Soft dollars are a practice in which an investment adviser uses client brokerage commissions (rather than hard cash from its own funds) to pay for research and other services that benefit the adviser's investment management business.
How it works: - The adviser directs client trades to a particular broker-dealer, often at a slightly higher commission rate than the best available. - The broker uses the extra commission revenue to pay for research services, Bloomberg terminals, financial data, or other tools. - The adviser receives valuable services without paying out of pocket — but the client pays through higher commissions.
The conflict of interest: The adviser has an incentive to direct trades to brokers based on the benefits they provide to the adviser (soft dollars), rather than based on best execution for the client.
Section 28(e) safe harbor: - The Investment Advisers Act's Section 28(e) provides a safe harbor that allows advisers to use client commissions for "brokerage and research services" without violating their fiduciary duty — IF: - The commissions are "reasonable" relative to the value of the services. - The research must benefit the clients in whose accounts the commissions were generated. - Permissible research includes research reports, databases, market data. - NOT permitted: office rent, computer hardware (unless dual-use), travel, entertainment.
Disclosure requirement: Advisers must disclose their soft dollar practices in Form ADV Part 2A.
> Exam tip: Soft dollars are permitted under Section 28(e) but must be disclosed and the research must benefit clients. The conflict is that advisers may favor brokers who provide research over those offering best execution. Tested on Series 65, Series 66, and CFP® exams.