Soft Dollar - Background and History

Background and History

In the brokerage business, soft dollars have been in use for many years. Prior to May 1, 1975, all brokerage firms used a fixed price commission schedule published by the New York Stock Exchange; the schedule was a matrix listing the number of shares in the trade on one axis, the stock's price per share on the other axis, and the corresponding commission charge in the cells of the matrix. Because broker/dealers traditionally were required to charge a fixed commission and could not compete by lowering the commission for a trade, they soon began to compete by providing additional services to their institutional clients. In the industry this became known as “bundling” services with commissions.

In the early 1970s, the U.S. government investigated the brokerage industry’s pricing practices. They concluded the industry was engaged in price fixing. The government told the brokerage industry that, as of May 1, 1975 it would be required to “fully negotiate” brokerage commissions with each client for each trade. As the May 1, 1975 deadline approached the brokerage industry went through several changes in an attempt to restructure itself so it could offer services and negotiate the price of each service separately. In the industry this process was known as “unbundling.” and created the Discount Brokerage segment of the industry. At the same time, the brokerage industry lobbied Congress to allow it to continue to include the cost of investment research given to institutional clients as part of the fully negotiated commission. Shortly after May 1, 1975 Congress passed an amendment to Section 28 of The Securities Exchange Act of 1934. Section 28(e) provides a "safe harbor" for any fiduciary that “pays-up” from its fully negotiated commission rate to receive qualifying research from its broker(s).

The Securities and Exchange Commission is responsible for interpreting and enforcing Section 28(e). In Section 28(e) the definition of qualifying services is detailed and explicit, but Section 28(e) is not a rule it is just a "safe harbor". The use of client commissions to pay for services which are not within the safe harbor of Section 28(e) is not defensible under the safe harbor. A fiduciary who “pays-up” in client commissions to receive non-qualifying services must be able to defend the use of the excess brokerage commissions (and the allocation of services received) on the basis of fiduciary law. Under fiduciary law it is the fiduciary's responsibility to use its client's assets for the exclusive benefit of the client / beneficiary /principal. Fiduciary law and ERISA have confirmed that institutional brokerage commissions are an asset of the client / beneficiary / principal.

Statistical studies over several recent years and large populations of institutional trade data have revealed that the cost of executing and clearing institutional trades is between 1.25 and 1.65 cents per share. Most institutional advisors pay 5 to 6 cents per share commissions to their brokers. Many of these institutional fiduciaries provide no disclosure of what "services" they are receiving for the excess over their fully negotiated commission rate. In bundled full service brokerage arrangements this lack of disclosure is particularly problematic because it makes it difficult to apply Section 28(e) tests and measure Section 28(e) compliance.