The OSC recently considered the issue of best execution with respect to trading by a portfolio manager. In a decision by the Director of the Compliance and Registrant Regulation Branch (CRR) of the OSC, the OSC ordered a Portfolio Manager (PM) to retain the services of an independent compliance consultant to assist in comparing trade execution options, and determine the most advantageous terms for the PM's clients. The order stems from a compliance review conducted by CRR where the OSC found that the PM placed all trades for individual clients with either a related dealer or a single third party dealer, and placed all trades for its affiliated funds with its related dealer. The OSC found that the PM's clients paid higher commissions when trades were placed with the related dealer than with the third party dealer.
In the decision, the OSC referred to the requirements in National Instrument 23-101 Trading Rules (NI 23-101) and Companion Policy 23-101CP to National Instrument 23-101 (23-101CP). Section 4.1(2) of 23-101CP requires that dealers or advisers, including portfolio managers, use "reasonable efforts" to achieve best execution. Section 4.1(3) of 23-101CP indicates that to meet the reasonable efforts test, a dealer or adviser should be able to demonstrate that it has, and has abided by, policies and procedures that outline the process it has designed toward the objective of achieving best execution. An adviser should consider a number of factors when selecting appropriate dealers and marketplaces and monitor the results on a regular basis.
The OSC reviewed the PM's policy and found that it did not describe the process it used to evaluate best execution. The policy did not include any provisions about selecting dealers or marketplaces, and the policy did not provide details how to review trading to determine if best execution had been achieved. The PM also did not have a system to monitor results of trading on a regular basis.
The OSC acknowledged that the provisions of NI 23-101 make it clear that one must consider a number of factors, including, but not limited to price, when considering whether the best execution obligation of an adviser has been met. The PM argued that it met its best execution obligations as a result of: (a) the related dealer's good execution; (b) continuous access to its related dealer's system database; (c) access to the related dealer's portfolio management software; and (d) freedom of delivery against payment problems which may exist at other institutions. The OSC submitted that the PM did not provide sufficient evidence to support the assertion that the higher price charged by the related dealer when compared to the price charged by the third party dealer was explained by the value of the research goods and services supplied by the related dealer.
In the face of the contradictory submissions and evidence, the OSC could not find that PM's clients sustained an adverse monetary impact as a result of the PM's failure to comply with its best execution obligations. The OSC stated that the lack of review and analysis completed by the PM made it necessary for the OSC to impose terms and conditions requiring the PM to engage a consultant to assist the PM in comparing trade execution options and arrangements. If the review found that PM's clients sustained an adverse monetary impact, then the PM would have likely been required to take steps to remediate the adverse impact.
The OSC also argued that the PM's practice of directing client trades to a related dealer, and paying higher commissions to the related dealer than would otherwise be payable to a dealer operating at arm's length from the PM, represented a failure on the part of the PM to respond to conflicts of interest with its clients. The OSC referred to section 13.4 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) that requires registered firms to take reasonable steps to identify and respond to existing and potential material conflicts of interest that may arise between the firm and a client. Based on the evidence provided, the OSC was not satisfied that the PM had effectively responded to the material conflict of interest and found that the PM failed to comply with section 13.4(2) of NI 31-103.
OSC Rule 31-505
The OSC also submitted that, by directing client account trades to a related dealer that appears to charge a higher commission for the same services as other dealers, the PM failed to comply with its obligation to deal fairly, honestly and in good faith with its clients as required by subsection 2.1(1) of OSC Rule 31-505 Conditions of Registration. Based on the evidence presented and findings related to NI 23-101 and NI 31-103, the OSC concluded that the PM did not comply with its obligation to deal fairly with its clients. There was insufficient evidence to conclude whether the PM dealt honestly and in good faith with its clients.
This decision is instructive as it sets out what may or may not constitute best execution for a portfolio manager, discusses the related issues around conflicts of interest and conditions of registration.