Ethics Case Study of the Week: Misleading Brokerage Services

By Gary Sarkissian posted 12-21-2020 08:00


CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to evolve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we will feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Each case is built upon a real-life example that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of the case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard I(C) Misrepresentation. 

(Note: We will be taking a holiday break from the Connect Blog and will be returning on January 4, 2021.  We wish you and your loved ones a safe and wonderful holiday season!)

Misleading Brokerage Services
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

A.  acceptable because clients are free to choose which of the three brokerage options to use.
B.  acceptable because Washington significantly discounts brokerage fees for clients choosing the Affiliated Brokerage option.
C.  acceptable because the conflicts regarding the Affiliated Brokerage option are fully disclosed in the advisory agreement.
D.  unacceptable.
E.  none of the above.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit

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.

Image by Arek Socha from Pixabay

© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.