On July 11, 2018, the U.S. Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) issued a risk alert reminding investment advisers of their obligation to seek the best execution of trades for clients under the Investment Advisers Act of 1940 (Advisers Act). The alert sites the most common deficiencies noted by OCIE staff during its recent examinations.
Securities transactions must be executed in a manner that promotes the most favorable costs or proceeds for client trades. The rule does not necessarily require the lowest cost but the best qualitative execution, which means when engaging broker-dealer services, an adviser must consider the value of research, execution capability, commission rate, financial responsibility, and responsiveness of the broker-dealer.
When an adviser receives brokerage and research services (soft-dollar arrangements), he or she must make a reasonable allocation of the costs of the products or services according to their use and keep appropriate documentation of such allocation. The adviser must disclose all soft-dollar arrangements and provide detailed disclosures for arrangements that do not qualify for safe harbor rules under the Advisers Act.
Following are the most common deficiencies noted by OCIE staff:
Securities transactions must be executed in a manner that promotes the most favorable costs or proceeds for client trades. The rule does not necessarily require the lowest cost but the best qualitative execution, which means when engaging broker-dealer services, an adviser must consider the value of research, execution capability, commission rate, financial responsibility, and responsiveness of the broker-dealer.
When an adviser receives brokerage and research services (soft-dollar arrangements), he or she must make a reasonable allocation of the costs of the products or services according to their use and keep appropriate documentation of such allocation. The adviser must disclose all soft-dollar arrangements and provide detailed disclosures for arrangements that do not qualify for safe harbor rules under the Advisers Act.
Following are the most common deficiencies noted by OCIE staff:
- Not performing best execution reviews. Some advisers could not demonstrate their periodic and systematic evaluation of the execution of brokerage services used for client transactions. They either did not evaluate the services prior to the selection of the broker-dealer or were unable to produce documentation demonstrating such a process.
- Not considering materially relevant factors during best execution reviews. As part of their review, advisers did not evaluate material qualitative factors in brokerage services such as execution capability, financial responsibility, and responsiveness to the advisers. In addition, in certain situations they did not consider inputs from the advisers’ traders and portfolio managers.
- Not seeking comparisons from other broker-dealers. Advisers used certain broker-dealer services without comparing initially or on an ongoing basis quality and cost of services available from other broker-dealers. Advisers who used a single broker-dealer performed only cursory review of the broker-dealer’s policies and rates. When a broker-dealer’s own brief summary was used for evaluation, comparisons from other broker-dealers were not obtained.
- Not fully disclosing best execution practices. Advisers did not provide full disclosure of best execution practices. Advisers did not disclose that certain client accounts might trade the same securities that are traded for other client accounts or the potential impact on best execution of such trades. In addition, contrary to the statements in their brochures, the advisers did not review trade prices to ensure that prices fell within an acceptable range.
- Not disclosing soft-dollar arrangements. Advisers did not provide full and fair disclosure in Form ADV of their soft-dollar arrangements. The advisers did not disclose that certain clients would bear a higher percentage of such costs than other clients. There appeared to be a lack of adequate and accurate disclosure regarding products and services acquired with soft dollars that did not qualify as eligible brokerage and research services under the safe harbor rules of the Advisers Act.
- Not properly administering mixed-use allocations. Mixed use under the Advisers Act is when products or services obtained with client commissions also serve other functions that are related to the making of investment decisions. Advisers did not make reasonable allocation of the cost of mixed-use allocations, or they did not maintain adequate documentation supporting such allocations.
- Inadequate policies and procedures relating to best execution. Advisers had inadequate compliance policies and procedures or internal controls regarding best execution. Certain advisers with inadequate internal controls around best execution failed to monitor broker-dealer execution performance. Best execution policies appear to not take into account the current business or types of securities an adviser is trading.
- Not following best execution policies and procedures. Advisers did not follow their own policies and procedures including service provider comparison, not allocating soft dollars in accordance with their own policies, or monitoring of execution prices, research efforts, and responsiveness of their broker-dealers.