Two SEC enforcement cases last week demonstrate (i) how using affiliated brokerage on an agency or principal basis raises potential conflicts of interest when dealing with ” best execution” concerns , and (ii) the importance of having robust best execution policies and procedures and then following them. In both cases, the SEC sanctioned investment advisers for not heeding these concerns in failing to seek best execution on client trades placed through in-house brokerage divisions.
While the duty of an adviser or fund to seek best execution may not expressly be stated in the federal securities laws, to the extent they are typical, these cases tend to follow a pattern: An SEC best execution enforcement action might involve the SEC’s examination staff first finding that a firm failed to disclose compensation on client brokerage, failed to adequately its brokerage practices or failed to properly disclose to clients the adviser’s best execution policies and procedures. The two recent cases are no exception.
In the first case against A.R. Schmeidler & Co. (ARS), a dually registered investment adviser and a broker-dealer, the SEC found that ARS failed to reevaluate whether it was providing best execution for its advisory clients when it negotiated more favorable terms with its clearing firm. This resulted in ARS retaining a greater share of the commissions it received from clients, a best execution violation. The SEC found that the firm also failed to implement policies and procedures reasonably designed to prevent the best execution violations. To settle the SEC charges, ARS agreed to pay disgorgement of $757,876.88, prejudgment interest of $78,688.57, and a penalty of $175,000. The firm also must engage an independent compliance consultant, and had to consent to a censure and cease-and-desist order.
The second case involved a CEO who also served as Chief Compliance Officer officer, Goelzer, and his Indianapolis-based dually registered firm Goelzer Investment Management (GIM). The SEC found that GIM made misrepresentations in its Form ADV about the process of selecting itself as broker for advisory clients. The SEC found that GIM failed to seek best execution for its clients by neglecting to conduct the comparative analysis of brokerage options described in its Form ADV, and recommended itself as broker for its advisory clients without evaluating other introducing-broker options as the firm represented it would. Goelzer and GIM agreed to pay nearly $500,000 to settle the charges that included GIM paying disgorgement of $309,994, prejudgment interest of $53,799, and a penalty of $100,000. The firm was also required to comply with certain undertakings, including the continued use of a compliance consultant and the separation of its chief compliance officer position from the firm’s business function. Goelzer agreed to pay a $35,000 penalty, and Goelzer and GIM consented to censures and cease-and-desist orders.
What are some of the lessons for advisers and funds engaged in managing potential conflicts related to best execution?
While the SEC provides no specific definition of “best execution,” it has said that managers should seek to execute securities transactions for clients in such a manner that the client’s total cost or net proceeds in each transaction is most favorable under the circumstances. The determinative factor is not necessarily the lowest commission cost, but whether the transaction represents the best qualitative execution for the managed account. So what should advisers learn from these cases?
- Recognize the importance of having strong written policies and procedures that provide guidance concerning the quality of trade execution while, at the same time, attending client investment objectives and constraints.
- Make sure that disclosures in Form ADV and elsewhere include information about trading and actual and potential trading conflicts of interest.
- Document compliance with best execution policies and procedures and disclosures to clients.
- Consider setting up a brokerage or trade management committee to review trade placement and best execution. The committee should address such topics as broker trading cost and execution, brokerage expertise and infrastructure and the broker’s willingness to explore alternative trading options.
- Test for best execution, including possibly hiring a third party service provider to periodically assess the broker’s capacity to evaluate which competing markets, market makers, or electronic communication networks (ECNs) offer the most favorable terms of execution, the speed of execution, and the likelihood that the trade will be executed.
There are numerous sources to consult when thinking about and developing best execution policies. A few advisers might want to consider include: Trade Management Guidelines (Nov. 2002), available at www.dfainstitute.org/standards/ethics/tmg; See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170 (Apr. 23, 1986) (“1986 Soft Dollar Release”); Lori Richards, Valuation, Trading, and Disclosure: The Compliance Imperative, Remarks at the 2001 Mutual Fund Compliance Conference of the Investment Company Institute (June 14, 2001), available at www.sec.gov/news/speech/spch499.htm.
In statements following these cases, the SEC warned all investment advisers with affiliated broker-dealers that it would hold them accountable to ensure clients are obtaining the most beneficial terms reasonably available for their orders.