SEC Issues Best Execution Risk Alert

The Office of Compliance Inspections and Examinations (“OCIE”) recently issued a Risk Alert regarding Best Execution The alert was targeted to investment advisers (“advisers”), investors and other market participants with information concerning many of the most common deficiencies that the staff of the Securities and Exchange Commission (“SEC”) has cited in recent examinations of advisers’ compliance with their best execution obligations under the Investment Advisers Act of 1940 (the “Advisers Act”).

To this end, the Advisers Act establishes a federal fiduciary standard for investment advisers.  As a fiduciary, when an adviser has the responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek to obtain “best execution” of client transactions, taking into consideration the circumstances of the 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.  In directing brokerage, an adviser should consider the full range and quality of a broker-dealer’s services including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the adviser.  As the Commission has stated, “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 managed account”.

An adviser’s assessment of best execution may also be impacted by the adviser’s receipt of brokerage and research services (“soft dollar arrangements”).  Under Section 28(e) of the Securities Exchange Act of 1934 (the “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. To this end, advisers must disclose soft dollar arrangements and must provide more detailed disclosure when the products or services they receive do not qualify for Section 28(e)’s safe harbor.

A number of the most common deficiencies associated with advisers’ best execution obligations identified by OCIE staff included:

  • Not performing best execution reviews and or the failure to demonstrate that they periodically and systematically evaluated the execution performance of broker-dealers used to execute client transactions.
  • Not considering materially relevant factors during best execution reviews. The staff observed advisers that did not consider the full range and quality of a broker-dealer’s services in directing brokerage.
  • 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.
  • Failure to fully disclosing best execution practices in the firms’ Form ADV.
  • 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.
  • With respect to mixed-use allocations, 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.
  • Some advisers appeared to have inadequate compliance policies and procedures or internal controls regarding best execution, including procedures related to broker/dealer execution performance.
  • It was noted a number of advisers failed to follow their own policies regarding best execution review, including seeking comparisons from competing broker-dealers to test for pricing and execution, soft dollar allocation of expenses and or their internal policies regarding the ongoing monitoring of execution price, research, and responsiveness of their broker-dealers.

For the full text of the OCIE Risk Alert on best execution for advisers, click Here.