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.

SEC Risk Alert: Business Continuity and Disaster Recovery Planning

The SEC has issued a new Risk Alert stemming from its observations of  the  business continuity and disaster recovery planning practices of  a number of  investment advisers.  The alert follows an National Examination Program (“NEP”) review of the plans of approximately 40 investment advisers following  Hurricane Sandy.  The SEC says the goal is to encourage investment advisers to review their business continuity and disaster recorvery plans (“BCPs”) to improve responses and recovery times for threats that might disrupt market operations.

Certain weakenesses observed, and that advisers would do well to heed,  include the following areas:

  • Preparation for widespread disruption. Some advisers whose BCPs did not adequately address and anticipate widespread events experienced more interruptions in their key business operations and inconsistent communications with clients and employees.
  • Planning for alternative locations.  Some advisers who switched to back-up sites or systems reported that the buildings where they usually conduct their business were closed for days.  At least, one adviser reported its building was closed for several weeks.  Other problems included extended outages of power, phone systems, and internet service and lack of geographically diverse office operations.
  • Preparedness of key vendors.  Some advisers failed to even evaluate the BCPs of their service providers or keep a list of vendor’s contact information.  Some advisers did not acquire or critically review service providers’ Statement on Standards for Attestation Engagements No. 16 reports. 
  • Telecommunications services and technology.  Some advisers failed to hire service providers to make sure back-up servers functioned properly, relying solely on self-maintenance, which led to more interruptions in their operations.
  • Communication plans.  Poor planning, inconsistencies and weak deployment in how to contact employees during a crisis.  Some plans did not identify which employees would execute and implement  various parts of the BCP.
  • Reviewing and testing.  Inadequate testing of operations and systems relative to size and nature of  advisory businesses.  Some problems here were based on adviser failures to conduct certain critical tests based on costs and other disincentives.  

The risk alert also encourages advisers to consider those best practices and lessons learned that were described in the Joint Review of Business Continuity and Disaster Recovery of Firms by the Commission’s National Examination Program, the Commodity Futures Trading Commission’s Division of Swap Dealers and Intermediary Oversight and the Financial Industry Regulatory Authority on August 16, 2013.  They are  available at http://www.sec.gov/about/offices/ocie/jointobservations-bcps08072013.pdf

While the alert serves as a friendly reminder, to avoid a potential enforcement action, the advice covered should be reviewed, and where appropriate, implemented.  The days of  preparing a boilerplate disaster recovery handbook to be left to collect dust on an adviser’s bookshelf have long passed.

SEC Risk Alert: Options Trading That Evades Short-Sale Rule Requirements

risk managementShort sale activity continues to be a significant focus of the SEC, particularly when it involves short sales without delivery, or “failures to deliver.”

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has now  issued a new Risk Alert raised by its examination staff’s observation that some options trading strategies are being used to evade the short-sale rule, Rule 10b-21.  The alert addresses the need for customers, broker-dealers and clearing firms to be aware of options trading activity that could be used to avoid complying with the close-out requirements of Reg SHO.

Under the rule,  it is fraudulent to sell an equity security if it deceives a person participating in the transaction about the seller’s  intention or ability to deliver the security by settlement date.  Rule 10b-21 covers such situations where a seller deceives a broker-dealer, participant of a registered clearing agency, or a purchaser about its intention to deliver securities by settlement date, and the seller then fails to deliver securities by settlement date.  The violative activity would include broker-dealers (including market makers) acting for their own accounts.  Broker-dealers could also be held liable for aiding and abetting a customer’s fraud under Rule 10b-21.

In addition to addressing, with examples, trading strategies that could be used to circumvent Reg SHO requirements, and other helpful ways that OCIE has observed that some firms have used to effectively detect and prevent violation of the rule, the alert provides summary guidance covering (a) Reg SHO Close-out Requirement; (b) Reg SHO Locate Requirement; (c) Rule 10b-21; (d) Key Trading Terms and Concepts; and (d) Option Activity Related to Hard to Borrow and/or Threshold Securities.