brokerage commissions are a client asset ??

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fatym

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Hi everyone,
I’m reviwing the ethics, and I found a question in the curriculum that said in the answer that: the brokerage commissions received shouldn’t be used in the operating expenses of the broker, and that they are an asset belonging to the client and he can ask the broker to buy with them goods or services for the client (called dirceted brokerage in this case)!!!
I don’t know what Am I missing, always thought the commissions are a revenue for the broker, eventually he can used them however he wants. Does “the brokerage commissions” have another meaning ??
PS: Usually I end up being wrong, please be patient with me :)
 
I was also very confused about that, I think we are talking about this question right:
Stafford is a portfolio manager for a specialized real estate mutual fund. Her firm clearly describes in the fund’s prospectus its soft dollar policies. Stafford decides that entering the CFA Program will enhance her investment decision-making skill and decides to use the fund’s soft dollar account to pay the registration and exam fees for the CFA Program. Which of the following statements is most likely correct?
Stafford did not violate the Code and Standards because the prospectus informed investors of the fund’s soft dollar policies.
Stafford violated the Code and Standards because improving her investment skills is not a reasonable use of the soft dollar account.
Stafford violated the Code and Standards because the CFA Program does not meet the definition of research allowed to be purchased with brokerage commissions.
Answer:
Answer C is correct. According to Standard III(A)–Loyalty, Prudence, and Care, the CFA Program would be considered a personal or firm expense and should not be paid for with the fund’s brokerage commissions. Soft dollar accounts should be used only to purchase research services that directly assist the investment manager in the investment decision-making process, not to assist the management of the firm or to further education. Thus, answer A is incorrect. Answer B is incorrect because the reasonableness of how the money is used is not an issue; the issue is that educational expense is not research.
What exactly are those brokerage commissions. I thought that was a fee that was paid to the broker in echange for services. And in the case of Soft Dollars, that would a be a non-monetary agreement (the portfolio manager scratches the broker’s back by lettin them buy and sell their stocks, and in return they get research???).
 
Porfolio managers may choose broker-dealers that are more expensive than other “best exectuion” B/Ds as long as the additional fees benefit the client. Specifically, the extra amount, called soft dollars, are limited to research that is for the direct benefit of the client. Portfolio managers cannot choose a more expensive B/D because (for example) the B/D has promised to give the manager things like TVs or vacations or office equipment or, in this case, CFA registration.
See this for a good explanation of what Soft Dollars can and can’t be used for and a history of the rule:
http://ssbb.com/index.php/publications/entry/188
 
But this is what is confusing me. I do understand the first part, i.e. the Portfolio Manager picks a more expensive broker because the extra fees benefit the client (because by using the more expensive B/D, the portfolio manager gets extra service, e.g. research from the B/D) . The other things (CFA Registration, TV) aren’t exactly things that the B/D can provide, unless he pays back the money, right?
The above examples and the section in the curriculum make it sound like those brokerage accounts are assets available to the portfolio manager:
“Soft Commission Policies
An investment manager often has discretion over the selection of brokers executing transactions. Conflicts may arise when an investment manager uses client brokerage to purchase research services, a practice commonly called “soft dollars” or “soft commissions.” A member or candidate who pays a higher brokerage commission than he or she would normally pay to allow for the purchase of goods or services, without corresponding benefit to the client, violates the duty of loyalty to the client.
From time to time, a client will direct a manager to use the client’s brokerage to purchase goods or services for the client, a practice that is commonly called “directed brokerage.” Because brokerage commission is an asset of the client and is used to benefit that client, not the manager, such a practice does not violate any duty of loyalty. However, a member or candidate is obligated to seek “best price” and “best execution” and be assured by the client that the goods or services purchased from the brokerage will benefit the account beneficiaries. “Best execution” refers to a trading process that seeks to maximize the value of the client’s portfolio within the client’s stated investment objectives and constraints. In addition, the member or candidate should disclose to the client that the client may not be getting best execution from the directed brokerage.”
These brokerage commissions aren’t on a separate account and cannot be quantified exactly can they??
It was my understanding that they are only the difference between the best execution B/Ds and the B/Ds with the extra services.
 
OK… Help me understand your confusion. There are two kinds of ways that B/D can be chossen by an investment manager:
(i) The Portfolio Manager Decides
In this case the portfolio manager has a fiduciary duty to the client, which can be satisfied in one of two ways:
(a) The Manager gets the actual best price/best execution for the trade.
(b) The Manager gets a worse price or worse execution, but in return, they get research that directly benefits the client. This has to be direct research, not things like TVs or CFA registration.
or:
(ii) The Client Decides (called Directed Brokerage)
The client tells the Manager which broker they want to use. The Manager is allowed to use that B/D as long as the extra benefits go to the account beneficiaries.
 
This helps a lot, thanks for decomposing the problem. Here is where I am still struggling:
i)
b) How exactly does the TV and CFA registration (or any item that is non-beneficial for the clients) part work? The reason I am confused is, because these kind of things are not part of the original services of a B/D but rather sound like, the B/D is returning the money to the Portfoliomanager and they go buy things that are not beneficial to the client (or the B/D buys it for them), but in any case it is not part of their services.
ii)
Here I am very confused because it sounds like the Client gets to decided how the Brokerage commissions should be used
(“From time to time, a client will direct a manager to use the client’s brokerage to purchase goods or services for the client, a practice that is commonly called “directed brokerage.” )
From how you described it, it sounds like the client tells the Portfolio Manager to buy all the stocks via Broker X. Thus, every time the broker is instructed to buy a stock, the client has to pay a commission to the broker. Now this should be the end of the whole transaction in my understanding, i.e. nobody owes anyone any services or money anymore. Why is the client still entitled to get additional goods and services?? Because that is how the above paragraph from the book makes it sound.
 
The upshot is that the product of client brokerage has to benefit the client.
If you use client brokerage for things that benefit the portfolio manager (or its firm), but not the client (directly), you’re in deep trouble.
 
OK. I would suggest you read the article I attached above. In the bad old days, B/D prices were fixed, so managers would pick B/Ds based on things like TVs and baseball tickets and even kickbacks. This practice was disallowed because it basically amounted to bribery; however, to eliminate soft dollars altogether would have put small managers who relied on B/Ds for research at a huge disadvantage to big managers who would have their own internal research departments.
So, the SEC decided to split the baby and allow soft dollars to continue, but to limit it to a couple of things, like research and similar kinds of things. The process continued to be abused, so they kept narrowing what can be accepted. (Read the article if you want the details).
In response to your further question:
From how you described it, it sounds like the client tells the Portfolio Manager to buy all the stocks via Broker X. Thus, every time the broker is instructed to buy a stock, the client has to pay a commission to the broker. Now this should be the end of the whole transaction in my understanding, i.e. nobody owes anyone any services or money anymore. Why is the client still entitled to get additional goods and services?? Because that is how the above paragraph from the book makes it sound.
Remember that not all B/Ds are created the same. You have execution only firms like E*Trade and you have full service brokerages like J.P. Morgan and the price difference may be significant. While J.P. Morgan wouldn’t generally provide you with a TV for selecting them, they may provide you (or your portfolio managers) with investment research or similar kinds of good and services. You are paying a higher price, but are getting something beyond just trade execution back.
In any case, brass tacks for the test, be sure that any soft dollars (i) directly (ii) benefits the account beneficiaries and (iii) not the portfolio manager.
 
Alrighty, got it!! Thanks guys.
I did read the article and I read a similar summary of the history/motivation of the regulation on Wiki. It is just the wording that is confusing me (“Because brokerage commission is an asset of the client...”), because it sounds, as if there was a pile of cash in the office of the portfolio manager with a note sticking to it “Client Brokerage Commission”, and on the back side of that note it reads “only use for the benefit of the client, this is not supposed to be used to tip the Pizza delivery guy etc.”.
While in reality, the portfolio manager never sees that money but instead that pile ends up directly in the office of the B/D.
I do get the part, that instead of choosing the bare minimum broker (E*Trade), the portfolio manager can at his/her discretion choose a different one, with all the bells and whistles (JPM), as long as those bells and whistles are benefitial to the client.
I guess, they just mean an asset in the wider sense. So as you suggested, I will stick to the brass tacks.
Thanks again!!!
 
Hi guys,
I’m so sorry I couldn’t reply and participate earlier. but thank u very much for all the insights:
@Tartaglia

that was the Question I was referring to, I hope the moderators wouldn’t mind posting, just to be able to discuss this matter well.
http://i86.servimg.com/u/f86/18/63/02/42/q210.png
Actually, I do agree with @JSD when it comes to paying for CFA, or pizza or what ever, it’s clearly a violation. as also it is to choose a more expensive service when getting personal benefits on it (for the firm or the manager).
But, this question states that brokerage commissions shouldn’t be used even to ” paying investment operating expenses” (C) , well that doesn’t sound logic for me. aren’t commissions the revenue of the broker and eventually can use them to cover the expenses of “the investment activity” (not personal use of course) ??
I hope I’m not confusing the meaning of “brokerage commission” here, as far as I’m concerned it’s “the spread” between get on procession an order or transaction in general… not really following why it’s considered an asset for the client ?? unless it includes also the “cost of execution of transaction” .
thank u in adavance my friends :)
 
Tartaglia wrote:
It is just the wording that is confusing me (“Because brokerage commission is an asset of the client...”), because it sounds, as if there was a pile of cash in the office of the portfolio manager with a note sticking to it “Client Brokerage Commission”, and on the back side of that note it reads “only use for the benefit of the client, this is not supposed to be used to tip the Pizza delivery guy etc.”
Click to expand...
It’s a pretty bad articulation, but what they are trying get at is that the money in the client’s account is for his benefit and not for the benefit of the manager. The manager can use it for things that help the client, like making investments, paying commissions, and buying research through soft dollars, however, the manager can’t use it for things that benefit himself (like paying $100/trade where he could get $10/trade because the broker is going to redecorate his office or pay for his CFA Registration.
fatym wrote:
But, this question states that brokerage commissions shouldn’t be used even to ” paying investment operating expenses” (C) , well that doesn’t sound logic for me. aren’t commissions the revenue of the broker and eventually can use them to cover the expenses of “the investment activity” (not personal use of course) ??
I hope I’m not confusing the meaning of “brokerage commission” here, as far as I’m concerned it’s “the spread” between get on procession an order or transaction in general… not really following why it’s considered an asset for the client ?? unless it includes also the “cost of execution of transaction” .
Click to expand...
The answer you cited references the I/M’s operating expenses, not the B/D’s. Clearly, once the B/D gets paid for providing the trade, that’s his money and he can use it to pay down his operational expense; if he’s in charge of his firm, he could even use it for pizzas and tvs and CFA registration (it’s his money at that point). However, that is different from the I/M, who gets compensated separately and outside of brokerage commissions, so he needs to keep his hands off the commissions and cannot use them for those purposes.
On your second question, think of the brokerage commission as the money paid by the manager to the B/D for the B/D for effect a trade on behalf of the client (whether it is represented by a spread or a fixed per trade cost). It is the B/D’s payment.
 
thank u so much JCD for the great insight :)
I guess that was my pb, I did confuse the I/M with the B/D. I should realized the difference of compensation type for each one of them.
thanks again my friend.
 
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