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SEC Crackdown on Advisers a Reminder of Best Execution Duties

Posted by Duane Thompson on August 14, 2013 in In the News

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>>>>In late July the Securities and Exchange Commission sanctioned two investment advisers for failing to seek best execution with their affiliated broker-dealers. A.R. Schmeidler & Co., Inc. (ARS), a dually registered New York bank subsidiary, agreed to pay more than $1 million in fines and disgorgement fees to clients. Indianapolis-based Goelzer Investment Management, Inc. (GIM), and its principal, Gregory W. Goelzer, agreed to pay nearly $500,000 to settle charges.

The latest enforcement actions by the SEC serve as a practical reminder of an adviser’s fiduciary duty of best execution. When acting in the capacity of a fee-only or dually registered adviser, the cardinal principles of due care and utmost good faith apply.

According to the SEC, an adviser with responsibility to direct client trades has an obligation to seek best execution. In contrast to a broker-dealer’s best execution duty, which typically focuses on the price at which an order is executed, the adviser’s much broader duties of loyalty and care come into play when evaluating best execution. In assessing the appropriate standard of care, an adviser must consider the full range and quality of a broker’s services, including not only transaction costs and execution capability, but also the brokerage firm’s financial solvency, responsiveness to the adviser, and the value of any research.

ARS failed to reevaluate whether it was providing best execution for its advisory clients when it negotiated more favorable trading terms with its clearing firm. According to the settlement order, when the new clearing firm was hired in 2005, ARS reduced the commission rate for clients from 8 cents to 6 cents a share. ARS retained 80 percent of the commissions, or 4.8 cents per share, and the clearing firm 1.2 cents. The clearing firm retained 100 percent of the commissions generated by ERISA and other non-taxable accounts.

Two years later ARS ignored its own written compliance policies and procedures by failing to conduct sufficient analysis on best execution when it renegotiated the terms of the clearing firm arrangement. At the time ARS increased its share of commission payout in the taxable accounts to 90 percent, or 5.4 cents per share.  ARS eventually agreed to pay disgorgement of more than $800,000, including interest, and a penalty of $175,000.

In a similar fashion, GIM also failed to properly disclose and follow its compliance policies and procedures when it modified its commission schedule over a period of seven years. According to the settlement order, most of GIM’s business was principally as an investment adviser to individuals and family households, with about $700 million in client assets under management. Its broker-dealer served primarily as a support to the advisory business. GIM’s portfolio managers essentially offered five model portfolios comprising core growth, core value, rising dividend, fixed income and alternative investment strategies. Client assets were allocated among the strategies. When individual securities were added or removed from a model portfolio, client accounts invested in those portfolios were traded as a result.

Unfortunately for GIM, the SEC characterized its client disclosures on best execution as “false and misleading.”  GIM’s Form ADV stated that trades effected through its broker-dealer were “consistent with its obligation to obtain best price and execution,” when in fact it did not take steps to ensure that it sought best price and execution by comparing its rates to competitors’. Moreover, GIM also stated in its Form ADV  that clients not using its broker-dealer would be unable to benefit from lower commission rates when it made block trades. This disclosure was misleading as well, since GIM never passed on these savings to its clients. Had it done so, according to the SEC, GIM’s 288 clients would have saved nearly $310,000 in commission costs over a six-year period.

“Instead,” according to the settlement order of the SEC, “GIM used itself as a broker for its advisory clients by default rather than as a result of a best execution analysis.”

These latest enforcement actions should come as no surprise to fiduciary advisers. As early as 1988, and perhaps earlier, the SEC took enforcement action against an adviser, In the Matter of Mark Bailey & Co., for failure to disclose that it did not negotiate commissions on directed trades, and that it would be in a better position to negotiate commissions in bunched transactions for non-directed trades.

A more recent, and perhaps more egregious example of a violation of an adviser’s best execution duty was an enforcement action taken in 2007 by the SEC against Folger Nolan Capital Management, an investment adviser that directed trades to its broker-dealer affiliate without disclosing commission rates that were twice as high as non-directed trades.

The independent investment adviser who is inclined to wave off these incidents as conflicts unique to a broker-dealer affiliation would be ignoring its own legal obligation to assess best execution as well as the reasonableness of other investment management fees.

Although the Commission offers no prescribed time period when commission rates should be reviewed against others, SEC interpretive guidance suggests that, in the context of brokerage and related research services, the adviser should “periodically and systematically” evaluate the execution it is receiving for clients, and that the scope of its duty may evolve as changes in the market give rise to improved execution, such as technology, that afford opportunities to trade at more reasonable prices.

For example, with the increased popularity of exchange-traded funds and the commensurate reduction or elimination of transaction fees, fee-only and other advisers should consider transaction (and best execution) costs compared to the purchase of other securities.

In terms of mutual fund expenses, a standard investment product used by financial planners, other factors should include a periodic review of the securities turnover rate within a fund. While direct costs may not be measurable, collateral effects of the turnover rate on client costs in a taxable account are, via capital gains exposure. Of course, overall expense ratios of mutual funds and other investment manager fees should be monitored and periodically benchmarked to peer groups along with investment performance.

Finally, fee-only advisers using discount brokers should periodically assess whether the commission rates paid by their clients and the execution services received are competitive with other firms. An adviser that uses soft dollar research, for example, as part of a commission arrangement in excess of what another broker-dealer would have charged solely for effecting securities transactions is permitted under the Section 28(e) safe harbor as long as the commissions paid are reasonable in relation to the investment research and execution services. An adviser would not be able to use other back office services under the soft dollars safe harbor. In such cases, and based upon advice of legal counsel, the better solution may be to incorporate such services as directed brokerage arrangements in the advisory agreement.

Best execution may not be a topic of popular interest in a client meeting or at an advisory conference, but advisers should view it as a bellwether sign of a firm’s commitment to fiduciary excellence. As long as regulators show a penchant for examining best execution, advisers would be well-served to pay attention to clear and concise disclosures, conduct periodic due diligence in reviewing trading costs, and carefully follow related procedures in the adviser’s compliance policy.

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