Soft-dollar clampdown explained

That scrutiny could lead to stepped-up enforcement action with NI 23-102, which regulates the use — the sharing — of client brokerage commissions, receiving approval from the Canadian Securities Administrators earlier this week. Once accepted by the country’s finance ministers, it will become effective June 30, 2010.

Acceptable goods and services provided through commission sharing include advice on the value of a security and whether to trade it; analysis of a security, portfolio strategy, issuer or industry; and databases and software that support these goods and services.

A fund could pay as low half a penny in trading commissions, but the overall commission load may vary.

But, the proposal shifts soft-dollar arrangements to the “middle ground” between a prescriptive regime and a principles-based one, with an emphasis on “good faith determination,” says Scott Peacock, deputy director, compliance and enforcement, with the Nova Scotia Securities Commission. He was speaking at a Strategy Institute summit on trading compliance and best execution, held in Toronto earlier this week.

Ellen Lee, vice-president, risk management, with TD Asset Management, applauds the regulators “for coming out with a sensible approach” with respect to disclosure.

Determining and justifying these costs, Lee notes, is “part of best execution,” which takes in proposed instrument NI 23-101, whose next iteration is expected toward December, as well as conflict of interest provisions in NI 31-103, the registration regime that came into effect at the end of September.

While both Ontario and Quebec have had rules on soft-dollar arrangements since 1986, global developments spurred regulators to publish a concept paper in 2005. Since that time, regulations in the U.S. and the U.K. have shaped the thinking of a Canadian policy, explains Serge Boisvert, regulatory analyst with the Autorité des marchés financiers. In addition, there were concerns about the availability of quantitative information when it came to client disclosure.

That proposal has changed, says Meg Tassie, senior advisor with the British Columbia Securities Commission. Instead, investment managers will have to provide a narrative report to clients, “so they can understand how their commissions are being used.” It also includes disclosure at the time a client opens an account.

Or, as Lee puts it, “the fund might have to sit down and write a story,” so the clients understand how advisors ensure they are not overpaying on commissions and how they benefit over time.

Commissions are supposed to be used for order execution and research. But the definition of order execution is complex. Jonathan Sylvestre, an accountant in market regulation with the Ontario Securities Commission, points out that there is a temporal standard, similar to what exists in the United States. Order execution begins when an investment manager makes an investment decision. Thus, market data, algorithmic software and order management systems may be integral to trade execution.

Goods and services received before the investment decision, however, are part of research, or perhaps a company’s overhead. Thus, databases and post-trade analytics may count as research goods and services. But then there are mixed-use goods, such as when order management systems are used not only for trade execution but also for compliance, accounting or recordkeeping. The portion of those costs involved has to be assumed by the business, as operating costs—and not by the client.

The new regulation will lead to a greater unbundling of services as well as growth in commission-sharing arrangements to satisfy best execution policies, suggests Sharon Persia, global head of commission sharing with UBS. Since the U.K. redefinition of soft-dollar rules in 2005 as commission-sharing arrangements, as well as the slightly later U.S. specification of client commission arrangements, Persia has seen UBS commission-sharing clients grow to 400 across the globe.

In the U.K., research costs are broken out separately from trade execution. That allows portfolio managers and fund advisors to target trading commissions to the best executing brokers, instead of directing them to mediocre ones just to receive their research. “People realize that it’s good business practice,” says Persia.

A fund manager might pay three basis points to the executing broker and accumulate 17 basis points in a pool to be used for propriety research or third-party research from other brokers. Typically, a fund manager will have five to 10 of these arrangements.

In Canada, these arrangements will require a policy on how commissions are allocated and whether supplying research services plays a role; a description of the nature of the arrangements for receiving research services; a list of the types of goods and services provided; and the names of any affiliates involved. Names of other brokers and third parties need not be explicitly disclosed, unless the client asks. In addition, managers will have to identify how they make a good faith determination that the services are a reasonable benefit for the client.

For his part, Peacock expects that “there will be an enforcement downside for failing to adhere to the intent and the purpose of the new instrument.”

While many head offices have rigid rules in harmony with the new regulations, they are not always observed at the branch level. “You must be able to produce a record for anything that results in a transaction,” he warns. Despite good faith determinations, “there must be a complete audit record.”