Investment Management Fees--Unraveling the Mystery

INVESTMENT MANAGEMENT FEES–UNRAVELING THE MYSTERY

Paul A. Green

Mooney, Green, Baker & Saindon, P.C.

Washington, D.C.

I. Introduction

Fees associated with the management of a pension plan’s investments are usually the largest administrative expense incurred by the plan. However, they are frequently not greatly scrutinized by plan trustees and are often structured in such an obscure and inscrutable manner that they are all but indecipherable. Moreover, in some cases (such as in the case of “soft dollars”), they are largely hidden. As fiduciaries, trustees are responsible for monitoring these fees, and ensuring that they are “reasonable.” This presentation is intended to provide trustees and other plan fiduciaries with some background to help them resolve this mystery.

II. Types of Fees Associated with the Management of Investments

A. Investment Management Fees – These are the fees paid directly to the investment manager.^{^[1]} Usually they are spelled-out explicitly in the investment management agreement between the plan and the manager. They may be paid directly by the Plan, or they may be deducted from the assets under management.

B. Brokerage Commissions – Usually not within the direct control of the plan, but are negotiated between the manager and the broker.^{^[2]} May be affected by any “soft-dollar” arrangements in place.

C. Custodial Fees – Usually negotiated between the plan and the custodian.

D. Consultant Fees – Negotiated between the consultant and the plan.

E. “Pass-Through” Expenses–Particularly prevalent in real estate and mutual funds. These are expenses of the manager that are “passed-through” directly to the plan. The types of expenses that may be passed through should be defined in the contract between the plan and the manager.

III.Fees Paid to Investment Managers or Advisors and Other Service Providers

A. Such fees are generally permitted if:

1. The arrangement is “reasonable”;

2. The payment is for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan;

3. No more than reasonable compensation is paid; and

4. There is no self-dealing.

B. An arrangement is “reasonable” if it can be terminated on reasonably short notice, without penalty, so that the plan does not become locked into an arrangement that has become disadvantageous to the plan. Termination fees are permitted if they are designed to actually compensate the service provider for reasonable start-up costs or other costs associated with the termination itself (provided the service provider has a duty to mitigate damages). 29 C.F.R. § 2550.408b-2(c).

C. An arrangement is “necessary” if it is “appropriate and helpful to the plan . . . in carrying out the purposes for which the plan is established or maintained.” 29 C.F.R. § 2550.408b-2(b).

D. There is no specific guidance on what constitutes “reasonable compensation” for investment-related services. However, these fees are usually scrutinized based upon what other service providers are charging for similar services. Thus, fees paid to a provider of investment services that are in line with what other similar providers are charging for comparable services are probably reasonable.

E. A fiduciary is engaged in prohibited self-dealing if that fiduciary uses his or her fiduciary authority:

1. “to cause a plan to pay an additional fee to such fiduciary (or to a person in which such fiduciary has an interest which may affect the exercise of such fiduciary’s best judgment as a fiduciary) to provide a service” or

2. “to cause a plan to enter into a transaction involving plan assets whereby such fiduciary (or a person in which such fiduciary has an interest which may affect the exercise of such fiduciary’s best judgment as a fiduciary) will receive consideration from a third party in connection with such transaction.” 29 C.F.R. § 2550.408b-2(e).

3. A fiduciary is considered to have an “interest which may affect the exercise of such fiduciary’s best judgment” if the person receiving the compensation is:

a. “a spouse, ancestor, lineal descendant, or spouse of a lineal descendant” of the fiduciary;

b. the fiduciary’s employer, or an owner, direct or indirect, of 50 percent or more of such employer;

c. any “corporation, partnership, or trust or estate” which is at least 50% owned by the fiduciary;

d. an employee of the fiduciary; or

e. a 10% or more partner or other joint venturer with the fiduciary. Id.

4. A fee structure that has the potential to create conflicts between the interests of the manager and of the plan may result in prohibited self-dealing.

a. Incentive fees, for example, are defined as fees where the manager’s compensation is linked to the manager’s performance. Typically, a manager earning incentive fees is paid more to the extent his or her investment performance exceeds a designated benchmark. Although incentive fees are not prohibited per se, the Department of Labor (“DOL”) takes the position that if an incentive fee creates a conflict between the interests of the manager and the plan, there is a prohibited transaction. DOL Opinion Letters 86-20 A and 86-21 A (August 29, 1986); DOL Opinion Letter 99-16 A (December 9, 1999).

b. Transactional fees, as another example, are fees paid to the manager upon the purchase or sale of property or other assets held for investment. Such an arrangement, however, places the manager in a position to determine his or her own compensation through the exercise of fiduciary responsibility (e.g., the more plan assets that the manager buys and sells, the greater the number of transaction fees paid to the manager). Transaction-based fees, therefore, create a conflict of interests between the manager and the plan, and are generally prohibited. See, e.g., 29 C.F.R. § 2550.408b-2(e).

F. Other arrangements may be permitted, pursuant to the terms of other statutory exemptions or administrative exemptions issued by the DOL. DOL Prohibited Transaction Exemptions may either be class exemptions or individual exemptions.

IV. Soft Dollars

A. Although there is no formal published definition, the term “Soft Dollars” generally refers to arrangements where brokerage commissions are higher than what would be required for basic execution (e.g., through a discount broker), with the excess available to be used for some defined purpose.

B. Two separate and distinct types of arrangements meet the definition of “soft dollar” arrangements:

1. Directed Brokerage Commission Arrangements

2. “Classic” Soft Dollar Arrangements

V. Directed Brokerage Commission Arrangements

A. These arrangements are defined contractually between the plan and one or more brokers. The broker may in turn have arrangements with a group of “correspondent” brokers. Alternatively, the arrangement may be between the plan and a third-party, which has in turn contracted with a pool of “correspondent” brokers.

B. Under these arrangements, when trades are conducted through the participating brokers, some share of the brokerage commission is either paid back to the plan (rebated) or is directed to a third-party to defray what would otherwise be a cash (“hard dollar”) expenditure of the plan. These arrangements are often used to compensate consultants and/or custodians.

C. The party with whom the plan has contracted usually keeps a portion of the directed commission for itself as compensation. This share should be specified in the contract with the plan.

D. Legal Considerations

1. Directed brokerage commission arrangements are generally permitted under ERISA because they directly benefit the plan, “provided that the amount paid for the brokerage and other goods and services is reasonable, and the investment manager has fulfilled its fiduciary duty to obtain best execution for the plan’s securities transactions.” DOL Technical Release 86-1 (May 22, 1986).

2. Nevertheless, Trustees retain a fiduciary responsibility to:

a. Initially determine that the broker is capable of achieving “best execution”;

b. Periodically monitor the execution;

c. Evaluate whether the brokerage commissions paid by the plan are “reasonable in light of the total services received by the plan.”

d. Assure that, to the extent the soft dollars are being paid to a third-party service provider, “the arrangement does not result in the payment of unreasonable compensation to” that provider. Ibid.

3. Directed brokerage arrangements are generally prohibited to the extent they are for the benefit of parties in interest, rather than the plan itself. Thus, if a directed brokerage arrangement involving plan assets inures to the benefit of a sponsoring employer, labor organization or trustee (other than incidentally), it would result in fiduciary violations and prohibited transactions.

VI. Classic Soft Dollar Arrangements

A. A classic soft dollar arrangement is where a broker provides the manager with something of value–“research”–in exchange for the manager directing trades to the broker.

B. Unlike directed brokerage commission arrangements, the direct benefit of a classic soft dollar arrangement goes to the manager rather than the plan. Any benefit to the plan whose assets are under management is, at best, indirect and incidental.

C. On their face, classic soft dollar arrangements would appear to violate the prohibited transactions rules of Section 406(a) and (b) ERISA. However, provided certain statutory requirements are met, they are specifically permitted pursuant to Section 28(e) of the Securities Exchange Act of 1934, 15 U.S.C. § 78bb(e) (reproduced in full at p. 9).

1. Prior to 1975, brokerage commissions were fixed by the Securities and Exchange Commission (“SEC”). Consequently, the only means brokers had to compete with each other was with additional services that they could provide. Managers came to depend upon some of these additional services.

2. In 1975, brokerage commissions were deregulated, permitting actual price competition between brokers. As a result of this deregulation, any manager that continued to receive services for its own benefit–including any services above and beyond pure brokerage and execution services–could well be accused of padding the commissions paid by its client for its own benefit. This would have been a violation both of the manager’s common law fiduciary obligations under the securities laws and an ERISA fiduciary violation and prohibited transaction.

3. Congress responded to the managers’ plight by enacting Section 28(e), which provides a limited exemption to all existing state and federal laws (both statutory and common law) governing a manager’s fiduciary obligations.

D. Managers typically (although not always) have quotas for the volume of transactions that they must trade through the broker in order to obtain the benefit of the soft dollars. Failure to direct enough transactions to satisfy the quota creates a “soft dollar deficit.”

E. Legal Limitations on Classic Soft Dollar Arrangements

1. Broker must obtain “best execution” on the trade.

2. Broker does not need to obtain best commission rate, although the commission rate must be “reasonable.”

3. Manager is obligated to disclose the existence and nature of soft dollar arrangements to the plan.

4. Broker may only provide manager with “research” and actual brokerage services. All other forms of compensation are outside the Section 28(e) exception and are therefore prohibited.

5. Classic Soft Dollar arrangements are usually only provided in equity transactions. Bonds are typically not traded through brokers.

6. Classic Soft Dollar arrangements do not apply to:

a. Futures transactions; or

b. Principal transactions (i.e., where the broker is trading on its own account, rather than on the account of a third-party).

F. What is “Research?”

1. According to Section 28(e) of the Securities Exchange Act of 1934, a broker provides:

brokerage and research services insofar as he--

A. furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities;

B. furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts; or

C. effects securities transactions and performs functions incidental thereto (such as clearance, settlement, and custody) or required in connection therewith by rules of the Commission or a self-regulatory organization of which such person is a member or person associated with a member or in which such person is a participant.

2. “The research provided can be either proprietary (created and provided by the broker-dealer, including tangible research products as well as access to analysts and traders) or third-party (created by a third party but provided by the broker-dealer). . . [T]he controlling principle to be used to determine whether something is research is whether it provides lawful and appropriate assistance to the money manager in the carrying out of his investment decision-making responsibilities,’ and that ‘[w]hat constitutes lawful and appropriate assistance in any particular case will depend on the nature of the relationship between the various parties involved and is not susceptible to hard and fast rules.’” Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, The Office of Compliance, Inspections and Examinations U.S. Securities & Exchange Commission, September 22, 1998.

3. Where the broker provides third-party services, although the services can be delivered directly by the third-party to the manager, the obligation to pay for the services must be that of the broker. Thus, for example, a broker is prohibited from reimbursing the manager for the cost of research services obtained by the manager.

4. Where the thing of value has “mixed uses” (i.e., can be both used for “research” and for other things), the manager has a duty to allocate the portion of the value of the thing that is used for research purposes and the portion used for other purposes. For example, if a broker gives a manager a computer system that can be used both for on-line research and market analysis, as well as for general recordkeeping, the manager must actually pay for the share of the computer system that will not be used for research.

G. What disclosure of research is required?

1. “An adviser need not list individually each product, item of research, or service received, but rather can state the types of products, research, or services obtained with enough specificity so that clients can understand what is being obtained. Disclosure to the effect that various research reports and products are obtained would not provide the specificity required.” Ibid.

2. Managers are also required to report Soft Dollar arrangements in their Form ADV^{^[3]}, including:

a. the products, research and services;

b. whether clients may pay commissions higher than those obtainable from other brokers in return for the research, products and services;

c. whether research is used to service all accounts or just those accounts paying for it; and

d. any procedures that the adviser used during the last fiscal year to direct client transactions to a particular broker in return for products, research and services received.

3. Managers may satisfy their legal obligation to disclose Soft Dollar arrangements to clients by providing copies of their annual Form ADV to the clients, provided, that they also provide separate and immediate notice of any material changes that occur in any such arrangements.

H. In its recent study of Soft Dollar arrangements, the SEC discovered non-compliance with the legal standard, as follows:

1. Fully 35% percent of the brokers examined provided some non-research good or service.

2. 27% of brokers provided reimbursement of expenses incurred by managers.

3. Virtually none of the abusive arrangements were disclosed in the required reporting.

4. Among the abuses uncovered by the SEC were the following:

#Payment of an adviser's research employee.

#Payment for most of an adviser's non-research information technology purchases.

#Payment for travel, airfare, hotels, meals, and other expenses of a research consultant.

#Payment for research services provided by a "consultant" operating out of the adviser's office.

#A research employee, who desired to relocate, quit his job at a mutual fund adviser. Rather than lose his services, the adviser retained him as an independent consultant (working from his new home) and convinced a broker to pay his fees via soft dollars.

#Payment for an adviser's office rent and equipment, cellular phone services and personal expenses of one of the adviser's principals, including computers and office equipment for home use, round-trip airfare to Hong Kong for the principal's son, postage and bottled water.

#An adviser who had a Soft Dollar credit with one broker had that broker send money to a second broker with whom the manager had a Soft Dollar deficit.

#An adviser directed $93,000 in soft dollars for "verbal regional research" and "strategic planning." Further investigation showed these payments going to family members of the adviser's principal. The adviser could not substantiate these payments as being research-related.

#Payment for tax and accounting software and for the cost of designing an administrative database.

#Payment of legal expenses.

#Payment of a consultant to design the manager’s web site.

#Payment for entertainment, theater tickets, limousine services, interior design and construction services, and installation of carpet tile.

#Payment to third parties for client referrals to the manager.

#Payment for services provided to the adviser's marketing department.

#Advisers frequently failed to pay for any share of “mixed use” goods and services.

#Payment of the fees for a speaker hired by the manager for a lecture open to the manager’s current and potential clients.

I. Trustees’ Duty to Monitor

1. Trustees are obligated to periodically review the execution secured by the manager to “assure that the manager has secured best execution.” TR 86-1.

2. Trustees are obligated to ensure that the brokerage commissions are “reasonable in relation to the value of the brokerage and research services provided to the plan.” Ibid.

VII. Comparisons Between Classic Soft Dollar Arrangements and Directed Brokerage Arrangements

A. Classic soft dollar arrangements benefit the manager, while directed brokerage arrangements benefit the plan.

B. Classic soft dollar arrangements are exempt from prohibited transaction rules under Section 28(e) of the Securities Act of 1934. Directed Brokerage arrangements are not subject to Section 28(e), and are therefore subject to fiduciary and prohibited transaction scrutiny. However, they are not generally fiduciary violations nor prohibited transactions because they are for the benefit of the plan, its participants and beneficiaries.

C. “Best Execution” is required for all securities transactions, regardless of whether classic soft dollars or directed brokerage is involved. The existence of one of these arrangements, however, raises the potential that best execution may be sacrificed.

D. Because classic soft dollar arrangements must meet the requirements of Section 28(e), they are limited in terms of the nature of the benefits provided to the manager and have specific reporting requirements. Directed brokerage arrangements, however, are not subject to the restrictions of Section 28(e). Therefore, the benefits provided to the plan may be in any form, including cash, and no special reporting is required.

E. In all cases, the commissions charged must be “reasonable” in view of the brokerage and other services provided to the plan.

F. Directed brokerage arrangements can “squeeze out” classic soft dollars by reducing the amount of the brokerage commission available to buy research.

G. The largest plans often do not have either type of soft dollar arrangement, because they have the market power to “ratchet-down” brokerage commissions, making rebates unnecessary and eliminating any surplus in the commissions beyond what is required for pure execution services.

VIII. Best Execution

A. Best execution is always required in every securities transaction.

B. Best execution is the responsibility of the broker and of the manager to whom the trustees have delegated discretionary investment responsibility.

C. Best execution is not explicitly defined, although the SEC has described it as follows:

The duty of best execution requires a broker-dealer to seek the most advantageous terms reasonably available under the circumstances for a customer’s transaction. The duty of best execution derives from the common law duty of loyalty, which obligates an agent to act exclusively in the principal’s best interest. When a broker-dealer acts as agent on behalf of a customer in a transaction, the agent is under a duty to exercise reasonable care to obtain the most advantageous terms for a customer. Traditionally price has been the predominant factor in determining whether a broker-dealer has satisfied its best execution obligations. We also have stated that broker-dealers should consider at least six additional factors: (1) the size of the order; (2) the speed of execution available on competing markets; (3) the trading characteristics of the security; (4) the availability of accurate information comparing markets and the technology to process such data; (5) the availability of access to competing markets; and (6) the cost of such access.

Federal Register, Vol. 66, No. 97, May 18, 2001, p. 27781, fn. 181.

D. Best execution is generally considered to be obtaining the best value for the plan (client). This does not necessarily mean the best price, but can take into account such factors as the quality of the execution (e.g., minimizing the risk of failure of execution), difficulty in execution (particularly in the case of securities with limited markets), etc.

E. How to measure “Best Execution?”

1. Because the intangible elements of “best execution” are so amorphous and difficult to measure, analysis generally focuses on whether a broker was able to obtain the best price.

2. Price, however, is also impossible to measure, because there is no way to exactly compare whether a broker got the “best price” on any given trade.

3. As an approximation of “best execution,” firms have developed daily weighted average methodologies to compare the prices obtained by the plan’s brokers with the overall weighted average prices for the same securities traded on that same day. Although such a comparison is not meaningful on any individual trade, the theory is that, over time, a broker who achieves “best execution” will tend to obtain a better price than the market over all (i.e., the broker will sell shares at a price that, on average, exceeds the weighted average for shares sold that same day, and will buy shares at a price below that weighted average). On the other hand, the theory goes, a broker who does not achieve “best execution” will tend over time to trade at prices worse than the market over all.

IX. The Debate Over Classic Soft Dollar Arrangements

A. Traditionally, the following arguments have been made in support of classic soft dollar arrangements:

1. The additional research services result in more effective management of client accounts.

2. Research provides money managers a continuous flow of information and opinions on securities, leading to higher confidence and better judgments by investors.

3. Classic soft dollar arrangements are of particular benefit to smaller money managers, who might not be able to afford in-house research specialists, and could not otherwise compete with the resources available to the larger managers. These smaller money managers would be at a disadvantage in attracting and serving clients.

4. Managers have more flexibility in choosing brokers who can provide the best overall mix of price, quality of execution and research or other services.

B. The following arguments are typically made by critics of classic soft dollar arrangements:

1. They can increase a client's expenses by enabling the manager to, in effect, pass through costs it would otherwise be forced to bear.

2. They can hide expenses that clients may believe are being paid for by the money manager. Therefore, money managers who extensively utilize soft dollar arrangements may be able to quote lower advisory fees than those who do not, even though the total costs to clients are in fact no lower.

3. They provide an incentive for managers to over-trade clients' accounts to generate more commissions.

4. Managers may select brokers for their willingness to provide research or services for soft dollars, rather than for their execution capabilities.

5. The ability of clients, particularly pension plan sponsors, to monitor money managers is impeded. If execution and research services were not bundled, each would be subject to the discipline of the marketplace, which in theory would more accurately measure their respective dollar values.

C. By enacting Section 28(e), Congress has clearly adopted the arguments in favor of classic soft dollar arrangements.

X. Practical Considerations

A. Trustees should be aware of the fees that they are paying to each of their investment service providers.

B. Trustees should review the basis for the fees charged to ensure that they are reasonable.

C. Trustees should be aware of any classic soft dollar arrangements in place that relate to plan assets, and should ensure that such arrangements are properly reported. Trustees may also want to consider either entering into directed brokerage arrangements or otherwise limiting brokerage commission rates in order to reduce the cost to the plan.

D. Trustees should consider how to attempt to measure the ability of the plan’s managers and brokers to obtain “best execution” on the plan’s securities transactions.

^{^[1]}Throughout this outline, the phrases “investment manager,” “manager,” and “adviser” (the phrase preferred by the Securities and Exchange Commission (“SEC”)) will be used interchangeably. Each of these phrases refers to a professional who provides investment advice, or who otherwise provides discretionary investment services, to an employee benefit plan, and who is therefore considered a “fiduciary” within the meaning of Section 3(21)(A) of ERISA.

^{^[2]}The terms “broker” and “broker/dealer” (the phrase preferred by the SEC) are used interchangeably throughout this outline.

^{^[3]}Form ADV is the annual registration form that must be filed by investment managers with the SEC and with various state agencies. Part II of the Form ADV (or a document containing equivalent information) must be either offered or actually provided to all of the manager’s clients.