhead trading. It was two sentences long and said that brokers would trade with each other and charge the same commission. From it came the NYSE. Since commissions were fixed, brokers differentiated themselves by bundling proprietary research with trade executions. Business 101. Separate yourself from competitors on service, not price.

With the Securities Acts Amendments of 1975 came the death of fixed commissions by congressional decree. By doing so, government put the focus on price rather than service. Confusion bloomed. The SEC Act of 1934, along with the Investment Advisors Act, the Investment Company Act (both in 1940) and the Employee Retirement Income Security Act (ERISA) of 1974, all placed restrictions on using client funds for brokerage services. But with commissions and other services unbundled, how were advisors to obtain research? How were brokers to differentiate themselves on any basis but price if fiduciary duty required institutions to pay the lowest possible commission?

Ah, the unintended consequences. Congress had to amend the Exchange Act of 1934 with Exception 28(e), since one law was now contradicting three other laws. With that exception to the rule, Soft Dollars were born. This safe harbor gave institutions and brokers the ability to use client funds for other services, so long as a good-faith belief in benefit and reasonableness buttressed the decision.

Well, disputes arose. Investigations ensued. The SEC issued a series of interpretive rulings, some reversing or contradicting earlier positions. Entire businesses such as Investment Information Inc, flourished, helping brokerages and their clients manage soft dollars, only to be wiped out by revised SEC views of what constituted compliance. From 1986 to present, interpretations have pulsed, coalesced, dimmed, brightened, flashed and fluctuated. And soft dollar programs exploded after Eliot Spitzer’s 2003 settlement with the sellside deprived brokerages of the capacity to associate research and trading at all.

Here’s an irony. Heavier soft dollars come from large investors that buy and hold stock. Why? Trading costs can eat up returns. Soft dollars offset that impact. So, it’s likely that position-building by large institutions will include soft dollars.

Now the SEC believes nefarious deeds lurk in the soft-dollar cesspool. No wonder. It’s a complicated construct. It demands good faith, the sort of thing in short supply with those who want to cheat.

It also demonstrates that replacing two sentences between businesses with reams of federal registry entries is neither healthy nor expedient. And it’s what happens when buyers stop paying sellers and turn instead to byzantine intermediary rebate and allocation schemes – the same notion that underpins maker-taker trading markets, social programs, defense spending, and health care in the United States.


Occam’s Razor. The law of economy. Simplest is best. The 14th Century Franciscan Friar Thomas of Ockham (Occam) wrote that “entities must not be multiplied beyond necessity.” Maybe we could learn from the good friar.

Soft dollars are the opposite of hard dollars. Which would we prefer?

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