Issues that Create Best Execution Problems and How to Resolve Them
Advisers have the responsibility of always seeking best execution for their clients. Doing so, however, is not as easy as it may initially sound – and advisers may find themselves in situations where they unexpectedly face issues that, in addition to being problems in and of themselves, create best execution problems. Advisers should be aware of when these may arise and how to handle them.
The SEC defines best execution as "seeking the best price for a security in the marketplace as well as ensuring that, in executing client transactions, clients do not incur unnecessary brokerage costs and charges."
It’s not as simple as that, of course. Advisers are not always obligated to get the lowest possible commission cost for their clients. There may be situations where it makes sense to pay a broker a bit more in exchange for a better qualitative execution, or because of added services that are deemed necessary, such as paying for research through soft dollars – which the SEC recognizes as legitimate, assuming all terms and conditions are met.
"Best execution is not easy to define," said Stradley Ronon partner Lawrence Stadulis. "It’s the best execution under the circumstances."
Trading-related issues that are not by themselves best execution problems, such as conflicts of interest or use of affiliated brokers, may not always lead to best execution problems, but they can, said Faegre Baker Daniels partner Jeffrey Blumberg.
Most best execution problems occur when advisory firms "do not have good internal procedures, such as an advisory firm that does not have a brokerage committee," said Mayer Brown attorney Adam Kanter. Advisory firms should also make a point of creating written policies and procedures to periodically monitor the brokers through which they trade and whether rates are competitive, said Stadulis.
Look out for these
Following is a list of issues that may result in best execution problems, as well as how to avoid and handle them.
Adviser fails to disclose use of directed brokerage. This occurs when there is a directed brokerage situation, and the adviser fails to disclose this fact, or the fact that there are lower commissions elsewhere, to the client. Typically, said Kanter, either the adviser effectively requires the client to direct it to place all trades through a particular broker-dealer, or the client independently insists that his or her trades go through a preferred broker-dealer. There may also be situations where the adviser is using a broker’s mutual fund platform to place all mutual fund trades. "Without proper disclosure, the adviser is not acting consistently with its duty to seek best execution," he said.
Undisclosed use of an affiliated broker. If the advisory firm has an affiliated broker that it uses from time to time and that broker may be executing some of the client’s transactions, that information needs to be disclosed to the client. There may be questions as to whether the affiliated broker will perform as well as a large brokerage house, like Morgan Stanley, said Kanter. The key here, aside from disclosure, "is having robust internal procedures on how to seek best execution, such as having a brokerage committee that looks at how the affiliated broker performs on quarterly basis. Was the price good? Was the execution as good as that provided by other brokers?"
Incorrect use of soft dollars. The SEC allows clients to be charged for using of what are known as "soft dollars" – money spent to pay for specific items that are seen as aiding investments, such as research. Use of soft dollars can be complicated, however, as they must fit within a specific safe harbor provided under the Securities Exchange Act of 1934 that, indirectly, allows for their use. If soft dollars are used outside the safe harbor, that can cause problems for the adviser and the broker in terms of best execution of client trades, said Kanter. "It gets more complex when other soft dollars are used to pay for things where they are partially paid for within the safe harbor, with the balance paid with ‘hard’ dollars.’" In addition, he said, since soft dollars result in higher commissions charged to the client, "there is an incentive to use certain brokers that provide, say, research reports, in order to authorize the soft dollars through that broker – and that broker may not have the best quantitative execution available for the type of investment in question." The solution here is to have the necessary internal procedures to review the quality and quantity of trading – and, as always, disclosure.
Cross trades where one party is favored over the other. Best execution can be difficult when an adviser is handling a cross trade between two of its clients. While the best outcome would be to strike a price at the midpoint between the bid and ask price, "sometimes that isn’t possible, or people screw up, and do it at a bad price," said Kanter. "This is particularly risky when the securities being traded are illiquid or thinly traded and there isn’t a good market price." The best way an adviser can protect itself and show that best execution was sought would be to document how the transaction price was reached.
Conflicts of interest. There may be significant issues with best execution when there is a conflict of interest between the advisory firm and the broker-dealer because the adviser or one of its employees has, say, an ownership interest in the broker. That advisory firm may choose the brokerage firm where its money is invested for reasons other than best execution for the client. "In this kind of conflict, you’d probably start with disclosure, but it would have to be quite robust, given the inherent self-enrichment when a material financial interest is involved," said Kanter.
Advisers should also expect the issue of best execution to come up during examinations.
"As part of a routine exam, the SEC commonly addresses best execution, and if an adviser has no process established around its best execution obligations, the agency will certainly include that fact as a significant deficiency," Blumberg said. "The SEC expects to see a robust process (for example, a best execution committee that meets on a regular basis and reviews the firm’s use of brokerage firms) for determining whether an adviser is pursuing best execution for its clients."
The key for that robust process, he said, is "tailoring it to the specifics of your firm – for instance, in determining who should be part of that committee, you would usually expect to see individuals from operations, portfolio management, trading and compliance at a minimum.
In addition, Blumberg said, the committee should create written reviews that reflect the analysis and decisions the committee makes with respect to approved brokers for the firm’s trading activity. "These reviews should include all of the relevant facts considered in determining whether a broker would or would not be approved such as execution cost, ability to handle large trades or thin issues, financial health, access to IPOs, and more."