Broker-Dealer Trading Activities - McGuireWoods



BROKER - DEALER TRADING ACTIVITIES

BY THOMAS J. MCGONIGLE, ROBERT P. HOWARD JR.,

AND M. ELIZABETH PARKS[1]

I. 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 broker-dealer 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 broker-dealer 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 obtain best execution for customer orders must also be modified to consider price opportunities that become 'reasonably available'." [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, 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.”

(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.

2. Rule 2320(a) - Best Execution

(a) “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.”

3. 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 IM-2440.” Rule 2320(f).

4. Rule 2320(g) - The “Three Quote” Rule[6]

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 system[7] 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 mediums[8] that permit quotation updates on a real-time basis must display the same priced quotations for the security in each medium."

5. 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 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. 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 broker-dealer'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]

D. Other Guidance Regarding Best Execution

1. Standard Industry Practice - The Third Circuit, in Merrill, Lynch[13] 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) 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]

(d) 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]

E. 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 requested special handling for execution[19] 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, Over-the-Counter Bulletin Board securities, and exchange-listed 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 near-the-quote limit. Order size is divided into 100-499, 500-1999, 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, 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 11Ac1-6[20] - 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 broker-dealer’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) 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 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 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) 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.

(d) 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.

II. BROKER-DEALERS AS SOFT DOLLAR PROVIDERS

A. Generally

1. “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-dealer in exchange for the direction by the adviser of client brokerage transactions to the broker-dealer.”[23]

2. 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.

B. 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 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]

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 broker-dealer 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:

a) 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;

b) Payments were made directly to the adviser. The broker-dealer did not maintain contractual privity with the adviser’s soft dollar vendors, thus the services were not “provided by” the broker-dealer;

c) 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

d) The broker dealer made soft dollar payments without receiving adequate documentation to establish that the expenses had actually been incurred by the investment adviser.

D. 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) Ensuring that the broker-dealer is contractually liable for each third-party arrangement;

b) Refusing to pay any invoices submitted by advisers;

c) Maintaining a written record of the products/services provided to the adviser in exchange for soft dollars; and

d) 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 broker-dealers should review and consider in relation to their soft dollar arrangements. The broker-dealer controls are as follows:

a) A designated person or committee is responsible for overseeing the firm’s soft dollar and client-directed brokerage activities and for establishing the firm’s operating policies for these activities;

b) 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;

c) Established procedures are used to determine whether products and services requested by advisers are consistent with the adviser’s authority over clients’ commissions;

d) At the time that a client of an adviser begins negotiations to establish a directed brokerage arrangement, the broker-dealer 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;

e) 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;

f) 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;

g) Invoices for products and services submitted by advisers for which the broker-dealer is not contractually liable for payment are not paid;

h) 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

i) 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]

D. Products and Services Provided by Broker-Dealers That Could Be Outside Section 28(e) Safe Harbor

1. 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 non-research areas, telephone service, employees’ salaries, messenger services, consulting services, postage, parking fees, office equipment, word processing software, tuition and tax preparation services.”[32]

E. Step-out Transactions

1. In a step-out arrangement, an adviser directs trades to a broker-dealer 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 stepped-out.”[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]

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) 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]

b) Congress did not intend to eliminate or restrict the use by brokers of normal correspondent relationships in enacting Section 28(e);[37]

c) 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]

G. Affiliated Broker-Dealer

1. 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 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 broker-dealer 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]

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[1] 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.")

[5] Order Execution Obligations (Final Rules), Exchange Act Rel. No. 37619A (Sept. 6, 1996), 61 Fed. Reg. 48290 (Sept. 12, 1996) (citations omitted).

[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).

[10] NASD Notice to Members 98-96 (December 1998) at 733.

[11] 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).

[13] 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)

[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.

[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.

[20] See also Disclosure of Order Routing, NASD Notice to Members 01-30 (May, 2001).

[21] 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.

[22] 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.

[23] 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)

[26] 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).

[30] 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).

[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).

[32] 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).

[35] 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).

[39] 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).

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