‘Soft’ dollars can lead to hard fines if they’re not accounted for and disclosed.

Soft dollars are credits or rebates from a brokerage firm on commissions that clients pay for trades executed in an investment adviser’s client accounts. If appropriately disclosed, an investment adviser may use the soft dollar credits to pay for such expenses as brokerage and research services that benefit clients.

Brokerages should be on the lookout for red flags in the form of soft dollars being used to pay for the advisor’s expenses, not for services that are beneficial to their clients.

The U.S. Securities and Exchange Commission “wants to ensure that current investors and prospective investors understand what the investment advisors’ conflicts of interests are and how they’re addressing them,” said Jillian Timmermans, vice president and partner at Cordium, which provides compliance advisory services. “Soft dollars is one of those areas that you need to disclose. You really need to go into detail there about whether or not you’re staying in a safe harbor, and whether or not other clients that might not be generating those benefits are actually receiving them.”

Money managers who obtain research services with soft dollars are not paying for those services with their own funds, which benefits the money manager and creates a conflict of interest in selection of the broker-dealer(s) to execute the clients’ trades. “The conflict there is that you’re doing business with a broker-dealer not because it’s providing best execution, and not because it’s in the best interest of advisory clients, but instead because you’re receiving soft dollars,” Timmermans said.

Under a ‘safe harbor’ provision, money managers are permitted to pay more than the lowest commission rate to obtain brokerage and research services, so long as they make a good faith determination regarding the reasonableness of commissions paid. A money manager that pays for brokerage and research services under circumstances that do not fall within the protection of the safe harbor could be liable for breach of fiduciary duty, while a broker-dealer that executes such trades could be liable for aiding and abetting the breach of fiduciary duty by the money manager.

“You really need to go into detail there about whether or not you’re staying in a safe harbor, and whether or not other clients that might not be generating those benefits are actually receiving them,” Timmermans said.

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