On July 11, 2018, the SEC’s Office of Compliance Inspections and Examinations (OCIE) published a Risk Alert identifying the most common deficiencies that its staff observed in recent examinations of registered investment advisers’ best execution practices. As with prior OCIE Risk Alerts, investment advisers should carefully examine their compliance policies and procedures in light of the issues identified by OCIE and make improvements where necessary.
An investment adviser that has authority to select the broker-dealers that execute securities transactions for its clients has an obligation to seek “best execution.” That is, transactions should be executed “in such a manner that the client’s total costs or proceeds in each transaction are the most favorable under the circumstances.”
Best execution does not mean, however, “lowest cost.” Indeed, OCIE stated in the Risk Alert 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 [client’s] account.” In addition, an adviser’s assessment of best execution may be affected by whether or not it receives brokerage or research services under soft-dollar arrangements entered into under the safe harbor in Section 28(e) of the Securities Exchange Act of 1934, which enables an adviser to pay more than the lowest commission rate available for a particular trade without breaching its fiduciary obligations, provided that the conditions of Section 28(e) are met.
Common Compliance Issues
In the Risk Alert, OCIE reminds investment advisers that they have an obligation to perform periodic and systematic reviews of the execution quality obtained from broker-dealers executing their clients’ transactions. Investment advisers also have disclosure obligations related to their best execution policies and their use of soft dollars. According to OCIE, the SEC staff has identified several common deficiencies related to these obligations:
- OCIE said that some advisers could not demonstrate that they periodically and systematically evaluate whether their clients are receiving best execution. OCIE’s concerns relate not only to the actual failure to conduct such reviews, but also to advisers’ inability to demonstrate to OCIE staff that such reviews have been conducted. Investment advisers should ensure that their recordkeeping procedures include records documenting best execution reviews, and that the reviews occur no less frequently than annually.
- OCIE also said that some advisers did not consider the “full range and quality of a broker-dealer’s services” when directing brokerage. Investment advisers should ensure that their best execution procedures require its supervised persons to consider qualitative factors such as execution capability and financial responsibility, and that traders and portfolio managers have input into such assessments, when making a decision to send trades to a particular broker-dealer.
- OCIE took issue with advisers that directed trades to certain broker-dealers without comparing their services to those available from other broker-dealers. Investment advisers should be cautious about directing trades to a single broker-dealer without seeking competitive data. Moreover, investment advisers should not utilize a single broker-dealer based solely on a high-level review of its policies and prices.
- OCIE raised concerns about certain disclosure practices, including a failure to adequately disclose that allowing certain types of client accounts to trade after other accounts managed by the adviser had traded could affect execution prices. OCIE also said that they identified certain investment advisers that did not follow the best execution policies disclosed in their Form ADV or appropriately review trades to ensure that execution costs fell within a reasonable range.
- Investment advisers should also ensure that their Form ADV brochure includes full and fair disclosure of their soft-dollar arrangements. Among other things, OCIE raised concerns about disclosure related to the types of products and services acquired with soft dollars, or that some clients may bear more of the cost of soft-dollar arrangements than other clients.
- OCIE also said that some advisers did not appear to make a reasonable allocation of the cost of a mixed-use product or service (that is, one acquired with both soft and hard dollars), or could not adequately document the rationale for mixed-use allocations.
- More generally, OCIE raised concerns about advisers that have inadequate – or nonexistent – policies and procedures related to best execution, and those that are not appropriately following their best execution policies.
As with prior Risk Alerts, OCIE’s decision to broadly identify the types of deficiencies it is seeing with respect to best execution gives advisers an opportunity to review their existing policies and procedures, and to ensure that they have appropriately addressed the identified concerns in the context of their particular business. To the extent an investment adviser determines that its disclosures, policies, or procedures are lacking, it should proactively amend such documents (or otherwise change its practices) to address the deficiency. Moreover, when conducting its periodic reviews of best execution and the appropriate level of comparisons among broker-dealers, an investment adviser should ensure that it evaluates execution-related factors other than just the cost of execution, and should conduct such reviews in the context of its particular business.