More Concern over Commission Sharing Agreements

I’ve been thinking about Michael Mayhew’s article, “CSA Agreements Pose Problems
For Some” which was posted on the Integrity Research web log on December 10,
2006 and which included a re-publication of a Wall Street Journal article titled, “Funds
Consider New Way to Pay For Research” by Tom Lauricella, originally published in the
WSJ on December 8, 2006; page C1.(1) I’ve also been thinking about Ivy Schmerken’s
article, “Buy Side Dilemma: Research vs. Execution” which was published in the
December issue of Advanced Trading.(2) And I’ve been thinking about the public
comments [some of which touched on Commission Sharing Agreements] that were
posted on the SEC website in the sections relating to the recent “Commission Guidance
Regarding The Appropriate Use of Client Commissions Under Section 28(e) of the
Securities Exchange Act of 1934.”(3)

In my opinion - in the present environment - there are two very important concerns
about the effects of the implementation of Commission Sharing Agreements (CSA’s)
that haven’t been sufficiently discussed. These two very important concerns are
disclosure and regulation.

Disclosure:
In many discussions about CSA’s comparisons are made to the soft dollar regulations
recently implemented by the Financial Services Authority (FSA) in Great Britain. Some
say that CSA’s seem to be working well in Great Britain, so it should be possible to
implement them in the U.S. without any problems. To me, this is alarming reasoning,
the soft dollar regulations implemented by the FSA are substantially different than those
implemented by the SEC in at least one significant respect. That is, The FSA mandated
guidelines for commission disclosure, the SEC has not mandated such guidelines or
issued interpretive guidance on disclosure.(4)

I believe it’s reasonable to assume, that without a mandate for disclosure, full service
brokerage firms and institutional investment advisors will continue to be tempted to use
client commissions to buy goods and services that do not accrue to the direct benefit of
the institutional investor whose commissions are paying for those goods and services.
In the Integrity Research web log article, “Marginal Values”(5) in the section titled,
Disclosure and Transparency I summarize how bundled undisclosed commission
arrangements have been used to obscure the quid-pro-quos that motivate conflicts of
interest and tempt brokerage employees and fiduciary investment advisors.

It should be obvious that many of the conflicts of interest and abuses of the past were
facilitated by the exchange of institutional clients’ brokerage commissions for favors
(IPO allocation, late trading consideration, mutual fund distribution & shelf space
arrangements, etc.). If CSA’s have the expected result of concentrating order execution
and the allocation of brokerage commissions at a few of the very largest brokerage
firms, is it reasonable to assume that commissions in excess of the cost of execution
(aka soft dollars) will be used exclusively for the direct benefit of the investor(s) whose
account paid the commission? I believe true disclosure of institutional commissions is
the best way to reduce the temptation for commission abuse.
Regulation:
No commenter seems to question that CSA’s will concentrate more order flow, trading
activity and commission revenue in a very few, extremely powerful brokerage firms. This
conclusion raises a serious concern, is it beneficial to strengthen what already seems
oligopoly domination of the brokerage industry?

For anybody who followed the news leading up to The Global Analyst Research
Settlement (6) it should come as no surprise that The Settlement was actually a
compromise between New York State Attorney General Eliot Spitzer and The U.S.
Securities and Exchange Commission. Mr. Spitzer was in favor of more severe
punishment for the perpetrators and overseers of fraud and abuse. The SEC argued in
favor of less severe less far reaching penalties - out of fear of severely damaging the
nation’s financial infrastructure. These two regulatory forces met somewhere in the
middle.

It seems that allowing the proliferation of loosely defined CSA’s which would predictably
fuel more consolidation and increase oligopoly power in an industry that’s already
known to be difficult to regulate is a prescription for further emboldening abusers, while
at the same time increasing risk to the nation’s financial infrastructure.

Conclusion:
It seems that without constructive commission disclosure and without a more formal
definition of the mechanics of CSA’s, their immediate implementation is fraught with
risk. It also seems that trading venues (exchanges) are evolving toward a natural
solution to the fragmentation of order flow, and that, in the near future this evolution may
provide increased liquidity. This evolution might make best execution a more evenly
distributed characteristic. I believe Lisa Shallet’s suggestion for third-party oversight of
Commission Sharing Arrangements (by a clearing-house operation like DTC) has a
great deal of merit and should be explored.

Footnotes:
(1) CSA Agreements Pose Problems for Some by Michael Mayhew Integrity Research web log
http://integrityresearch.blogdrive.com/archive/cm-12_cy-2006_m-12_d-12_y-2006_o-1.html

(2) Advanced Trading Magazine “The Buy Side Dilemma: Research vs Execution” by Ivy Schmerken,
Senior Editor December 2006 issue.
http://www.advancedtrading.com/issues/200612/showArticle.jhtml;jsessionid=3O4JVBETWIJ4UQSNDLO
SKH0CJUNN2JVN?articleID=196513715

(3) See, comment letters to The SEC on ‘final’ version of Commission Guidance
http://www.sec.gov/comments/s7-13-06/s71306.shtml
And, see comment letters to The SEC on The Proposed Interpretive Guidance
http://www.sec.gov/rules/interp/s70905.shtml

(4) The FSA has adopted Great Britain’s Investment Management Association’s “Pension Disclosure
Code” as its working model for brokerage commission disclosure.
http://www.investmentuk.org/news/standards/pfdc2.pdf

(5) “Marginal Values” by Bill George published on The Integrity Research web log.
http://integrityresearch.blogdrive.com/archive/cm-12_cy-2006_m-12_d-12_y-2006_o-3.html

(6) SEC Fact Sheet: The Global Analyst Research Settlement

http://www.sec.gov/news/speech/factsheet.htm