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Commentary: The $5 billion consideration for governmental and ERISA plan fiduciaries

Updated with correction

Not all fiduciaries of public and private retirement plans may realize that the broker-dealers handling securities execution might have a conflict of interests that could cost "mutual funds, pension funds and ordinary investors as much as $5 billion a year," according to the New York Times.

Rebates from stock exchanges and other trading venues (e.g., alternative trading systems) are paid to the broker-dealers for routing a customer's order to them for execution, even if that venue does not offer the best price on the security or otherwise provide best execution. Regardless of whether, and in what amount, a commission is paid on the transaction, governmental and ERISA plans might be suffering from poor execution quality.

The potential conflict of interests arises out of a widespread and controversial, albeit permissible, practice whereby stock exchanges and other trading venues will pay a per-share rebate (e.g., 0.3 cents a share) to broker-dealers in return for having their customers' trades executed on that venue. These orders, in turn, will be placed in a queue at the selected trading venue for execution. In the typical model, counterparties to that transaction, who "take" liquidity from the exchange, will pay a fee to the venue. The exchange stands to profit on the transaction in the amount of the difference it paid in rebates (to the broker-dealer, for instance) and fees it collected from the "taker." Convoluted and complicated, it is.

One might ask why these rebate programs are even necessary. In a highly fragmented market, competition for the broker-dealer's customer orders is fierce. The rebates help attract order flow to a venue and away from others. With now 13 exchanges and more than 30 alternative trading systems in the U.S. market, brokers have choice.

Defenders of rebates claim these payments result in lower commissions, greater competition among trading venues (and, thereby, helping with price discovery) and narrower spreads. Securities and Exchange Commission staff, however, have cautioned that "venues that offer the highest rebates and lowest fees may not provide the best execution of customer orders, given the type of order flow they tend to attract." One reason this occurs is because the queues at venues that offer generous rebates tend to be longer. The longer a pending trade sits in the queue, the greater the odds the market moves against the investor, even if other trading venues, which paid lower or no rebates, had shorter queues.

Broker-dealers have a duty to seek the best execution of its customers' orders. Best execution, as described in FINRA regulatory notice 15-46, requires a broker-dealer "to exercise reasonable care to obtain the most advantageous terms for the customer." There is not a bright line for whether best execution has been achieved because it is based on myriad variables, such as the size of the order, market characteristics, as well as cost and difficulty of executing a transaction in a particular market. Bloomberg has aptly described best execution as "the lowest price, the speediest trade or the one most likely to be completed." The SEC has indicated that while the receipt of a payment for order flow does not necessarily violate a broker-dealer's best execution obligations, it does "raise concerns about whether a firm is meeting" those obligations.

Because broker-dealers typically do not pass these rebates and fees on to customers, regulators are increasingly worried that investors, retail and institutional alike — including governmental and ERISA plans — are not receiving best execution on their transactions. FINRA, in its recent examination findings, found a number of deficiencies of some broker-dealers, including a failure "to compare the quality of the executions firms obtained via their order routing and execution arrangements (including the internalization of order flow) against the quality of the executions they could have obtained from competing markets." In other words, some broker-dealers failed "to assure that order flow was directed to markets providing the most beneficial terms for their customer' orders." The chief securities regulator in Massachusetts, William Galvin, reportedly is investigating numerous large U.S. brokers over this practice.

In a recent op-ed on rebates for the New York Times, David Swensen and Jonathan Macey of Yale wrote, "[a]lthough the harm suffered on each trade is minuscule — fractions of a cent per share — the aggregate kickbacks amount to billions of dollars a year."

These implicit costs of trades executed by venues providing less than optimal terms are relatively slight and difficult to detect. They are far less conspicuous than explicit transaction costs, such as commissions, but the dangers are the same: small transaction costs of institutional investors compound over time. Even $5 billion worth. This is why plan fiduciaries should be aware of this practice.

Whether the broker-dealers handling governmental and ERISA plan transactions are satisfying their best execution obligations should matter to plan fiduciaries. ERISA plan fiduciaries (e.g., plan investment committees, third-party investment managers, etc.) should be mindful of Department of Labor technical bulletin 86-1, in which the agency made three important points: 1) investment committees or other named fiduciaries have a duty to monitor third-party investment managers "to assure that the manager has secured best execution of the plan's brokerage transactions" where investment discretion has been outsourced (the investment managers would separately have a duty to act prudently, within the meaning of ERISA, in selecting broker-dealers); 2) investment committees or other named fiduciaries have a duty "to determine that the broker-dealer is capable of providing best execution for the plan's brokerage transactions" where investment discretion over those transactions has not been outsourced; and 3) a prudent analysis (by either the investment committee or the investment manager) requires consideration of both commissions charged and the quality of the execution. In other words, "best execution" means the explicit transaction costs (e.g., commissions) and whether the plan is achieving the best terms in the transaction reasonably available under the circumstances. The DOL has echoed these points in subsequent guidance.

Governmental plans and their fiduciaries should also be aware that their own rules and regulations might very well impose a duty of best execution (both in oversight and implementation), similar to their ERISA cousins. The Tampa (Fla.) General Employees' Retirement Fund's statement of investment policy, for example, imposes a duty on investment managers to "ensure that brokers will be selected only on a competitive, best execution basis." The investment committee, in turn, has the responsibility to "determine whether those responsible for investment results are meeting the guidelines and criteria identified in this policy." The Los Angeles City Employees' Retirement System has considered the importance of best execution and crucially recognizes that best execution encompasses not only the amount of commission recapture (and soft dollars), but also that the trading itself meet best execution requirements. The Public Employees Retirement Association of New Mexico has also been thinking deeply about the importance of quality execution and not simply the amount of commissions paid or recaptured.

The complex order routing of institutional investor orders can hinder plan fiduciaries' awareness of how plan trades are handled, routed and ultimately executed. Investment committees and third-party managers each have their own obligations to ensure that the quality of the execution meets best execution requirements, even if commission rates are favorable to the plan. The SEC proposed enhanced disclosures on order routing in 2016 for institutional investors. The proposal would help investors (including plan fiduciaries) assess and compare order handling by broker-dealers. In the meantime, broker-dealers appear willing to provide certain information on routing decisions upon request. Governmental and ERISA plan fiduciaries should each keep this issue top-of-mind, request as much information as is available and seek to ascertain that the plan is not suffering from poor execution quality because of rebates the broker-dealer has received.

George Michael Gerstein is counsel at Stradley Ronon Stevens & Young LLP in Washington. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.