Handling FINRA Inquiries into Improper Soft Dollar Arrangements

Soft dollar arrangements, are a controversial practice, in the investment industry. They, involve investment managers directing trades, to brokers who provide research, or other services, instead of executing trades, through the lowest-cost channels. While, soft dollars can provide valuable research, they also raise concerns, about conflicts of interest, lack of transparency, and potential harm, to investors’ returns.

What are Soft Dollar Arrangements?

Soft dollar arrangements, allow investment managers, to receive research, market data, and other services, from brokers, in exchange for directing trades, through those brokers. The “soft dollars” refer, to the commission revenues, brokers receive from executing trades, which cover the cost, of the services provided.The services, can include:

• Investment research reports
• Software and data feeds
• Access to expert networks
• Conference attendance fees

Brokers, provide these services, at no explicit charge, to investment managers, who then direct trades, through those brokers, generating commission revenues.

Potential Benefits of Soft Dollars

Proponents, argue soft dollars, provide valuable research, and services to investment managers, which can enhance, their investment decision-making, and ultimately benefit clients. They, contend soft dollars, are a cost-effective way, to obtain high-quality research, without directly passing on costs, to clients.1

Concerns and Criticisms

However, critics argue, soft dollar arrangements, create conflicts of interest, and lack transparency, which can harm investors:

1. Conflicts of Interest: Investment managers, may have incentives, to direct trades, to brokers providing soft dollars, rather than executing trades, through the lowest-cost channels. This, can increase trading costs, and eat into returns.2
2. Lack of Transparency: Soft dollar costs, are not explicitly disclosed, to investors, making it difficult, to assess their impact, on returns.3
3. Potential for Abuse: There is a risk, investment managers, may use soft dollars, for non-research purposes, such as entertainment, or other expenses, not benefiting clients.4
4. Questionable Value: Some studies, suggest the research, obtained through soft dollars, may not actually enhance, investment performance.5

Regulatory Scrutiny and Reform

Due to these concerns, regulators, have increased scrutiny, of soft dollar practices. In 2006, the SEC, introduced new disclosure requirements, for investment managers, regarding their use, of client commissions.6The European Union’s MiFID II regulations, implemented in 2018, effectively banned, the use of soft dollars, for investment research, requiring explicit payment, for such services.7While soft dollars, remain permissible, in the United States, under certain conditions, the regulatory landscape, is shifting towards, greater transparency and accountability.

Best Practices for Investment Managers

To mitigate risks, and ensure compliance, investment managers, should consider:

1. Robust Policies and Procedures: Establish clear policies, governing the use, of soft dollars, including what qualifies, as permissible research, and how to evaluate, and document, the research’s value.
2. Disclosure and Transparency: Provide detailed disclosure, to clients, about soft dollar arrangements, including the types of services received, and their estimated value.
3. Periodic Reviews: Regularly review soft dollar practices, to ensure they align, with the firm’s policies, regulatory requirements, and clients’ best interests.
4. Consider Explicit Payment: Evaluate whether explicitly paying, for research and services, rather than using soft dollars, may be more transparent and cost-effective.
5. Stay Informed: Closely monitor regulatory developments, and industry best practices, regarding soft dollar arrangements.