We dissent from the finding in this Order that Huntleigh Advisors, Inc. and Datatex Investment Services, Inc. (together, the “Advisers”) breached their duty to seek best execution “by causing certain advisory clients to invest in fund share classes that charged 12b-1 fees when share classes of the same funds were available to the clients that presented a more favorable value under the particular circumstances in place at the time of the transactions.”[1] In a substantive area where significant efforts have been undertaken to define fiduciary duty through the notice and comment process, it is unfortunate that the Commission chooses to create novel regulatory interpretations through enforcement.

The Advisers are both registered with the Commission as investment advisers. Under the Investment Advisers Act of 1940 (“Advisers Act”), an investment adviser owes a fiduciary duty to its clients.[2] This fiduciary duty comprises a duty of care and a duty of loyalty.[3] The Commission has articulated three components of the duty of care: (1) the duty to provide advice that is in the best interest of the client, (2) the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades, and (3) the duty to provide advice and monitoring over the course of the relationship.[4] Under an investment adviser’s duty of loyalty, an adviser must not subordinate its clients’ interests to its own.[5] According to the Commission, to satisfy its duty of loyalty, an adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship, including eliminating or disclosing all conflicts of interest.[6] The Commission may bring enforcement actions against an adviser that has breached its fiduciary duty under the anti-fraud provisions of Section 206 of the Advisers Act.[7]

The Commission Order makes a compelling case for a violation of Section 206(2) by finding that the Advisers breached their fiduciary duties by failing to “disclose either the existence of a conflict of interest or all material facts regarding the conflict of interest that arose when they invested advisory clients in a share class that would generate 12b-1 fee revenue for [the Advisers’ affiliated broker-dealer] while a share class of the same fund was available that would not provide [that broker-dealer] with that additional compensation.”[8] But the Commission Order goes further by finding that the Advisers breached the component of the duty of care that requires an adviser to seek best execution by selecting a more expensive share class.[9] The Commission Order makes clear that this duty of care violation is separate and distinct from the “failure to disclose” violation.

There is no legal authority cited in the Commission Order for the finding that mutual fund share class selection implicates an investment adviser’s duty to seek best execution. The Commission has stated that this duty means that an adviser must “[seek] to obtain the execution of securities transactions on behalf of a client with the goal of maximizing value for the client under the particular circumstances occurring at the time of the transaction.”[10] Explaining what it means to “maximize value” in this context, the Commission quotes from a Commission release that interprets the scope of Section 28(e) of the Securities Exchange Act of 1934.[11] Section 28(e) provides a safe harbor for persons who exercise investment discretion over beneficiaries’ or clients’ accounts to pay for research and brokerage services with commission dollars generated by account transactions.[12] Taken together, it is our view that the Commission’s interpretations stand for the proposition that an investment adviser’s duty to seek best execution concerns the manner in which the investment adviser places securities transactions through broker-dealers, with a particular focus on the price at which the order is executed and the commission rate paid to the broker-dealer.

The conduct that implicates the duty to seek best execution is inapplicable to purchases of mutual fund shares for two reasons. First, mutual funds are required to sell and redeem their shares at a price based on the net asset value next calculated after the receipt of the purchase or redemption order.[13] Accordingly, execution quality is not relevant to the selection of mutual fund share classes. Second, Rule 12b-1 fees are paid out of the assets of a mutual fund on an ongoing basis. These fees are unlike commissions that are paid to broker-dealers, which are transaction-based, meaning that they are charged by broker-dealers for facilitating the purchase or sale of a particular security at a particular point in time. Whereas brokerage commission rates may vary among broker-dealers, all shareholders of a mutual fund share class are assessed the same Rule 12b-1 fee rate, regardless of who facilitated the purchase of fund shares. In other words, when an adviser selects a mutual fund share class for clients, there is no mechanism by which an intermediary can improve execution price, and any Rule 12b-1 fee is an asset-based fee that applies to all shareholders of the class equally. Scrutinizing this conduct through the lens of the duty to seek best execution is forcing a square peg into a round hole.

Some might argue that a recent district court case affirms the view that mutual fund share class selection implicates an adviser’s duty to seek best execution. In Securities and Exchange Commission v. Ambassador Advisors, LLC, et al,[14] the Commission brought an action in federal district court alleging that a registered investment adviser and its principals breached their fiduciary duties in violation of Section 206(2) of the Advisers Act by investing client assets in mutual fund share classes that charged Rule 12b-1 fees, portions of which were paid back to the adviser. The Commission also alleged that the adviser violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder by failing to adopt adequate compliance policies and procedures regarding conflict disclosure.[15] In a memorandum opinion,[16] the court granted the Commission’s motion for summary judgment as to the Section 206(4) and Rule 206(4)-7 allegations and denied the Commission’s motion for summary judgment as to the Section 206(2) allegations.

One of the Commission’s Section 206(2) allegations in Ambassador Advisors was that the adviser failed to seek best execution.[17] In its memorandum opinion, the court found that the duty to seek best execution falls within an adviser’s duty of loyalty, not its duty of care.[18] In that regard, the court failed to grant summary judgment on the best execution allegation because it was not clear “whether Defendants obtained their clients’ consent to engage in this investment practice.”[19] Importantly, the Court found that “[i]f Defendants did give their clients enough information to obtain their consent, then Defendants would not have violated their duties of best interest or best execution by following through with the arrangement.”[20] This is at odds with the Commission’s own interpretation regarding an investment adviser’s standard of conduct, which places the duty to seek best execution within the duty of care.

Because the court framed the issue through the duty of loyalty, the court also ruled that adequate disclosure regarding the mutual fund share class selection arrangement at issue would have satisfied the adviser’s duty to seek best execution, even if the adviser ended up selecting a more expensive share class than what otherwise was available. Accordingly, the Ambassador Advisors court and the Commission Order are referring to two different things when they invoke the duty to seek best execution. The Ambassador Advisors court’s conception of the duty to seek best execution is akin to the “failure to disclose” violation cited in the Commission Order, which is premised on the lack of adequate disclosure regarding a conflict of interest.

The Commission Order in the present action finds that – in addition to a violation stemming from lack of adequate disclosure – the Advisers’ share class selection practices constituted a breach of the duty of care, which even adequate disclosure presumably would not have cured. Since the Ambassador Advisors opinion does not stand as authority for the proposition that certain mutual fund share class selection practices constitute a breach of the duty to seek best execution under the duty of care, the opinion undermines the Commission’s application of the duty to seek best execution in this case.

Although mutual fund share class selection does not implicate an adviser’s duty to seek best execution, one might make a reasonable argument that this practice implicates a different component of an investment adviser’s duty of care: the duty to provide advice that is in the best interest of the client. In fact, when the Commission issued its proposed interpretation regarding the standard of conduct for investment advisers in 2018, the Commission specifically discussed mutual fund share class selection in the context of this duty, not the duty to seek best execution.[21] However, the Commission’s final interpretation, issued in 2019, deleted the reference to mutual fund share class selection entirely.[22] While the Commission’s final interpretation is silent as to which duty might be implicated by this particular conduct, the selection of mutual fund share classes fits more naturally within the duty to provide advice that is in the best interests of clients than within the duty to seek best execution. In this regard, the Commission Order should have referenced only the “best interests” prong of the duty of care rather than taking the extra step of misapplying the duty to seek best execution.

This action is only the latest in a long line of actions alleging that mutual fund share class selection implicates the duty to seek best execution.[23] In these cases, although the Commission could establish a violation of Section 206(2) of the Advisers Act by making findings solely with respect to the advisers’ disclosure failures, the Commission went a step further and alleged best execution violations. This is problematic. If the Commission’s interpretations regarding an adviser’s standard of conduct are to have any meaning, the different categories of duties and the corresponding conduct that those duties implicate must be respected. Forcing a certain set of conduct into a category of duties that does not fit undermines the Commission’s authority to interpret the statutory provisions that it seeks to enforce.

Incorrectly applying an adviser’s fiduciary duty to a specific type of conduct is more than a matter of semantics. The ripple effect has tangible detrimental consequences for all regulated entities. The Commission only should allege violations that are supported by adequate legal authority. For that reason, we cannot support the best execution violations cited in the Commission Order.