1

Trendy money managers and brokers take on the role of chief cook and bottle

washer when they opt to be all things to all clients. In the context of this article, we are

interested in those situations when they opt to be their client’s broker (or introducing

broker) and investment adviser (either to a fund or private client). By becoming a broker,

the money manager can significantly increase his bottom line as he is now entitled to

sales commissions, third party selling fees and in some cases increased access to margin

(a key point if the manager runs a hedge fund or a proprietary trading firm). As his

client’s investment adviser, the money manager can earn those hefty tax-advantaged

advisory fees we have all been reading about in the mainstream press for months.

Purveyors of both advisory and brokerage services need to be aware of the mix of statutes

and judicial doctrines that affect them. The purpose of this article is to flag the concerns

of the investment adviser and the weightier concerns of the broker.

Brokers (B) typically set up as an investment adviser in one of two ways. He may either

register his brokerage as an investment adviser or establish an affiliated investment

advisory business. Investment advisors (IA) transition to the brokerage business either

by registering his investment adviser business as a broker or by establishing an affiliated

brokerage firm. When a service provider offers both investment adviser and brokerage

services to his clients, the broker/investment adviser (B/IA) will execute client

transactions through its affiliated brokerage firm. Endemic to this kitchen table

arrangement are economic conflicts that trigger regulatory and client concerns, if not

headaches.

The primary concerns are as follows:

clients to pay too high a price for securities execution?

A B/IA must “test for integrity” all his sales and advisory activities under the following

statutes and judicial doctrines.

The Investment Advisers Act of 1940 (IA Act) does not impose any specific restrictions

on the B/IA with respect to an affiliated brokerage. In play is the general fiduciary duty

imposed on investment advisers by Section 206 of the IA Act. A B/IA should use an

affiliated broker only if he can satisfy the duty of best execution. The B/IA’s use of an

affiliated broker must be fully and clearly disclosed in the B/IA’s Form ADV Part II

(Schedule F). Appropriate disclosure may include a clause in the advisory contract

allowing the client to acknowledge that the B/IA is affiliated with the B/IA’s brokerage

2

or that the B/IA is also a broker. The client must explicitly authorize the B/IA to execute

transactions consistent with the B/IA's duty of best execution. The B/IA’s Form ADV

Part II (Schedule F) should explain the B/IA's practice of engaging in affiliated brokerage

transactions.

up to date as well as accurate.

Affiliated brokerage transactions are of interest to an SEC (or state SEC) inspection team.

When (not if, but when) the B/IA is audited, the inspection team will review the B/IA's

disclosures with respect to affiliated brokerage transactions and review whether the

commissions paid to an affiliated brokerage are in accordance with industry standards.

Three other statutes and a handful of judicial doctrines impose specific regulatory

restrictions on the provider of affiliated brokerage services. Those statutes are the

Securities Exchange Act of 1934, the Investment Company Act of 1940, and Employee

Retirement Income Security Act (ERISA) of 1974.

member of a national securities exchange or affiliated with a member. Section 11(a) of

Securities Exchange Act of 1934 (SEA) prohibits an exchange member from engaging in

transactions on the exchange floor for an account in which it or an affiliated IA has

investment discretion unless the advisory client gives authorization and the client is

provided with an annual statement of the compensation paid to the exchange member in

connection with those transactions.

Section 17(e)(2), limits the sales (and other) commissions paid to an affiliated brokerdealer.

Payments have to be “usual and customary.” The limits imposed on affiliated

broker payments by Section 17(e)(2) of the IC Act vary depending on the transaction.

Rule 17e-1 of the IC Act establishes guidelines as to when commissions are deemed to

fall within the usual and customary standard. Commission must be reasonable and fair

compared to the commission received by other brokers in connection with comparable

transactions involving similar securities being purchased or sold on a securities exchange

during a comparable period of time. The rule also requires that a fund's board of directors

(in the case of a mutual fund) adopt procedures designed to achieve compliance with the

rule. They also have to make sure (at least quarterly) that any affiliated broker

transactions comply with the rule. A mutual fund must disclose its business practices

involving affiliated brokers

Those firms truly attempting it all: providing investment adviser, broker, and proprietary

trading services need to be very cautious in its billing practices.

3

private pension plans are the largest single category of institutional holders of corporate

stocks. It is common to find pension plans being handled by a B/IA. In such cases, when

the fiduciary duties of the B/IA to the plan are prescribed by ERISA. ERISA permits a

fiduciary to use an affiliated broker for plan transactions under limited circumstances.

The transactions must be executed pursuant to a written authorization executed by a plan

fiduciary who is independent of the investment adviser or broker. Such authorization is

made by the plan sponsor (typically the employer). The written authorization must be

terminable at will by the plan without penalty. The affiliated broker must make annual

disclosures concerning (among other things) the total of all charges incurred by the plan

that relate to securities transactions.

The scope of ERISA is broad. The applicability of ERISA will depend on whether the

plan is covered by the statute and on whether the broker falls within the ERISA's

definition of the term "fiduciary." Under ERISA, a fiduciary is a person who (1) exercises

any discretionary authority or control regarding the management of a plan or the

management or disposition of its assets; (2) renders investment advice for a fee or other

compensation (direct or indirect) or has authority or responsibility to do so; or (3) has any

discretionary authority or discretionary responsibility in the administration of the plan. A

broker is a fiduciary if it exercises discretionary authority as to the investments of a plan

or if it provides the plan with investment advice for a fee (beyond the normal

compensation of a broker). In addition, if a broker is named as a trustee of a plan, it will

fall within the definition of fiduciary.

Department of Labor regulations provide, however, a person will be deemed to be giving

investment advice only if (1) the person has discretionary authority or control; and (2)

there is an understanding between the plan and the fiduciary that the advice will serve as

a primary basis for the plan's investment decisions, and that the person will render

individualized investment advice based on the particular needs of the plan. For a

brokerage firm to be an ERISA fiduciary, it must have discretionary authority over

management of the plan or discretionary authority or control over the assets. If an

employee of a broker is the investment adviser to a plan (meaning that he is responsible

for making investment decisions for the plan's account), both the employee and the firm

employing him are fiduciaries under ERISA.

ERISA requires fiduciaries to discharge their duties solely in the interest of the

participants and beneficiaries of the plan. They must also act with skill, prudence, and

diligence They must diversify the investments of the plan so as to minimize the risk of

large losses, unless under the circumstances it is clearly prudent not to do so. That is

quite a large burden.

of his duties. The fiduciary may be required to restore to the plan any profits that the

fiduciary has made through his breach of duty, and may also be subject to other equitable

or remedial relief.

4

While affiliated broker fees paid on behalf of a plan generally constitute prohibited self

dealing, the Department of Labor established an exemption. Affiliated brokers can

charge fees under certain conditions. Affiliated broker transactions cannot be excessive

either in amount or frequency.

adviser of the plan, had breached its fiduciary duty by charging the fund excessive

commissions and by paying a portion of these commissions to investment managers (who

also were fiduciaries of the fund). The fund also made a claim against a director of

Hutton and the registered representative who handled the fund's account for making

intentional misrepresentations about Hutton's fees. The court denied the director’s motion

for summary judgment on grounds that even if he was not himself a fiduciary, he

knowingly participated in the fiduciaries' activities.

Courts impose common law duties on the B/IA which serve as an additional restraint on

behavior, much like the statutes cited in this article.

good faith, integrity, and loyalty. A broker must disclose to his customer all material facts

within his knowledge that in any way affect the transaction or the relationship. A broker's

exact duties depend on the scope of his agency. A broker who has authority to make and

manage investments or who effectively controls his customer's account (even though he

does not have formal discretionary authority over the account) owes his customer duties

of faithful service. This is a standard similar to that imposed on the trustee of a formal

trust.

The fiduciary duties of a broker include the duty to use the skill and diligence necessary

to protect his customer's interests. Negligent conduct may be a breach of fiduciary duty.

A broker must employ such care, skill, prudence, diligence, and judgment as might

reasonably be expected of a person skilled in his calling.

A client does not have to prove wrongful intent in order to establish a breach of fiduciary

claim. Neither constructive fraud nor breach of fiduciary duty requires actual dishonesty

or actual intent to deceive.

loyalty requires a showing that the broker acted with intent to deceive

In determining the applicable standard of care in a particular situation, a court may take

into consideration a variety of authorities, including the rules of self-regulatory

organizations, the internal rules and practices that the brokerage firm adopted to govern

the conduct of its employees, industry customs and professional practices. The content of

these rules and practices will shed some light on the broker's knowledge of the risks

involved and the precautions taken to prevent the risks.

5

standard of care. A court could very well go off on a tangent and create a new or higher

standard of care.

every broker (including a broker handling a nondiscretionary account) is the duty to

avoid self-dealing. A broker cannot refuse to disclose any personal interest he has in a

particular recommended security. Brokerage firms simultaneously engage in a variety of

activities for clients and for their own account. Broker’s are supposed to act in a

customer's best interest and refrain from self-dealing unless the customer consents (after

full disclosure). A broker can be held accountable for breaching his duty of loyalty

whenever the broker has a direct economic interest in the transaction.

account ahead of an order that a customer has given for execution.

whether the account is discretionary or nondiscretionary) includes a duty not to

misrepresent any fact material to the transaction.

security or investment program that is unsuitable for his customer in light of the

customer’s financial situation, needs, or investment objectives can be held accountable

for a breach of fiduciary duty or for negligence.

account owes a duty to his customer to monitor the account’s performance. A broker

handling a nondiscretionary account normally does not have such a duty. If a broker does

not have discretionary authority, the agency relationship begins when the customer places

an order to buy or sell a security and ends when the transaction ordered is complete. A

broker does not automatically assume a continuing obligation to keep abreast of the

securities in nondiscretionary customer accounts or to advise these customers of any

information that might affect the securities.

A broker handling a nondiscretionary account is under a duty to his customer not to buy

or sell securities unless the customer gives prior approval for each transaction. An agent

owes his principal a duty to act only as authorized.

Providers of B/IA services need to be aware of the “black letter law” and common law

doctrines that govern his services. Providers of B/IA services should not only avoid

impropriety but also the appearance of such. A good reputation of 20 years can be lost in

5 minutes. See you in the Soup!

6

Hannah Terhune is an attorney. Ms. Terhune and her staff of professionals, through

Capital Management Law Group, PLLC, provides advice to a wide range of clients,

including investment advisers, active traders, hedge funds, forex funds, commodity pools,

proprietary trading firms, and brokers. Ms. Terhune has written over 100 articles and

white papers on hedge funds and tax matters. Ms. Terhune holds degrees in law from

New York University (LLM in Taxation, 1991) and George Mason University (JD,

1989). She has served as a Lecturer in taxation and business at George Mason University

and at Catholic University. Her prior military service includes serving as Judge Advocate

in the U.S. Army Special Forces. For any questions concerning this article, contact her

hannah.terhune.attorney.us. For permission to reprint this article, please contact

Stephanie Jones at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .