CHRISTOPHER COX REGIONAL OFFICES DISTRICT OFFICES SECURITIES AND EXCHANGE COMMISSION May 17, 2007 ‘The Honorable Christopher Dodd Chairman Committee on Banking, Housing, and Urban Affairs United States Senate 534 Dirksen Senate Office Building Washington, DC 20510 Dear Chairman Dodd: Lam writing to urge the Senate Banking Committee to consider legislation that would repeal or substantially revise Section 28(c) of the Securities Exchange Act of 1934, which provides a safe harbor for certain “soft dollar” arrangements between broker-dealers and money ‘managers. Iam concemed that this overly complicated provision of the law hurts investors and USS. capital markets by protecting arrangements that involve substantial conflicts of interest, may contribute to higher brokerage costs, is difficult to administer, and may operate to impede the further development of efficient markets for brokerage as well as certain advisory services. When Congress acted in 1975 to abolish fixed brokerage commission rates, it provided a “safe harbor” in Section 28(e) of the Exchange Act to protect money managers that entered into certain so-called “soft dollar” arrangements with broker-dealers. Under these arrangements, the broker-dealer provides the money manager with research services (in addition to trade execution and functions incidental thereto) in return for the money manager’s direction of client brokerage to the broker-dealer. Section 28(e) protects money managers from liability under state or federal law for a breach of fiduciary duty alleged solely on the basis that the manager paid more than the lowest commission rate in order to receive “brokerage and research services.” To use this safe harbor, the money manager must determine in good faith that the amount of the commission paid was reasonable in relation to the value of the brokerage and research services provided by the broker-dealer, In other words, Section 28(¢) permits managers of mutual funds, pension funds, and other advisory clients to use their clients’ commissions to buy research that the managers would otherwise have to pay for out of their own pockets or produce themselves. In some cases, the research is produced by the broker-dealer effecting the transaction; in other cases, it is produced by a third party but paid for by the broker-dealer. Last year, money managers directed almost $1 billion of client commissions to purchase third-party equity research and services. Soft dollar arrangements are troubling for several reasons. First, they involve an inherent conflict of interest between a money manager and its clients. They compromise a money manager’s fiduciary responsibilities by inducing it to direct trades to broker-dealers that offer research that the money manager wants, rather than to the broker-dealers that can best execute the advisory clients’ transactions. They encourage managers to “overtrade” client portfolios in ChaIRMANOFFiCE@sEC.covThe Honorable Christopher Dodd Page 2 order to generate soft dollar credits. They permit managers to use one client’s commissions to buy research that the manager uses primarily, sometimes even solely, with respect to a different client's account. And they interfere with clients” ability to control the real cost of money management because the soft dollar arrangements hide the manager's costs within its clients? commissions rather than expose them in the manager’s advisory fees. Second, soft dollar arrangements may contribute to higher brokerage costs, which are bome not by money managers, but by their clients, and indirectly by millions of pension fund beneficiaries and mutual fund investors. Because of increasing use of sophisticated trading technologies, institutional trades can today be executed, on average, at a cost ranging between one and two cents per share. Yet brokers may charge up to five cents per share for their brokerage services, and some significant portion of this charge is attributable to the research and other benefits the money manager obtains from the broker-dealer. Clients — even institutional clients ~ find it impossible to monitor the reasons their money manager chooses a given broker- dealer. Third, Section 28(e) has been difficult for the Commission and the securities industry to administer over the years and requires the constant involvement of lawyers in business decisions that should be made based solely on the best interest of clients. Last year, in light of rapid market developments, we issued our third comprehensive interpretation of Section 28(e), which required the parsing of terms and legislative history written over thirty years ago. Yet our staf? continues to field inquiries regarding the availability of arrangements that Congress could not have envisioned in 1975. Section 28(e) may have been fully justified in 1975 in order to shield the research arms of broker dealers and protect smaller money managers that may have grown dependent upon the receipt of “free” research from broker-dealers. ‘The securities industry, however, has long since adjusted to the rigors of competitive commissions and rapid innovation in financial research and products. The number of money managers has grown significantly and the need to protect inefficient suppliers of research or money management is hardly a compelling argument to support the complicated safe harbor. Moreover, money managers can adapt their practices to avoid potential fiduciary violations by separately paying for valuable research provided by brokers. appreciate your consideration of tis request, which reflects my views and not necessarily the views of the other Commissioners or of the President. T look forward to working with you on this matter and, should you so desire, would be pleased to submit to you legislative language to address this issue. If you have any questions, please feel free to call me directly at 202-551-2100 or to have your staff call Jonathan Burks, Director of Legislative and Intergovernmental Affairs, at 202-551-2010. Clare Christopher Cox Chairman