RISK ALERT: ADVISER BEST EXECUTION PRACTICES

The SEC National Exam Program has issued a new Risk Alert addressing some of the most common deficiencies associated with advisers’ best execution obligations identified by OCIE staff.  In addressing the deficiencies, the alert reminds advisers of existing requirement that in determining best execution an adviser must seek to obtain the execution of transactions for clients in such a manner that the client’s total cost in each transaction is the most favorable under the circumstances. “[T]he  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.” The SEC has brought enforcement actions against advisers who fail to meet this standard.

Common adviser best execution deficiencies that were observed by the staff include:

failure to demonstrate periodic and systematic evaluation of the execution performance of broker-dealers used to execute client transactions.

failure to consider the full range and quality of a broker-dealer’s services in directing brokerage.

failure to seek or consider the quality and costs of services available from other broker-dealers.

advisers who failed to provide full disclosure of best execution practices.

•failure to provide full and fair disclosure in Form ADV of their soft dollar arrangements.

•advisers who 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.”

•advisers that appeared to fail to have adequate compliance policies and procedures or internal controls for best execution.

advisers who failed to follow their policies and procedures regarding best execution, including failing to seek comparisons from competing broker-dealers to test for pricing and execution, not allocating soft dollar expenses in accordance with their policies, and not conducting ongoing monitoring of execution price, research, and responsiveness of their broker-dealers.

Advisers should remember that as fiduciaries, they have a duty to obtain best execution in client transactions. The alert list several actions advisers may want to consider when cleaning up such deficiencies.  Actions that might be taken by advisers include, amending their best execution or soft dollar arrangements disclosures, revising compliance policies and procedures, and changing their practices regarding best execution or soft dollar arrangements.

ACHIEVING “BEST EXECUTION” AND RECENT SEC ENFORCEMENT

Two SEC enforcement cases last week demonstrate (i) how using affiliated brokerage on an agency or principal basis raises potential conflicts of interest  when dealing with ” best execution” concerns , and (ii) the importance of having robust best execution policies and procedures and then following them.  In both cases, the SEC sanctioned investment advisers for not heeding these concerns in failing to seek best execution on client trades placed through in-house brokerage divisions.

While the duty of an adviser or fund to seek best execution may not expressly be stated in the federal securities laws, to the extent they are typical, these cases tend to follow a pattern:  An SEC best execution enforcement action might involve the SEC’s examination staff first finding that a firm failed to disclose compensation on client brokerage, failed to adequately its brokerage practices or failed to properly disclose to clients the adviser’s best execution policies and procedures.  The two recent cases are no exception.

In the first case against A.R. Schmeidler & Co. (ARS), a dually registered investment adviser and a broker-dealer, the SEC found that ARS failed to reevaluate whether it was providing best execution for its advisory clients when it negotiated more favorable terms with its clearing firm.  This resulted in ARS retaining a greater share of the commissions it received from clients, a best execution violation.  The SEC found that the firm also failed to implement policies and procedures reasonably designed to prevent the best execution violations.  To settle the SEC charges, ARS agreed to pay disgorgement of $757,876.88, prejudgment interest of $78,688.57, and a penalty of $175,000.  The firm also must engage an independent compliance consultant, and had to consent to a censure and cease-and-desist order.

The second case involved a CEO who also served as Chief Compliance Officer officer, Goelzer, and his Indianapolis-based dually registered firm Goelzer Investment Management (GIM).  The SEC found that GIM made misrepresentations in its Form ADV about the process of selecting itself as broker for advisory clients.  The SEC found that GIM failed to seek best execution for its clients by neglecting to conduct the comparative analysis of brokerage options described in its Form ADV, and recommended itself as broker for its advisory clients without evaluating other introducing-broker options as the firm represented it would.  Goelzer and GIM agreed to pay nearly $500,000 to settle the charges that included GIM paying disgorgement of $309,994, prejudgment interest of $53,799, and a penalty of $100,000.  The firm was also required to comply with certain undertakings, including the continued use of a compliance consultant and the separation of its chief compliance officer position from the firm’s business function.  Goelzer agreed to pay a $35,000 penalty, and Goelzer and GIM consented to censures and cease-and-desist orders.

What are some of the lessons for advisers and funds engaged in managing potential conflicts related to best execution?

While the SEC provides no specific definition of “best execution,” it has said that managers should seek to execute securities transactions for clients in such a manner that the client’s total cost or net proceeds in each transaction is most favorable under the circumstances. The determinative factor is not necessarily the lowest commission cost, but whether the transaction represents the best qualitative execution for the managed account.  So what  should advisers learn from these cases?    

  • Recognize the importance of having strong written policies and procedures that provide guidance concerning the quality of trade execution while, at the same time, attending client investment objectives and constraints.
  • Make sure that disclosures in Form ADV and elsewhere include information about trading and actual and potential trading conflicts of interest.
  • Document compliance with best execution policies and procedures and disclosures to clients.
  • Consider setting up a brokerage or trade management committee to review trade placement and best execution. The committee should address such topics as broker trading cost and execution, brokerage expertise and infrastructure and the broker’s willingness to explore alternative trading options.
  • Test for best execution, including possibly hiring a third party service provider to periodically assess the broker’s capacity to evaluate which competing markets, market makers, or electronic communication networks (ECNs) offer the most favorable terms of execution, the speed of execution, and the likelihood that the trade will be executed.   

There are numerous sources to consult when thinking about and developing best execution policies.  A few advisers might want to consider include:  Trade Management Guidelines (Nov. 2002), available at www.dfainstitute.org/standards/ethics/tmg; See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170 (Apr. 23, 1986) (“1986 Soft Dollar Release”); Lori Richards, Valuation, Trading, and Disclosure: The Compliance Imperative, Remarks at the 2001 Mutual Fund Compliance Conference of the Investment Company Institute (June 14, 2001), available at www.sec.gov/news/speech/spch499.htm.   

In statements following these cases, the SEC warned all investment advisers with affiliated broker-dealers that it would hold them accountable to ensure clients are obtaining the most beneficial terms reasonably available for their orders.