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New Investment Management Director Discusses Institutional Brokerage Practices

Andrew Donohue, director of the SEC's Division of Investment Management, is concerned about whether investment advisers are truly seeking best execution for their clients, or whether other considerations are influencing their placements of client trades. He discussed brokerage practices in an address to the Securities Industry Ass'n.'s institutional brokerage conference. His remarks are posted on the SEC's Web site.

Donohue said that when it comes to placement of client trades, investment advisers understand that they have an obligation to seek best execution. However, recent enforcement cases suggest that they may not always be meeting this requirement.

He noted that in recent cases against investment advisers to mutual funds, the advisers were directing brokerage to particular brokers in order to meet or offset the advisers' revenue sharing obligations with those brokers. Some advisers were engaging in this practice without fully informing the fund boards or discussing with them the conflict of interest inherent in this practice, he said.

Donohue noted that the SEC responded to this abuse by adopting new rule 12b-1(h). That rule requires funds to approve and implement policies reasonably designed to prevent persons responsible for selecting brokers from taking into account the brokers' promotion or sale of shares issued by the fund or any other fund.

He warned that advisers should be aware that the rule applies to all of a mutual fund's portfolio trades and arrangements with brokers and dealers, and not just to brokerage as did a prior NASD rule. Asset managers should expand the controls in place on their trading desks that addressing this area to include principal trades, he said.

Donohue acknowledged that revenue sharing arrangements were not an issue when most asset management firms established their controls for directed brokerage practices. The arrangements have evolved over time and many firms have not gone back to reconsider their controls in light of this recent development, he said.

The industry should learn from this example, Donohue said, and look for other areas where conflicts may have arisen between asset managers and their obligations to clients. He believes that before placing a trade, asset managers should ask themselves whether they are using the chosen broker because it best for their client or because of other considerations. If the answer is that it is best for the client, then the adviser has met its fiduciary obligations, he said.

He said that he understands that the analysis may not always be this simple. Advisers face a tougher situation when the other considerations factored into the placement of a trade may benefit the adviser or its personnel, he noted.

In his view, personal benefits should not be a motivating factor in an adviser's determination of how, where, when and with whom to place a client trade. Donohue said that if personal benefits are being considered, then advisers should rethink their practices, disclosure and control structures.

On the topic of best execution, Donohue encouraged asset managers not to focus exclusively on the trading of equities. Advisers have an equal obligation to seek best execution of trades in fixed income securities and other asset classes, he noted. He urged asset managers and their clients to pay attention to this uncharted area.

He said that he hopes the advisory industry will develop meaningful, quantifiable fixed income execution measures and methods of evaluation to assist it in meeting its best execution obligations. He knows that tools are being developed to measure non-equity trade execution, and Donohue encouraged asset managers, broker-dealers and their clients to participate in trying to perfect those tools.

John Filar Atwood