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News November 6, 2006 Issue

Donohue Warns on Fixed Income Best Ex and Soft Dollar Conflicts

Best ex isnít just for equities.

Speaking at the Securities Industry Associationís Institutional Brokerage conference last week, IM Division director Buddy Donohue warned that an adviserís duty to seek best ex applies "equally" to non-equity securities. "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 managerís attention," he said.

Of course, it may not be easy. For some securities, such as municipal securities, he said, "there may be limited supply or liquidity, which can make trade execution challenging." Donohue also noted that it can be "much more difficult to quantify overall trading costs and therefore determine execution quality with respect to certain fixed income securities." Nonetheless, he encouraged advisers, as well as their clients, to focus on best ex in these markets: "There is a tendency to measure what is easy to measure, such as execution costs of trades in large cap equity securities." But the execution costs in a municipal securities transaction may be "just as, if not more, important to measure." Donohue expressed hope that the advisory industry would develop meaningful, quantifiable fixed income execution measures and methods to evaluate execution quality for non-equity securities.

Use of other clientsí soft dollars. Although advisers are permitted to use soft dollar research to benefit all of their accounts, including accounts whose commissions were not used to pay for the research, Donohue cautioned that there are "questions of fairness and equity that advisers would be wise to consider when faced with certain situations." He listed a number of categories of advisory clients that may benefit from research obtained by other advisory clientsí commissions: clients that have directed their own brokerage, wrap clients, and clients that have prohibited their adviser from paying up for research or that permit proprietary research but not third-party research. In each of these cases, said Donohue, "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 adviserís brokerage discretion." He encouraged advisers to consider whether they have appropriately evaluated the conflicts that these types of situations create and whether their clients understand these conflicts or whether enhanced disclosure 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," he said.

Must an investment adviser accept client direction? Recently, IM Insight had a conversation with a CCO who wondered whether his advisory firm was required to accept a clientís direction. In our view, the answer was no. "Business is business," we said. An adviser could always tell a client, in essence: "You know what? We are not going to accept your direction. If you want us to manage your money, weíre going to trade where we think is best. If you donít like that, go find another adviser."

Which is why we were a bit surprised to come across the following two sentences in Donohueís speech:

"You, as a professional investment adviser, may not think that the broker-dealer to which your clients direct 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 clientís right and then it is your responsibility to do so."

Donohue wasnít implying that advisers had to accept direction from their clients, right?


IM Insight has confirmed that Donohue was merely indicating that if an adviser had previously agreed to accept direction from a client, the adviser is thereafter duty-bound to follow that direction. But an adviser is free, from a business perspective, to reject the direction. Of course, per the Mark Bailey and Jamison, Eaton & Wood cases, an adviser that accepts a clientís direction should make appropriate disclosures to the client and periodically assess the quality of executions provided under the directed brokerage arrangement.