The Securities and Exchange Commission, Institutional Investor has learned, is gathering information for a regulatory review of brokerage commission bundling. Under this long-standing practice, fund managers use clients’ assets to pay brokerage firms for a wide array of services that critics charge broadly benefit the managers rather than their individual customers. Billions of dollars in annual commissions are involved, but investors receive little or no information on what their money is used to purchase.
“SEC staff are very actively scrutinizing the use of brokerage by advisers and funds to pay for various services,” says Lori Richards, head of the SEC’s office of compliance inspections and examinations.
Commissions may be legally used to pay for trading and research. But what constitutes research has blurred over time, permitting potential abuses that have caught the SEC’s attention. Broker-supplied services have grown to include third-party analytics such as Bloomberg terminals, consulting services and computer hardware and software. All of these are paid for with bundled commissions and so-called soft dollars -- credits that fund managers earn for directing commissions to brokers. Commissions also may underwrite myriad other services that generally benefit a fund company rather than the investors whose assets fund those payments. Mutual fund firms, for example, have begun to direct commissions to brokerage firms to induce them to sell the firms’ funds (Institutional Investor, June 2003) and to obtain allocations of hot IPOs.
“While the law allows advisers and funds to purchase research with soft dollars, too often there is a lack in transparency in these payments,” says the SEC’s Richards. “We are concerned about this lack of transparency, particularly given the conflict of interest in the adviser using client money to pay for services that the adviser would otherwise have to pay for itself.”
Critics contend that payment for services should be “unbundled” from the trading commissions so that fund shareholders can receive a strict accounting of what they’re paying for. Moreover, they argue, fund companies should closely scrutinize commissions to determine which services they’re willing to pay for. If a service benefits a fund generally but not individual customers specifically, critics say, the fund ought to pay for it out of pocket rather than charge customer assets.
The SEC’s probe is in its preliminary stages. Agency inspectors are still collecting information from fund managers and brokerages about how commissions are used. Any regulatory action is months away and could involve remedies that fall far short of unbundling.
But bundled commissions are so fundamental to Wall Street commerce that even modest changes could have a huge impact on the bottom lines of both brokerages and asset managers. “Unbundling would be on a par with May Day, in my mind,” says Seth Merrin, CEO of Liquidnet, an electronic network that matches institutional block trades. When commission rates were deregulated on May 1, 1975, investors’ trading costs tumbled, and scores of brokerages were forced out of business or into the arms of competitors. With unbundling, “you’re talking about the economic heart of this business,” says Merrin. “The impact would be absolutely mind-boggling.”
The SEC is sure to tread carefully. The agency encountered stiff industry resistance in the late 1990s when it conducted soft-dollar compliance sweeps. It found that money managers were using commissions to pay for everything from office equipment to mobile phones to employee salaries to -- in at least one case -- home improvements. The SEC urged fund managers to improve controls and more fully disclose soft-dollar practices, but, faced with fierce opposition from securities and fund industry lobbies, it issued no restrictions. In any case, the bull market was raging, and few investors decried the practice.
This time could be different. Three years of wrenching stock market losses have compelled investors and politicians to pay more attention to Wall Street’s hidden costs. In March, U.S. Representative Richard Baker, a Louisiana Republican who heads a key subcommittee on capital markets, asked the SEC to investigate fund costs. That inquiry helped spark the current one.
Upstaged by New York State Attorney General Eliot Spitzer on stock research conflicts and questionable mutual fund trading practices, the SEC has ample reason to aggressively pursue the commission inquiry: It’s already behind some foreign regulators. The U.K., acting on a two-year-old report by former Gartmore Investment Management chairman Paul Myners, is encouraging separate payment for trading and nontrading services (Institutional Investor, November 2002). The SEC is determined not to be seen as a laggard on this issue, say those familiar with the thinking of its officials.
Ironically, it was the SEC’s current chairman -- 72-year-old Bill Donaldson -- who created bundling in the first place. More than 40 years ago, the co-founder of Donaldson, Lufkin & Jenrette, along with his partners, came up with the idea of offering in-depth stock research to institutions and getting them to pay for it by trading with DLJ.
From that modest start, however, bundling has evolved into a far broader system that is much more susceptible to conflicts.
“It is an elaborate kickback scheme,” says Benn Steil, the André Meyer senior fellow in international economics at the Council on Foreign Relations, who has studied trading issues extensively. “In my opinion, this is bigger than tainted research. Most people realize that when an investment bank says, ‘Buy this stock,’ it’s marketing and salesmanship. But soft commissions are completely hidden. Nobody knows what’s going on behind the scenes.”
The SEC’s regulatory response could take any number of forms. At one extreme, the agency could force brokerages to charge for services separately, while requiring funds to pay for them in cash. At the other extreme (apart from doing nothing), the SEC could order increased disclosure of how commissions are being spent. A possible compromise: forcing funds to pay commissions out of their own pockets.
No matter what the remedy, it is sure to result in reduced payments for nontrading services, experts say. And that could prompt the same kinds of sweeping changes in the competitive landscape that May Day did. Fund managers’ costs would rise, forcing them to raise their fees or, conceivably, consolidate to gain economies of scale. Brokerage firm revenues would shrink, causing a similar emphasis on efficiency and size. Meanwhile, execution-only brokerages and alternative-trading venues would benefit, as asset managers sought out the best, cheapest execution for their nickel -- or penny.
