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SEC Whistleblowers can Help Uncover "Soft Dollar" Practices

Friday, December 10, 2010

Hedge Fund WhistleblowerHedge fund operators (politely called “Investment Managers” on Wall Street) can make the plaintiffs’ bar look like expensively dressed social workers. The hedge fund industry is estimated to be a $2.5 trillion industry. Potential hedge fund whistleblowers should know that the SEC and the DOJ are taking real aim at certain practices of the hedge fund industry and Investment Managers including their use of so-called “soft dollars,” and that SEC whistleblower incentives are available should the whistleblower qualify.

What are Soft Dollars?

When hedge funds purchase a stock from a broker, studies indicate that it should cost those hedge funds between 1.25 to 1.65 cents-per-share. Hedge Funds can pay up to 5 cents per share though to the broker. The broker effectively sets aside the difference (sometimes referred to as the spread) between what the actual trade costs and the actual price paid for the benefit of the Investment Manager of the hedge fund.  The Investment Manager of the hedge fund can then direct the broker to use that money to pay third parties or pay other divisions of the broker (referred to as “Third Party”) for services that the Third Party provides to the Investment Manager of the hedge fund.  These monies are what Wall Street calls “Soft Dollars.” Industry watchers estimate that Wall Street generates over $12 billion a year in these Soft Dollars.

Two reasons why Soft Dollars are so valuable to Investment Managers of hedge funds.

  • Investment Managers can offload costs of managing a hedge fund - Hedge funds are traditionally set up as limited liability partnerships.  A hedge fund will contract with an Investment Manger to manage the investments of the hedge fund. Typically, an Investment Manager receives a management fee that is a percentage of fund assets (usually 2%). The Investment Manager also receives a performance fee that is typically a percentage of the profits made based upon hedge fund profits.  Soft Dollars effectively give the Investment Manager the ability to transfer costs from the management fee to the performance fee, which means greater profits to the Investment Manager.
  • Investment Managers can limit disclosure requirements - An Investment Manager to a hedge fund typically must report actual hard dollars spent as part of the Investment Manager’s report to investors.  No such requirement exists for Soft Dollars and under the current laws, Investment Managers of Hedge Funds do not need to disclose the use of Soft Dollars under Section 28 of The Securities Exchange Act of 1934 (as other Wall Street players must).

I have just described a real life scenario where Wall Street operators have near unfettered ability to charge investors billions of dollars and not report how those billions or dollars are in fact spent.  

Abuses?  Come on, man. 

Hedge Fund operations are all quite creative, which leads to many potential illegal uses of Soft Dollars.