OCIE Reveals Most Common Best Execution Deficiencies Found by Examiners
Wouldn’t it be great to know what examiners expect to find – and, as a result, will be looking for – when they visit? In the area of best execution, at least, that is no longer a mystery. The SEC’s Office of Compliance Inspections and Examinations on July 11 released a risk alert containing "the most common deficiencies associated with advisers’ best execution obligations identified by OCIE staff."
The list, containing eight best execution deficiencies, joins past lists of common deficiencies released by OCIE that examiners have found in other areas, including advertising, fees and expenses, and the most frequent deficiencies across all topic lines. With that in mind, advisers might be wise to anticipate future OCIE lists covering most common deficiencies in areas like custody, books and records, disclosures and more – although the agency has not yet announced if such lists are forthcoming.
OCIE, in releasing the best execution list, said it was doing so to "provide investment advisers, investors and other market participants with information concerning many of the most common deficiencies that the staff has cited in recent examinations of advisers’ compliance with their best execution obligations under the Investment Advisers Act of 1940."
"It’s good that the SEC staff is doing this," said Mayer Brown partner Adam Kanter. "From the perspective of an external law firm, the attorney may make suggestions to a client, and the client will sometimes say, ‘Show me where it says I have to do this.’ Risk alerts like this one and others from the SEC provide that kind of information. Nothing beats having it come straight from the horse’s mouth."
From an advisory firm’s perspective, he said, "it’s helpful for a chief compliance officer to go through the risk alert as a kind of checklist. ‘Do we evaluate qualitative factors, as the risk alert says we should do? Do our meeting minutes reflect this?’ You can do this for pretty much everything listed in this risk alert."
The risk alert "covers no new ground, but it is a reminder about fundamental things that advisers need to be doing," said Sidley Austin counsel Kara Brown. "Since there is no actual rule that specifically addresses best execution, a risk alert containing guidance like this is very helpful."
After reading the alert, advisers would be wise to take a new look at their policies and procedures and make sure that the firm is following the directions they provide, such as seeking pricing quotes from multiple broker-dealers when seeking best execution. "Also, if there are factors they look at in best execution that are not currently included in their procedures, they should work them in, as advisers should attempt to make their best execution analysis as prescriptive as appropriate, rather than ad hoc."
Fiduciary duty and best execution
In the alert, OCIE notes that the Advisers Act includes a fiduciary standard for advisers. It points to two cases to support this position. In the first, Transamerica Mortgage Advisors, Inc. v. Lewis from 1979, it quotes the settlement order as stating that "[Section] 206 established federal fiduciary standards to govern the conduct of investment advisers." The second case it cites in support of its proposition is SEC v. Capital Gains Research Bureau, Inc. from 1963, from which it quotes that "the Investment Advisers Act of 1940 thus reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship."
"As a fiduciary, when an adviser has the responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek to obtain ‘best execution’ of client transactions, taking into consideration the circumstances of the particular transaction," OCIE said. Doing so, however, does not always mean that an adviser must always take the arrangement with the lowest possible commission. "The determinative factor [in the adviser’s best execution analysis] is not the lowest possible commission cost, but whether the transaction represents the best qualitative execution for the managed account."
Other factors to consider for best execution, in addition to commission, include the full range and quality of a broker-dealer’s services, the value of research provided, financial responsibility, responsiveness to the adviser, and the use of soft dollars. Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor that allows advisory firms to pay more than the lowest commission rate because of soft dollar arrangements without breaching its fiduciary obligation, if certain conditions are met. Those conditions include a reasonable allocation of the costs involved, the keeping of adequate books and records, and disclosure of the soft dollar arrangements.
Most common deficiencies
The list of eight deficiencies provided by OCIE offers only some of the best execution deficiencies examiners found, the agency said. Further, the risk alert does not appear to list the deficiencies in any discernable order, such as most common, or even alphabetically.
Not performing best execution reviews. "The staff observed advisers that could not demonstrate that they periodically and systematically evaluated the execution performance of broker-dealers used to execute client transactions," OCIE said. As an example, it noted that examiners found advisers that did not conduct an evaluation of best execution when selecting a broker-dealer, or that were unable to demonstrate, either through documentation or some other way, that they had done so.
Not considering materially relevant factors during best execution reviews. Advisers "did not consider the full range and quality of a broker-dealer’s services in directing brokerage," the agency said. As examples, it noted that advisers, in doing their best execution reviews, "did not evaluate any qualitative factors relating to a broker-dealer including, among other things, the broker-dealer’s execution capability, financial responsibility, and responsiveness to the adviser." In addition, it found that advisers, as part of their best execution reviews, "did not solicit and review input from the adviser’s traders and portfolio managers," OCIE said.
Not seeking comparisons from other broker-dealers. Some advisers were found using certain broker-dealers when that adviser did not seek out or consider the quality and costs of services from other broker-dealers, the risk alert says. As examples, OCIE noted that some advisers "utilized a single broker-dealer for all clients without seeking comparisons from competing broker-dealers initially and/or on an ongoing basis to assess their chosen broker-dealer’s execution performance," "utilized a single broker-dealer based solely on cursory reviews of the broker-dealer’s policies and procedures," or "utilized a broker-dealer based solely on that broker-dealer’s brief summary of its services without seeking comparisons from other broker-dealers."
Not fully disclosing best execution practices. In this category, examiners observed advisers that failed to disclose that certain types of client accounts may trade the same securities after other client accounts and "the potential impact of this practice on execution practices," OCIE said. The staff also found advisers that, "contrary to statements in their brochures, did not review trades to ensure that prices obtained fell within an acceptable range."
Not disclosing soft dollar arrangements. Full and fair disclosure in Form ADV of these arrangements was not always provided, according to the risk alert. Examples of this provided in the risk alert included observations by the staff that advisers: did not appear to adequately disclose the use of soft dollar arrangements, did not disclose that certain clients may bear more of the cost of soft dollar arrangements than other clients, and did not appear to provide adequate or accurate disclosure regarding products and services acquired with soft dollars that did not qualify as eligible brokerage and research services under Section 28(e) safe harbor.
Not properly administering mixed use allocations. In this category, "the staff observed advisers that did not appear to make a reasonable allocation of the cost of a mixed use product or services according to its use or did not produce support, through documentation or otherwise, of the rationale for mixed use allocations," the risk alert says.
Inadequate best execution policies and procedures. Examiners, according to the risk alert, found advisers that "appeared to have inadequate compliance policies and procedures or internal controls regarding best execution," OCIE said. It provided three examples: 1) advisers that did not have any policies relating to best execution; 2) advisers with insufficient internal controls because the advisers failed to monitor broker-dealer execution performance; and 3) advisers with policies that did not take into account the current business of the adviser, including the type of securities traded.
Not following best execution policies and procedures. Even if you have the policies and procedures, examiners will still cite you for failing to follow them, which, in their eyes, is often worse than not having the policies and procedures at all. It’s like saying, "I knew what to do, but I chose not to do it." Here, examiners found three examples where best execution policies and procedures did not appear to have been followed. The first, according to the risk alert, involved advisers "that did not follow their own policies regarding best execution review, including seeking comparisons from competing broker-dealers to test for pricing and execution." The second involved advisers that "did not allocate soft dollar expenses in accordance with their policies," and the third was about "advisers that did not follow their internal procedures regarding the ongoing monitoring of execution price, research and responsiveness of their broker-dealers."
What should advisory firms do if any of the descriptions above match their own practices? According to OCIE, the examinations within the review "resulted in a range of actions" from the advisory firms where they were found to exist. "Some advisers elected to amend their disclosures regarding best execution or soft dollar arrangements, revise their compliance policies and procedures, or otherwise change their practices regarding best execution or soft dollar arrangements."
Sounds like OCIE is suggesting that advisers reading this risk alert do the same. In case there is any doubt, the examination agency said that it "encourages advisers to reflect upon their own practices, policies and procedures in these areas and to promote improvements in adviser compliance programs."