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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Luncheon Address Before the SIA Institutional Brokerage Conference


Andrew J. Donohue1

Director, Division of Investment Management
U.S. Securities and Exchange Commission

New York, New York
October 30, 2006

I.  Introduction

Good afternoon. It is a pleasure to be with you here today. And I would like to thank the Securities Industry Association for hosting a conference on institutional brokerage, which is one of the most rapidly evolving areas of the securities industry -- because of both regulatory and marketplace developments. Many years from now, I expect that our successors will look back at the first decade of this century as a pivotal time in the development of brokerage practices, in particular, and buy- and sell-side relationships in general. Perhaps they will view this period and the developments that occur in the same way we view "May Day," May 1, 1975 and the unfixing of commissions. With respect to brokerage practices, our world is certainly evolving-and doing so at a rapid clip.

I look forward to speaking to you today about some of the challenges that, in my experience, asset managers face with respect to brokerage and trade execution. Before I do so, however, I need to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the staff.

II.  Soft Dollars Interpretive Release

The primary development related to institutional brokerage to come out of the Commission during the past year was, obviously, the soft dollars interpretive release issued by the SEC in July. My staff worked closely with the staff of the Division of Market Regulation, which took the lead on recommending that release to the Commission, and I think the product that resulted provided useful and meaningful guidance to both the asset management and brokerage industries regarding their obligations in this area.

I am hopeful that the next step of the process, which Division of Investment Management Associate Director Robert Plaze may discuss on the next panel, will be equally productive. That step involves providing additional disclosure and related guidance to fund boards regarding soft dollars and brokerage practices. It is my expectation that this piece of the SEC's soft dollar initiative will result in better informed investors as well as fund directors who have updated disclosure and related guidance from the Commission that will help them fulfill their responsibilities with respect to soft dollars as well as oversight of brokerage execution developments, policies and practices.

III.  Brokerage Practices from the Asset Manager's Perspective

I would now like to turn to a discussion of brokerage and trade execution practices and obligations from an asset manager's perspective. I have been involved in the asset management industry for a few years, and I have spent much of that time as general counsel for relatively large asset management firms. During that time, I have witnessed tremendous evolution in brokerage and trading practices, and with each development, I have seen positive benefits for clients as well as the emergence of new risks and client conflicts. It is from that perspective that I take on my new role as a federal regulator, heading up the SEC's Division of Investment Management. In this new role, I will continue to concentrate on new developments and the positive benefits as well as new risks and conflicts that arise, although my energy and attention is now devoted to focusing the industry on identifying and properly addressing those risks and conflicts - rather than doing so only for the benefit of my own firm and its clients.

When it comes to the placement of client trades, it is well settled that investment advisers have an obligation to seek best execution. As a regulator and as a general counsel before that, I have a continuing concern over whether advisers in all cases are truly seeking best execution, or whether in certain instances other considerations may be influencing their decisions regarding the placement of client trades. This is a concern we all should have.

For instance, the Commission has brought cases against investment advisers to mutual funds that were directing brokerage, i.e., sending their mutual fund clients' trades, to particular brokers in order to meet or offset the advisers' revenue sharing obligations or expectations with those brokers. While there was an NASD rule that addressed this area, many were apparently not following the letter and spirit of that rule. Some investment advisers were also engaging in this practice without fully informing the fund boards or discussing with them the obvious conflict of interest involving the adviser and its mutual fund clients inherent in this practice.

In part as a result of this abuse, the Commission adopted new SEC rule 12b-1(h), which requires funds to approve and implement policies and procedures reasonably designed to prevent persons responsible for selecting brokers and dealers to effect a fund's portfolio securities transactions from taking into account the brokers' and dealers' promotion or sale of shares issued by the fund or any other fund. The NASD also made conforming changes to its rule. Thus the practice of directing brokerage in exchange for distribution-related activities, and therefore the conflict, are now eliminated. Advisers should be mindful of the fact that the new SEC rule applies to all of a mutual fund's portfolio trades and arrangements with both brokers and dealers, and does not refer only to brokerage, as did the prior NASD rule. Therefore, asset managers must expand the controls in place on their trading desks addressing this area to include principal trades.

The practice of directing fund brokerage to offset an adviser's revenue sharing obligations evolved directly from the significant growth in the last decade of revenue sharing arrangements. When many of us in the investment management industry initially established our controls for directed brokerage practices, consideration of revenue sharing obligations was not an issue. The arrangements did not yet exist.

As revenue sharing practices developed, some firms failed to re-consider their directed brokerage arrangements in light of the conflicts that were created when asset managers expanded their use of client commission dollars to satisfy the firms' own revenue sharing obligations. We should learn from this example and consider other instances where evolving business practices, especially those related to trade placement, create new conflicts between asset managers and their obligations to their clients.

As a practical matter, before placing a trade, I would encourage asset managers to consider one key question: Am I using this broker-dealer on the basis chosen because it is best for my client, or because of other considerations? If the answer is "because it is best for my client," the analysis is done, the adviser has generally met its fiduciary obligations, and the trade should go forward as contemplated.

At times, however, there may be other considerations-both legitimate and ones that may be more troublesome. One common consideration is client directed brokerage. You, as a professional investment adviser, may not think that the broker-dealer to which your clients directs you to send a trade is actually the broker-dealer that is best suited to execute it. However, if your client directs that you send trades to a particular broker-dealer, that is the client's right and then it is your responsibility to do so. Life is not always that simple, however. In many cases, the request is not a direction from the client but may be framed as a request that "subject to best execution" you place a trade with a particular broker-dealer.

Advisers face a tougher situation when the "other considerations" factored into the placement of a trade may involve a benefit to the adviser or its personnel. To my mind, personal benefits or considerations should not be a motivating factor in an adviser's determination regarding how, where, when and with whom to place a client trade. If such factors are being considered, I strongly encourage you to re-think your practices, your disclosure and your control structures.

IV. Technological Developments

Speaking of control structures, a constantly evolving area involves the development of meaningful tools to assist investment advisers, clients and consultants in monitoring how well advisers meet their best execution obligations. In addition, technological developments have enabled, some might say obligated, advisers to use automated trade management systems, which enable investment advisers to allocate trades, and their costs, among multiple clients and route trades to alternative markets. As we know, our world is becoming more automated and more technology-dependent, and brokerage, trade routing and trade allocation are no exception.

I encourage you to make use of these technological developments, where appropriate, to better serve your clients. As this area becomes more automated, it certainly becomes increasingly subject to objective measurement and third-party evaluation. When I first started in the investment management industry, there was a high degree of subjectivity when it came to brokerage allocation, placement and best execution. And this subjectivity was generally recognized as real and accepted. There was more subjectivity than exists today, and certainly more than will exist, or be acceptable, tomorrow.

Today, there is increasing client pressure on investment advisers to be in a position to demonstrate that they are properly meeting their best execution obligation. Their institutional clients, fund boards and others are focusing on execution quality, and where possible, seeking quantifiable measures, from a practical if not a legal perspective. An adviser's word that it is seeking best execution may not be good enough anymore for some clients, especially in light of the fact that execution quality increasingly can be measured and quantified, at least in part, as well as the fact that trade placement decisions often involve inherent conflicts, since the adviser is using its client's brokerage in ways that may benefit itself.

If basic brokerage is now becoming more of a commodity, at least for many large-cap equity trades, any time that an adviser is paying more than just a bare-minimum execution-only rate for a client trade, the adviser may open itself up to questioning from its clients regarding whether the additional cost was appropriate. Advisers should keep in mind that not every trade is the same, and some trades may be easily routed to low-cost, alternative trading platforms. Other trades may require more management, servicing, discretion and perhaps broker capital. I encourage advisers to make effective use of technology and their own professional judgment to help them consider which trades may be appropriate for low-cost platforms and which require greater human management and cost to execute.

V.  Best Execution for Non-Equities

When considering an investment adviser's best execution obligations, both regulators and industry participants tend to focus mostly, if not exclusively, on the trading of equities. However, an investment adviser's duties with respect to seeking best execution apply equally to fixed income securities and other asset classes. The bond markets, including those for Treasury securities, municipal securities and corporate debt pose their own best execution challenges that deserve recognition and an asset manager's attention. For example, for some securities, such as municipal securities, there may be limited supply or liquidity, which can make trade execution challenging. In addition, in many cases, it is much more difficult to quantify overall trading costs and therefore determine execution quality with respect to certain fixed income securities.

I encourage asset managers, and their clients, to focus on this important but relatively uncharted area. There is a tendency to measure what is easy to measure, such as execution costs of trades in large cap equity securities, rather than measure what may be more challenging, yet just as, if not more, important to measure, such as the execution costs of a municipal securities transaction. I am hopeful that the advisory industry will develop meaningful, quantifiable fixed income execution measures and methods of evaluation to assist them in meeting their best execution obligations and evaluating their execution quality for non-equity securities. There are developing tools to measure non-equity trade execution, and I encourage the asset management industry, their clients and the dealer community to work to improve and perfect these tools.

VI.  Use of Research

One area where I see many investment advisers facing brokerage-related challenges relates to how those advisers allocate the use of research obtained through soft dollars. Under Section 28(e) of the Securities Exchange Act of 1934, an adviser is not required to use research obtained through soft dollars for the benefit of the client account that actually paid for the commissions that led to the research. The adviser under Section 28(e) shall not be deemed to have acted unlawfully or breached a fiduciary duty if it determines that a stepped-up commission paid for a trade was reasonable, "viewed in terms of either that particular transaction or [the adviser's] overall responsibilities with respect to accounts as to which [it] exercises investment discretion." Thus, while using soft dollars to benefit accounts that did not pay for the research is certainly permitted under the law, there are some questions of fairness and equity that advisers would be wise to consider when faced with certain situations.

For example, some clients, as I mentioned before, direct their own brokerage. Thus, those clients require an investment adviser to send their trades to a particular broker in some cases so that the client may receive some direct benefit. Similarly, advisers managing assets in wrap fee programs or SMAs are, in practice, somewhat limited in their brokerage placement discretion and very often send the bulk of trades to the program's broker-dealer sponsor, which may or may not provide research. Other advisory clients may prohibit an investment adviser from paying up for research or permit proprietary research but not third-party research.

In each of these cases, an investment adviser must still meet its best execution responsibilities, subject to the trading parameters set by the client. In addition, however, in each of these cases, these advisory clients may be benefiting, through an improved investment process, from research obtained through commission dollars of other clients that have not so restricted an adviser's brokerage discretion.

I encourage investment advisers to consider these types of situations and consider whether they have appropriately evaluated the conflicts that this type of situation creates. In addition, I further encourage you to consider whether your clients understand these conflicts, or whether enhanced disclosure by you may be necessary. These questions may be tough ones, and the answers may not always be easy, but the conflicts are real and should be properly addressed.

VII.  Conclusion

As I stated in my introduction, this is time of tremendous and, in most cases, welcome change in brokerage and trade placement practices and the relationship between brokers-dealers and asset managers. However, with that change, comes evolving challenges, especially for investment adviser fiduciaries that have an obligation to place their clients' interests above their own. At all times, advisers must remember that commission dollars and other execution-related charges are a client asset and do not belong to the adviser. This principle should guide all trade execution determinations.

I appreciate the opportunity to speak before you and once again thank you for your commitment to focus on these important and challenging institutional brokerage issues. Thank you very much.



Modified: 11/01/2006