OCIE Warns Advisers Regarding Best Execution Obligations

On July 11, 2018, the Securities and Exchange Commission (SEC) issued a risk alert outlining certain compliance issues identified by its Office of Compliance Inspections and Examinations (OCIE) related to the obligation to seek best execution under the Investment Advisers Act of 1940 (the Act).

Registered advisers should review their policies and practices in light of OCIE’s alert in order to ensure their compliance programs meet their obligations in this regard — and make any necessary improvements.

Under the Act, advisers’ fiduciary obligations require that when they select broker-dealers and execute client trades, they seek the “best execution” of client transactions, including by ensuring that the client’s total costs or proceeds are the most favorable under the circumstances in each transaction. Specifically, the SEC reiterated 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 managed account.” To that end, the SEC recommended that advisers “periodically and systematically evaluate the execution quality of broker-dealers executing their clients’ transactions.”

In this regard, OCIE indicated that an adviser’s receipt of soft dollars such as brokerage and research services as part of so-called soft dollar arrangements may affect an adviser's best execution assessment. While advisers’ fiduciary duty does not require them to pay the lowest-available rate for such services, OCIE stated that “an adviser should make a reasonable allocation of the costs of the product or service according to its use and keep adequate books and records concerning such allocation. Advisers must disclose soft dollar arrangements and must provide more detailed disclosure when the products or services they receive do not qualify for Section 28(e)’s safe harbor.”

The risk alert further elaborated on several of the most common deficiencies OCIE staff discovered during examinations of advisers’ best execution obligations. These included:

• Not performing best execution reviews — Certain advisers could not demonstrate they conducted periodic and systematic evaluations of the execution performance of the broker-dealers they used in connection with the execution of client transactions. In fact, OCIE staff noted that some advisers did not conduct a best execution evaluation when selecting a broker-dealer, while others were unable to demonstrate, through documentation or otherwise, that they performed such an evaluation.
• Not considering material factors during reviews — Staff observed that some advisers did not consider the full range and quality of a broker-dealer’s services. In this regard, the OCIE staff indicated that some advisers failed to evaluate any qualitative factors associated with the broker-dealer (including, but not limited to, the broker-dealer’s execution capability, financial responsibility and responsiveness to the adviser), and did not solicit or review input from the adviser’s traders and portfolio managers during a review of a broker-dealer’s services.
• Not seeking comparisons from other broker-dealers — Some advisers did not seek out or consider the quality and costs of services available from other competing broker-dealers, either initially or on an ongoing basis. Other advisers utilized a single broker-dealer “based solely on cursory reviews of the broker-dealer’s policies and prices” or relied solely on the broker-dealer’s “brief summary of its services without seeking comparisons from other broker-dealers,” making it impossible to determine whether they were meeting their best execution obligations.
• Not fully disclosing best execution practices — OCIE staff observed that some advisers did not provide full disclosure of best execution practices, including failing to disclose information 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. Other advisers did not fulfill representations made in their brochures that they would review trades to ensure that prices fell within an acceptable range.
• Not disclosing soft dollar arrangements — Certain advisers did not provide full and fair disclosure in Form ADV of their soft dollar arrangements, including their use of such arrangements or the potential cost for investors.
• Not properly administering mixed use allocations — Staff observed deficiencies related to mixed use allocations, such as advisers that 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 supporting reasons for such mixed use allocations.
• Inadequate best execution policies and procedures — Staff observed advisers that had inadequate compliance policies and procedures or internal controls regarding best execution. This included advisers that lacked any policy relating to best execution, and others that had insufficient internal controls due to their failure to monitor broker-dealer execution performance or had policies that did not consider the current business of the adviser, such as the type of securities traded.
• Not following best execution policies and procedures — The OCIE staff also noted that some advisers were not following their own policies and procedures regarding best execution, including some that did not follow policies regarding best execution review, seeking comparisons from competing broker-dealers or allocating soft dollar expenses.

In response to OCIE’s examinations, some advisers have modified their disclosures regarding best execution and/or soft dollar arrangements, revised their compliance policies and procedures, or otherwise updated their practices in these areas. OCIE encouraged advisers to review their own practices, policies and procedures in the outlined areas and make any required improvements in order to ensure their compliance programs meet their obligations.