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News November 22, 2004 Issue

Seeking Best Ex: Compliance Department Shouldn’t Go it Alone

The compliance department shouldnít be the only group in the firm seeking best execution.

At last monthís NRS conference, co-panelists James Anderson, partner at Wilmer Cutler Pickering Hale and Dorr, and Barbara Brooke Manning, CCO of Schroder Investment Management, emphasized the need to involve the firmís business line in overseeing trading activities. "Set up an oversight system that doesnít depend solely on the role of the compliance officer," said Anderson, noting that the firmís portfolio managers, traders, and operations personnel all could be involved in the process.

Manning agreed. "You really have to address how the business ó not compliance ó is going to determine whether or not it is getting best execution for its clients," she said.

With that in mind, here are a number of best-ex related tips from their presentation:

Hold a broker vote and set a budget. The practice of holding a broker vote is "very common" among institutional money managers, said Manning. Typically, a firmís portfolio managers, analysts, and traders will get together and vote on the brokers that they plan to use. Manning said that this is done at her firm semiannually. Based on the results of the vote, the firm will pick the ten or so brokers that it intends to direct the most business to and create an annual budget, which Manning described as a "target." She emphasized that her firm expects to receive best execution from each broker on the list.

Anderson agreed that it makes sense to have a process where the firm identifies brokers and sets up a budget in advance, and therefore is able to demonstrate to regulators that the firm has "thought about" the selection of brokers. "You are less likely to be second guessed" by establishing a process in advance, he said. "It doesnít seem like you are doing it by the seat of your pants." Having a plan in place, he added, "gives you a lot of credibility with the regulators."

Consider whether to measure your execution costs. Manning said that her firm uses Plexus to measure the performance of the brokers they use, as well as the performance of her firmís traders and even that of the firmís portfolio managers. For example, Plexus will look to see if portfolio managers feed out a small trade and then, the next day, increase the order. "There is a measure of how effective or not effective that is," she said. One conference attendee noted, however, that the use of outside execution measurement services may not make as much sense for smaller firms with low trading volume.

Form a trading performance review committee. Manning said that her firm has a global trading performance review committee as well as various regional committees. Each committee meets quarterly and reviews execution, the performance of the brokers utilized, use as well as performance of the firmís traders. She said that the committees are not part of the firmís compliance department (although she said that she sits on the trading committee in her firmís New York office, where she is located). Instead, she said, "they are part of the procedures that the business undertakes to see that if gets best execution."

Document the reason behind outlier trades. Anderson noted that when looking at an adviserís executions, SEC examiners often go "trade-by-trade down the list" and may focus on instances where the firm paid more than, say, five cents per share. Of course, as Anderson pointed out, "there is an art to trading, itís not all science." His advice: review trades and document the reason for outliers. The explanation might be along the lines of "the trader said next time we have to sell a security on short notice and we need somebody to commit their own capital, heís going to work with us."

Have the business line, not compliance, perform daily reviews. Anderson suggested that the firmís portfolio manager or its chief investment officer review trading records every day, rather than the firmís compliance department. A compliance officer, he said, might perform periodic testing on a weekly or bi-weekly basis. Anderson said that if he was a compliance officer, "Iíd try to get myself off the hook for doing it on a daily basis." His advice: "Make a business person stand up and say ĎAll right, Iíve looked at it, weíve followed the rules, we did what weíre supposed to doí." Otherwise, he said, compliance is "going to be completely overwhelmed." The business people "need to step up and take responsibility for their business," he added.

Determine what percentage of brokerage commissions will be used for soft dollars. Manning said that she is responsible for signing off on products that come within 28(e) from a legal perspective, but that the decision of whether a particular product is valuable or not is made by the firmís business line. She noted that it is important to have the right documentation for review. And, she added, if faced with a choice between softing one product or another because of a small budget, "I would soft the one that is 100 percent softable as opposed to doing the mixed use . . . . that just makes it easier." Manning said that it is "imperative" that business review the soft dollar budget at least annually and make the determination that the product is worth the brokerage that is being paid for it.

What if you are behind your target? If, at the end of a quarter, the firm finds itself doing a tremendous amount of trading with one particular broker-dealer in order to satisfy a soft dollar commitment, "that should be a warning sign to compliance personnel," said Anderson. The risk, he explained, is that regulators will question whether the firm is turning over accounts for no good reason, in order to hit the soft dollar commitment. Increased trading with one broker, to the exclusion of others, implies that the firm is trading with that broker irrespective of its obligation to get best execution, he added. "Thereís going to be a lot more scrutiny of your best execution determination if all of a sudden you are going to the same place over and over again," said Anderson. "Were you getting best execution or did you forget about best execution in order to satisfy your soft dollar obligations?"

Manning suggested that traders update actual versus targeted commissions on a monthly basis so that any shortfall is addressed sooner, rather than later.

Donít forget about fixed income. Anderson noted that SEC examinations over the past few years have increasingly focused on best ex in the fixed income context. Manning indicated that her firm reviews fixed income executions using a slightly different process than equity executions. On the buy side, she noted that the prevailing view in the industry is that since price is a significant component of yield, "a portfolio manager is not going to buy a bond that he doesnít think is being offered at a good price." On the sell side, "to the extent that . . . we can get multiple bids, we will get that." Those multiple bids are documented by the portfolio managers, she said.

Anderson noted that his firm is involved in crafting fixed income best execution procedures for several clients. He agreed that when selling a bond, "one of the things you can do is just document multiple bids." If a firm has attempted to obtain multiple bids from reputable brokers, and has documented those bids, "itís hard to quibble with the idea that at the end of the day you took the best bid you got." On the buy side, he said, "itís more difficult" to determine best execution. But Anderson noted that the SEC staff has emphasized the need for advisers to build a process around best execution. His advice: form a committee, consider the available data, and make an effort to form a judgment on fixed income executions on the basis of that data.