A Broker's Duty of Best Execution in the Nineteenth and Early Twentieth Centuries

Although a broker-dealer's duty of best execution can now be located in federal common law, self-regulatory organization ("SRO") regulations, or state common law, the root of the doctrine is conventionally found in the third area, state law. In this view, the common law duty of best execution is a particular manifestation of a broker's more general duties as an agent to its customers. The duty of best execution may be broadly characterized as a fiduciary one, or as a limited duty, due with respect only to a particular purchase or sale. Even in jurisdictions where a broker is not a fiduciary, however, courts require brokers, as agents, to give best execution to their customers. One well known treatise has summarized the common law duty of best execution as consisting of three things: "the duty to execute promptly; the duty to execute in an appropriate market; and the duty to obtain the best price.” Different types of customers put differing emphases on the various components of best execution. First, one should distinguish between "informed and uninformed" trades, in other words, between trades by those who "trade in order to profit from private information relevant to the future return on a security" and trades by those "whose sales and purchases are prompted by the desire to consume or save." Second, one should distinguish between traders based on the size of their trades. Large traders may be either informed or uninformed, although most small trades are uninformed or will be treated as such. A large institutional trader such as a mutual fund or pension fund may well be an uninformed trader. Informed trades have an impact on a security's price because of the implicit information conveyed by the trades themselves. In addition, the type of trader conveys information that impacts a security's price. Both informed traders and uninformed large traders have incentives to conceal the size of their trades. Large orders are one signal that an informed trade is occurring. Another signal is the speed with which the trade must be made. Informed and large uninformed traders will seek executions from brokers that "reduce as much as possible the price impact of the customer's order." An informed trader will care about the speed of execution and concealing both the trader's identity and the size of its order, in addition to the price. A large uninformed trader may seek a slower execution to signal to the market that the trades are being done by an uninformed trader. Finally, uninformed small traders will care above all else about the price they receive or pay. Part of the puzzle that this article is unable to adequately address is the nature of trading prior to the 1930s. In other words, to what extent was the market made up by informed and uninformed customers and how did this change over time? The more uninformed customers there were, the more likely that price would have been the paramount concern. Some general information on the nature of customers is discussed in Part 1II, below, but the Author is unaware of any historical analysis of the clients of brokers during this period. The concept of best execution has moved to center stage in current discussions of many widespread broker-dealer practices and market structure reforms. The most controversial of the proposed market structure reforms has been the Trade-Through Rule, which attracted over 700 comment letters to the SEC. The rule is designed to "require trading centers either to execute ... orders at the best, immediately accessible prices or to route the orders to trading centers displaying such prices." The SEC's concern has been to encourage limit orders, which "typically establish the best prices for an NMS [National Market System] stock" and to ensure that market orders are "executed at the best prices." This article, however, does not examine the current debate. Rather, this article is concerned with the early common law history of the doctrine of best execution. This article examines the development of the common law concept of best execution in order to explain why the doctrine has developed from the very simple injunction that a broker should act in good faith when executing its customers' orders, to a much more elaborate duty. The duty is now primarily embodied in federal law and requires a broker to be concerned with multiple aspects of how its customers' orders are executed. One of the significant differences between the state and federal duties of best execution is that, at least with respect to a breach of a broker's state law duty of loyalty, some states do not require a showing of the broker's intent to deceive (scienter in the federal scheme). This article started out very simply as an attempt by the Author to trace the common law roots of the duty of best execution. To the Author's amazement, there did not seem to be a common law basis beyond the vague formulation that a broker has a duty of good faith to its customer. The impact of this formulation on particular purchases and sales of securities, however, does not seem to have been explicitly litigated in the courts prior to the 1930s or to have been commented upon in any of the early treatises on brokers or the securities markets. In examining this puzzle, a series of obvious questions about the structure of the securities markets must be answered. Perhaps the lack of an articulated duty of best execution arose from the inability to execute a particular securities transaction on multiple exchanges. Perhaps it was due to the inability to quickly communicate bid and offer prices on different financial exchanges for the same security. The fact that arbitrage between markets was a common nineteenth and early twentieth century phenomenon is the strongest argument against these market structure arguments. Ultimately, none of these market structure explanations are satisfying. Another possible set of explanations arises from the dominant ideologies that shaped the viewpoint of the market participants. Insofar as society has moved from a view of the securities markets in which they are criticized as the equivalent of gambling casinos and as the locus of a money trust, to a view in which the securities markets are generally accepted, we can expect that criticism will become more focused on the particular problems of market mechanics, rather than overarching critiques. The twentieth century growth of academic analysis of security trading, culminating in the various forms of the efficient market hypothesis, developed congruently with the focus on market mechanics. In a world where individuals cannot expect to consistently beat the market, transaction costs are a primary concern to investors. Best execution is ultimately about a type of transaction cost. Indeed, open the Wall Street Journal on almost any day and there will be a discussion of transaction costs in buying various types of securities. At least once in any given week there will be a discussion of transaction costs in buying various types of securities and mutual funds, and how these costs and fees affect performance. This article suggests that the doctrine of best execution initially developed as a result of regulatory oversight by the SEC and then as a result of the development of the class action. Most losses due to a broker's failure to meet its best execution obligations would be relatively small, often pennies per share. No individual investor would have an incentive to pursue such small losses. Only a regulator or an attorney able to recover fees from a common fund would have the resources to pursue such a claim. When one combines these economic and legal facts with the speculative orientation of nineteenth and early twentieth century investors, it is not surprising that best execution is a doctrine that awaited the birth of the SEC, more sophisticated theories about security markets and the pricing of securities, and the development of the class action suit. This article suggests an approach to studying the doctrine of best execution. Professor James Fanto, who commented upon an earlier draft of this article at the Pace University School of Law's Investor Rights Symposium, suggested one general lesson of legal history that can be drawn from this preliminary work. Although we have all become legal realists, we sometimes forget the contingent nature of legal doctrine. As this article argues, the preconditions for the development of best execution as a legal doctrine existed in the late nineteenth century, but the doctrine only became prominent in the 1930s. As Professor Fanto wrote, this article provides an "example of how a legal right, which is now the subject of considerable debate, has a complex, somewhat contingent origin. That is, legal rights often appear not just when conditions permit, but when there is a spark or catalyst to bring them about ...”