On July 11, 2018, the Office of Compliance Inspections and Examinations (OCIE) of the SEC published a National Exam Program Risk Alert (the Risk Alert) concerning compliance issues related to investment advisers’ best execution obligations under the Investment Advisers Act of 1940 (the Advisers Act). The Risk Alert is intended to highlight for advisers risks and issues associated with best execution that OCIE staff has identified in deficiency letters from over 1,500 adviser examinations. OCIE “encourages advisers to reflect upon their own practices, policies, and procedures in these areas.”
Background: Duty to Seek Best Execution
As fiduciaries, investment advisers owe their clients a duty of care, which includes, among other things, the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades. To satisfy this obligation, an adviser must seek to obtain the execution of transactions for each of its clients such that the client’s total cost or proceeds in each transaction are the most favorable under the circumstances; that is, the adviser should maximize value for the client given the particular circumstances. As the SEC stated in its proposed interpretation regarding the standard of conduct for investment advisers issued in April,1 maximizing value can encompass more than just minimizing cost—i.e., the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution. Thus, advisers should consider the full range and quality of a broker’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. The Risk Alert reminds advisers that they should periodically and systematically evaluate the execution quality of broker-dealers executing their clients’ transactions.
Compliance Issues Relating to Best Execution
Examples of common deficiencies associated with advisers’ best execution obligations observed by OCIE staff include the following:
- Not Performing Best Execution Reviews. Advisers failed to conduct periodic and systematic evaluations of the execution performance of broker-dealers used or did not maintain adequate records demonstrating that such evaluations occurred.
- Not Considering Materially Relevant Factors during Best Execution Reviews. Advisers failed to adequately evaluate the full range and quality of a broker-dealer’s services, including qualitative factors relating to a broker-dealer (such as execution capability, financial responsibility and responsiveness to the adviser), and did not solicit and review input from the adviser’s traders and portfolio managers in the brokerage selection process.
- Not Seeking Comparisons from Other Broker-Dealers. Advisers used certain broker-dealers or a single broker-dealer—initially and/or on an ongoing basis—without considering the quality and costs of services available from other broker-dealers, or after only performing a superficial review.
- Not Fully Disclosing Best Execution Practices. Advisers failed to fully disclose their best execution practices, such as not disclosing 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. OCIE also observed advisers that, contrary to their brochure disclosures, did not review trades to ensure that prices obtained fell within an acceptable range.
- Not Disclosing Soft Dollar Arrangements. Advisers failed to provide full and fair disclosure of their soft dollar arrangements in their brochures, including their use of such arrangements or the potential cost for clients (e.g., where certain clients may bear more of the cost of soft dollar arrangements than other clients).
- Not Properly Administering Mixed Use Allocations. Advisers did not appear to make reasonable allocations of the costs of mixed use products or services and/or did not document the reasoning for their decisions.
- Inadequate Policies and Procedures Relating to Best Execution. Advisers did not have sufficient best execution compliance policies and procedures or internal controls, demonstrated by the failure to monitor broker-dealer execution performance or policies not appropriately tailored to an adviser’s business and/or investment activities.
- Not Following Best Execution Policies and Procedures. Advisers did not comply with their best execution policies and procedures, including as to best execution review, soft dollar allocation and ongoing monitoring of broker-dealer performance.
The Risk Alert notes that “[t]he examinations within the scope of this review resulted in a range of actions.” In response to OCIE’s observations, some advisers took remedial actions that included amending disclosures regarding best execution or soft dollar arrangements, revising compliance policies and procedures, or otherwise changing practices regarding best execution or soft dollar arrangements.
The Risk Alert is available at: https://www.sec.gov/ocie/announcement/risk-alert-most-frequent-best-executionissues-cited-adviser-exams-1