On July 11, 2018, the Office of Compliance Inspections and Examinations (“OCIE”) of the Securities and Exchange Commission published a Risk Alert relating to best execution deficiencies on the part of investment advisers. Under section 28(e) of the Securities and Exchange Act of 1934 (the “Act”), as a fiduciary, an adviser with responsibility to direct client trades is obligated to seek “best execution” in client transactions. This encompasses evaluating the full range and quality of a broker-dealer’s services such as transaction costs, execution capability, the firm’s financial wherewithal, and responsiveness to the investment adviser. This duty is broader than the best execution requirement to which registered representatives are subject under FINRA Rule 5310, which focuses primarily on execution costs. (Best execution was also a topic in FINRA’s December 2017 report on its examination findings, which we discussed in a prior Law Alert, OCIE noted that “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.”
OCIE also noted that best execution could be impacted by the adviser’s receipt of soft dollar arrangements. Section 28(e) of the Act provides a safe harbor to money managers who use the commission dollars of their advised accounts to obtain investment research and brokerage services “soft dollar arrangements”), provided that certain conditions are satisfied. Where a product or service obtained with client commissions also serves other functions unrelated to investment decisions (“mixed use”), the adviser must make a reasonable allocation of a mixed use product or service and keep adequate books. The adviser must also disclose soft dollar arrangements and such disclosure should be more detailed when the products or services fall outside of the section 28(e) safe harbor.
The Risk Alert identified common deficiencies from examinations of over 1,500 investment advisers. The most common deficiencies identified by OCIE staff include:
- Failure by advisers to perform periodic execution performance by broker-dealers;
- Failing to consider materially relevant factors during best execution reviews such as execution capability, financial responsibility, responsiveness, input from traders and portfolio managers;
- Comparing performance to other broker-dealers;
- Failure to fully disclose best execution practices;
- Failing to disclose soft dollar arrangements;
- Improper administration of mixed use allocations;
- Inadequate best execution policies and procedures; and
- Failing to follow existing best execution policies and procedures.
Takeaways
Registered investment advisers and broker-dealers should review existing best execution policies and procedures to ensure they do not suffer from the same deficiencies as those described in the Risk Alert or in the December 2017 Report on FINRA Examination Findings, as applicable. Note that a Letter of Acceptance, Waiver and Consent (“AWC”) was recently issued which provided for censure and a fine by FINRA where it found that a firm’s supervisory systems were not reasonably designed to achieve best execution.
Please contact Stephen Wilkes if you have any questions.