17.4 Proxy Voting & Other Obligations

Investment advisers have important obligations related to proxy voting, best execution, and trade allocation. These duties flow from the adviser's fiduciary relationship with clients.

Proxy Voting (Rule 206(4)-6)

When the Rule Applies

Rule 206(4)-6 applies when an investment adviser:

- Has voting authority over client securities (explicit or implicit)

- Exercises discretion that includes proxy voting authority

- Has not specifically excluded proxy voting from the advisory agreement

Requirements for Advisers with Voting Authority

Written Policies: Must adopt and implement written proxy voting policies

Vote in Best Interest: Must vote proxies in clients' best interests

Conflict Disclosure: Must address how conflicts of interest are handled

Client Disclosure: Must describe policies in Form ADV Part 2A

Provide Upon Request: Must provide copy of policies and voting records

Recordkeeping: Must maintain records for 5 years

Conflicts of Interest

Advisers must address how they handle conflicts, such as:

- Voting on securities of clients who are issuers

- Voting when adviser has business relationship with issuer

- Voting when adviser or personnel have personal interests

Use of Proxy Advisory Firms

If using a proxy advisory firm (like ISS or Glass Lewis):

- Must conduct due diligence on the firm's capabilities

- Must assess accuracy and conflicts of the firm

- Cannot blindly follow recommendations

- Ultimate responsibility remains with the adviser

Record Retention Requirements

Must maintain for 5 years:

- Proxy voting policies and procedures

- Proxy statements received (or where available)

- Records of actual votes cast

- Client requests for voting information

- Documents prepared for voting decisions

Best Execution

The Duty of Best Execution

Investment advisers have a duty to seek the most favorable terms reasonably available under the circumstances for client transactions.

Factors to Consider

Price: Most important but not the only factor

Commission/Spread: Cost of execution

Speed: How quickly the order is executed

Likelihood of Execution: Can the order be filled?

Size of Order: Impact on market

Settlement: Settlement capabilities

Broker Reputation: Financial responsibility and integrity

Research: Value of research services (soft dollars)

Soft Dollar Arrangements

Definition: Using client commission dollars to pay for research and brokerage services.

Section 28(e) Safe Harbor: Protects advisers from breach of fiduciary duty claims if:

Eligible Services: Only brokerage and research services qualify

Lawful Assistance: Services must assist in investment decision-making

Good Faith Determination: Adviser believes commissions are reasonable for services

Eligible vs. Ineligible Services

Eligible (Safe Harbor): Research reports and analysis; Trading systems for execution; Market data services; Financial publications; Seminars on investment topics

Ineligible (Not Protected): Office rent and equipment; General administrative expenses; Marketing costs; Employee salaries; Travel expenses (most)

Mixed-Use Items

For items that are partly eligible and partly ineligible:

- Must make reasonable allocation

- Only eligible portion can be paid with soft dollars

- Ineligible portion must be paid with adviser's own funds

- Documentation of allocation required

Disclosure Requirements

Soft dollar arrangements must be disclosed in:

- Form ADV Part 2A (Item 12 - Brokerage Practices)

- Description of products/services received

- Description of how they benefit clients

Directed Brokerage

Client-Directed Brokerage

When a client directs the use of a particular broker:

- Client may not receive best execution

- Adviser must disclose this risk

- Client must consent to the arrangement

- Trades may cost more or execute at inferior prices

Adviser-Directed Brokerage

When an adviser directs brokerage for non-best execution reasons:

- May create conflicts of interest

- Must be disclosed

- Must still consider client interests

Trade Allocation

Fair Allocation Requirements

When an adviser manages multiple accounts with similar investment objectives:

- Must allocate trades fairly among clients

- Cannot favor certain clients over others

- Cannot allocate based on fee structure

- Must have written allocation policies

Aggregation (Bunching) of Orders

Purpose: Reduce costs and improve execution

Average Price: All participating accounts receive same average price

Pro-Rata Allocation: Generally allocated proportionally

Partial Fills: Must be allocated fairly

Documentation: Written policies and procedures required

Prohibited Practices

- Favoring accounts that pay higher fees

- "Cherry-picking" profitable trades for certain accounts

- Allocating IPO shares unfairly

- Giving preferential treatment to proprietary accounts

On the Exam: Know the three-step test for Section 28(e) safe harbor for soft dollars: (1) eligible service, (2) lawful assistance in investment decisions, (3) good faith belief that commissions are reasonable. Also know that proxy voting authority creates specific compliance obligations.

Key Takeaways

- Proxy voting authority requires written policies and best-interest voting

- Best execution considers multiple factors, not just lowest cost

- Section 28(e) provides safe harbor for eligible soft dollar arrangements

- Trade allocation must be fair - no favoritism allowed

- All these obligations flow from the adviser's fiduciary duty