OCIE issues risk alert on best execution
27 July 2018
The SEC’s Office of Compliance Inspections and Examinations (OCIE) released the second Risk Alert of 2018, identifying the most common deficiencies found by OCIE related to investment adviser equity trading practices. The findings were reported following recent examinations of advisers’ compliance with their best execution obligations under the Investment Advisers Act of 1940 (the Advisers Act), which sets out certain fiduciary standards related to the selection of broker-dealers executing trades on their behalf. The Advisers Act stipulates advisers have an obligation to obtain “best execution” when executing client trades or sending client trades for execution. The aim is for advisers to choose broker-dealers who provide the most favorable circumstances and at the lowest commission rates, taking into account other considerations such as the value of research provided, capital commitment, execution capability and responsiveness. Under Section 28(e) of the Securities Exchange Act of 1934 (the Exchange Act) the adviser can obtain research services through soft dollars at a higher commission rate than a standalone execution.
While this practice was banned across Europe post-MiFID II, the SEC issued a No Action letter in October of 2017 addressing how the manner in which a money manager can use client commissions to purchase “brokerage and research services” without breaching its fiduciary duty by allowing US advisers to continue to rely on the safe harbor of the Exchange Act under certain provisions.
In the chart below we outline the deficiencies and suggested strategies for addressing:
|Deficiency||What this means||What you should be doing|
|Not considering materially relevant factors during best execution reviews||OCIE identified advisers were not evaluating any qualitative factors relating to a broker-dealer’s services, such as receiving input from the portfolio managers.||Regularly assess trends, outcomes and use of brokers, and ensure sufficient and accurate data is captured to support the requirement. Factors to be considered should include research quality as ranked by portfolio managers, responsiveness, promptness and accuracy of confirmation statements, ability and willingness to commit capital, financial condition, and business reputation of the broker-dealer.|
|Not seeking comparisons from other broker-dealers||Advisers were also not assessing the quality and costs of services available from other broker-dealers and were utilizing a single broker-dealer based solely on cursory reviews of the broker-dealer’s policies and prices||Reviewing appropriate management information reports to assess the execution quality, exception reporting and highlight weaknesses of practices that require remediation. Best execution scorecards are a good mechanism to track this.|
|Not fully disclosing best execution practices, having inadequate policies and procedures relating to best execution and following best execution policies and procedures
|Certain advisers were not disclosing that certain types of client accounts may trade the same securities after other client accounts and therefore not taking into consideration the potential impact of this practice on execution prices.
Several advisers also did not have appropriate best execution policies and procedures in place and insufficient internal controls to monitor broker-dealer execution performance.Of the firms that did have policies and procedures in place, OCIE found instances where they were not appropriately being followed.
|Establish a best execution or broker oversight committee to provide oversight of the overall execution framework practices and outcomes. This will help to ensure that policies, procedures and monitoring controls are in place as well as serve as escalation point for execution related issues.|
|Not disclosing soft dollar arrangements||It is a requirement on Form ADV to disclose soft dollar arrangements and OCIE found that certain firms did not adequately disclose the usage of soft dollar arrangements. Additionally, there were several instances where advisers used soft dollars to procure services that are not permissible under the Section 28(e) safe harbor.||Material aspects of the brokerage practices firms need to be fully disclosed in Form ADV, describing the factors considered in selecting broker-dealers and determining the reasonableness of their commissions and trade allocations. Firm’s should review their best execution disclosures related to soft dollars in Form ADV and other client facing documents etc. to make sure they align with practice|
|Not properly administering mixed use allocations||There are certain items that can be purchased partially through commissions and the rest hard dollars (‘mix usage’ services). OCIE found that firms were not reasonably allocating the cost of a mixed use product or service according to its use or did not document the rationale behind calculating the mixed use.
|Review what is deemed as a ‘mix use’ service and provide documented rationale behind allowing it to be paid for, along with the breakdown.|
Regulators in Europe and the US have conflicting regulations governing best execution and commission spending practices, and the implementation of MiFID II in January 2018 brought even more attention to how divergent the practices are. Over the years the SEC has softened its approach that a fiduciary “has an obligation to obtain ‘best execution’ of clients’ transactions” to an expectation now where fiduciaries are required “to seek the best execution for client trades”. This contrasts with the standard required under MiFID II. Under the first iteration of MiFID, firms were required firms take “all reasonable steps” whereas firms now are required to take “all sufficient steps” when executing orders. MiFID II also introduced the concept of a completely unbundled equity trading environment, whereby MiFID firms were forced to either pay for research services out of P&L or introduce Research Payment Accounts (RPAs) which would operate similarly to the previous model (which was only seen as best practice) known as Commission Sharing Agreements (CSAs Because of the operational complexities associated with paying for research out of P&L, CSA/RPA adoption has continued to grow in the US The unbundling of services puts more focus on the actual cost of trading and impact of the performance and quality of a trading decision and its execution.
The OCIE Risk Alert makes it clear that the SEC sees best execution practices as an area of improvement for investment advisers. Therefore advisers should review and strengthen policies and controls, undertake more comprehensive reviews of whether their counterparties are helping them to achieve best execution, and place more focus on Transaction Cost Analysis (TCA). As with previous Risk Alerts, the SEC has provided insight on practices it views as deficient. What remains to be seen is whether the SEC may be looking follow suit to European regulation.
We can help
Regular monitoring of your procedures and the effectiveness of your reviews is critical to remaining in compliance with securities law. As part of our services, we can assist you in reviewing your compliance protocols, and work with you to develop a monitoring program that works for your business and culture, while also considering your specific risks and the SEC’s exam priorities.
We will revisit your policies and procedures, and test to make certain they are being followed in the day-to-day practice of your business, use monitoring and forensic methods to test your compliance and order management systems and identify potential gaps and assist with best execution and commission spend reviews and evaluate your trade blotters and trading practices.
Lastly our global reach enables us to stay on top of regulation across all jurisdictions and work with our clients to interpret regulation across the world.