Soft Dollar - Examples

Examples

As an example, let's assume fund ABC Capital purchases computer equipment from XYZ Computers. Rather than paying XYZ for the computers, ABC adds a few cents to the brokerage fees it pays for executing transactions through its broker, LMN Brokers. LMN then sends payment to XYZ. (Of course, in this arrangement where third-party services have been acquired, there would be invoices and statements which would be documented in the broker's books and records and would serve as documentation of the expense.) If ABC had paid XYZ directly, the transaction would have been designated as a "hard dollar" cost.The costs of research services are generally not disclosed to the funds' investors. Fully disclosed third-party brokerage facilitates the provision of independently produced research, which may have fewer potential conflicts of interest.

An example of illegal use of undisclosed soft dollars might be when a mutual fund manager pays excess commissions and as a quid pro quo receives an allocation of a hot IPO from his broker (so he can flip the IPO, generally before the end of the stabilization period, for a fast profit). Or, a situation where a fund manager wants to reward a wire-house for providing "shelf space" and marketing favoritism for her family of funds, or perhaps where an investment manager wants to earn favoritism for late trading consideration by paying-up in commissions. Such brokerage arrangements, where favors are traded in exchange for institutional clients' excess commissions have been criticized by securities regulators. Full-service brokerage bundled commission arrangements involving the exchange of brokerage firms' undisclosed proprietary services provided for institutional clients' brokerage commissions (paid in excess of a fully negotiated execution only commission rate) can create conflicts of interest and motivate fraud. The lack of transparency in these full-service brokerage arrangements may shield abuses from immediate detection.

In soft dollar arrangements, the brokerage commissions are higher than they would be for an "execution only" trading relationship, and over time investment performance may suffer by that higher commission cost. Because institutional funds can trade a significant number of shares every day, the soft dollars add-up quickly. The amount of soft dollars institutional funds use is quite high (estimated in 2007 to be in excess of 11 billion dollars). (Note that soft dollar amounts do not have to be disclosed to anyone, not even the agencies responsible for oversight, so only estimates are available.) Because hard dollars eventually end up being reported as part of the management fee the fund charges its investors, soft dollar transactions are also a way for funds to lower their apparent fees (even though investors pay for the expense). But, over time, investment performance will deteriorate if the soft dollars are not used to purchase research that enhances performance. And the performance of individual investment accounts will deteriorate if the benefits of the services are not allocated back to the accounts that paid the extra commissions for the services.

Although soft dollar transactions have incurred a lot of scrutiny lately, the practice is still allowed Under Section 28(e)of The Securities Exchange Act of 1934, soft dollars are regulated by the U.S. Securities and Exchange Commission. In Australia soft dollars are not illegal although they are discouraged and must be disclosed in plain language terms to clients.