Ethics in Practice: Brokerage Commissions. Case and Analysis–Week of 15 April
How did you do evaluating this week’s (15 April) case? Check out the analysis below.
Washington is a senior portfolio manager for Valley Forge Asset Management, a US registered investment adviser and broker/dealer. Valley Forge provides advisory services on a discretionary basis to approximately 2,000 separately managed retail and institutional accounts, focusing its investments on large-capitalization stocks and fixed-income securities. Valley Forge offers its advisory clients three choices for brokerage services, all of which are outlined in its investment advisory contract with clients: Affiliated Brokerage, Directed Brokerage, or Discretionary Brokerage.
Under an Affiliated Brokerage, clients can direct their brokerage to Valley Forge’s own “full-service brokerage.” Valley Forge discloses in the client agreement that this arrangement could be viewed as a conflict of interest, the firm would benefit monetarily, similar services by other brokers may be offered at lower prices, and clients should “carefully consider the services offered relative to the brokerage commission being paid.” But Washington informs clients that they can negotiate a commission rate, and that the firm is willing to provide a discount of at least 70% off Valley Forge’s “full commission rate.” Around 1,200 clients choose Affiliated Brokerage, and 92% of these clients received the 70% discount.
The Directed Brokerage allows clients to designate a third-party broker/dealer to handle all aspects of the brokerage relationship. Under this option, the client negotiates the fees and/or commissions directly with the third-party broker/dealer. Of the nearly 840 clients who choose this option, approximately 690 clients choose Broker B, a broker referred by Washington. Under the Discretionary Brokerage, clients choose where their assets will be custodied and designate a “preferred broker,” but Valley Forge has discretion to select the broker/dealer for each trade on a “best price and execution basis.” Only about 24 clients choose this option.
Washington does not disclose what services Valley Forge provides to its Affiliated Brokerage clients, and Valley Forge does not provide any services to its Affiliated Brokerage clients that are not also provided to clients who choose the other brokerage options. The brokerage costs under the Affiliated Brokerage are 4.5 times higher than those under the other two options, even with the 70% discount on Valley Forge’s supposed retail brokerage rate. Nearly every trade is more expensive with the Affiliated Brokerage option because the minimum commission per trade is more than double the maximum commission charged for each trade under the other options. Washington’s actions are
- acceptable because clients are free to choose which of the three brokerage options to use.
- acceptable because Washington significantly discounts brokerage fees for clients choosing the Affiliated Brokerage option.
- acceptable because the conflicts regarding the Affiliated Brokerage option are fully disclosed in the advisory agreement.
- none of the above.
Washington’s statements regarding Valley Forge’s brokerage options are misleading by giving the impression that clients will receive a high level of service at low cost. CFA Institute Standard I(C): Misrepresentation prohibits CFA Institute members from knowingly making any misrepresentations about their investment services. Washington states that Valley Forge’s Affiliated Brokerage option provides full-service brokerage services, but the firm does not provide any services to Affiliated Brokerage clients that are not also provided to clients who chose one of the other brokerage options, which have significantly lower costs. And although clients can choose their brokerage option, because Washington does not disclose what services Valley Forge is providing to its Affiliated Brokerage clients, clients cannot effectively “consider the services offered relative to the brokerage commission being paid” as directed in the investment advisory contract. Nearly 92% of Valley Forge’s Affiliated Brokerage clients receive the 70% discount on the full commission retail rate, but this discounted price is still significantly higher than other available options, rendering inaccurate Washington’s suggestion that the pricing of the Affiliated Brokerage option works to clients’ benefit.
Washington and Valley Forge have an obligation to disclose fully all material facts to advisory clients, including any conflicts of interest that could affect the advisory relationship. To meet this disclosure obligation, Washington and Valley Forge are required to provide advisory clients with sufficient information so they can understand and give informed consent to the conflicts or choose another course of action. Although the conflict of interest around the Affiliated Brokerage option is disclosed, Valley Forge’s clients lack the information they need to truly evaluate these conflicts of interest and to make an informed decision regarding their brokerage options because of Washington’s misleading statements. An adviser’s duty of loyalty, prudence, and care to act in the client’s best interest is implicated when the adviser explains and recommends brokerage arrangements to a client. That duty includes an obligation to not mislead clients regarding the services provided and their costs. Choice D is the best response.
This case is based on a March 2019 Enforcement Action by the US Securities and Exchange Commission.
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More About the Ethics in Practice Series
Just as you need to practice to become proficient at playing a musical instrument, public speaking, or playing a sport, practicing assessing and analyzing situations and making ethical decisions develops your ethical decision-making skills. The Ethics in Practice series gives you an opportunity to “exercise” your ethical decision-making skills. Each week, we post a short vignette, drawn from real-world circumstances, regulatory cases, and CFA Institute Professional Conduct investigations, along with possible responses/actions. We then encourage you to assess the case using the CFA Institute Ethical Decision-Making Framework and through the lens of the CFA Institute Code of Ethics and Standards of Professional Conduct. Then join the conversation and let us know which of the choices you believe is the right one and explain why. Later in the week, we will post an analysis of the case and you can see how your response compares.
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