Every registered investment adviser has a fiduciary duty to seek best execution when placing transactions for clients. In addition to seeking best execution, the Securities and Exchange Commission (“SEC”) has issued a variety of guidance stating that advisory firms must also perform and document reviews of their brokerage and trading practices to help ensure that clients are receiving the best overall deal for each transaction in light of applicable circumstances. Even though states have not be as forthcoming in their guidance, they generally take the same position.
In this Risk Management Update, we discuss consideration factors for seeking best execution, testing protocols for different types of securities, and steps for performing and documenting required reviews.
Seeking Best Execution
There are many important factors to consider when seeking best execution that go beyond execution price and transaction costs. To begin, a firm should perform and document analysis, both initially and at least annually, of the range of services that will be provided by each broker-dealer being selected for client trading. Some of these include, for example:
- Execution capabilities and opportunity for price improvement;
- The promptness of execution;
- Handling large trades;
- Ability to maintain the confidentiality of trading intentions;
- Availability of technology to process trades;
- Reliable and accurate settlement capabilities;
- Research capabilities;
- Access to company management and IPOs;
- Competitiveness in the marketplace;
- Financial responsibility and responsiveness to the adviser; and
- Additional services provided to clients (e.g., custodial services).
It’s also extremely vital that advisers identify and address conflicts of interest surrounding their brokerage selection and trading practices. Associated conflicts can arise under several scenarios, such as: (i) using an affiliated broker for trading; (ii) having soft dollar arrangements; (iii) trading in investment products that provide compensation to the firm, affiliates, and/or its supervised persons; (iv) entering into revenue sharing arrangements with the broker; (v) receiving services from the broker that do not benefit clients; and (vi) obtaining client referrals under directed brokerage arrangements.
While clear and transparent disclosure regarding a firm’s brokerage selection and applicable conflicts is required, certain conflicts may need to be eliminated for the firm to ensure adherence to its fiduciary responsibility. This would be the case in a situation where trading with an unaffiliated broker could provide a client with lower overall costs and/or more benefits.
Another relevant factor is how brokerage selection and trading are structured at a firm. A common practice for medium to large size firms is having a list of approved brokers, which usually is created by the portfolio management team, along with dedicated trading personnel that has the authority to place trades with any approved broker they believe will provide the best trade execution. Larger advisers tend to have a formal governance structure around brokerage and usually will have a trading oversight committee that approves the broker selection and other matters, such as best execution. Smaller advisers usually work with one or two brokerage firms, which have “institutional” platforms that provide both custody and trade execution (“Custodian Brokers”). Generally, under this type of arrangement, the custody services are provided at no cost so long that client transactions are placed with the broker for execution. In addition, the transaction costs are lower than the amount charged to retail clients.
The framework for both types of structures is set up to assist with the goal of obtaining best execution for clients; however, additional considerations are necessary for each. For example, having trading personnel supervised by the Chief Operations Officer or similar segregates trading authority away from portfolio management, which is important since they usually select brokers based on, among other things, the research and investment ideas provided.
Under the Custodian Broker platform, the adviser should perform a detailed comparison (both initially and ongoing) of the costs and services provided by the selected Custodian Broker to others that provide similar services. The adviser also will need to disclose in detail the benefits they receive under this type of arrangement.
Testing the Quality of Executions
The testing process needs to be customized based on the types of securities traded, along with trading frequency. The good news is that firms have choices on testing methods. Using technology and/or a service provider is an efficient way to test, and the extent of their testing is usually extensive and meaningful; however associated costs related to trade cost analysis providers can be rather high. The least expensive method is to perform the testing internally, which can be accomplished by comparing executed prices against an appropriate benchmark. For example, a good benchmark for equity trades could be the volume-weighted average price (“VWAP”) for the time between the placement of the trade and the execution. If the firm does not have access to VWAP, they can compare the open, close, high, and low prices for the equity security for the trade date. For municipal bonds, firms can compare their execution price against trade data outlined on the Municipal Securities Rulemaking Board (“MSRB”) website. For corporate bonds, trade data can be obtained through TRACE (which requires licensing fee payments). This type of forensic testing helps firms determine how brokers are performing over time.
Notably, advisers are not required to test the execution of every client trade, but it’s important to include a representative amount that is based on the volume of trade activity in order for the data to be useful.
Reviewing and Documenting Best Execution
While testing trade execution is an essential part of determining whether the firm is achieving best execution for its clients, it is only one component of the review process. Firms also need to analyze pre-trade, trading, and post-trade protocols to help evaluate whether the firm is fulfilling its fiduciary duty and meeting regulatory requirements. This should include:
- Reviewing broker analysis documentation to confirm they are being vetted properly;
- Examining trading policies and procedures to determine adequacy;
- Obtaining input from portfolio managers and traders on the appropriateness of the firm’s current process;
- Assessing trade execution testing reports to identify any outliers;
- Analyzing soft dollar arrangements to consider whether mixed-use and ensure the costs are reasonable considering research and services being provided;
- Looking at client disclosures regarding the firm’s brokerage and trading practices to verify adequacy;
- Comparing trade execution quality and routing reports from brokers used with others to assess performance vs. peers; and
- Reviews of the commission charge to ensure that brokers are not overcharging clients.
The frequency of the reviews will mainly depend on the extensiveness and complexity of a firm’s trading and the types of securities traded. The responsible party(ies) performing reviews is usually driven by the same factors, along with the size of the firm. Senior management can appoint a committee or delegate the responsibility to a department or even a single employee. Suffice it to say that a large advisory firm that trades tens of thousands of shares or more a day should have a committee that meets at least quarterly. Additionally, compliance staff should independently review and test the process at least annually and attend the committee meetings.
Documentation is key and is necessary to substantiate a firm’s review and best execution determination. Committees should have minutes of each meeting that outline what they reviewed, their findings and any recommendations made to senior management. Employees tasked with reviews should maintain memoranda that contain the same information noted above. Also, all supporting documents substantiating the findings should be retained.
Best execution is just one of the SEC’s current focus areas for which they continue to find deficiencies. Others include safeguarding client non-public information, assessing and billing advisory fees, dealing with senior investors, electronic communication policies, marketing, and advertising, mutual fund share class selection, cybersecurity, and solicitor arrangements, just to name a few.
As fiduciaries, investment advisers are tasked with ensuring that they always act in the best interest of clients. This can be accomplished by having a strong compliance program in place, which includes detailed policies and procedures that reflect the firm’s business practices and address applicable regulatory requirements, along with having robust testing and review processes.
Even if you feel that your program is in good shape, it always helps to get a second opinion. Core Compliance consultants have extensive experience in performing reviews and assisting firms with ensuring their compliance programs are healthy and appropriate for their business model.
For more information about our services, please contact us at (619) 278-0020 or visit us at www.corecls.com for more information.
Author: Tina Mitchell, Managing Director, Consultation Services; Editor: Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon regarding any particular facts or circumstances without first consulting with a lawyer and/or tax professional.
 See SEC Risk Alert “Compliance Issues Related to Best Execution by Investment Advisers” issued July 11, 2018 at https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20IA%20Best%20Execution.pdf; “General Information on the Regulation of Investment Advisers” at https://www.sec.gov/divisions/investment/iaregulation/memoia.htm; and “Compliance Programs for Investment Companies and Investment Advisers” at https://www.sec.gov/rules/final/ia-2204.htm
 This list is not inclusive of all conflicts, it is only showing some of the more common ones.