BROKER - DEALER TRADING ACTIVITIES
BY THOMAS J. MCGONIGLE, ROBERT P. HOWARD JR.,
AND M. ELIZABETH PARKS1
I.
1
BEST EXECUTION
A.
Generally
1.
There is no statutory definition of "best execution". The origins of
the duty of best execution have been said to predate the Federal
Securities law and rooted in the common law agency obligations of
undivided loyalty and reasonable care that an agent or fiduciary
owes to his or her principal.2 Under the “shingle theory,” a brokerdealer impliedly represents to its customers that it will deal with
them fairly and in accordance with the standards of the industry.3
These obligations have been combined by the Commission and
some courts in finding that a broker-dealer's failure to seek the
most favorable terms reasonably available under the circumstances
may constitute a material misrepresentation or omission in
violation of the anti-fraud provisions of the Federal Securities laws
if the requisite scienter is present.4
2.
"A broker-dealer's duty of best execution derives from common
law agency principles and fiduciary obligations, and is
incorporated both in SRO rules and through judicial and
Commission decisions, in the anti-fraud provisions of the federal
securities laws. This duty of best execution requires a brokerdealer to seek the most favorable terms reasonably available under
the circumstances for a customer's transaction. The scope of this
duty of best execution must evolve as changes occur in the market
that give rise to improved executions for customer orders,
including opportunities to trade at more advantageous prices. As
these changes occur, broker-dealers' procedures for seeking to
Mr. McGonigle is a partner, and Mr. Howard and Ms. Parks are associates at the law firm of
McGuireWoods LLP, located in Washington, D.C. (202) 857-1700.
2
Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, (3d Cir.)(en banc), cert. denied sub
nom., Merrill Lynch, Pierce Fenner & Smith, Inc. v. Kravitz, 119 S.Ct. 44 (1998); Restatement of Agency
(Second) §424 (1958) (Agent must "use reasonable care to obtain terms which best satisfy the manifested
purposes of the principal.").
3
Duker & Duker, 6 S.E.C. 386 (1939); See also Charles Hughes & Co. v. SEC, 1939 F.2d 434 (2d Cir.
1943), cert. denied, 131 U.S. 786 (1944).
4
Thompson & McKinnon, 43 S.E.C. 785 (1968) ("We have on numerous occasions stressed the importance
of the broker's fiduciary obligation to get the best price for his customers. That obligation is basic and vital
to the broker-customer relationship.")
obtain best execution for customer orders must also be modified to
consider price opportunities that become 'reasonably available'." 5
5
B.
NASD Rules & Guidance
1.
NASD Notice to Members 01-22 (April 2001) - Best Execution
(a)
Executing small orders on a automated basis - “The SEC
and the NASD have recognized the practical necessity of
automating the handling of small orders. In the context of
aggregate order handling decisions however, the
importance of the opportunity for customer orders to be
executed at prices that are better than the NBBO is a factor
in the Best Execution determinations.
(b)
Regular and rigorous reviews - “An important focus of the
NASD’s examination program concerns the review of a
member’s procedures to regularly and rigorously examine
execution quality likely to be obtained from the different
markets or market makers trading a security.
The
requirement to regularly and rigorously examine execution
quality flow from the SEC’s acknowledgement that it may
be impracticable for broker/dealers to provide
individualized treatment for certain classes of orders . . .
although the reach of the regular and rigorous requirement
has been articulated by the SEC in a variety of ways
throughout the years, it is clear that a broker/dealer may
conduct a regular and rigorous review (as opposed to an
order-by-order review) for small orders routed or executed
pursuant to a predetermined arrangement, including
internally executed orders where order-by-order routing is
impracticable.”
(c)
Focus of review - “The focus of the analysis is to determine
whether any ‘material’ differences in execution quality
exist and, if so, to modify the firm’s routing arrangements
or justify why it is not modifying its routing arrangements.
This analysis must compare the quality of the execution the
firm is obtaining via current order routing and execution
arrangements (including the internalization of order flow)
to the quality of the executions that the firm could obtain
from competing markets and market centers. Accordingly,
Order Execution Obligations (Final Rules), Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61 Fed. Reg.
48290 (Sept. 12, 1996) (citations omitted).
a broker/dealer must evaluate whether opportunities exist
for obtaining improved executions of customer orders”
(d)
Factors to Consider - The NASD quoted, verbatim, the
SEC’s guidance as follows:
“Where material price differences exist between the
price improvement opportunities offered by markets
or market-makers, these differences must be taken
into account by the broker-dealer. Similarly in
evaluating its procedure for handling limit orders,
the broker-dealer must take into account any
material differences in execution quality (e.g., the
likelihood of execution) among various markets or
market centers to which limit orders may be routed.
The traditional non-price factors affecting the cost
or efficiency of executions should also continue to
be considered; however, broker-dealers must not
allow an order-routing inducement, such as
payment for order flow or the opportunity to trade
with that order as principal, to interfere with its duty
of best execution.”
(e)
Introducing firm versus clearing firm review - “NASD
Regulation believes that an introducing broker/dealer must
take reasonable steps to insure that the introducing
broker/dealer and its executing broker/dealer are complying
with the duty of best execution. An introducing firm that
routes its order flow to its clearing firm or other executing
broker/dealer can rely on the clearing or executing firm’s
regular and rigorous review as long as the statistical results
and rationale of the review are fully disclosed to the
introducing firm and the introducing firm periodically
reviews how the clearing or executing firm is conducting
that review as well as the results of that review.”
“An introducing firm should request from its executing
broker/dealer a copy of any analysis that the executing
broker/dealer has done . . ..”
(f)
Frequency of review - “At a minimum, firm should conduct
such reviews on a quarterly basis; however, members
should consider, based on the firm’s business, whether
more frequent reviews are needed, particularly in light of
the monthly market center statistics made available under
Rule 11Ac1-5.”
2.
(g)
Structure of review - “At a minimum, firms must
demonstrate procedures that describe who at the firm is
responsible for conducting regular and rigorous review;
how the review is going to be conducted; the frequency
with which the review will be conducted; and how the
review will be evidenced.”
(h)
Sources of information - Firms can gather information
regarding execution statistics and alternative executions for
comparison from a variety of sources including: the NASD
Regulation “Compliance Report Cards” issued to member
firms; the reports created pursuant to Rule 11Ac1-5 under
the Exchange Act; and the firm reports created pursuant to
Rule 11Ac1-6 under the Exchange Act.
Rule 2320(a) - Best Execution
(a)
3.
“In any transaction for or with a customer, a member and
persons associated with a member shall use reasonable
diligence to ascertain the best inter-dealer market for the
subject security and buy or sell in such market so that the
resultant price to the customer is as favorable as possible
under prevailing market conditions. Among the factors that
will be considered in determining whether a member has
used "reasonable diligence" are:
(1)
The character of the market for the security, e.g.,
price, volatility, relative liquidity, and pressure on
available communications;
(2)
the size and type of transaction;
(3)
the number of primary markets checked;
(4)
location and accessibility to the customer's
broker/dealer of primary markets and quotations
sources.”
Rule 2320(b)-(f) - Interpositioning
(a)
“In any transaction for or with a customer, no member or
person associated with a member shall interject a third
party between the member and the best available market
except in cases where the member can demonstrate that to
his knowledge at the time of the transaction the total cost or
proceeds of the transaction, as confirmed to the member
acting for or with the customer, was better than the
prevailing inter-dealer market for the security. A member's
obligations to his customer are generally not fulfilled when
he channels transactions through another broker/dealer or
some person in a similar position, unless he can show that
by so doing he reduced the costs of the transactions to the
customer.” Rule 2320(b).
(b)
“When a member cannot execute directly with a market
maker but must employ a broker's broker or some other
means in order to insure an execution advantageous to the
customer, the burden of showing the acceptable
circumstances for doing so is on the retail firm. Examples
of acceptable circumstances are where a customer's order is
"crossed" with another retail firm which has a
corresponding order on the other side, or where the identity
of the retail firm, if known, would likely cause undue price
movements adversely affecting the cost or proceeds to the
customer.” Rule 2320(c).
(c)
“Failure to maintain or adequately staff an over-the-counter
order room or other department assigned to execute
customers' orders cannot be considered justification for
executing away from the best available market; nor can
channeling orders through a third party as described above
as reciprocation for service or business operate to relieve a
member of his obligations. However, the channeling of
customers' orders through a broker's broker or third party
pursuant to established correspondent relationships under
which executions are confirmed directly to the member
acting as agent for the customer, such as where the third
party gives up the name of the retail firm, are not prohibited
if the cost of such service is not borne by the customer.”
Rule 2320 (d).
(d)
“A member through whom a retail order is channeled, as
described above, and who knowingly is a party to an
arrangement whereby the initiating member has not
fulfilled his obligations under this Rule, will also be
deemed to have violated this Rule.” Rule 2320(e).
(e)
“The obligations described in paragraphs (a) through (e) [of
Rule 2320] exist not only where the member acts as agent
for the account of his customer but also where retail
transactions
are
executed
as
principal
and
contemporaneously offset. Such obligations do not relate
to the reasonableness of commission rates, markups or
markdowns which are governed by Rule 2440 and IM2440.” Rule 2320(f).
4.
5.
Rule 2320(g) - The “Three Quote” Rule6
(a)
Rule 2320(g)(1) states that “unless two or more priced
quotations for a non-Nasdaq security (as defined in the
Rule 700 Series) are displayed in an inter-dealer quotation
system7 that permits quotation updates on a real-time basis,
in any transaction for or with a customer pertaining to the
execution of an order in a non-Nasdaq security, a member
or person associated with a member, shall contact and
obtain quotations from three dealers (or all dealers if three
or less) to determine the best inter-dealer market for the
subject security."
(b)
“Members that display priced quotations on a real-time
basis for a non-Nasdaq security in two or more quotation
mediums8 that permit quotation updates on a real-time basis
must display the same priced quotations for the security in
each medium."
NASD Rule 3010 - Supervision
(a) Rule 3010 provides that each NASD member must “establish
and maintain a system to supervise the activities of each
registered representative and associated person that is
reasonably designed to achieve compliance with applicable
securities laws and regulations, and with the Rules of this
Association.”9
(b)
In discussing the requirements of NASD Rule 3010 relating
to Best Execution, the NASD has stated the following:
“[Both] the NASD and the SEC have recently emphasized
the importance of a broker/dealer’s best execution
obligations. Whether a firm has fulfilled these obligations
depends upon the different facts and circumstances present
at each member firm. Nevertheless, as the SEC has
6
The SEC approved Amendments to this rule. The amendments primarily affect securities traded on the
OTC Bulletin Board (“OTCBB”) or in the Electronic Quotation Service operated by Pink Sheet LLC
(“Pink Sheets”). See Release No. 34-43319; 65 Fed. Reg. 58589 (Sept. 29, 2000).
7
The term "inter-dealer quotation system" means any system of general circulation to brokers or dealers
that regularly disseminates quotations of identified brokers or dealers. Rule 2320(g)(3).
8
The term "quotation medium" means any inter-dealer quotation system or any publication or electronic
communications network or other device that is used by brokers or dealers to make known to others their
interest in transactions in any security, including offers to buy-or sell at a stated price or otherwise, or
invitations of offer's to buy or sell. Rule 2320(g)(4).
9
NASD Rule 3010(a).
repeatedly stated, to comply with the supervisory
obligations that flow from best execution, a supervisory
system must provide a mechanism for regularly and
rigorously comparing execution quality likely to be
obtained from different markets or Market Makers, and for
determining that such analyses are performed.”10
C.
10
Small Orders
1.
Regular & Rigorous Examinations - "The Commission believes
that broker-dealers deciding where to route or execute small
customer orders in listed or OTC securities must carefully evaluate
the extent to which this order flow would be afforded better terms
if executed in a market or with a market maker offering price
improvement opportunities. In conducting the requisite evaluation
of its internal order handling procedures, a broker-dealer must
regularly and rigorously examine execution quality likely to be
obtained from the different market or market makers trading a
security. If different markets may be more suitable for different
types of orders or particular securities, the broker-dealer will also
need to consider such factors."11
2.
NBBO, Not Necessarily Sufficient - "The Commission has
emphasized that best execution obligations require that brokerdealer's routing orders for automatic execution must periodically
assess the quality of competing markets to assure that order flow is
directed to markets providing the most beneficial terms for their
customers' orders. While in the past quote-based executions in
OTC securities were generally recognized as satisfying best
executions obligations, the development of efficient new facilities
has altered what broker-dealers must consider in seeking best
execution of customer orders. The Commission thus noted the
importance of the opportunity for price improvement as a factor in
best execution, speaking in the context of aggregate order handling
decisions for both listed and OTC stocks. Therefore, the
Commission believes that routing order flow for automated
execution, or internally executing order flow on an automated
basis, at the best bid or offer quotation would not necessarily
satisfy a broker-dealer's duty of best execution for small orders
listed and OTC securities."12
NASD Notice to Members 98-96 (December 1998) at 733.
Order Execution Obligations (Final Rules), Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61 Fed.Reg.
48290 (Sept. 12, 1996) (citations omitted).
12
Order Execution Obligations (Final Rules), Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61
FedReg.48290 (Sept. 12, 1996)(citations omitted).
11
D.
Other Guidance Regarding Best Execution
1.
Standard Industry Practice - The Third Circuit, in Merrill, Lynch13
rejected defendants assertion that they were entitled to summary
judgment on the theory that execution of customer orders at the
National Best Bid and Offer ("NBBO") was a practice “widely, if
not universally followed.”
2.
Frequency of Reviews - The regulations provide no clear guidance
as to how frequently reviews must take place:
(a) "The Commission is not suggesting that broker-dealers
must engage in manual handling of small orders if
necessary to access [systems not classified as ECNs].
Nonetheless, the Commission believes that because
technology is rapidly making these systems more
accessible, broker-dealers must regularly evaluate
whether prices or other benefits offered by these
systems are reasonably available for purposes of
seeking best execution of these customer orders.14
(b) "The Commission continues to believe that a broker
routing retail orders in a particular security to a single
market (whether by automated or other means) must at
least make periodic assessments of the quality of
competing markets to assure that it is taking all
reasonable steps under the circumstances to seek out
best execution of customers' orders."15
(c)
13
Frequency of review - “At a minimum, firm should conduct
such reviews on a quarterly basis; however, members
should consider, based on the firm’s business, whether
more frequent reviews are needed, particularly in light of
the monthly market center statistics made available under
Rule 11Ac1-5.”16
Newton, et al. v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266 (3d Cir. 1998) (en banc),
cert. denied sub. nom., Merrill, Lynch, Pierce Fenner & Smith, Inc. v. Kravitz, 199 S.Ct. 44 (1998), Citing
Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1171-72 (2d Cir. 1970)(non-disclosure of widespread
industry practice may still be non-disclosure of material fact); Opper v. Hancock Securities Corp., 250
F.Supp. 668, 676 (S.D.N.Y.) (industry custom may be found fraudulent, especially on first occasion it is
litigated) aff'd, 367 F.2d 157 (2d Cir. 1966).
14
Order Execution Obligations (Final Rules), Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61 Fed.
Reg. 48290 (Sept. 12, 1996) (citations omitted).
15
Development of a National Market System, Exchange Act Rel. No. 15671 (March 22, 1979), 44 Fed.
Reg. 20360, 20366 (Apr. 4, 1979).
16
Best Execution, NASD Notice to Members 01-22 (April 1, 2001)
(d)
E.
But, certain NASDR Staff have indicated that quarterly
reviews are not frequent enough.
Speaking at the
NASDR's Spring Securities Conference in April 2000,
Thomas Gira, Vice President Market Regulation
Compliance, stated that quarterly reviews of best execution
are no longer adequate to meet the volume and pace of
trading and that the firms should conduct at least monthly
or weekly reviews, depending on the circumstances.17
Sources of Information for Review
1.
Disclosure of Order-Execution Practices Rule 11Ac1-5 - Rule
11Ac1-5 is intended to assure that all market centers publicly
disclose on a monthly basis basic standardized information
concerning handling and execution of orders. The Rule adopts
basic measures of execution quality and provides specific
instructions on how the measures are to be calculated. The
statistical information must be categorized by individual security,
by five types of order, and four order sizes.
(a)
Scope - Rule 11Ac1-5 requires that every market center
make publicly available each calendar month an electronic
report on the covered orders in national market system
securities that it received for execution from any person.
(1) Market Center - A Market Center is defined in
paragraph (a)(14) of Rule 11Ac1-5 as any exchange
market maker, OTC market maker, alternative trading
system, national securities exchange, or national
securities association.
(2) Covered Order - Paragraph (a)(8) of Rule 11c1-5
defines “covered order.” This definition limits the
scope of the Rule to apply only to market orders and
limit orders that are received by a market center during
regular trading hours, and if executed, executed during
such time. In addition, this Rule applies only to orders
that are received during the time that a “consolidated
best bid and offer” is being disseminated.18 A covered
order does not include any order for which a customer
17
Introducing Firms Must Monitor Best Execution by Clearing Brokers, 32 Sec. Reg. & L. Rep. (BNA)
567 (May 1, 2000).
18
“Consolidated best bid and offer” is defined in paragraph (a)(7) as the highest firm bid and the lowest
firm offer for a security that is calculated and disseminated on a current and continuous basis pursuant to an
effective national market system plan. Consolidated Quotation Plan and Nasdaq/National Market System
Plan are two plans that provide for this calculation.
requested special handling for execution19 or orders to
be executed at a market opening price.
Market centers are not required to report on orders
that it receives manually. The Commission has
issued an exemption pursuant to paragraph (c) of
the Rule that temporarily exempts orders received
by a market center otherwise than through
automated systems
(3) National Market System Securities - Rule 11Ac1-5
applies only to exchange-listed securities and equities
included in the National Market tier of Nasdaq, and
does not apply to Nasdaq SmallCap securities, Overthe-Counter Bulletin Board securities, and exchangelisted options.
(b)
Required Information - Market center reports must be
categorized by individual security, order type, and order
size. These categories are defined in paragraphs (a)(4) –
(a)(6). The five types of orders are market, marketable
limit, inside-the-quote limit, at-the-quote limit, and nearthe-quote limit. Order size is divided into 100-499, 5001999, 2000-4999, and 5000 or more shares.
Paragraph (b)(1)(i) specifies eleven columns of information
that must be provided for each subcategory of
security/order type/order size. The first five column
provide general information on the orders: the first column
is “the number of covered orders,” the second is “the
cumulative number of shares of covered orders,” and
thereafter all statistics required by the Rule are expressed
either in number of shares or in share weighted amounts.
The Rule requires disclosure of the number of shares
cancelled prior to execution, and the number of shares
executed at both the receiving market center and at any
other venue.
The next five columns required by paragraph (b)(1)(i) of
the Rule asks for the number of shares executed within five
specified periods of time after order receipt: 0 to 9 seconds,
19
Examples include orders to be executed at a market opening or closing price, stop orders, orders such as
short sales that must be executed on a particular tick or bid, orders submitted on a “not held” basis, orders
for other than regular settlement, orders to be executed at prices unrelated to the market price at the time of
execution, and all-or-none orders.
10 to 29 seconds, 30 to 59 seconds, 60 to 299 seconds, and
5 minutes to 30 minutes.
The final column of information required for all types of
orders is the average realized spread. “Average realized
spread” is defined in paragraph (a)(3) and is calculated by
comparing the execution price of an order with the
midpoint of the consolidated best bid and offer as it stands
five minutes after the time of order execution. The SEC
considers the average realized spread an essential measure
for evaluating a market center’s order execution practice.
(c)
Information Required for Market and Marketable Limit
Orders - Subparagraph (b)(1)(ii) of Rule 11Ac1-5 specifies
nine additional columns of information for subcategories of
market orders and marketable limit orders.
The first required column is the average effective spread.
Average effective spread is defined in paragraph (a)(2) of
the Rule and is calculated by comparing the execution price
of an order with the midpoint of the consolidated best bid
and offer at the time of order receipt. The other eight
columns of information required by the rule are essentially
the major determinants of execution quality. Orders are
classified based on whether they were “executed with price
improvement,” “executed at quote,” or “executed outside
the quote.” For shares executed with price improvement
and shares executed outside the quote, market centers will
disclose the number of shares, the average amount per
share of price improvement or disimprovement, and the
average speed of execution. For shares executed at the
quote, market centers will disclose the number of shares
and the average speed of execution.
(d)
Procedures for Making Reports Available to the Public The monthly reports required by paragraph (b)(1) of the
Rule must be made available by market centers in
electronic form. Paragraph (b)(2) directs the SROs to act
jointly in establishing procedures for market centers to
follow in making their monthly reports available to the
public in a readily accessible, uniform, and usable format.
A market center need not make its reports available on its
own Internet site. Market centers have the option to make
arrangements with other entities to make their reports
available to the public. Market centers need not make their
reports available in a separate data file; for example, an
SRO may make the monthly reports available for all its
members in a single file.
(e)
Phase-In Schedule - The first phase-in of securities subject
to the Rule will begin on Tuesday, May 1, 2001. As of this
date, the Rule will apply to the 1000 NYSE securities, 1000
NASDAQ securities, and 200 Amex securities with the
highest average daily share volume for the quarter ending
December 31, 2000. On May 1, 2001, market centers must
begin collecting the necessary data to prepare their monthly
reports, and they must make their report for May 2001
available at the end of June 2001.
The second phase-in will be July 2, 2001. From this date
forward the Rule will apply to the next 1000 NYSE
securities, 1000 Nasdaq securities, and 200 Amex securities
with the highest average daily share volume for the quarter
ending March 31, 2001.
The third phase-in will begin October 1, 2001. For this
date forward, the Rule will apply to all national market
system securities.
On April 12, 2001, the SEC issued a letter to the Securities
Industry Association providing a temporary exemption
until July 30, 2001 from the reporting requirements of the
Rule for orders that are qualified for inclusion in the
National Market tier of Nasdaq.
2.
Disclosure of Order-Routing Practices Rule 11Ac1-620 - Under
Rule 11Ac1-6, a broker-dealer that routes orders on behalf of
customers will be required to prepare quarterly reports that
disclose the identity of the venues to which it routed orders for
execution. The reports will also disclose the nature of the brokerdealer’s relationship with those venues. Finally, a broker-dealer
will be required to disclose, upon customer request, where they
routed a customer’s individual order for execution.
(a)
20
Scope - Rule 11Ac1-6 covers a broader range of securities
than Rule 11Ac1-5. The definition of a “covered security”
includes national market securities, Nasdaq SmallCap
equities and listed options. The Rule also applies to all
broker-dealers that route orders on behalf of their
See also Disclosure of Order Routing, NASD Notice to Members 01-30 (May, 2001).
customers. The term “customer order” is defined as any
order to buy or sell a covered security that is not for the
account of a broker-dealer, but excludes any order for a
quantity of a security having a market value of at least
$50,000 for a covered security that is an option contract
and a market value of at least $200,000 for any other
covered security. Rule 11Ac1-6 also applies to all types of
orders, but broker-dealers must give an overview of their
routing practices only for “non-directed orders.”21
(b)
Quarterly Reports - Paragraph (b)(1) of Rule 11Ac1-6
requires broker-dealers to make publicly available for each
calendar quarter a report on its routing of non-directed
orders in covered securities. To make the report “publicly
available,” the broker-dealer must post a free Internet web
site, furnish a written copy on request, and notify customers
at least annually that a written copy will be furnished on
request. Paragraph (b)(2) requires that a quarterly report be
made publicly available within one month after the end of
the quarter addressed in the report.
Rule 11Ac1-6 requires that a quarterly report be divided
into four separate sections for four different types of
covered securities: one for equity securities listed on the
NYSE, one for equity securities qualified for inclusion in
Nasdaq, one for equity securities listed on the Amex or any
other national securities exchange, and one for options.
For each of these four sections, paragraph (b)(1)(i) and (ii)
require the broker-dealer to give a quantitative description
of the aggregate nature of their order flow. The
quantitative description of order routing must include the
percentage of total customer orders for a particular section
that were non-directed orders, and the percentages of total
non-directed orders for a section that were market orders,
limit orders, and other orders. The description should also
include the identity of the ten venues to which the largest
number of non-directed orders for the section were routed
for execution, as well as any venue to which five percent or
more of non-directed orders were routed.
Under paragraph (b)(1)(iii), a broker-dealer will also be
required to discuss the material aspects of its relationship
Paragraph (a)(5) of the Rule defines a “non-directed order” as any customer order other than a directed
order. Paragraph (a)(3) of the Rule defines a directed order as a customer order that the customer
specifically instructs the broker-dealer to route to a particular venue for execution.
21
with each venue identified in each section, including a
description of any payment for order flow arrangement or
profit-sharing relationships as it relates to the type of
securities for that section. Rule 11Ac1-6 does not require a
broker-dealer to provide a quantitative estimate of the
aggregate dollar amount of payment for order flow received
during a quarter for each order execution venue, but a
description of a payment for order flow arrangement must
include disclosure of the material aspects of the
arrangement.22
The Rule does not require that broker-dealers provide a
narrative discussion and analysis of their order routing
practices.
(c)
(d)
II.
Phase-In Dates - Rule 11Ac1-6 is effective 60 days after
publication in the Federal Register, and all broker-dealers
must comply with the Rule for all covered securities on
July 2, 2001. Thus, the first required report must cover
transactions during the quarter ending on September 30,
2001. The report must be made publicly available by
October 31, 2001.
BROKER-DEALERS AS SOFT DOLLAR PROVIDERS
A.
Generally
1.
22
Customer Requests for Information - Paragraph (c) of Rule
11Ac1-6 requires broker-dealers, on request of a customer,
to disclose to the customer the identity of the venue to
which the customer’s orders were routed for execution in
the six months prior to the request, whether the orders were
directed orders or non-directed orders, and the time of the
transactions, if any, that resulted from such orders.
Broker-dealers must notify their customers at least annually
of their option to request such information.
“The Commission has defined soft dollar practices as arrangements
under which products or services other than execution of securities
transactions are obtained by an adviser from or through a broker-
Material aspects of the arrangement would include a description of terms of the arrangement, such as any
amounts per share or per order that the broker receives. Or, in describing a profit-sharing relationship, a
broker would be expected to disclose the extent to which it could share in the profits.
dealer in exchange for the direction by the adviser of client
brokerage transactions to the broker-dealer.”23
2.
B.
23
On May 1, 1975 the Commission abolished fixed commission rates
for securities transactions. In connection with the abolition of
fixed commission rates, money managers and broker-dealers
expressed concern that if money managers were to pay more than
the lowest commission rate available to a broker-dealer in return
for services other than execution, such as research, they would be
exposed to charges that they had breached a fiduciary duty. This
concern was based on the traditional fiduciary principle that a
fiduciary cannot use trust assets to benefit himself.24 Accordingly,
Congress enacted Section 28(e) of the Securities Exchange Act of
1934 to create a “safe harbor” for money managers who use the
commission dollars of their advised accounts to obtain investment
research and brokerage services, provided that certain conditions
are met.
Section 28(e) Safe Harbor
1.
Section 28(e) provides that a person that exercises investment
discretion shall not be deemed to have acted unlawfully or to have
breached a fiduciary duty under State or Federal Law “solely by
reason of his having caused the account to pay a member of an
exchange, broker, or dealer an amount of commission for effecting
a securities transaction in excess of the amount of commission
another member of an exchange, broker, or dealer would have
charged for effecting that transaction, if such person determined in
good faith that such amount of commission was reasonable in
relation to the value of the brokerage and research services
provided by such member, broker, or dealer, viewed in terms of
either that particular transaction or his overall responsibilities with
respect to the accounts as to which he exercises investment
discretion.”25
2.
The Commission has stated that “Congress concluded that general
fiduciary principles did not contemplate that the lowest
commission rate would necessarily be in the beneficiary’s best
interest, and it adopted Section 28(e) in order to assure money
Office of Compliance, Inspections and Examinations, Securities & Exchange Commission, Inspection
Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, (Sept. 22,
1998), citing Disclosure by Investment Advisers Regarding Soft Dollar Practices, Advisers Act Release
No. 1469 (Feb. 14, 1995).
24
Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and
Related Matters, 51 Fed.Reg. 16004 (April 30, 1986).
25
15 USC § 28bb(e)(1)
managers that, under a system of competitive commission rates,
they might use reasonable business judgment in selecting brokers
and causing accounts under management to pay commissions.”26
C.
Broker-Dealers Potential Liability for Payments Under Soft-Dollar
Arrangements
1.
In a 1980 Exchange Act Release, the Commission stated that:
“[b]rokers should recognize that compliance with any
direction or suggestion by a fiduciary which would appear
to involve a violation of the fiduciary’s duty to its
beneficiaries could implicate them in a course of conduct
violating the anti-fraud provisions of the federal securities
laws . . . [and] [a] broker which causes or assists an
institution to violate a duty to the investor may be aiding or
abetting a fraudulent or deceptive act or practice.
Furthermore, a broker would have a duty to inquire with
respect to his participation in a course of conduct which, to
a reasonable person, would raise a question of fraudulent or
deceptive acts or practices.”27
26
2.
In the 1998 Release, Staff further strengthened this pronouncement
stating that “The staff believes that broker-dealers may be found
liable for aiding and abetting investment advisers’ violations of
their fiduciary duties to advisory clients, where the broker-dealer
continues participation in a course of conduct that the brokerdealer either knows, or should reasonably be aware, is
fraudulent.”28
3.
In 1999, in a highly-publicized case, the Commission entered into
a Cease and Desist Order with a broker-dealer and its president for
aiding and abetting an adviser’s alleged soft-dollar violations.29
According to the SEC’s allegations, the broker-dealer ignored a
number of “red flags” and made payment without further inquiry.
The red flags described in the Commission’s Order are as follows:
Office of Compliance, Inspections and Examinations, Securities and Exchange Commission, Inspection
Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, (Sept. 22,
1998).
27
Report of Investigation in the Matter of Investment Information Inc. Relating to the Activities of Certain
Investment Advisers, Banks, and Broker-Dealers, Exchange Act Release No. 16679 (March 19, 1980).
28
Office of Compliance, Inspections and Examinations, Securities and Exchange Commission, Inspection
Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, (Sept. 22,
1998), citing Section 15(b)(4)(E) of the Exchange Act and Section 203(e)(6) of the Advisers Act.
29
In re Republic New York Securities Corp. and James Edward Sweeney, Exchange Act Rel. 41036 (Feb.
10, 1999).
(a)
(b)
(c)
(d)
D.
Invoices submitted to broker-dealer related to non-research
expenses that revealed on their face that the expenses were
not for research and brokerage services;
Payments were made directly to the adviser. The brokerdealer did not maintain contractual privity with the
adviser’s soft dollar vendors, thus the services were not
“provided by” the broker-dealer;
The invoices on their face contained indications of fraud.
For example, the Commission stated that some of the
invoices provided for the payment of “consulting services”
where the broker-dealer knew the person was not a
consultant but was a full-time employee of the investment
adviser; and
The broker dealer made soft dollar payments without
receiving adequate documentation to establish that the
expenses had actually been incurred by the investment
adviser.
Broker-Dealers Supervisory Procedures
1. The Commission’s 1998 Soft Dollar Report also stated that, in relation
to soft dollar arrangements, “broker-dealers should have supervisory
systems and compliance procedures to assure that all aspects of their
activities are in compliance with the law.” The staff went on to
describe, with approval, certain “key controls” that were in place at a
handful of broker-dealers relating to soft dollars which included:
(a)
(b)
(c)
(d)
Ensuring that the broker-dealer is contractually liable for
each third-party arrangement;
Refusing to pay any invoices submitted by advisers;
Maintaining a written record of the products/services
provided to the adviser in exchange for soft dollars; and
A deliberative process for determining whether products
and services fall within the safe harbor.30
2. In addition to these “key controls” the staff provided an Appendix that
set forth certain internal control procedures that they believed brokerdealers should review and consider in relation to their soft dollar
arrangements. The broker-dealer controls are as follows:
(a)
30
A designated person or committee is responsible for
overseeing the firm’s soft dollar and client-directed
Office of Compliance, Inspections and Examinations, Securities and Exchange Commission, Inspection
Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22,
1998).
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
31
brokerage activities and for establishing the firm’s
operating policies for these activities;
At the time that a soft dollar arrangement is being
established, a broker-dealer determines whether the adviser
has discretionary management authority for its clients’
assets and requests and obtains a written description of the
adviser’s authority, and the types of products and services
the adviser is authorized to obtain;
Established procedures are used to determine whether
products and services requested by advisers are consistent
with the adviser’s authority over clients’ commissions;
At the time that a client of an adviser begins negotiations to
establish a directed brokerage arrangement, the brokerdealer determines whether the rebates of commissions or
products/services to be supplied are within the advisory
client’s authority to request and that the party receiving the
benefits under the arrangements is authorized to receive
such benefits. The firm requests and obtains from the
client a written description of its authority to enter into the
arrangement and to receive the indicated products/services;
The broker-dealer establishes a contractual relationship
with each third-party vendor of research products and
services so that it is obligated for payment under all such
contract;
An appropriate unit of the broker-dealer produces a master
approved list of all third-party soft dollar arrangements and
client-directed brokerage arrangements. No payments are
made to third-party vendors or to clients under rebate
programs unless the arrangement appears on this list;
Invoices for products and services submitted by advisers
for which the broker-dealer is not contractually liable for
payment are not paid;
Commissions paid under each soft dollar arrangement by
advisers are periodically reviewed in a relation to the
products and services provided to the advisers, and advisers
are informed if their commission situations are materially
out of balance; and
The broker-dealer sends each adviser a periodic statement
of all proprietary and third-party research and non-research
provided, including commitment amounts and year-to-date
commissions directed.31
Office of Compliance, Inspections and Examinations, Securities and Exchange Commission, Inspection
Report of the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds, Appendix F
(Sept. 22, 1998).
D.
Products and Services Provided by Broker-Dealers That Could Be Outside
Section 28(e) Safe Harbor
1.
E.
32
In the 1998 Examination, the Commission determined that
approximately 35% of the broker-dealers that were examined paid
for at least one product or service that appeared to be unrelated to
research or execution. The products/services included, among
other things: rent, computer hardware use for administrative or
personal use, CFA Exam Review Courses, AIMR membership
dues, travel expenses, cable and satellite television for nonresearch areas, telephone service, employees’ salaries, messenger
services, consulting services, postage, parking fees, office
equipment, word processing software, tuition and tax preparation
services.”32
Step-out Transactions
1.
In a step-out arrangement, an adviser directs trades to a brokerdealer with the instruction that the broker-dealer execute the
transaction and that another broker-dealer provides soft dollar
products/services. The broker-dealer that provides the execution
of the trade “steps-out” of a portion of the commission in favor of
the broker-dealer that provides the soft dollar product/services.
2.
In the context of step-out transactions, the Commission staff noted
in their 1998 survey that “broker-dealer confirmations to advisers
did not clearly indicate which broker-dealer actually executed the
step-out trade, which broker-dealer received a step-out portion of
the commission, and what portion of the commission was steppedout.”33 The staff reminded brokers that “rule 10b-10 requires
broker-dealers to send written confirmations of each securities
transaction with a customer at or before completion of the
transaction, containing certain material information about the
transaction. In a step-out transaction, Rule 10b-10 requires both
the executing broker-dealer and the broker-dealer providing the
soft dollar services to send a written confirmation containing all
the information required by the rule.”34
Office of Compliance, Inspections and Examinations, Securities and Exchange Commission, Inspection
Report of the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22,
1998).
33
Office of Compliance, Inspections and Examinations, Securities and Exchange Commission, Inspection
Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22,
1998).
34
Office of Compliance, Inspections and Examinations, Securities and Exchange Commission, Inspection
Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22,
1998); see also 17 CFR 240.10b-10; Exchange Acts Release No. 29492 (July 26, 1991).
F.
Introducing-Clearing Arrangements
1.
In an introducing-clearing arrangement, the responsibilities of each
broker-dealer are determined pursuant to a written agreement that
is provided to the customer upon the establishment of the account
or the establishment of the introducing-clearing arrangement.
Customers thereafter have a reasonable expectation of the
responsibilities of both the introducing-dealer and the clearing
broker-dealer in transactions affected for their account.
2.
In the introducing-clearing context, the Commission has stated that
the Section 28(e) Safe Harbor applied to a Commission paid in
good faith to an introducing broker for executing and clearing
services performed by the introducing broker’s normal and
legitimate correspondent.35
3.
Additionally, in the introducing-clearing arrangement, the SEC has
issued a series of no-action letters providing further guidance with
respect to safe harbor and correspondent relationships.
(a)
(b)
(c)
G.
Affiliated Broker-Dealer
1.
35
Correspondent relationship between clearing and
introducing broker where customers of introducing broker
may place trades directly through a clearing broker does
not necessarily deprive an adviser of protection of Section
28(e);36
Congress did not intend to eliminate or restrict the use by
brokers of normal correspondent relationships in enacting
Section 28(e);37
A proposed correspondent relationship where the
introducing broker had no role in the transaction other than
through a commission-splitting arrangement was not a
within Section 28(e) safe harbor.38
The Commission has stated that there is a higher level of care that
must be exercised when the broker-dealer and adviser are
affiliated. The Commission has stated that “[w]here the adviser is
affiliated with or has a relationship with the brokerage firm
executing the transaction, particular care must be exercised so that
the adviser’s fiduciary obligation to act solely in the interest of his
Interpretive Release Concerning the Scope of Section 28(e) of the Securities and Exchange Act of 1934
and Related Matters, Exchange Act Release 34-23170, 51 FR 16004 (April 30, 1986).
36
SEI Financial Services Co.,1983 SEC No-Act LEXIS 3136 (Dec. 15, 1983).
37
Becker Securities Corp., 1976 SEC No-Act LEXIS 1428 (June 28, 1976).
38
Robert John Gentry, 1981 SEC No-Act LEXIS 3584 (May 20, 2981).
beneficiary is satisfied. In such a case of self-dealing, the burden
of justifying paying a Commission rate in excess of the lowest rate
available is particularly heavy. Applying the proper standard
would mean, with respect to any transaction to which
competitively determined rates are applicable, that the execution
should not be placed with the affiliated broker at a commission rate
less favorable than the broker’s contemporaneous charges for its
other most-favored, but unaffiliated, customers. In addition, in
determining to place an order with such a broker, the adviser must
make the good faith judgment that such broker is qualified to
obtain the best price on the particular transaction and that the
Commission in respect of such transaction is at least as favorable
to the company as that charged by other qualified brokers.”39
2.
Section 11(a) of the Securities and Exchange Act of 1934 covers
situations where an adviser is a member of a National Securities
Exchange or affiliated with a member. In sum, Section 11(a)
prohibits Exchange members from affecting transactions on the
trading floor for an account in which it or an affiliated adviser has
investment discretion unless: (1) the client has given express
authorization for such transactions prior to any such transactions
having taking place; and 2) the client receives a statement, at least
annually, disclosing the aggregate compensation received by the
member in affecting such transactions.40
3.
The payment of commissions to an affiliated brokerage would
generally constitute a prohibited self-dealing under ERISA absent
the transaction exemptions contained in 86-128 established by the
Department of Labor.
4.
The Commission has also stated that “where an investment
manager, in return for research services, pays an affiliated brokerdealer more than normal charges for execution of brokerage
transactions, the manager ‘would be under a heavy burden to show
that such payments were appropriate.’”41
Applicability of the Commission’s Policy Statement on the Future Structure of the Securities Markets
Through Selection of Brokers and Payment of Commissions by Institutional Managers, Securities Act
Release No. 5250, 37 Fed. Reg. 9988 (May 9, 1972).
40
15 USC § 78k(a).
41
Exchange Act Release No. 23170, Quoting Securities Act Release No. 6019 (Jan.30, 1979).
39