Soft dollars

Soft dollar arrangements allow hedge fund managers to obtain research, data, analytics, and other services from brokers. Instead of paying cash directly, managers pay by directing their trading activity through those brokers. The broker then provides the extra services as part of the trading relationship.

This practice creates potential . The fund's clients ultimately pay for these services through higher trading commissions. However, the investment manager receives the benefits of the research and services. For example, a manager might use soft dollars to get expensive market research that would normally cost the firm thousands of dollars in cash. The manager benefits from this research when making investment decisions, but the fund's investors pay for it through their trading costs.

Before 1975, all brokerage commission rates were set by fixed schedules. Since brokers couldn't compete on price, they competed by offering additional services alongside trade execution. These services included research reports, market analysis, and trading software.

In 1975, regulators eliminated fixed commission rates. Brokers could now set their own prices and compete on execution costs. However, many brokers continued bundling extra services with their trading services. This created a problematic situation. Managers could justify choosing more expensive brokers—and directing client money to those brokers—even when the main benefit went to the manager's operations rather than to the client accounts that were paying the higher costs.

Congress recognized this conflict and created Section 28(e) of the to address it. This law created a "" that allowed managers to pay higher-than-minimum commissions to brokers in exchange for research and brokerage services. The safe harbor protected managers from certain legal challenges, but only if they met specific conditions.

In 2006, the SEC issued guidance that clarified what types of research services qualified for this protection. The guidance explained whether specific products or services provided appropriate assistance to investment managers in their decision-making process.

Some products and services have dual purposes. They partly support investment decision-making activities that qualify for Section 28(e) protection, and partly support other business functions that don't qualify.

When this happens, advisers must split the costs between these two categories. They can use soft dollars to pay for the portion that helps with investment decisions. The adviser's firm must pay for the non-qualifying portion from its own cash resources.

For example, a trading platform might provide both portfolio analysis tools (qualifying) and general office management features (non-qualifying). The adviser would need to determine what percentage of the cost relates to each function and allocate payments accordingly.

Investment advisers have a to their clients. This means they must ensure that client commissions—including additional fees on trades—provide value back to those same clients. Advisers can't just use client money to buy services that only benefit the management company.

Advisers must also maintain transparency with clients. They should explain their general practices for using these commissions to acquire soft dollar products and services. Investment managers should describe their soft dollar practices in . They must also continuously monitor their broker relationships to ensure that client trades continue to receive the quality.

Investment managers must be careful when they receive benefits from products or services purchased with soft dollars that don't relate to providing investment advice to clients. When these "mixed-use" situations arise, managers should reasonably allocate costs between what the adviser pays and what clients pay.

SEC examiners regularly find problems where advisers don't adequately disclose mixed-use arrangements or incorrectly allocate costs between safe harbor and non-safe harbor uses. This continues to be an active area of SEC examination focus. The agency emphasizes that advisers must maintain strong compliance controls over their soft dollar practices and fulfill their best execution obligations to clients.