Compliance Solutions for Investment Advisers

FAQs — Directed Brokerage

 

What is directed brokerage?

Directed brokerage is when a client asks the investment adviser to direct commission business to a particular broker.

What are the consequences of a directed brokerage arrangement?

The most important consequence is that a directed brokerage arrangement may end up costing the client more money and creating additional disclosure and compliance obligations for the adviser.

How does a directed brokerage arrangement cost a client more money?

A directed brokerage arrangement may cost a client more money for two reasons. First, because the client is telling the adviser which broker to use, the adviser may not be able to achieve most favorable execution of that client’s transactions. Indeed, when a client directs brokerage, the investment adviser is actually relieved of its fiduciary duty to obtain best execution. Second, because the client’s account may not be maintained with the same broker/custodian as the adviser’s other clients, the adviser will not be able to aggregate the client’s orders with those of adviser’s other clients. As a result, the client will forego any benefit from savings on execution costs that the adviser might obtain for its other clients through trade aggregation.

Is an investment adviser required to allow a client to direct brokerage?

No. The typical position of most advisers is to not allow directed brokerage.

What is an investment adviser required to do if the adviser does allow clients to direct brokerage?

An adviser that allows clients to direct brokerage has certain disclosure obligations. In Item 12 of Form ADV Part 2A, the adviser must disclose that directed brokerage arrangements (i) limits the advisory firm’s ability to seek best execution and negotiate commissions; (ii) limits clients’ ability to participate in aggregated trades; and, as a result, (iii) may cost clients more money.

Are there other compliance requirements that are triggered by directed brokerage?

An investment adviser must obtain a directed brokerage letter of authorization from those clients that are directing brokerage. The directed brokerage letter should list those brokers that the adviser is permitted to use. In addition, it would be prudent to reiterate the disclosures the adviser must make in Item 12 of Form ADV Part 2A in the authorization letter.

Is an investment adviser required to indicate on the trade ticket whether the client directed brokerage?

Yes.

What types of records will the SEC request during or prior to an examination?

The SEC will typically request a list of all clients or investors that have requested that the advisory firm or its related persons direct brokerage to a particular broker-dealer and the name of the broker-dealer.

What are some best practices in the area of directed brokerage?

As with most things, documentation is an essential element of directed brokerage best practices. For example, a best practice would be to have your advisory firm periodically prepare directed brokerage reports that include: (i) the name of the client; (ii) the name of the broker-dealer; (iii) the current amount of client commissions directed to the broker-dealer; (iv) the client’s requested percentage that is to be directed to the broker-dealer; (v) the actual percentage of the client’s total commissions directed to the broker-dealer; and (vi) any deviation from requested amount.

 

Important Information

The information contained in this Frequently Asked Questions is only a summary and is not intended to be a comprehensive analysis of the rules and regulations applicable to registered investment advisers. It is not intended to constitute legal or compliance consulting advice or apply to any one investment adviser’s particular situation. For more information, please see our Terms of Use.

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