Ottershaw Capital sends customer orders in a thinly traded security to an affiliated broker-dealer, which executes them in the market and passes them back with its own fee added. Under what circumstance is placing that affiliate between the firm and the market permissible?
- A.Whenever the intermediary is itself a registered broker-dealer carrying the same best execution obligation.Wrong. Passing the duty along does not undo the cost the extra link adds to the customer's price.
- B.Never, because routing a customer order through a second broker-dealer is prohibited in every case.Wrong. It states a flat ban where the standard is conditional, and would outlaw ordinary correspondent routing.
- C.Whenever the customer has consented to the routing arrangement in writing before the order is entered.Wrong. Consent is drawn from the disclosure side of the rulebook; it cannot license a price the customer should not have received.
- D.Only where the customer's resulting price is still as favourable as it would have been without the extra party in the chain.Correct. It applies the price-based test that decides whether the interposition is consistent with the underlying duty.
Why: Interpositioning is the practice of interjecting a third party between the member and the best market for the security. It is not prohibited outright; it is prohibited when it is done in a way that is inconsistent with the duty to obtain a price for the customer that is as favourable as possible under prevailing conditions. The test therefore looks through the arrangement to the price the customer ends up with, and the extra fee is the reason the arrangement usually fails it. If the affiliate could reach a market the firm could not, and the customer's net price was no worse for the detour, the routing would survive.
Kestrelmoor Securities receives a customer order to buy 20,000 shares of a Nasdaq-listed company. Rather than trading directly with the market maker displaying the best offer, Kestrelmoor routes the order through Ashlade Brokerage, an unaffiliated firm, which buys from that same market maker and immediately resells the shares to Kestrelmoor at a higher price. Ashlade keeps the difference, and Kestrelmoor's principal has an informal reciprocal referral arrangement with Ashlade's owner. The customer pays more than the best available offer. This practice is:
- A.Permitted, because using another broker-dealer to help execute a large order is an ordinary practice in the securities business.Incorrect. Routing through another firm is proper when it benefits the customer. Here the best offer was directly accessible and the added layer only cost the customer money.
- B.Interpositioning: inserting a third party between the customer and the best available market with no benefit to the customer, violating the duty of best execution, and prohibited regardless of how small the added cost is.Correct. The best offer was displayed and reachable, the extra layer served the principals' reciprocal relationship rather than the customer, and best execution was not obtained.
- C.Permitted so long as the additional cost attributable to the second firm is disclosed on the customer's confirmation.Incorrect. Best execution is an obligation in handling the order, not a disclosure obligation afterward. Reporting a worse execution does not cure it.
- D.Churning, because the firm generated additional compensation from the customer's order.Incorrect. Churning is excessive trading in a customer account to generate compensation. This is a single order that was routed improperly, which is interpositioning.
Why: This is interpositioning: inserting a third party between the customer and the best available market when doing so provides no benefit to the customer. A firm handling a customer order owes a duty of best execution, meaning it must use reasonable diligence to obtain the most favorable terms reasonably available under the circumstances. Here the best offer was displayed and directly accessible; routing through Ashlade added a layer of compensation paid, in effect, by the customer. The reciprocal arrangement between the two principals shows whose interest the routing actually served. Interpositioning is a prohibited practice whether or not the added cost is large, because the wrong lies in subordinating the customer's execution to the firm's own relationships.