On July 11, the Office of Compliance Inspections and Examinations (OCIE) of the Securities and Exchange Commission issued a Risk Alert to provide investment advisers and other market participants with information concerning many of the most common deficiencies that OCIE staff has found in recent examinations of investment advisers’ compliance with their best execution obligations under the Investment Advisers Act of 1940 (the “Advisers Act”). The Advisers Act best execution obligation requires an investment adviser to execute securities transactions for clients in such a manner that the client’s total costs, or proceeds in each transaction, are the most favorable under the circumstances taking into consideration the full range and quality of a broker-dealer’s services including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the investment adviser. Furthermore, an investment adviser should periodically evaluate the execution quality of broker-dealers executing their clients’ transactions.
In evaluating best execution, an investment adviser who is in receipt of brokerage and research services (“soft dollar arrangements”) covered by Section 28(e) of the Securities Exchange Act of 1934 (“Section 28(e) Safe Harbor”) may pay more than the lowest commission rate to receive such brokerage and research without breaching its best execution obligation. However, if an investment adviser receives products or services that are used for both eligible Section 28(e) brokerage and research and other functions (“mixed use”) the adviser must make a reasonable allocation of the costs of the products or services according to their use. Specifically, to be able to rely on the 28(e) Safe Harbor with respect to mixed-use items, the investment adviser may pay for the portions of the product or service used for Section 28(e) eligible brokerage and research with commission dollars while the portions of the product or service used for other purposes must be paid for by the investment adviser from its own assets. Furthermore, the investment adviser must maintain adequate books and records regarding such allocations.
The Risk Alert provided the following examples of the most common deficiencies observed by the OCIE staff associated with investment advisers’ best execution obligations:
- Not performing best execution reviews. Certain investment advisers could not demonstrate that they periodically and systematically evaluated the execution performance of broker-dealers used to execute client transactions.
- Not considering materially relevant factors during best execution reviews. Certain investment advisers did not consider the full range and quality of a broker-dealer’s services in directing brokerage, including evaluating qualitative factors relating to a broker-dealer or not soliciting and reviewing input from the investment adviser’s traders and portfolio managers during the review.
- Not seeking comparisons from other broker-dealers. Certain investment advisers utilized certain broker-dealers without seeking out or considering the quality and costs of services available from other broker-dealers.
- Not fully disclosing best execution practices. Certain investment advisers did not provide full disclosure of best execution practices. For example, certain investment advisers did not disclose that certain types of client accounts may trade the same securities after other client accounts or the potential impact of this practice on execution prices.
- Not disclosing soft dollar arrangements. Certain investment advisers did not appear to provide full and fair disclosure in Form ADV of their soft dollar arrangements. Examples of inadequate disclosures included: improperly disclosing the use of soft dollar arrangements, not disclosing that certain clients may bear more of the cost of soft dollar arrangements, and not disclosing that certain products and services acquired by soft dollars were not eligible under Section 28(e) of the Securities Exchange Act of 1934.
- Not properly administering mixed use allocations. Certain investment advisers did not appear to make a reasonable allocation of the cost of a mixed use product or service or did not produce support of the rationale for mixed use allocations.
- Inadequate policies and procedures relating to best execution. / Not following best execution policies and procedures. Certain investment advisers did not appear to have adequate compliance policies and procedures or internal controls regarding best execution. Alternatively, certain investment advisers did not follow their policies and procedures regarding best execution. Examples of policies not followed included best execution review policies and soft dollar expense allocations policies, and ongoing monitoring policies.
The Risk Alert is available here.