Along with the many other fiduciary obligations owed by RIAs, firms also owe a duty to seek best execution of clients’ transactions. In particular, RIAs violate Section 206 of the Investment Advisers Act if they fail to seek best execution for their clients. RIAs must seek to execute securities transactions for clients in a manner that the client’s total cost or net proceeds in each transaction is the most favorable under the circumstances. Price is not the only factor governing best execution. The crucial factor is whether a transaction represents the best qualitative execution for the managed account.
SEC’s Advice Regarding Best Execution
In its document entitled Information for Newly-Registered Investment Advisers, which can be found in U.S. Securities and Exchange Commission Information, and online at:
http://www.sec.gov/divisions/investment/advoverview.htm, the SEC said this:
“As a fiduciary, you are required to act in the best interests of your advisory clients, and to seek to obtain the best price and execution for their securities transactions. The term “best execution” means seeking the best price for a security in the marketplace as well as ensuring that, in executing client transactions, clients do not incur unnecessary brokerage costs and charges. You are not obligated to get the lowest possible commission cost, but rather, you should determine whether the transaction represents the best qualitative execution for your clients. In addition, whenever trading may create a conflicting interest between you and your clients, you have an obligation, before engaging in the activity, to obtain the informed consent from your clients after providing full and fair disclosure of all material facts.”
The SEC’s guidance urges RIAs to consider the full range and quality of services provided by the broker-dealer. The price for executing transactions is just one aspect of best execution. RIAs must also evaluate a broker-dealer’s:
- ability to execute, clear, and settle trades;
- ability to facilitate transfers and payments to and from accounts, such as wire transfers and check requests;
- access to investment products and expertise;
- speed of execution;
- the value of research provided;
- commission rate;
- financial responsibility; and
- customer service.
As we will discover in the next chapter, an RIA may determine that it is reasonable for clients to pay higher commission rates for obtaining certain products or services from a broker dealer. These products and services are usually referred to as soft dollars.
SEC staff members have said that an RIA may aggregate or bunch orders on behalf of two or more client accounts, as long as the bunching is done for the purpose of achieving best execution. Furthermore, no client should be systematically advantaged or disadvantaged by the bunching. If an RIA does not aggregate orders for client accounts, the firm should disclose this fact in Form ADV and the impact it has on best execution.
When clients limit how an RIA may execute securities transactions on their behalf, such as directing the firm to exclusively use a specific broker-dealer, RIAs must disclose the adverse impact this limitation may have. Figure 15-1 is an example of the type of language some RIAs used in disclosing the complications of allowing clients to direct broker-dealer executed transactions:
Figure 15-1. Form ADV Broker-dealer Disclosure
“In limited circumstances, and at our discretion, some clients may instruct our firm to use one or more particular brokers for the transactions in their accounts. If you choose to direct our firm to use a particular broker, you should understand that this might prevent our firm from aggregating trades with other client accounts or from effectively negotiating brokerage commissions on your behalf. This practice may also prevent our firm from obtaining favorable net price and execution. Thus, when directing brokerage business, you should consider whether the commission expenses, execution, clearance, and settlement capabilities that you will obtain through your broker are adequately favorable in comparison to those that we would otherwise obtain for you.”
*Used with permission from National Compliance Services, Inc.
Many registered representatives of broker-dealers start or join RIAs, so they can leave the brokerage field behind and offer truly objective investment advice. Other registered representatives, however, start or join RIAs without cutting their ties to a broker-dealer. Best execution is more complicated when an IAR is also a registered representative of a broker-dealer. Dually-registered representatives may be forbidden from conducting securities transactions away from their broker-dealers without authorization to do so. Therefore, these representatives are usually limited to conducting securities transactions through that particular broker-dealer.
An IAR that is also a registered representative must disclose that the broker-dealer may charge higher transactions costs and/or custodial fees than other brokerage firms. Furthermore, they must disclose on Form ADV that they receive commissions in their capacities as registered representatives for that broker-dealer. They must also disclose a potential conflict of interest in that there is an incentive to effect securities transactions for the purpose of generating commissions. Registered representatives must disclose that they may not be able to accept certain clients if they are unwilling to utilize their broker-dealer.
Figure 15-2 shows how some RIAs’ Form ADVs address the issue of best execution when representatives are dually registered.
Figure 15-2. Form ADV Dually-registered Representative Disclosure
Persons providing investment advice on behalf of our firm, who are registered representatives of a broker-dealer, will recommend that firm to you for brokerage services. These individuals are subject to applicable rules that restrict them from conducting securities transactions away from the broker-dealer unless the firm provides the representative with written authorization to do so. Therefore, these individuals are generally limited to conducting securities transactions through that broker-dealer. It may be the case that the broker-dealer charges higher transactions costs and/or custodial fees than another broker charges for the same types of services. If transactions are executed though this broker-dealer, these individuals (in their separate capacities as registered representatives of the brokerage firm) may earn commission-based compensation as result of placing the recommended securities transactions through the broker-dealer. This practice presents a conflict of interest because these registered representatives have an incentive to effect securities transactions for the purpose of generating commissions rather than solely based on your needs. You may utilize the broker-dealer of your choice and have no obligation to purchase or sell securities through this brokerage firm. However, if you do not use the broker-dealer, we may not be able to accept your account. Please see the “Fees and Compensation” section in this Brochure for more information on the compensation received by registered representatives who are affiliated with our firm.
*Used with permission from National Compliance Services, Inc.
If clients read dually-registered firms’ Form ADVs, they will be fully apprised on the extra costs that may be incurred.
The Big Picture
A one-time evaluation of best execution is not enough. RIAs must periodically evaluate the execution performance of broker-dealers used to execute clients’ transactions. Forensic tests can be used to analyze the quality of brokerage executions. These tests can help an RIA evaluate whether the firm is fulfilling its duty of best execution.
It is not just fiduciary duty that should drive an RIA to pursue best execution for clients. Unintended transaction costs and poor execution can have a negative impact on the performance of clients’ portfolios. Furthermore, higher transaction and execution costs will adversely affect the overall investment performance of an advisory firm. If clients’ investment returns are negatively impacted by these costs, they may choose a different RIA to manage their portfolios. An RIA that hopes to advertise the performance of accounts it manages for clients will be adversely affected if those returns suffer because of higher brokerage fees and other expenses. We will discuss performance advertising in Advertising Advisor Services and Credentials.
An RIA’s policies and procedures should spell out how the advisor seeks best execution. These policies and procedures should be consistent with the firm’s advisory agreement, as well as its Form ADV disclosure brochure. It is imperative that advisory personnel adhere to those procedures. Securities examiners evaluation of an RIA’s efforts to achieve best execution may be influenced by whether the investment advisor receives soft dollar credits from clients’ commissions.