The term soft dollars refers to money that is paid to a brokerage firm through its regular commissions for services that are not traditionally commission based. The soft dollars are a way to get information and services without having to totally disclose what is being paid for what. In the end, the payment to the brokerage firm ends up being close to what it would have received anyway. The situation can benefit both the broker and the client, but it is controversial.
The explanation of soft dollars is probably best accomplished by means of an example. If an investment client, Mutual Fund A, wants some research done for any of a number of reasons, the brokerage firm will provide it for a fee. If the brokerage firm might charge $15,000 US Dollars (USD) in hard dollars for that service, it may accept $30,000 USD in soft dollars. In other words, the client would promise $30,000 in commission-based business. In actuality, the $15,000 USD fee still exists; it is just built into the commission fee.
The benefit to the brokerage firm is that it now has not one project but two. It will get paid for research, and will also get paid for its trading services, which represent the bread and butter for the company. This helps the company in its planning, and also builds a relationship with the client. Both have positive implications for the future, especially if the research is satisfactory, and the company has good customer service when it comes to executing trades.
The client benefits by not having to pay hard money for services that involve no actual trading. This is something that some of the mutual fund's customers may have questions about. While there may be a perfectly valid explanation, it may be easier to handle it through the commission process. Also, the client is working on developing a relationship with the brokerage, and may even get a discount on future arrangements.
The controversy with soft dollars is that the expenses are often hidden from the secondary clients, which means a mutual fund administrator, or other money manager, does not have to justify them. With questions regarding expenses and accountability becoming increasingly important in financial matters, the use of soft dollars is seen in an increasingly negative light. Thus, in light of the negative attention, there has been a push from some politicians to outlaw the practice altogether in the United States.