OCIE Publishes Risk Alert on Most Frequent Best Execution Compliance Issues Found During Examinations

The U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations issued a National Exam Program Risk Alert on July 11, 2018.¹ The Risk Alert highlights OCIE’s observations of compliance issues related to an adviser’s duty to seek best execution of client trades under the Investment Advisers Act of 1940, as well as an adviser’s receipt of brokerage and research services (soft dollar arrangements) under section 28(e) of the Securities Exchange Act of 1934.² 

The Risk Alert builds on, and in some ways advances, the SEC’s recent proposed interpretation regarding a standard of conduct for investment advisers (Proposed IA Interpretation)³ in which the SEC set forth its view that the duty to seek best execution is an element of the adviser’s duty of care, with the discussion of this duty citing to prior soft dollar interpretive releases under the Exchange Act.⁴ Similarly echoing the Proposed IA Interpretation, the Risk Alert expresses OCIE’s view that the Advisers Act imposes a fiduciary duty on advisers. As such a duty is not explicitly defined in that statute, the Risk Alert cites to the same equitable common law principles and case law and dicta as the Proposed IA Interpretation.⁵

Duty to Seek Best Execution 

An adviser with discretion to direct trading has a duty to seek best execution of all client trades, which, according to interpretive guidance, means seeking the most favorable terms (i.e., the client's total cost or proceeds) in each transaction under the circumstances.⁶ In directing trades, an adviser is also faced with conflicts of interest, as “soft dollars” generated by client trades may be used to pay for research or brokerage services that may benefit the adviser. When using soft dollars under the section 28(e) safe harbor, an adviser must determine in good faith that the items acquired: are eligible for the safe harbor; provide lawful and appropriate assistance; and are acquired at a cost that is reasonable in relation to their value.⁷

An adviser must also fully and fairly disclose its trading policies and soft dollar practices to its advisory clients, including in Form ADV. Further, an adviser must have reasonably designed written policies and procedures that address “[t]rading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services (‘soft dollar arrangements’), and allocates aggregated trades among clients.”⁸

Risk Alert 

The Risk Alert identifies the following as examples of the most common compliance issues relating to best execution as observed by OCIE in advisers’ examinations: 

• Not performing best execution reviews. The staff observed that some advisers did not evaluate best execution in pre-trade selection of brokers, and could not demonstrate periodic and systematic evaluation of the execution performance of such broker-dealers. 
  
  
• Not considering materially relevant factors during best execution reviews. The staff observed that some best execution reviews did not consider the full range and quality of a broker-dealer’s services in directing trades, including evaluating qualitative factors (e.g., execution capability, financial responsibility, responsiveness to the adviser) and “solicit[ing] and review[ing] input from the adviser’s traders and portfolio managers.”
  
  
• Not seeking comparisons from other broker-dealers. The staff observed that some advisers directed client trades to certain broker-dealers (or a single broker-dealer) without assessing competitors’ offerings, either initially or on an ongoing basis, instead basing selection of a broker-dealer “solely” on, for example, “cursory reviews of the broker-dealer’s policies and prices” or the “broker-dealer’s brief summary of its services.” 
  
  
• Not fully disclosing best execution practices. The staff observed that disclosure of some advisory practices was either inadequate (e.g., with respect to trading certain types of accounts before others in the same securities, and the resulting “potential impact” on execution prices) or inaccurate (e.g., “not review[ing] trades to ensure that prices obtained fell within an acceptable range” as stated in Part 2A of Form ADV). 
  
  
• Not disclosing soft dollar arrangements. The staff observed that some advisers did not adequately or accurately describe soft dollar arrangements in Form ADV (e.g., the use of such arrangements, that “certain clients may bear more of the cost of soft dollar arrangements,” payment with soft dollars for ineligible brokerage or research services). 
  
  
• Not properly administering mixed use allocations. The staff observed that some advisers’ mixed use allocations did not appear reasonable in light of the actual use of soft dollar items, or that the “rationale” for such allocations was not documented. 
  
  
• Inadequate policies and procedures relating to best execution. The staff observed what it described as inadequacies in some advisers’ compliance programs, such as: lack of a best execution policy; insufficient monitoring of execution performance; or policies not tailored to the adviser’s current business. 
  
  
• Not following best execution policies and procedures. The staff observed that some advisers’ practices diverged from their written policy (e.g., with respect to assessment of competitors, allocation of soft dollar expenses, monitoring of execution). 

Implications for Advisers 

In the Risk Alert, the OCIE staff, perhaps emboldened by the Proposed IA Interpretation, describes advisers’ best execution obligations in more specific and prescriptive terms than in the past. This particularity may signal more aggressive examinations of best execution. To this point, the Risk Alert notes that the examinations within its scope resulted in “a range of actions” – an oblique but unmistakable reference to enforcement actions and deficiency letters. Balancing this language, the Risk Alert discusses remedial measures taken by advisers, including (among others): amending relevant disclosure; revising applicable policies and procedures; and altering practices. Thus, the Risk Alert serves as a reminder that review, active evaluation, remediation and documentation are essential to a well-designed compliance program. 

Footnotes 

_{1) Most Frequent Best Execution Issues Cited in Adviser Exams.
2) According to the Risk Alert, OCIE’s observations were based on “deficiency letters from over 1,500 adviser examinations.”
3) Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, SEC Rel. No. IA-4889 (May 9, 2018).
4) Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, SEC Rel. No. 34-23170 (Apr. 28, 1986) (1986 Soft Dollar Release); Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, SEC Rel. No. 34-54165 (July 18, 2006) (2006 Soft Dollar Release).
5) The Risk Alert cites as examples Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979) and SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191 (1963). The Proposed IA Interpretation suggests that where a conflict is not fully mitigated, an adviser must obtain a client’s informed consent (whether explicit or implied) to the conflict.
6) 1986 Soft Dollar Release; 2006 Soft Dollar Release. For further information as to the 2006 release, please refer to Dechert OnPoint, SEC Releases New Interpretive Guidance on Soft Dollar Arrangements.
7)  2006 Soft Dollar Guidance.
8) Compliance Programs of Investment Companies and Investment Advisers, SEC Rel. No. IA-2204 (Dec. 17, 2003).}