Only an outright ban of 'soft dollars' makes sense

Investor's Business Daily: Breaking News: "The Securities and Exchange Commission is finally attacking a legal form of kickback that has plagued the financial industry for years, allowing money managers to use their customers' trades to pay for computers, software, research reports and other items that in years past included limousine rentals and magazine subscriptions.

The kickback is called a "soft dollar" and it's given as a credit to managers who trade through certain brokerages. These credits can then be used to purchase things. Think of it as a frequent-flyer program where you, the average investor, are picking up the bill while someone else, your money management firm, is getting to use all those "free points."

Two weeks ago the SEC sent out an Interpretative Release revising what it believes are acceptable soft-dollar purchases. People have until Nov. 25 to comment.

Here's one comment: The rules don't go far enough and there should be an outright ban on soft dollars. Because soft dollars pose an inherent conflict of interest.

Here's why: Money managers have an obligation to get the best price per share for customers when they trade stocks. This means they cannot trade through a brokerage house that jacks up commissions or fails to obtain the best "market price" for an order.

The problem is, commission structures are murky and "best execution," or that best-price-per-share mandate, is arguable. The market timing, conditions and size of trade orders all impact what amount to the manager's obligation, as a fiduciary, to get best execution.

So, while a manager may have the opportunity to get the exact same order filled at the exact same price between two rival brokerages, it would behoove him or her to trade through the one offering a better soft dollar deal.

That means no matter how you spin it, a conflict is embedded in the decision-making process.

Sure, soft-dollar defenders can claim that they are required to disclose their commission arrangements, and that banning soft dollars tips the scales in favor of bigger managers who can afford better research. Moreover they can argue, as the SEC itself does, that an outright soft-dollar ban impinges independent, third-party research.

But that's a complicated and, at its base, poor, defense. It would be much easier to create a more-transparent trading environment whereby managers outright pay for "research" with hard cash.

The SEC is proposing that soft-dollar arrangements be limited to "advice", "analyses" and "reports." It further states "physical items, such as computer hardware" will no longer be acceptable soft-dollar purchases. However, "brokerage and research services" that "effect" a trade will still be up for soft-dollar grabs.

This new guidance ignores the overarching raison d'etre of soft dollars -- to curry favor.

After all, the whole point of frequent-flyer or affinity programs is to build brand loyalty. Sometimes people are willing to pay a little more or take a less convenient flight in order to rack up more award points. Fine when it's your money. Money managers can't claim this right. If anything, their customers, that'd be you, should receive the credit benefits. Give it back to your money manager as a holiday gift if you want, but the decision should be yours.

Instead, the SEC is meekly revising the practice of soft-dollar rewards -- after almost 20 years, during which time we've seen the most abusive Wall Street scandals in history.

Some of these scandals have included soft-dollar use. If that's not enough, take the SEC's own 1998 study of hundreds of money managers and their soft-dollar practices: 28% of advisers and 35% of broker-dealers provided and received nonresearch products and services in soft-dollar arrangements including employees' salaries, hotel and rental car costs, personal travel and entertainment, it found.

Now, I wouldn't mind getting some of my trips paid for with my brokerage award points. But I do mind that my money manager has the potential to take a vacation on my trading dollar.

That kind of temptation should not be present when a money manager makes a trading decision. Making a hard rule to ban soft dollars would wipe away the estimated $1 billion a year practice that tantalizes Wall Street, but that insiders know shouldn't really exist."