Do All Investment Advisers Really Have a Fiduciary Duty to Seek “Best Execution”?

Posted on

An investment adviser’s fiduciary duty to seek best execution of its clients’ securities transactions has recently stepped back into the spotlight. In July, the SEC issued a Risk Alert entitled “Compliance Issues Related to Best Execution by Investment Advisers,” and in April it released its much-anticipated proposed interpretive guidance regarding investment advisers’ standard of conduct (included as part of the SEC’s “Regulation Best Interest” and  “Form CRS” proposal package). The proposed interpretive guidance specifically references the duty to seek best execution as part of an adviser’s fiduciary duty of care.

The concept of an adviser’s fiduciary duty to seek best execution of client trades is nothing new, and has been promulgated by the SEC for decades through interpretive guidance, case law, and administrative proceedings (and now a Risk Alert). However, an important nuance is often glossed over: the fiduciary duty to seek best execution of client trades does not apply uniformly across all investment advisers.

But first, let’s step back to define the concept of best execution itself. When securities transactions are to occur in a client’s managed account, such transactions are often executed by a broker-dealer that is either affiliated with or independent of the adviser managing the account. Such broker-dealers typically do not perform their execution services for free, and charge the client a transaction charge or commission for effecting the transactions. Furthermore, no two broker-dealers are identical; they often differ dramatically in terms of their execution abilities, transaction costs, accuracy, responsiveness, financial stability, etc. Thus, if an adviser is in a position to choose which broker-dealer(s) are utilized to execute a client’s trades, the adviser indirectly controls the charges imposed on the client and the quality of execution services the client receives. Because of this weighty responsibility, the adviser has a fiduciary duty to seek out the best overall execution – but not necessarily the cheapest execution – for the client’s trades.

But what if the adviser is not in a position to choose which broker-dealer(s) are utilized to execute a client’s trades? In other words, what if the client selects a broker-dealer him- or herself, and directs the adviser to place trades through the selected broker-dealer? How about if an adviser only recommends a broker-dealer for execution services, but it is up to the client to accept or reject the adviser’s recommendations? And what if an adviser only has an agreement with one or two broker-dealers, such that the adviser can operationally only facilitate trading through the broker-dealer(s) with whom it has an agreement?

This is where things get complicated… or not?

The aforementioned Risk Alert states “As a fiduciary, when an adviser has the responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek to obtain “best execution” of client transactions, taking into consideration the circumstances of the particular transaction” [emphasis added].

The aforementioned proposed interpretive guidance also states “We have addressed an investment adviser’s duty of care in the context of trade execution where the adviser has the responsibility to select broker-dealers to execute client trades (typically in the case of discretionary accounts). We have said that, in this context, an adviser has the duty to seek best execution of a client’s transactions” [emphasis added].

Even the SEC’s Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934 (i.e. “soft dollar” practices, a separate but related topic) describes how soft dollars can “…  give incentives for managers to disregard their best execution obligations when directing orders to obtain client commission services…” [emphasis added].

The point is that if an adviser does not have the discretion to unilaterally select the executing broker-dealer on behalf of clients, it cannot reasonably be expected to seek best execution; a client that directs the adviser to use a particular broker-dealer practically assumes this responsibility. In the sources cited above, the qualifiers “when,” “where,” and “in this context” should not be overlooked.

So is that the end of the story? Not exactly.

Item 12 of Form ADV Part 2A requires a description of the factors an adviser considers “… in selecting or recommending broker-dealers for client transactions and determining the reasonableness of their compensation (e.g., commissions)” [emphasis added]. Thus, even if the client retains the ultimate responsibility to select the executing broker-dealer, an adviser that recommends one or more executing broker-dealers must still describe the factors it uses to make such a recommendation. These factors should generally encompass the same or similar factors expected of a best execution analysis; namely, from the same Risk Alert, “… the full range and quality of a broker-dealer’s services including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the adviser.”

Because the adviser is still in a position of trust and confidence with respect to its clients when making broker-dealer recommendations, it should still incorporate the principles of seeking best execution (if not the specific fiduciary duty). This is particularly important if (a) the adviser is receiving soft dollars or other benefits and incentives from the recommended broker-dealer(s), or (b) for all intents and purposes, the client is required to execute transitions through one or more specific broker-dealers with whom the adviser has an agreement. Such arrangements are commonplace for advisers that have partnered with only a few custodial broker-dealers, and should be disclosed appropriately in Form ADV Part 2.

On a related note, advisers are encouraged to review their responses to Item 8(C) – 8(G) of Form ADV Part 1 to ensure they align with what is disclosed in Form ADV Part 2A Item 12.

The overall takeaway is that best execution is an important concept for all advisers to understand (regardless of whether broker-dealers are selected or recommended), and to expect SEC inquiry about best execution practices in the course of an exam.