Best Execution – US Rules
The first problem is to define the term “best execution”.
“The SEC has explained that a broker has ‘a duty to seek to obtain the best execution for customer orders, which is understood to mean that a broker-dealer must obtain the most favourable terms available under the circumstances for a customer’s transaction’” (Allen Ferrell, A Proposal for Solving The “Payment for Order Flow Problem”, 74 S. Cal. L. Rev. 1027, 1066 (2001))
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Scholars considered this standard amorphous, though the SEC provided a list of non-exhaustive factors for consideration. Price was not necessarily deemed the sole factor. Other elements informing the choice are: characteristics of the security, favourable market, availability of technology, and size of the order. Court decisions enforce the duty but have failed to provide more precision to the broker’s obligation (E.g., Newton v. Merrill Lynch, 135 F.3d 266 (3rd Cir.), cert. denied, 525 U.S. 811 (1998) (finding that broker filled all orders at NBBO price breached the duty of best execution) Best execution is simply the duty of an agent to act in the best interests of its client.
The SEC in Rule 611 of Regulation NMS specified one aspect of the broker’s duty by forbidding executions based on “trade through”, that is, an order not executed at the best possible price given quoted prices at other exchanges. Subject to some exceptions, an investor must receive the price equivalent to the price quoted on any other trading centre. Rule 611 is known as the “order protection rule”.
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The order protection rule requires that each exchange establish and enforce policies to ensure consistent price quotation for all NMS stocks, which include those on the major stock exchanges as well as many over-the-counter (OTC) stocks (Rule 611a provides, “A trading centre shall establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent trade-throughs on that trading centre of protected quotations in NMS stocks that do not fall within an exception set forth in paragraph (b) of this section and, if relying on such an exception, that are reasonably designed to assure compliance with the terms of the exception.” )
Nevertheless, Rule 611 does not alter or diminish the duty of best execution. Regulation NMS provides:
A broker-dealer has a legal duty to seek to obtain best execution of customer orders. According to the Report of the Special Study of Securities Markets, “[t]he integrity of the industry can be maintained only if the fundamental principle that a customer should at all times get the best available price which can reasonably be obtained for him is followed.
A broker-dealer’s duty of best execution derives from common law agency principles and fiduciary obligations, and is incorporated in SRO rules and, through judicial and Commission decisions, the antifraud provisions of the federal securities laws. The duty of best execution requires broker-dealers to execute customers’ trades at the most favorable terms reasonably available under the circumstances, i.e., at the best reasonably available price.
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The Commission has not viewed the duty of best execution as inconsistent with the automated routing of orders or requiring automated routing on an order-by-order basis to the market with the best-quoted price at the time. Rather, the duty of best execution requires broker-dealers to periodically assess the quality of competing markets to assure that order flow is directed to the markets providing the most beneficial terms for their customer orders. Broker-dealers must examine their procedures for seeking to obtain best execution in light of market and technology changes and modify those practices if necessary to enable their customers to obtain the best reasonably available prices. In doing so, broker-dealers must take into account price improvement opportunities, and whether different markets may be more suitable for different types of orders or particular securities.
The protection against trade-throughs required of trading centers by Rule 611 undergirds the broker-dealer’s duty of best execution, by helping ensure that customer orders are not executed at prices inferior to the best protected quotations. Nonetheless, the Order Protection Rule does not supplant or diminish the broker-dealer’s responsibility for achieving best execution, including its duty to evaluate the execution quality of markets to which it routes customer orders, regardless of the exceptions set forth in the Rule (Regulation NMS supra note 45 at 159-61)
The duty of best execution and the “order protection rule” are effectuated based on the structure of the NMS. In 1971, the SEC instituted the Intermarket Trading System Plan that is a market to market routing system enabling orders to be transferred from one market to another to determine which market is offering the best price. The ITS plan links over-the-counter dealers with all securities exchanges. The Regulation also provides for the development of private linkages to enhance intermarket communication. In addition, various reporting systems provide virtually instantaneously securities transaction data, for example, the Consolidated Tape, various systems run by NASDAQ, and the Consolidated Quotation System also operated by NASDAQ. Regulation NMS also contains a “new access rule” to promote “fair and non-discriminatory access to quotations displayed by NMS trading centres through a private linkage approach”.
