When an investment adviser serves as an asset manager and has the responsibility to select broker-dealers and execute client trades, the adviser assumes a fiduciary obligation to seek best execution. The discretionary control exercised by advisers in directing transactions to broker-dealers means they must pay close attention to how the broker-dealers they use manage the costs, quality and conflicts associated with trading.
Best execution may not be a top-of-mind issue for investment advisers, but the SEC is working hard to change that, with help from Finra. Both regulators have a history of including best execution on their annual lists of examination priorities, and their attention to the topic is intensifying.
The Financial Industry Regulatory Authority Inc., in its list of examination priorities for 2019, said that it is "concerned about [broker-dealer] firms failing to use reasonable diligence to assure that their customer order flow is directed to the best market given the size and types of transactions, the terms and conditions of orders and other factors." Finra has put firms on notice that it will be examining "how firms quantify the benefits to customers from firms' receipt of order routing inducements and how firms manage the conflict of interest between their duty of best execution and any inducements they receive from the routing or internalization of customer orders."
In July, the Securities and Exchange Commission's Office of Compliance Inspections and Examinations issued a national exam program risk alert summarizing the most common best-execution deficiencies found in recent examinations of investment advisers.
As described in the alert, the duty of best-execution requires an adviser to "execute 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." Further, the adviser is to "consider the full range and quality of a broker-dealer's services." Following selection, the adviser is expected to "periodically and systematically evaluate the execution quality of broker-dealers executing their clients' transactions."
The risk alert highlighted these six most frequent best-execution issues identified in deficiency letters associated with over 1,500 examinations:
• Not performing periodic and systematic best-execution reviews.
• Not considering materially relevant factors during best-execution reviews.
• Not seeking comparisons from other broker-dealers.
• Not fully disclosing best-execution practices.
• Not disclosing the use of soft dollar arrangements, how they operate and cost considerations.
• Weak best-execution policies and procedures or failure to follow policies and procedures.
The inverse of each deficiency necessarily points to a practice that advisers should follow. The last one is most important because it points to the importance of having and following prudent policies and procedures that cover all major responsibilities, including the ones associated with the other five deficiencies.
The following are suggested best-execution policies and practices for investment advisers drawn from the list of deficiencies and other regulatory guidance:
• Assign responsibility for broker-dealer selection and monitoring, and establish procedures for periodic and systematic best-execution reviews.
• Evaluate materially relevant factors during best-execution reviews covering the full range and quality of the broker-dealers' services, including securities pricing, execution capabilities and quality, commission rate, financial responsibility and reliability, responsiveness to the adviser, value of research and other available services, conflicts and conflict management practices, and adequacy of policies and procedures governing best execution.
• Evaluate differences in best-execution capabilities of broker-dealers across different markets in which trading will be conducted (e.g., equities versus fixed income).
• Compare the materially relevant quantitative and qualitative factors of current broker-dealers providing trade execution services to the adviser versus those of competing broker-dealers.
• Evaluate soft dollar arrangements to determine if they comply with (Section 28(e)) safe harbor requirements that the value of the services received justifies the cost involved, that costs are properly allocated to clients to reflect the relative value received and that conflicts of interest are satisfactorily managed.
• Fully disclose the adviser's best-execution policies and procedures.
To summarize, advisers who direct trades to a broker-dealer have a fiduciary duty to seek best execution. Their obligation is to periodically and systematically evaluate which broker-dealers can reasonably be expected to execute their clients' transactions best. When Finra is concerned about some broker-dealers not fulfilling their best-execution responsibilities, advisers must be especially vigilant to find ones that are.
Blaine F. Aikin is executive chairman of fi360 Inc.