Soft Dollar Arrangement

A fund pays brokers to execute its trades. Sometimes the broker charges a little more and, in return, provides research or other services to the fund manager. The manager gets the research without paying for it from its own pocket; the fund's investors pay through higher brokerage. That is a soft dollar arrangement.

The workbook describes it as an arrangement in which "the Category III AIF may use clients' money as a medium to pay for third-party research and proprietary research". Because such arrangements "can indirectly add to the cost of investment, which is indirectly borne by the investors", they are a potential conflict of interest.

The workbook's line is clear: research should be bought with client assets only if its primary use directly assists the manager in the investment decision-making process — not in the management of the investment firm. Proprietary research should be paid for from the investment manager's own assets.

The good-practice rules the workbook sets out (Chapter 10, prohibiting conflicts of interest):

• Distributors should abstain from entering into soft dollar arrangements with investment managers.
• Research may be purchased with client assets only where its primary use directly assists investment decision-making.
• Proprietary research is paid for from the investment manager's assets, not the fund's.
• Investment managers must consider the capabilities of the brokers appointed, so that clients get best execution.
• Distributors should ensure that the manager acts as a fiduciary and discloses all benefits it receives through a client's brokerage.
• Industry best practice is for distributors to document soft dollar arrangements with clients.
• The investment manager must disclose to the client that the Category III AIF may engage in soft dollar arrangements.

Related conflicts in the same section. Distributors should not extend pass-backs to investors, and should avoid getting capital commitments from their own subsidiaries, associates or affiliates, or from an entity in which the distributor is a director or holds more than 10% of the paid-up capital.

The sample question. "Distributors shall enter into Soft Dollar Arrangements with investment managers of a Category III AIF, without disclosing to clients" — false.

Illustrative figures. Konkan Alpha Fund, a Category III AIF with NAV of Rs 500 crore, trades about Rs 1,500 crore of equities a year.

Routing trades to Broker B costs the fund Rs 45 lakh more a year. The question the workbook's rules ask is what that Rs 45 lakh buys:

• Sector research reports used in picking stocks — directly assists investment decision-making; may be paid from client assets, if disclosed.
• The market-data terminal used for firm administration and the conference tickets — benefit the management firm, not investment decisions; these should be paid from the manager's own assets.

A compliant approach: the manager pays Broker B separately for the terminal and tickets from its own funds, discloses to investors that the fund may engage in soft dollar arrangements, and confirms that Broker B still provides best execution. Mr Desai, the fund's distributor, documents the arrangement for his clients — and takes no soft dollar benefit himself.

Chapter 10 (Good Practices) discusses soft dollar arrangements within the model code of conduct for Category III AIF distributors, in the section on conflicts of interest, alongside pass-backs and related-party commitments; one of the chapter's sample questions is a true/false on undisclosed soft dollar arrangements. Expect questions on what research may be paid from client assets, who pays for proprietary research, and the disclosure requirement.

• Soft dollar arrangements must be disclosed to clients. The sample question's "without disclosing to clients" is false.
• Distributors should abstain from entering into them with investment managers.
• Only research whose primary use directly assists investment decisions may be paid with client assets — not research or services for managing the firm.
• Proprietary research is paid from the investment manager's assets.
• They add to investors' cost indirectly, which is why they are a conflict of interest.
• Best execution still applies — a broker cannot be chosen for its research bundle at the expense of execution quality.
• Pass-backs are a separate unfair practice discussed in the same section.