The Canadian Securities Administrators have taken another crack at establishing a rule governing the use of so-called “soft dollars” after their first attempt was met with plenty of industry outcry.

This latest effort reflects the regulators’ response to the many criticisms that were levelled at the rule it first published for comment back in the summer of 2006. More than 40 comments were received then, primarily from buy-side firms. The comments were largely critical of the initiative designed to limit the use of soft dollars — the practice of money managers paying indirectly for research and other services from brokerage firms through their allocation of trading commissions — and to enhance disclosure to clients about the use of soft dollars.

Some of those who commented warned that the rule was so onerous that it would drive firms out of the country to escape its grasp. Others complained that the new rule would be too expensive to implement and would unnecessarily add to costs that must ultimately be passed on to clients.

Based on this latest version of the rule, released on Jan. 11, it appears that regulators took much of that criticism to heart. It proposes to narrow the scope of the rule so that it only applies to trades that portfolio managers make on behalf of accounts that they have discretion over, and for which the dealer charges a commission. It also aims to do a better job of defining what is considered an order execution service, what constitutes research and clarifying what sorts of goods and services would be considered eligible to be paid for with soft dollars.

The new version also attempts to focus the rule on whether the things that money managers want to buy with brokerage commissions actually benefit the clients that are ultimately funding these payments. This was also the underlying purpose of the original rule, but regulators have now added guidance to the rule indicating that for goods and services to be considered a benefit to clients, they must help them either make investment decisions or carry out trades. The advisor should also be able to “demonstrate” how the goods and services paid for with brokerage commissions help the clients, it notes.

As a result of this new guidance, the regulators have deleted the obligation in the original rule that money managers must ensure that the research received adds value to their decisions.

Other changes include relaxing some of the language in the rule so that firms don’t have to be able to draw a direct connection between particular goods and services and specific clients. Advisors also aren’t required to accurately value the goods and services received, only to make a good faith effort to ensure that the amount of commission paid is reasonable in light of the services received.

VOLUME AND VALUE

Firms also complained about the volume and value of additional disclosure that would be required under the proposed new regime. Here again, the regulators are making changes to the rule, but they insist that additional disclosure is necessary to improve transparency to clients and, by implication, client oversight of their advisors’ spending habits.

“To respond to the comments, though, we have made changes to the proposed disclosure requirements that we think provide an appropriate balance between the need for transparency and accountability, the associated bur-
den and costs that might be imposed on advisors, and the aim for consistency with disclosure in the U.S.,” the CSA notice explains.

In general, those changes include cutting back on some of the quantitative disclosure demands (shifting the requirement from the client level to disclosure on an aggregated basis) while increasing discussion of why brokers are chosen and how firms ensure they are getting value for their commissions.

Additionally, the CSA is proposing that firms be given a six-month transition period after the rule is approved until it takes effect. Regulators say that, as they have removed some of the original rule’s more onerous requirements, a six-month transition period should be good enough. However, they are willing to consider whether there should be a longer transition period just for the new disclosure requirements to give firms and regulators time to see whether U.S. regulators come out with anything new on the subject.

@page_break@The U.S. Securities and Exchange Commission published guidance on the use of soft dollars back in 2006, but there is also some sense that the SEC may yet introduce reforms of its own to improve transparency around the use of such commissions.

In addition to possibly considering a different transition period for the disclosure part of the rule, the CSA also proposes the idea of allowing an advisor the flexibility of complying with another jurisdiction’s disclosure requirements if they can demonstrate that those requirements are similar to the ones the CSA is proposing. This is a nod toward the fact that so many of the goods and services covered by this sort of rule are utilized cross-border and that regulators in the U.S. and Britain have been grappling with these same issues in recent years.

One of the main complaints about the CSA’s original proposal was that it seemed to impose obligations that were tougher than those in other jurisdictions. The CSA acknowledges that those who provided comment generally suggested that the Canadian regime should be harmonized with the U.S. and Britain — although, it points out, this ignores the fact that there are also differences between those regimes.

It remains to be seen if the industry is any happier with the CSA’s latest effort. It seemingly attempts to address the primary complaints against the first proposal — that the requirements were too onerous and too different from those in other jurisdictions.

Nevertheless, there still isn’t unanimity among the regulators on this issue. The British Columbia Securities Commission published its own notice on the issue back in 2006, when the rest of the CSA came out with the proposed rule. It suggested that the existing regulatory obligations and rules were enough to ensure appropriate regulation of soft dollars.

This time around, the BCSC is participating in the publication of the rule with the rest of the CSA. But it notes that the commission’s board has not yet decided whether it will adopt the proposed rule.

This version will go out for another 90-day comment period, indicating that regulators want to give the industry plenty of time to consider its implications. Firms have been scaling back their use of soft dollars in recent years in preparation for some kind of regulatory restriction on them. The latest data from Greenwich Research Inc. indicates that firms trimmed their allocation to soft dollars to 7% of brokerage commissions in 2007 from 8% in 2006 and 11% in 2005.

Greenwich has observed the same basic trend in the U.S., with firms cutting their use of soft dollars in anticipation of regulation. But more recently, it notes that as firms came to believe that soft dollars aren’t going to be banned outright, or treated very restrictively, they’ve started to plan to ramp up their use again. IE