SEC’s Inspections and Examinations Office Demands Best Execution

Earlier in July, the Office of Compliance Inspections and Examinations (OCIE) of the Securities and Exchange Commission (SEC) published a Risk Alert relating to best execution deficiencies on the part of investment advisers.

As the SEC pointed out, under Section 28(e) of the Securities and Exchange Act of 1934, as a fiduciary, an adviser with responsibility to direct client trades is obligated to seek “best execution” in client transactions.

According to attorneys with the Wagner Law Group, who this week published a helpful overview of the OCIE Risk Alert, this duty to pursue best execution “encompasses evaluating the full range and quality of a broker/dealer’s services such as transaction costs, execution capability, the firm’s financial wherewithal, and responsiveness to the investment adviser.”

“This duty is broader than the best execution requirement to which registered representatives are subject under FINRA Rule 5310, which focuses primarily on execution costs,” the Wagner attorneys warn. “OCIE also noted that best execution could be impacted by the adviser’s receipt of soft dollar arrangements.”

The Wagner attorneys point out that Section 28(e) of the Securities and Exchange Act provides a safe harbor to money managers who use the commission dollars of their advised accounts to obtain investment research and brokerage services, provided that certain conditions are satisfied.

“Where a product or service obtained with client commissions also serves other functions unrelated to investment decisions (mixed use), the adviser must make a reasonable allocation of a mixed use product or service and keep adequate books,” the Wagner attorneys note. “The adviser must also disclose soft dollar arrangements and such disclosure should be more detailed when the products or services fall outside of the section 28(e) safe harbor.”

As interpreted by the Wagner attorneys, the recent OCIE Risk Alert identifies some common deficiencies, based on examinations of over 1,500 investment advisers. The most common deficiencies identified by OCIE staff include failure by advisers to periodically analyze execution performance by broker/dealers; failure to consider materially relevant factors during best execution reviews, such as execution capability, financial responsibility, responsiveness, and input from traders and portfolio managers; failure to compare performance to other broker/dealers; failure to fully disclose best execution practices; failure to disclose soft dollar arrangements; improper administration of mixed use allocations; inadequate best execution policies and procedures; and failing to follow existing best execution policies and procedures.

In their view, the Wagner attorneys argue the main takeaway of the OCIE risk alert is that “registered investment advisers and broker/dealers should review existing best execution policies and procedures to ensure they do not suffer from the same deficiencies as those described in the Risk Alert or in the December 2017 Report on FINRA Examination Findings, as applicable.”

In a related analysis published by attorneys with Drinker Biddle and Reath, similar conclusions are emphasized. In particular, the Drinker Biddle attorneys emphasize that the OCIE closes its Risk Alert by advising that it “encourages advisers to reflect upon their own practices, policies, and procedures in these areas and to promote improvements in adviser compliance programs.” This has implications for the near- and mid-term future, the attorneys propose.

“The SEC’s follow-up efforts regarding its risk alerts have evolved significantly to become much more than encouragement and promotion,” they warn. “For example, in July 2016, OCIE issued a risk alert titled OCIE’s 2016 Share Class Initiative. Approximately 18 months later, the SEC’s Division of Enforcement announced its Share Class Selection Disclosure Initiative.”

According to the Drinker Biddle attorneys, the number of best execution cases filed by the SEC’s enforcement arm against advisers has increased over the past several years.

“Advisers should view this Risk Alert as the SEC putting them on notice of increasing OCIE and SEC enforcement scrutiny of adviser best execution,” they conclude. “Advisers may consider, therefore, conducting assessments of their best execution policies, procedures and practices, and disclosures to clients in a manner that aligns with the guidance in the Risk Alert, as well as documenting these efforts.”