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Outlawing "soft dollars" will crush the independents.


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Donald L. Luskin

I’ve been a vigorous defender of the investment-banking and mutual fund industries against over-reaching shakedowns by regulatory vigilante Eliot Spitzer. But now, in at attempt to deflect attention from the scandals raised by Spitzer, the funds business has done something so sleazy that I’m practically sorry I ever said a kind word about it.

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The Investment Company Institute — the powerful Washington lobbying organization that serves the mutual fund industry — has come out with a public call for the Securities and Exchange Commission to outlaw the use of so-called “soft dollar” brokerage commissions. Of course it’s all draped in grandiose rhetoric about how this “will benefit fund investors” and “restore trust and confidence in mutual funds, upon which tens of millions of Americans depend.” And besides, anything called “soft dollars” just must be bad, right?

Wrong. “Soft dollars” are one of the few remaining mechanisms that make it possible for independent investment research firms and small brokerage firms to compete against the Wall Street goliaths, and also allow smaller mutual funds and investment managers to compete against the behemoths of that industry. This is business as usual for industry lobbyists: The ICI’s initiative is all about entrenching the interests of the biggest players. And if it steals headlines from Eliot Spitzer for a couple of news cycles, so much the better.

I know the soft-dollar business intimately. My company — Trend Macrolytics LLC, a small, independent economics-research firm — depends on soft dollars for much of its revenues.

Here’s how it works:

An investment manager — perhaps a mutual fund manager — decides he’d like to receive our research, seeing it as an alternative or a complement to research he is already receiving from the big investment banks like Goldman Sachs or Salomon Smith Barney. Instead of simply writing a check to my company, the investment manager instructs a broker to pay me, and promises to do a certain amount of trading business with that broker in compensation. That’s soft dollars.

Critics say that’s not right. Why should commission dollars — paid out of the investment manager’s clients’ money — go to provide a research service that the manager himself ought to pay for out of his own pocket? That’s a fair question, but it begs a much bigger one: If that’s not right, then how come the manager can get comparable research from Goldman and Salomon without paying for it out of his own pocket? In truth, that research is also being paid for by commissions. There’s no such thing as a free lunch, or a free research report.

Congress addressed this matter in 1975 when it enacted section 28(e) of the Securities and Exchange Act of 1934. This statute makes it clear that investment managers may use clients’ commission dollars to pay for services — like research — that lie beyond trade execution. The statute makes no distinction as to whether such services must necessarily come from personnel of the same broker that executes the trades. Indeed, any such distinction is entirely meaningless and arbitrary.

Yet the ICI wants the SEC to make this distinction — and it’s a distinction that would put me and other small firms like mine out of business, leaving the giants of Wall Street free of independent competition. Make no mistake about it: the ICI wants the SEC to ban soft dollars only for independent research. They say they “urged the SEC to limit the use of soft dollars to the narrow category of proprietary research that reflects unique intellectual content.” ICI spokesperson John Collins confirmed to me that “proprietary” means research produced by brokers.

Would such an outcome serve investors? Hardly. Independent research firms were the ones who warned investors about Enron, Tyco, and Worldcom, while Wall Street maintained its “buy” ratings right up to the bitter end. And its independent research firms who, by definition, have no investment-banking conflicts. Are they the good guys we should be trying to encourage?

By the way, who, exactly, is served by the ICI’s initiative? The Wall Street giants, of course. The abolition of soft dollars would not only destroy Wall Street’s research competitors, but also its smaller-brokerage competitors — many of whom specialize in soft-dollar business.

And what a coincidence: Those Wall Street giants are the same firms whose sales forces sell mutual funds — like the huge American Funds family. And who is executive vice president and director of Capital Research and Management, the investment manager for American Funds? None other than Paul G. Haaga, Jr., chairman of the Investment Company Institute.

The big mutual fund families — like American Funds — would also be winners at the expense of their smaller rivals who have less influence in the corridors of power within the ICI. When the few surviving independent research companies must be paid out of investment managers’ own pockets, only the largest managers will have deep enough pockets to pay them. So only the giants will have access to the best research. The little guys will be stuck with nothing but Wall Street’s perpetual “buy” ratings.

What adds special irony to the ICI’s self-interested regulatory crusading is that — unlike “late trading” or “market timing” or other matters that have tainted the mutual fund industry of late — soft dollars have received constant and intense regulatory scrutiny for years, and have always come up with a clean bill of health. Even the ICI has had to admit that a 1998 SEC study of soft dollars — which was actually an industry-wide surprise audit — “found no soft dollar abuses by mutual funds.”

Perfect! The mutual fund industry — cowering under Eliot Spitzer’s rubber hose, and with so much housecleaning to do — distracts the SEC and the public with a scandal in which there have been no abuses! This is scandal “lite”: all the sensationalism with none of the guilt.

If the mutual fund industry gives a hoot about the welfare of the investing public, it really has only two choices. It should either take on Eliot Spitzer head-on and end the regime of this self-appointed regulatory czar, or confess its sins and put in place rigorous systems to make sure they’ll never happen again.

But this tomfoolery with soft dollars is nothing but self-serving, transparent grandstanding. It’s no way for the mutual fund industry to restore public trust.

– Donald Luskin is chief investment officer of Trend Macrolytics LLC, an independent economics and investment-research firm. He welcomes your comments at [email protected].



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