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News May 2, 2011 Issue

Notes On Best Execution

"This is an area where judgment is as important as understanding," said Mayer Brown partner Elizabeth Knoblock. "We’re talking about price and a lot of qualitative and quantitative factors," she said.

That observation began a best execution dialog among Knoblock, SEC Division of Investment Management Chief Counsel Doug Scheidt, and Clearbridge Advisors CCO Barbara Manning at the Investment Adviser Association annual Compliance Conference in March.

What justifies paying more than the lowest price available for a security?

The average commission rate is under three cents per share, said Knoblock. The rate a firm gets will depend on the firm’s size, what the firm can negotiate, and the asset class at issue – illiquid versus liquid, for example. The SEC is not a rate setting body, she said, the issue is one of market clout.

So much trading is done today without touching a single piece of paper, said Manning. Institutional traders are very big on using dark pools to preserve their anonymity. Trading venues can differ widely within the same broker-dealer. Algorithms, electronic communications networks, and old-fashioned, so-called "high-touch" trades are all employed to accomplish client trades. Different costs are associated with each.

What does the SEC look for?

The SEC is looking for comprehensive policies and procedures in this area, and that the firm appropriately addresses any conflicts, said Scheidt. There should be clear guidelines on broker-dealer selection. One question firms should be able to answer is whether the execution is consistent with client expectations.

"If you have a system like this then you have a story to tell," said Scheidt. It demonstrates why and how you do what you do.

Once a firm establishes its best execution program, it should not only adhere to it, but also evaluate it periodically. Business is dynamic and compliance systems should be, too. Tweaks going forward will ensure you’re doing your best for your clients. Then you are in a much more defensible position when the SEC comes in, said Scheidt.

There’s no particular focus on best execution issues currently on the staff that he was aware of, he said, but that can always change. The SEC staff will risk assess firm disclosures with respect to best execution practices to determine if further inquiry is warranted.

Check out the competition.

Now that adviser brochures will be publicly available, observed Knoblock, advisers should be going online, looking at competitor disclosures and thinking about whether and how they affect the adviser’s own business. Advisers should tailor their disclosures appropriately, and be ready to defend the disclosures to SEC regulators. The SEC can review all brochures of similarly situated advisers, she noted, and as a result staff questions in an examination will be more pointed.

Best execution is an exercise in post-trade analytics, said Knoblock. Larger firms should conduct post-trading analyses at least quarterly. Smaller firms may be able to reduce that to an annual exercise. The "flip side" of best execution is client directed brokerage. Disclosure is key there, said Knoblock. Clients should be aware that when self-directing brokerage, they may pay more for trade execution and it could be a lot more.