OCIE Risk Alert – Compliance Issues Related to Best Execution by Investment Advisers

By July 11, 2018Blog, Risk Alert

On July 11, 2018, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert addressing deficiencies observed in their recent examinations of investment advisers’ best execution practices. For years, advisers have been required to obtain and document best execution on behalf of client account, yet firms continue to struggle with sustainable and effective best execution policy and procedure, according to SEC staff.

The Investment Advisers Act of 1940 (“Advisers Act”) establishes a federal fiduciary standard for investment advisers. As a fiduciary with responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek “best execution” of client transactions, taking into consideration the circumstances of each particular transaction. An adviser must execute securities transactions for clients in such a manner that the client’s total costs or proceeds in each transaction are the most favorable under the circumstances.

As the Commission makes clear, the determinative factor in an adviser’s best execution analysis is not the lowest possible commission cost but whether the transaction represents the “best qualitative execution” for the account. Of course, to comply with Rule 206(4)-7, advisers must tangibly demonstrate best qualitative execution. And this presents the greatest challenge to advisers, according to the SEC.

An adviser’s assessment of best execution may be impacted by the adviser’s receipt of brokerage and research services (“soft dollar arrangements”).  Advisers are required to develop and document a reasonable allocation of the costs of the products or services received pursuant to the soft dollar safe harbor. Under Section 28(e) of the Securities Exchange Act of 1934 (“Exchange Act”), an adviser may pay more than the lowest commission rate in soft dollar arrangements without breaching its fiduciary obligation, provided that certain specified conditions are met.

OCIE Exam Deficiencies – Best Execution
Below are examples of the most common deficiencies associated with advisers’ best execution obligations, identified by OCIE staff in recent examinations.

  • Not performing best execution reviews. Advisers could not demonstrate that they periodically and systematically evaluated the execution performance of broker-dealers used to execute client transactions (and therefore could not prove that client transactions achieved best qualitative execution).
  • Not considering materially relevant factors during best execution reviews. The staff observed that advisers did not consider the full range and quality of a broker-dealer’s services in directing brokerage.  For example, OCIE detected the following:
    • Advisers did not evaluate any qualitative factors relating to broker-dealer selection, including, among other things, the broker-dealer’s execution capability, financial responsibility, and responsiveness to the adviser.
    • Advisers did not solicit and review input from traders and portfolio managers.
  • Not seeking comparisons from other broker-dealers. The staff observed advisers that utilized certain broker-dealers without seeking out or considering the quality and costs of services available from other broker-dealers.  For example, the staff observed:
    • Advisers that utilized a single broker-dealer for all clients without seeking comparisons from competing broker-dealers initially and/or on an ongoing basis to assess their chosen broker-dealer’s execution performance.
    • Advisers that utilized a single broker-dealer based solely on cursory reviews of the broker-dealer’s policies and prices.
    • Advisers that utilized a broker-dealer based solely on that broker-dealer’s brief summary of its services without seeking comparisons from other broker-dealers.
  • Not fully disclosing best execution practices. The staff observed advisers that did not provide full disclosure of best execution practices.  For example, the staff observed advisers that did not disclose that certain types of client accounts may trade the same securities after other client accounts and the potential impact of this practice on execution prices. In addition, the staff observed advisers that, contrary to statements in their brochures, did not review trades to ensure that prices obtained fell within an acceptable range.
  • Not disclosing soft dollar arrangements. The staff observed advisers that did not appear to provide full and fair disclosure in Form ADV of their soft dollar arrangements. OCIE observations included the following:
    • Advisers that did not appear to adequately disclose the use of soft dollar arrangements.
    • Advisers that did not disclose that certain clients may bear more of the cost of soft dollar arrangements than other clients.
    • Advisers that did not appear to provide adequate or accurate disclosure regarding products and services acquired with soft dollars that did not qualify as eligible brokerage and research services under the Section 28(e) safe harbor.
  • Not properly administering mixed use allocations. The staff observed deficiencies related to soft dollar mixed use allocations.  For example, the staff observed advisers that did not appear to make a reasonable allocation of the cost of a mixed-use product or service according to its use or did not produce support, through documentation or otherwise, of the rationale for mixed use allocations as required under Section 28(e).

Action Plan
Below we outline various components of a sound trade management policy which may assist advisers in achieving best execution.

Approved Brokers: Many investment advisers maintain a list of approved brokers, populated with firms that have been vetted by the adviser from a due diligence standpoint.  Due diligence inquiry should address several important variables including financial condition, regulatory history, affiliate party relationships and business continuity planning. In certain advisory business models, the trade counterparty is the client’s custodian. However, even in such models, the adviser generally retains the authority to step away from the custodian when it is necessary to obtain best execution. Typical examples of step away (or “step out”) situations include the purchase of a security not available from the custodian, time sensitive transactions, or transactions in highly illiquid securities that require special trading expertise to avoid material market impact on execution prices. Step out procedures, if adopted, must be fully disclosed to clients in Form ADV and referenced in the advisory agreement where appropriate.

Governance:  Best execution oversight is critical to effective trade management. Because the trader is closest to the trade, he/she is often in the best position to determine if best execution has been achieved on a trade-by-trade basis. However, it is precisely because the trader is closest to the trade that an adviser’s governance framework should include professionals not executing trades. Governance considerations relative to the development and implementation of best execution policy should include:

  • Representatives from portfolio management, trading, operations, risk oversight, and compliance
  • The oversight team should include professionals who are independent of the trade management process, i.e., not compensated on achievement of best execution
  • The forensic review of transaction data is critical to the governance framework
    • transaction cost analysis may include measures such as volume weighted average price (“VWAP”), reversion, implementation shortfall, and others
    • implementation shortfall measures the difference between the average price of an execution and the price prevailing at the time the trade is received by a broker or exchange (arrival time)
    • transaction data may be available from executing brokers, as well as independent vendors
  • The SEC has stated that advisers must “periodically and systematically” evaluate the quality of execution services received from the broker-dealers that are used to execute client trades; the governance framework should specify the frequency with which best execution will be evaluated

Quantitative Factors (Cost): The evaluation of best execution should include the actual cost of trading. Cost factors most often include:

  • Commission rates
  • Flat trade fees
  • Transaction prices
  • Exchange fees
  • Service fees
  • Step out fees

Qualitative Factors: Cost is not the only best execution factor to be considered. As noted, the SEC concedes that the objective of best execution is not necessarily to achieve the lowest cost of execution. Qualitative factors should also be evaluated when selecting broker-dealers, including:

  • Execution capability (market access, natural order flow, security types, capital commitment, IPO access, etc.)
  • Quality of research (including soft dollars)
  • Operational capability (service, errors, etc.)
  • Quality of execution (market intelligence, confidentiality, minimizing market impact, access to liquidity, handling of difficult orders, trade error history, etc.)
  • Organizational factors (financial soundness and stability, reputation, sales coverage, etc.)

The creation of a scorecard that is used by governance professionals is a common means of evaluating the qualitative aspect of best execution. It is imperative that advisers implement policies, procedures and controls which reflect these qualitative attributes of the firm’s best execution practices and further, incorporate these qualitative variables in best execution management reports.

Security Type Considerations: The security type certainly impacts best execution protocol. However, no security type is exempt from best execution analysis, whether private equity, bonds, equities, or mutual funds. Cost factors to be considered in each case may include, without limitation:

  • Private equity:
    • Deal execution speed
    • Certainty of financing
    • Operational and strategic expertise, including industry, geography, management team, market potential, product considerations, and growth capabilities
  • Bonds:
    • Bid-ask spreads
    • Odd-lot pricing
    • Competing bids and offers
    • Access to bonds, including new issues
    • Availability of liquidity or volume
  • Equities:
    • Market venue and market conditions
    • Character of the market for the security (e.g., price volatility, relative liquidity, etc.)
    • Size and type of transaction
    • Accessibility of price quotes
    • Number of markets checked
    • Terms and conditions of the order
  • Mutual funds:
    • Expense ratios
    • Investment manager fees
    • Portfolio turnover (higher turnover = higher trading expenses)
    • Share class availability

Soft Dollars: The Risk Alert specifically calls out soft dollars as an area of deficiency cited in examinations. The entire soft dollar landscape is shifting in today’s marketplace for many reasons, including MIFID II. Soft dollars present a conflict of interest because they represent a mechanism for an adviser to use client assets, in the form of commission dollars, to pay for services that would otherwise come out of the adviser’s hard dollar budget. Some brokerage services are not fully protected under the safe harbor, which means the adviser must carefully allocate costs between hard and soft dollars, which requires careful analysis and objectivity. Services paid with soft dollars must be proven to assist in the formulation of investment advice and must meet strict safe harbor guidelines. Not all clients are required to participate in soft dollar arrangements, however advisers must make it clear that those clients whose commissions are used to satisfy soft dollar commitments may likely be footing the bill for those not participating in such arrangements. Disclosures must be clear, detailed, and unambiguous. 

Written Policies: Although there is no best execution rule per say, best execution is specifically named as one of the areas advisers are expected to consider in establishing their written compliance programs under SEC Compliance Rule 206(4)-7. The factors listed above, along with other procedures and controls, should be memorialized in written policies and procedures.

Books and Records: It is vital that investment advisers document their best execution activities. As with most compliance activities, the SEC’s view is if there is no written documentation to evidence the adviser’s pursuit of best execution, the adviser has not met its fiduciary duty to seek best execution.

Disclosures: Do what you say you do! Brokerage disclosures must match the adviser’s actual practices, policies, and procedures. Conflicts of interest inherent in trading practices must be identified, mitigated, and disclosed to the extent they are not removed. Typical conflicts related to best execution include soft dollars, directed brokerage, performance fees, IPO access, step-out trades, block trading, trade rotation and allocation, obtaining client referrals from trade counterparties, cross trading, principal trading, and use of affiliated broker-dealers.

The closing statement of the Risk Alert bears consideration: “In sharing the information in this Risk Alert, OCIE encourages advisers to reflect upon their own practices, policies, and procedures in these areas and to promote improvements in adviser compliance programs.”  As we say often, forewarned is forearmed. The SEC has tipped its hand when it comes to its expectations around best execution policies and controls, and therefore investment advisers must adjust their playbook accordingly! 

View the Risk Alert Here: Most Frequent Best Execution Issues Cited in Adviser Exams 

Betsy Rathz

Author Betsy Rathz

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