As indicated in last month’s column (see “Fiduciary Duty: Best Practices for Fulfilling Suitability Obligations,” Investment Advisor, June 2012), the United States Supreme Court, in 1963, held in SEC v. Capital Gains Research Bureau Inc. that the Investment Advisers Act of 1940 imposes a fiduciary duty on advisors by operation of law. In order to fulfill this duty, an advisor is required to always act in his clients’ best interests and to make full and fair disclosure of all material facts, especially when the advisor’s interests may conflict with those of his clients. In this column, we will address an advisor’s fiduciary duty relative to “best execution” issues.
As fiduciaries, advisors must seek the best available execution for each client’s securities trade. This requires investment advisors to have their clients’ orders executed at prices that are as favorable as possible under prevailing market conditions. An advisory firm should seek to meet its duty of best execution by selecting and recommending broker-dealers that can provide the best qualitative execution, taking into consideration various factors. Such factors include, but are not limited to, the value of research provided (if any), the capability of the firm to execute trades efficiently, quality of price execution, the competitiveness of commission rates and transaction fees, and the overall level of customer service. Thus, while the firm should give significant weight to the competitiveness of the available commission and transaction rates, it may not necessarily select the BD that offers the lowest possible rates. Additionally, even where the firm uses its best efforts to seek the lowest possible commission rate, it may not necessarily obtain the lowest rate for client account transactions. In the event that the recommended BD’s commissions and transactions fees are meaningfully higher than similar BDs, the advisor has the fiduciary duty to clearly disclose that to the client.
The firm can determine if it has obtained best execution (cost and quality of execution) by a variety of methods, including its historical experience, conducting its own surveys, obtaining execution data or best execution reports from the executing broker-dealers, or reviewing trading data from third-party industry research sources. The extent and frequency of a firm’s review and monitoring procedures depends on its business operations and trading practices. For instance, if a firm’s trading is primarily limited to the purchase and sale of open-end mutual funds, price execution is not a factor, and the corresponding best execution obligation is generally limited to determining two things:
- The broker-dealer or custodian is effectively processing transactions.
- If certain mutual funds are assessed transaction fees, the advisor has made a reasonable determination that the transaction fee fund was superior to similar funds without transaction fees, and the amount of the transaction fee was comparable to the fees charged by similar BDs.
If a client directs the firm to effect all securities transactions through a particular BD with which the advisory firm does not have a relationship, the firm should be prepared to demonstrate to regulators that the client made the direction and was informed that he or she will be responsible for negotiating the terms and arrangements for the account with that BD. Generally, the firm will be correspondingly unable to seek better execution services or prices from such directed BDs nor will it be able to “bunch” the client’s transactions with orders for other accounts. Additionally, the firm should be prepared to show regulators that it has disclosed to the client that he or she may incur higher commissions or other transaction costs than would otherwise be the case had the client determined to effect transactions through the brokerage relationships generally recommended by the advisory firm.
