Broker-Dealer Settles SEC Claims Alleging Violations Of The Duty Of Best Execution And Related Misstatements
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  • Broker-Dealer Settles SEC Claims Alleging Violations Of The Duty Of Best Execution And Related Misstatements

    On December 17, 2020, the Securities and Exchange Commission (“SEC”) announced the filing of settled administrative proceedings against a significant retail broker-dealer (the “Company”) for alleged violations of the duty of best execution and related misstatements.  According to the SEC, the Company “fail[ed] to satisfy its duty to seek the best reasonably available terms to execute customer orders” and simultaneously made “repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them” in lieu of routing such orders to other trading firms that may have resulted in improved customer executions.  SEC Press Release 2020-321 (Dec. 17, 2020).  Without admitting or denying the allegations, the Company has agreed to settle the claims by agreeing to pay a $65 million civil penalty, as well as agreeing to hire an independent compliance consultant who will be required to review the Company’s policies and procedures relating to customer communications, payment for order flow, and best execution of customer orders, and to report to the SEC on the Company’s compliance.

    The Company is a retail brokerage business that launched in 2015.  One of its advertised advantages was that it allowed its customers to buy and sell securities without charging any trading commission.  Instead, the Company generated much of its revenue through “payment for order flow”—a permitted though controversial practice by which trading firms would provide payment to the Company in exchange for sending its customers’ orders to those firms for execution.  The SEC alleges that the Company negotiated high payment for order flow rates, and “explicitly offered to accept less price improvement for its customers than what the principal trading firms were offering, in exchange for receiving a higher rate of payment for order flow for itself.”  Exchange Act Release No. 90694 (Dec. 17, 2020) (the “Order”) ¶ 23.  As a result of the Company’s high rate of payment for order flow, the SEC alleges that the execution prices that its customers received were inferior to those of its competitors, and this difference would have been more than the commission its competitors would have charged on larger orders.  Id. ¶ 2.  The SEC alleges that between October 2016 and June 2019, these decisions cost the Company’s customers roughly $34 million, even when factoring in the amount saved from a lack of commission.  Id. ¶ 42.

    The SEC alleges that the Company thus violated its “duty of best execution.”  Id. ¶ 30.  According to the SEC, best execution “requires that a broker-dealer endeavor to execute customer orders on the most favorable terms reasonably available in the market under the circumstances.”  Id. ¶ 13.  With respect to payments for order flow, the Order states that “[a] broker-dealer must not allow payment for order flow to interfere with its efforts to obtain best execution.”  Id. ¶ 14; see also Payment for Order Flow, SEC Final Rule Release, Exchange Act Release No. 34902, 59 Fed. Reg. 55006, 55009 (Oct. 27, 1994).  The Company allegedly had “notice that its high payment for order flow rates could lead to less price improvement,” and certain senior personnel were aware of internal analyses which showed that its “execution quality and price improvement metrics were substantially worse than other retail broker-dealers in many respects.”  Order ¶ 29.  The Company’s internal Best Execution Committee allegedly did not take appropriate steps in light of this information and failed to “conduct adequate regular and rigorous reviews that involved benchmarking its execution quality against competitor broker-dealers to determine whether it was obtaining the best terms reasonably available for customer orders.”  Id. ¶ 30.
    It remains to be seen whether, standing alone, these alleged failures of best execution would have led to such a significant penalty; but the SEC also alleged that the Company committed related violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act.  Id. ¶ 43.  Section 17(a)(2) prohibits receiving money “by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”  Section 17(a)(3) prohibits engaging “in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.”  In this case, the SEC claimed that the Company allegedly violated these sections by making misleading statements and omissions regarding how it made money—while simultaneously touting its lack of commissions, for example.  The SEC claimed that the Company did not adequately disclose that it made money through payment for order flow.  Indeed, according to the SEC, for a certain period, the Company omitted such information from an FAQ portion of its website designed to answer questions as to how the Company makes money, even though during that same period payment for order flow was the Company’s primary revenue source.  Id. ¶ 32.
    While not breaking new legal ground, the Order is a strong reminder of how seriously the SEC takes the duty of best execution and how careful firms must be in terms of any disclosures they may make regarding their revenue sources.