Best Practices for Investment Advisers on Trade Execution: An Analysis of Two Recent SEC Settlements

On July 31, 2013, the U.S. Securities and Exchange Commission (SEC) announced that two investment advisers allegedly failed to seek best execution on client trades placed with their in-house brokerage divisions and misled their clients.[1] As discussed further below, given the SEC's increasing scrutiny of investment advisers and recent concerns relating to dual registrants, these two consent orders illustrate the risks for investment advisers of not tailoring their disclosure forms, policies and procedures to address the particular circumstances of their business.


Without admitting or denying the SEC's allegations, A.R. Schmeidler & Co., Inc. (ARS) consented to the entry of an administrative order alleging violations of the anti-fraud provisions of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder for failing (i) to seek best execution for its advisory clients and (ii) to implement procedures reasonably designed to prevent those violations.[2]

According to the consent order, ARS served as an investment adviser and introducing broker-dealer for certain clients who paid ARS both investment advisory fees and brokerage commissions. The SEC alleged that ARS did not conduct sufficient analysis to determine whether it properly sought best execution of trades for certain clients, after ARS renegotiated its commission split with a clearing firm. The SEC noted that, although ARS's written policies and procedures governed its best execution analysis, ARS allegedly failed to implement those policies and procedures.

Pursuant to the consent order, ARS agreed to (i) engage a qualified independent consultant to assist it in developing and implementing policies and procedures reasonably designed to promote compliance with its duty to seek best execution for its advisory clients, (ii) cease and desist from violations of Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, (iii) be censured, and (iv) pay disgorgement of $757,876.88, prejudgment interest of $78,688.57 and a civil penalty of $175,000.


Without admitting or denying the SEC's allegations, Goelzer Investment Management, Inc. (GIM) and its former Chief Compliance Officer, Gregory W. Goelzer, consented to the entry of an administrative order alleging violations of Sections 206(2), 206(4) and 207 of the Advisers Act and Rule 206(4)-7 for failing (i) to seek best execution for its advisory clients, (ii) to implement policies and procedures to ensure that GIM sought best execution as represented in its Form ADV Part II and Part 2A, and (iii) to accurately disclose its brokerage commission rates, analysis and policies in its Form ADV Part II and Part 2A.[3]

According to the consent order, GIM provided basic brokerage services for its advisory clients and utilized its broker-dealer to execute trades for nearly all of its advisory clients, except when a client directed it to use a different broker-dealer. At issue were GIM's disclosures in its Form ADV Part II and Part 2A, which allegedly contained the following false and misleading statements:

  • GIM effected transactions for advisory clients through GIM as a broker "consistent with its obligation to obtain best price and execution" -- even though GIM had no basis for this statement because it did not take steps to ensure best price or execution;
  • Based on several factors (including the products offered, the level of service, the quality of trade execution, the record keeping and reporting capabilities, the trading platforms offered and the ability to meet client needs), GIM recommended that its clients use GIM as their broker -- even though GIM failed to evaluate brokerage options for its clients; and
  • If an advisory client chose another broker-dealer, the client would not be able to participate in and receive the benefits of lower commission costs as a result of GIM's use of block trades -- even though clients never benefited from lower commissions when GIM block traded.

GIM also allegedly failed to disclose that its advisory fees were negotiable even though Item 1.D of Form ADV Part II required such disclosure.

The SEC alleged that these disclosure failures resulted from GIM's deficient policies and procedures relating to best execution. In particular, GIM allegedly neither compared what it offered clients to the services and costs available at other brokerage firms nor conducted any analysis of its brokerage services.

As GIM's CCO during the relevant time period, Goelzer allegedly was responsible for developing and enforcing policies and procedures for GIM that were reasonably designed to detect and prevent these violations. (Goelzer also served as GIM's CEO for part of the relevant time period.)

In determining to accept GIM and Goelzer's settlement offers, the SEC noted that it considered the following remedial acts promptly undertaken by GIM during the SEC investigation:

  • Hiring a compliance consultant to conduct a comprehensive review of its compliance program through an on-site review of GIM's business and its policies and procedures;
  • Sharing with the SEC the compliance consultant's report, which detailed its work, findings and recommendations;
  • Implementing the compliance consultant's recommendations, including drafting new policies and procedures and a code of ethics, as well as developing and implementing a new supervisory framework and internal controls; and
  • Having the compliance consultant conduct an annual review to assess the adequacy and effectiveness of its new policies and procedures, including its Form ADV and best execution practices.

Pursuant to the consent order, GIM agreed to (i) retain the compliance consultant, which will conduct annual compliance reviews of GIM for the years ended December 31, 2013, and December 31, 2014, (ii) employ a CCO for a period of five years whose sole responsibility will be to serve in that position, (iii) preserve any record of GIM's compliance with the consent order's undertaking for six years, (iv) provide notice to its advisory clients of the consent order, (v) cease and desist from violating Sections 206(2), 206(4) and 207 of the Advisers Act and Rule 206(4)-7 thereunder, (vi) be censured, and (vii) pay disgorgement of $309,994, prejudgment interest of $53,799 and a civil penalty of $100,000.

Pursuant to the consent order, Goelzer agreed to (i) cease and desist from violating Sections 206(2), 206(4) and 207 of the Advisers Act and Rule 206(4)-7 thereunder, (ii) be censured, and (viii) pay a civil penalty of $35,000.


Both the ARS and GIM consent orders address one of the concerns that Bruce Karpati, former chief of the SEC Enforcement Division's Asset Management Unit, highlighted at the end of last year about the potential for conflicts of interest in the investment adviser industry depending on particular aspects of each adviser's operating model.[4] In particular, Karpati cautioned: "Because some hedge fund managers may control every aspect of their business, severe conflicts of interest can arise. The fund manager may have the opportunity and incentive to put his or her personal interests ahead of investors. Related-party transactions, through which the manager can misappropriate money by engaging in self-serving transactions or to hide losses, are examples of these types of conflicts."

He also warned: "The adviser may have the opportunity and incentive to give favored treatment to certain investors through preferential redemptions or side letters. Though the hedge fund structure leaves advisers with wide latitude on how to invest, advisers must be sure to avoid conflicts of interest in areas such as commonly managed accounts, allocation practices, affiliated broker dealers, undisclosed compensation arrangements, soft-dollars, and best execution."

Karpati's concerns were echoed earlier this year by the SEC's Office of Compliance Inspections and Examinations in its Examination Priorities for 2013, which identified conflicts of interest resulting from the "convergence in the investment adviser and broker-dealer industry" as one of the National Exam Program's "new and emerging issues."[5]


As Karpati noted in his speech, investment advisers "should adopt and implement a compliance program and controls geared to the risks and investment strategy of the firm." These risks are particularly heightened when the investment adviser is dually registered or uses the services of an affiliated broker-dealer, as was the case in both consent orders.

To be sure, Marshall S. Sprung, current co-chief of the SEC Enforcement Division's Asset Management Unit, noted in the release accompanying the consent orders: "There is a clear conflict of interest when investment advisers execute client trades through their broker-dealer arm. The unit is focused on pursuing dually registered firms that fail to address this conflict through robust disclosure, best execution analysis, and compliance procedures."

Given these risks and the SEC's increasing focus on them, investment advisers should, among other things, assess (i) their policies and procedures to ensure that they are seeking best execution of their clients' securities transactions and (ii) their disclosures to safeguard against any material misstatements or omissions regarding their broker-dealer arrangements. For example, as suggested in the GIM consent order, an investment adviser may help meet its best execution obligations by conducting periodic analyses comparing its brokerage services and rates with its competitors'.

Investment advisers also should assign responsibility to specific persons outside of the business lines for, among other things, maintaining and periodically reviewing the adviser's compliance policies and procedures. Indeed, both the ARS and GIM consent orders suggested that the alleged violations could have been avoided if the investment advisers conducted a periodic review to make sure that its policies and procedures were updated and observed by its business personnel.

While the ARS and GIM consent orders provide valuable guidance for assessing the adequacy of policies and procedures, investment advisers would be well advised to review the investment adviser resource materials posted on the SEC's website,[6] including the best execution section contained in the SEC's manual on the Regulation of Investment Advisers.[7] This section counsels that "an adviser must seek to obtain the execution of transactions for clients in such a manner that the client's total cost or proceeds in each transaction is the most favorable under the circumstances." In this sense, investment advisers are required to "consider the total transaction cost to its client," including, among other things, "execution capability, commission rate, financial responsibility, responsiveness to the adviser, and the value of any research provided."

At bottom, although there is no bright line test for best execution, an investment adviser should have a reasonable and articulable basis to justify using in-house brokerage services.


As the SEC continues to scrutinize investment advisers, no doubt it will provide additional guidance through speeches, alerts and enforcement proceedings on best execution policies and procedures.[8] We will continue to keep you updated on these and other issues as enforcement and regulatory developments unfold.