glenn tongue
Whitney Tilson

I found some interesting comments by Whitney Tilson regarding the recent insider trading charges against several firms. Below are his comments:

Interesting to see that the insider trading case is related to soft dollars:

A sweeping insider-trading investigation is raising questions about how hedge funds and other big investors dole out a common, and controversial, currency that flows freely across Wall Street. The currency is known as soft dollars.

Stock brokerages award soft dollars to investors much like an airline doles out frequent-flier miles, giving the most clout to the biggest traders. The clients then use the soft dollars in a variety of ways, but largely spend them on investment research.

Investigators now want to know whether brokerages and their clients may be abusing those otherwise legitimate soft-dollar funds, directing payments to so-called expert networks and other middlemen in search of inside information.

We’ve long believed the soft dollars are nothing more than a legal form of kickbacks and have called for banning soft dollars.  Below is an article I wrote 6 ½ years ago about this called “The Disgrace of Soft Dollars”:

Massachusetts Financial Services Co. (MFS), the oldest and 11th-largest mutual fund company, announced this week that it has stopped paying brokers in “soft dollars.” I can hear the yawns across America, but this is an important issue because investors are being bilked out of billions.

Soft dollars (don’t you love such benign-sounding euphemisms?) are excess trading commissions that funds pay to brokerage firms, which are then rebated to the funds in the form of investment research and software, Bloomberg terminals, magazine subscriptions, and the like. These are expenses that in almost all cases would be paid for by the fund out of its management fee income, but instead are shifted to the fund’s investors via inflated trading costs.

These costs are especially insidious because they’re nearly invisible…

…So why am I not leaping at a soft dollar-subsidized rent deal? Because I’d be screwing my investors! They already pay me a 1% management fee, which is supposed to cover all of my expenses. Paying inflated commissions so that my broker will pay expenses like rent (or a Bloomberg terminal, third-party research, etc.) would simply be shifting costs that are supposed to be paid out of the management fee to my investors in the form of hidden, extra commission charges.

I won’t go so far as to call using soft dollars stealing — as discussed below, it’s typically disclosed, at least in the fine print — but it’s pretty darn close.

This adds up to big numbers. If half of the $12.7 billion in commissions paid by mutual funds (not even counting the billions generated by hedge funds) are used to pay for research and other services that should be paid from management fees, then mutual fund investors are paying roughly $6.3 billion that they shouldn’t be! That’s about $21 for every man, woman, and child in this country. As I was saying, big numbers…