Hallgerd Ostrowski instructs Penwarden Asset Management to place all of her trades through a particular broker-dealer with which she has a separate banking relationship. In its Form ADV Part 2A discussion of brokerage practices, Penwarden must:
- A.Represent that directed brokerage always achieves best execution because the client selected the brokerThat is affirmatively misleading. Constraining venue selection generally makes best execution harder to obtain, not automatic.
- B.Disclose that it permits directed brokerage and explain that it may then be unable to negotiate commissions, obtain volume discounts or aggregate her orders with those of other clients, so she may pay more or receive less favourable executionCorrect. The practice is permitted, and its costs must be disclosed.
- C.Refuse the instruction, because client-directed brokerage is a prohibited practiceClients may direct brokerage. The adviser obligation is disclosure, not refusal.
- D.Disclose only its soft dollar arrangements, since client-directed brokerage is not a brochure itemDirected brokerage is an express subject of the brokerage practices disclosure.
Why: Where an adviser permits clients to direct brokerage, the brochure must say so and must explain the consequences. A directed-brokerage client may pay higher commissions because the adviser cannot negotiate rates on her behalf, may lose volume discounts, and generally cannot have her orders aggregated with those of other clients, which can produce less favourable execution and a different average price. Disclosing those consequences lets the client decide whether the separate relationship is worth the cost.
Bellinger Croft, a client of Thrapstone Advisory, instructs the adviser to place all of his trades through his brother-in-law's brokerage firm. Thrapstone normally aggregates client orders and routes them to a broker it has selected for execution quality and cost. Thrapstone is willing to follow the instruction. Before doing so, it must:
- A.obtain the Administrator's written consent to the directed brokerage arrangementNo regulatory consent is required for client-directed brokerage.
- B.disclose to Bellinger that it will not negotiate commissions for him, that he may pay more or receive less favourable execution than other clients, and that his orders may not be aggregated with theirsCorrect. Client-directed brokerage must be accompanied by disclosure of the costs the direction imposes on the client.
- C.refuse the instruction, because an adviser may not knowingly route orders to a broker other than the one offering the best termsA client may direct brokerage. The adviser's duty is to disclose the consequences, not to override the client.
- D.follow the instruction without comment, because the choice of broker belongs entirely to the clientThe choice belongs to the client, but the adviser still owes disclosure of what the direction costs him.
Why: A client is entitled to direct the adviser's choice of broker, but the adviser must make sure the client understands what he is giving up. Where brokerage is client-directed, the adviser should disclose that it will not be negotiating commissions on the client's behalf, that the client may therefore pay higher commissions or receive less favourable execution than other clients, and that his orders may not be aggregated with other clients' orders - which can mean a different average price and the loss of volume pricing. The adviser is not obliged to refuse the instruction, nor is it obliged to certify that the chosen broker is the best available.