Ethics Case Study of the Week: Using Soft Dollars for Overhead Expenses?

By Gary Sarkissian posted 14 days ago


CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to evolve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we will feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Each case is built upon a real-life example that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of the case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard III(A) Loyalty, Prudence, and Care. 

Using Soft Dollars for Overhead Expenses?
Murdoch is founder, president, and head portfolio manager of IOM Capital Management (IOM), an investment adviser providing investment advice to four affiliated hedge funds as well as separate client accounts. IOM accumulates and uses soft dollar credits primarily at a single broker/dealer through equity and options trading for the IOM funds and individual client accounts. IOM discloses allowable uses of soft dollars through its regulatory filings and offering memoranda for IOM funds. The disclosures provide that soft dollars may be used for “overhead expenses,” including “office services, equipment, and supplies.” IOM rents a portion of Murdoch’s personal residence to conduct its business. IOM pays $6,000 in rent to a company Murdoch owns, which, in turn, pays $5,855 to a local bank to cover the monthly mortgage payment for the property. Eventually, IOM and Murdoch request that the broker use soft dollars to make the rental payment. Once the broker starts paying rent using soft dollars, Murdoch raises the rent first to $10,000 per month and then to $15,000 per month. Murdoch’s actions are

A.  appropriate because rental payment on office space is an acceptable use of soft dollars.
B.  appropriate because IOM disclosed that it would use soft dollars for overhead expenses.
C.  appropriate because Murdoch may charge (and increase) rental rates for use of his property to the extent that the market will bear.
D.  inappropriate.
E.  none of the above.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit.

This case relates to Standard III(A) Loyalty, Prudence, and Care and the use of soft dollar credits. Soft dollar credits arise from the client commission arrangement between an investment adviser and the broker/dealer that handles the trades for the adviser. Generally, a client’s investment assets are used to pay additional commissions — called “soft dollar credits” — that the broker/dealer sets aside as payment for legitimate research and expenses of the adviser. CFA Institute members who pay higher brokerage commissions to receive soft dollar credits to purchase goods or services, without ensuring a corresponding benefit to the client, violate their duty of loyalty to the client under CFA Institute Standard III(A). In many regulatory regimes and under CFA Institute soft dollar standards, using soft dollars to make office rental payments would not be an acceptable use of soft dollars. Even assuming that such a practice was allowed, in this case, Murdoch and IOM disclose only that soft dollars will be used for “overhead expenses,” but they do not provide that soft dollars would be used to pay rent. Therefore, the disclosure is incomplete and ineffective. Finally, it appears that the 150% increase in rent once soft dollars are used to make payments is simply an attempt to enrich Murdoch at the expense of his clients. A reasonable client or investor would not know that IOM uses its commissions to pay rent on a property that Murdoch also uses for personal purposes, that IOM pays inflated rent on that personal property, and that Murdoch could divert soft dollars for his personal use. Choice D is the best response.

This case is based on a May 2019 Enforcement Action by the US Securities and Exchange Commission.

Image by mohamed Hassan from Pixabay  

© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.