SEC Gearing Up for New Rules

Get ready. The Securities and Exchange Commission is expected to issue a new rule this year on soft dollars as well as amendments to Form ADV Part II. Plus, the securities regulator has started a new risk-based exam cycle for advisors–called “risk targeted sweeps”– and has implemented a new exam hotline that advisors can call if they want to rant about an exam. Advisors, too, can expect a money-laundering rule from the U.S. Treasury Department this year.

In March, the SEC decided against requiring a mandatory 2% redemption fee on mutual fund shares that are sold within five days of purchase. The Commission voted instead for a voluntary seven-day redemption fee. This has prompted many investment professionals to question why the SEC even bothered to issue a rule, since mutual fund boards could already voluntarily set a redemption fee to thwart market timers.

Greg Knopf, managing director of Highmark Funds in San Francisco, is one such fund manager who’s still scratching his head. “I think the SEC could have easily done nothing and let funds act individually,” he says. In December, his firm implemented a 2% redemption fee for a period of five days. “Whether we will change that to seven days” is uncertain, he says. “You’re going to thwart market timing with five days just as you would with seven.”

Jeffrey Ptak, a senior mutual fund analyst at Morningstar, says that “it’s disappointing that the SEC wasn’t able to find its way to mandating this” redemption fee rule. A 2% fee on redemptions made within five days is “hardly something that would crimp the style of a lot of shareholders,” he says. Further, in “the original proposal the SEC had carved out exceptions for shareholders with smaller [withdrawal] amounts, and also people that had to withdraw in certain hardship situations.”

The SEC has also decided not to completely do away with soft dollars, a measure the Commission was contemplating last year. “We are not banning soft dollars,” Nancy Morris, an attorney in the SEC’s Division of Investment Management told advisors at a compliance conference in Washington held by the Investment Counsel Association of America (ICAA) and IA Week in early March. “The SEC is looking at recordkeeping, and what information brokers and advisors must keep,” she said. Everyone expected the SEC to put out a rule on soft dollars early in 2005, but we’ll have to wait until later this year.

Robert Haggerty, a senior analyst at TowerGroup, a financial services research firm in Needham, Massachusetts, says the SEC is “doing the right thing” by not banning soft dollars and focusing on transparency and disclosure. “The real issue with soft dollars is trying to achieve best execution,” he says. “It’s hard to imagine investment managers are really achieving best execution when agreements have been made to trade a certain amount for a broker because the [broker] provided [the manager] with some research.” He adds that investment managers should be disclosing “who they are doing business with, and whether it’s soft or hard dollars, combined with [whether they are] achieving best execution of trades.”

Morris with SEC said the regulator was not moving toward requiring brokers and money managers to unbundle commissions–a practice that’s now used in the UK. Rather, the SEC wants “people to know where the money is being spent,” Morris said. But John Meserve, president of Westminster Research, a subsidiary of Bank of New York, argues that if “recordkeeping and disclosure requires Goldman Sachs to tell Putnam what’s in a commission dollar, you are effectively unbundling.”

All Research the Same

At Westminster, a third-party research firm, clients get a statement that tells them how much money they’ve paid for research and how much for execution, so clients see “what’s in the commission,” Meserve says. But the real issue with soft dollars according to SEC Chairman William Donaldson, he says, is what types of information does “a proprietary firm have to give to its fund manager clients.” Thomas Lemke, a partner with the law firm Morgan Lewis & Bockius in Washington, told ICAA conference attendees that the SEC thinks proprietary and third-party research should be treated the same. Donaldson told Congress last year that independent third-party research and proprietary research “need to be treated alike so that they are on a level playing field,” Meserve adds.

Indeed, Donaldson confirmed those opinions in testimony before the Senate Banking Committee last month. He said SEC staff is examining the definition of “research” as used in Section 28(e) of the Securities Exchange Act of 1934. “Soft-dollar arrangements present many of the same concerns irrespective of whether research is provided on a proprietary basis, or by an independent research provider,” he told Congress. Donaldson said he expects SEC staff to accord similar treatment to research that is provided on a proprietary basis and to research by independent providers.

What’s going on now, Meserve says, is that the “money managers that have been in the regulatory spotlight have said, ‘Let’s pay cash for third-party research’” instead of using soft dollars. A lot of fund companies have “been paralyzed as to what to do [now that] some of the larger fund companies are suggesting paying cash for these services,” he says. “They are looking for clarity from the SEC.”