So-called “soft dollars” are seen as little more than payola by some, yet they are a treasured business practice for others. A proposed new rule that aims to restrict their use, and improve disclosure, is raising fears of dire consequences for the investment-management industry.

Soft dollars are theoretically used by money managers to pay for broker research by directing trading business toward firms that give them good ideas, paying commission rates that are higher than for basic trade execution. The range of goods and services the money managers get in return, however, may extend far beyond traditional research reports and often includes items ranging from data to software and newspaper subscriptions.

Critics of the practice argue that many of the expenses should be paid out of the money manager’s revenue and not clients’ assets, which is effectively what happens if managers are paying more than they should for trading.

Defenders argue that everything paid for with soft dollars is used to help inform managers’ trading decisions, which are made on behalf of clients. Client assets are being used, but they are getting a benefit as well.

The practice of using soft dollars has long had its share of skeptics, but it has come under more scrutiny in recent years — particularly after the mutual fund market-timing scandals in the U.S. brought fund industry integrity into serious question. If fund firms were letting certain investors time their funds at the expense of other clients, then why should firms be trusted to use client assets only for the benefit of those clients? Moreover, are the commissions charged to some clients being used to subsidize benefits that accrue to others?

These types of bundled commission arrangements are vulnerable to all kinds of abuse. And, at a time when clients and regulators have been given reasons not to trust fund managers to do the right thing, soft dollars have naturally fallen under greater suspicion. In response, some firms voluntarily gave up the use of soft dollars, while others became more disciplined about it and enhanced their disclosure. Nevertheless, regulators in Britain, the U.S. and now Canada have decided some intervention is necessary to raise the bar for the industry.

Earlier this year, the Canadian Securities Administrators issued a proposed rule that aims to define what can and can’t be paid for with soft dollars, and imposes added disclosure requirements on managers. The proposed rule restricts the use of soft dollars to research and order-execution services, including third-party providers.

The issue is sensitive to the asset-management industry, which is reflected in the fact that the CSA has received more than 40 comment letters on its proposed rule. Most are broadly supportive of the CSA’s intentions.

“We believe that more transparency in the use of soft dollars is in the best interests of investors. We support the Canadian Securities Administrators’ efforts to shed more light on this practice,” wrote the CPP Investment Board, the Toronto-based federal Crown corporation that invests the assets of the Canada Pension Plan.

But others have serious misgivings about details of the initiative.

And, typical of significant and controversial rule proposals, much of the commentary is self-serving and some of it is overwrought. Firms that rely on the entrenched practice of using soft-dollar commissions plead that their product should continue to qualify for soft dollars. Smaller firms fret that they will be harmed disproportionately by the rule, while big firms that can afford to implement whatever changes are necessary are more encouraging of the proposal.

The complaints include numerous arguments about what should be permissible to be paid for with soft dollars. Some argue that raw market data are essential to their trading decisions, while others insist they should not qualify. Others claim the cost of preparing the disclosure demanded by the rule could be crippling.

Toronto-based Heathbridge Capital Management Ltd. warns that the scale and scope of disclosure that the rule seems to require would effectively amount to a ban on soft dollars.

“Implementing the proposed policy as it is currently drafted would be exceptionally costly and disruptive. For our firm, the cost of implementing this policy would far exceed the amount of annual soft-dollar commissions,” it declares in its comment. “If you plan to kill soft dollars, simply do so. Don’t pretend to be permitting them, but strangle the practice for smaller investment counsellors in excessive disclosure requirements.”

@page_break@It’s not just small investment counsellors that worry about the cost. AGF Funds Inc. , for instance, insists the regulators seriously underestimate the start-up and ongoing compliance costs of the rule. AGF warns that, rather than costing $2,800 for each firm to implement, as the CSA has estimated, the cost could run into hundreds of thousands of dollars, if not millions.

AGF also argues that the rule doesn’t reflect the reality of the money-management industry; it requires “irrelevant and potentially misleading” disclosure; brokers should be required to unbundle their commissions; and the proposal isn’t harmonized with similar initiatives in the U.S. and Britain.

The CSA’s attempt to tackle the issues follows comparable efforts by Britain’s Financial Services Authority and the U.S. Securities and Exchange Commission. Numerous commentators argue that the CSA’s proposal deviates too far from the measures adopted by the FSA and the SEC — specifically that the CSA rule requires more detailed reporting and applies more broadly.

The apparent fear is that imposing more onerous requirements than have been implemented in other major jurisdictions exposes Canada’s asset-management industry to competition that is potentially crippling.

For example, the comment from Commission Direct Inc. states that foreign managers compete with Canadian managers for business, and if the former have a cost advantage over domestic firms, it “could translate into the decimation of the Canadian money-management industry. Domestic advisors will eventually have to make the choice of accepting lower margins as research costs are shifted to them or moving to more receptive jurisdictions,” Commission Direct warns. “Hollowing out Canada’s money-management industry would not be in the interests of investors or advisors.”

AGF insists the costs of implementing the proposed CSA rule will “dwarf” the potential benefits. It questions whether any benefits will emerge from the initiative, particularly from the new disclosure requirements.

Other commentators point out that money-management fees will simply increase to make up the difference if the managers are forced to pay for more of the tools they use.

But, even if the incremental expenses were passed along to the clients, however, they would presumably be offset by lower trading costs. Still, managers would surely prefer to avoid having such conversations with their clients.

Critics say it is difficult to believe the issue would be enough, in itself, to drive asset-management firms out of Canada. Almost as difficult as it is to believe opaque, bundled trading commissions, which are ripe for potential conflicts of interest, ultimately benefit clients. IE