In doing so for your firm, it is your responsibility to explain these trading practices (in your Form ADV and compliance manual), as well as the policies and procedures in place to ensure they are followed consistently.
Likewise, certain trading practices create conflicts of interest which must be disclosed, along with any procedures implemented to prevent or mitigate these conflicts.
Trading Practices & Conflicts In a Nutshell
Your RIA firm must disclose to clients specific details on your brokerage practices, including any conflicts of interest that could influence your decisions relating to placing trades on their behalf. Below we describe the specific trading-related practices and conflicts that you disclose in your Form ADV and compliance manual.Note: We will cover other trading-related practices (like trade allocation) in a future blog post that specifically covers the topic of portfolio management.
Brokerage Affiliations
If your firm places trades through an affiliated broker-dealer (where your firm or its principals receive economic benefit from the trades), you must disclose this conflict in your Form ADV.
Regulators expect a higher level of care to be exercised when the broker-dealer and adviser are affiliated "so that the adviser’s fiduciary obligation to act solely in the interest of his beneficiary is satisfied." The burden of justifying paying a commission rate in excess of the lowest rate available is particularly heavy. Placing trades with an affiliated broker-dealer means that you must make the good faith judgment that this broker is uniquely qualified to obtain the best price on these trades and that the trading costs are at least as favorable as those charged by other qualified brokers.
Client Directed Brokerage
There may be circumstances where a client asks your firm to direct their trades to a certain broker-dealer. This is, of course, allowable, as long as you obtain written instructions from the client either as part of the Investment Advisory Agreement or by separate instruction.
Client directed brokerage transactions may result in the client receiving a price that is less favorable than the price your firm could obtain by batching their trade along with those of other clients. They may also result in higher commissions or less favorable net prices than might achieved if your firm was empowered to select the broker-dealer. If you accept client directed brokerage, this must be disclosed in your Form ADV Part 1 and the ramifications described above must be disclosed via Form ADV Part 2A.
Soft Dollars
Your RIA firm may direct brokerage transactions to broker-dealers who provide research services to your firm consistent with the safe harbor provision under Section 28(e) of the Exchange Act of 1934.
Only research products and services that are used for the benefit of clients may be obtained with client commission dollars. The amount of the commission paid must be reasonable in relation to the value of the research services provided by the broker-dealer. By obtaining soft dollar products and services via soft dollars, it is expected that you are doing so to reduce expenditures you would otherwise obtain via "hard dollars."
When utilizing soft dollars, your firm will be expected to maintain a complete set of books and records that quantify soft dollar commissions paid and the nature of all services received.
Principal and Agency Trades
Principal and agency transactions are two examples where your firm has an interest in the circumstances or outcome of the clients' trades (i.e. a conflict of interest.)
Principal trades involve securities transactions in which your firm has a proprietary interest in the securities being traded. Principal transactions must be disclosed to the client in writing prior to the completion of the transaction. Written client consent must also be obtained. This consent may be obtained after execution, but prior to settlement, of the transaction.
Agency trades involve securities transactions in which your firm acts directly (or through an affiliate) as the client’s advisor and as broker for the person on the other side of the transaction. Advisors may execute agency trades as long as they can show that they are in the best interests of the advisory clients involved in the transaction.
For both principal and agency trades, your firm must disclose this in Form ADV Parts 1 and 2A and maintain appropriate documentation to support these transactions.
Absorbing Transaction Costs
In some instances, RIA firms absorb ticket charges or other transaction-based costs for client trading. If you absorb ticket charges for all of your clients this does not present a conflict. If you do so for a subset of clients, this represents a conflict and must be properly disclosed. The rationale behind this is that you will have a bias towards limiting transaction frequency in those accounts where your firm bears the transaction costs.
Through the Regulator's Eyes
Regulators operate under the premise that transaction costs and commissions paid are the client’s property, so you must treat them as such and ensure that the benefits of these ultimately accrue to the client.When circumstances exist that would alter your objectivity with respect to trading (the conflicts described above), these must be clearly disclosed as well.
CCO Best Practices for Trading Practices and Conflicts
- Review your firm's Form ADV Part 1 and 2A to confirm that each of these trading practices are appropriately disclosed.
- In instances where conflicts of interest result, confirm that they are properly disclosed in Form ADV Part 2A in a way that identifies the conflict, why it is a conflict, and what procedures you have in place to prevent or mitigate these conflicts.
- Maintain books and records that document all client directed brokerage, soft dollar usage and principal and agency trades. Each must be maintained for at least five years, two of which must be immediately accessible by your firm.
- For trades placed through an affiliated broker-dealer, maintain documentation that demonstrates the rationale for selecting this affiliate over other qualified broker-dealers.
- If you utilize soft dollars, maintain a soft dollar policy that explains the rules related to paying for research with client commissions, the actual amounts paid and the specific services received.
The AdvisorAssist CCO Series is a collection of blog posts that cover each of the elements of your RIA's compliance program. Each post will provide an overview of one compliance topic, including our insights on how regulators view each topic as well as some practical steps to help Chief Compliance Officers address this topic. As always, we would welcome your comments and thoughts.
Brian Lauzon
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