How to Navigate the SEC’s Best Execution Risk Alert

How to Navigate the SEC’s Best Execution Risk Alert

02 August 2018

“Best execution,” is a subjective target that is difficult to measure, rank, or define.  In general, best execution is the effort of an adviser, to seek best price while also factoring in:

  • expertise,
  • sophistication,
  • speed, and
  • “the full range and quality of a broker-dealer’s services including, among other things,
    • the value of research provided as well as execution capability,
    • commission rate,
    • financial responsibility, and
    • responsiveness to the adviser,” (OCIE Compliance Issues Related to Best Execution by Investment Advisers).

 

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) recently released a Risk Alert focusing on the most common deficiencies related to best execution.  However, it laid little ground work for advisers to follow to avoid any best execution road blocks.

It’s nice to know what the problems are, but it’s even more helpful to have some guidance on how to navigate the issues…  Below, we take a look at the deficiencies OCIE noted in the Risk Alert and map out some solutions for various investment types and advisory styles.

Evaluate the Quality of Broker-Dealers

From the Risk Alert

As the Commission has stated, “the determinative factor [in an 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.”

SCS Suggests

Advisers should periodically and systematically evaluate the execution quality of broker-dealers executing their clients’ transactions.

  • Document your best execution review. You must be able to substantiate to an examiner that you have reviewed for best execution.   It can in the form of meeting minutes (if you have a best execution committee – although that is not a requirement), an excel spreadsheet that ranks and identifies the qualitative and quantitative factors used in determining which brokers to use, or even an internal memo.
  • Review on a systematic schedule either annually, bi-annual or quarterly.  The frequency depends on your firm, the volume of trading, and the types of securities you trade.   It is to your discretion and should be one that also adds value to the firm and doesn’t just feel like “busy” work.
  • Include members from portfolio management, trading, compliance, and operations. If you are a one woman/man shop, then of course it will be your review.
  • Include in the review discussions of commission costs per share by broker, the value of each broker from the standpoint of portfolio management and trading, and any issues with brokers (recent trade errors or change of personnel).
  • Consider documenting why you use a particular broker. For example, perhaps said broker will take smaller trade lots, specializes in certain security types, or provides better customer service to you, a smaller advisory firm. Just make sure to document the reasons you choose your brokers.

 

Compare Broker-Dealers

From the Risk Alert

The Staff observed advisers that utilized broker-dealers without seeking out or considering the quality and costs of services available from other broker-dealers.

SCS Suggests

Larger firms may not understand this struggle. However, smaller advisers typically use 1-2 brokers and cannot afford to diversify their relationships.

  • Particularly with retail brokers, compliance staff can obtain cost details regarding price per share, price per trade, and asset minimums which would contribute to a best execution evaluation.
  • We suggest an annual or every-other-year documentation of 1-2 brokers and costs in conjunction with your best execution review, tapping into your trading staff to evaluate quality. Or if you have history working at another firm and with other brokers document this fact and your understanding of the services being received.
  • Analyze post trade data, such as volume-weighted average price (“VWAP”) or closing price compared to your executed price.
  • Is your firm too small for another broker? Document the assets or trading volume required at the other broker(s) to show your due diligence process.

 

Provide Full Disclosure of Best Execution Practices

From the Risk Alert

The Staff observed advisers that did not provide full disclosure of best execution practices.

SCS Suggests

  • The ADV Part 2A (Item 12 Brokerage Practices) is your disclosure document. Use it to describe your best execution process in plain English.  For example, “in selecting broker-dealers, [firm name] considers not just lowest commission and execution price but also research and other services provided, effectiveness and sophistication of broker-dealers, expertise in a particular security type, settlement abilities, financial standing of broker-dealers, and other factors.”
  • If you use a trade rotation, or if certain types of accounts will trade (notice we did not say “may” there…) the same security before other types of accounts, then discuss this in Item 12. Remember to outline the impact these trading practices have on accounts.
  • If you perform post-trade reviews, disclose and document this practice (remember that best execution meeting you are documenting…?), including any acceptable dispersion of execution price and frequencies of reviews.
  • And most importantly, revisit your disclosures and compare against actual practice and written policies. You should update at least annually to make certain they are all consistent.

 

Disclose Soft Dollar Arrangements

From the Risk Alert

The Staff observed advisers that did not appear to provide full and fair disclosure in Form ADV of their soft dollar arrangements.

SCS Suggests

ADV Part 2A, Item 12, again.  If you use soft dollars, document the use and how certain clients will benefit from soft dollars despite not “paying” soft dollars.  The instructions make it very clear that the following specific disclosures MUST be included:

  • Explain that when you use client brokerage commissions (or markups or markdowns) to obtain research or other products or services, you receive a benefit because you do not have to produce or pay for the research, products, or services.
  • Disclose that you may have an incentive to select or recommend a broker-dealer based on your interest in receiving the research or other products or services, rather than on your clients’ interest in receiving most favorable execution.
  • If you may cause clients to pay commissions (or markups or markdowns) higher than those charged by other broker-dealers in return for soft dollar benefits (known as paying-up), disclose this fact.
  • Disclose whether you use soft dollar benefits to service all of your clients’ accounts or only those that paid for the benefits. Disclose whether you seek to allocate soft dollar benefits to client accounts proportionately to the soft dollar credits the accounts generate.
  • Describe the types of products and services you or any of your related persons acquired with client brokerage commissions (or markups or markdowns) within your last fiscal year.

 

Properly Administer Mixed-Use Allocations

From the Risk Alert

The Staff observed deficiencies related to mixed-use allocations, for example, advisers did not appear to make a reasonable allocation of mixed use products and services.

SCS Suggests

  • Identify services that are used for both research services and other services (such as client services for reporting), and document a process by which you have determined to allocate payments to soft dollars and hard dollars. For example, if four people use software and two of those people use the software solely for research while two people use the software solely for accounting or performance measurement, the service could be paid 50% hard dollars and 50% soft dollars.  Or, perhaps you look at the time spent using a service and determine that 25% of the time is soft-dollar eligible use and the other 75% must be paid by the firm.
  • Document, at least annually, your rationale and calculations and stay consistent in how you pay for your mix-use services throughout the year.

 

Develop Adequate Compliance Policies and Procedures

From the Risk Alert

The Staff observed advisers that appeared to have inadequate compliance policies and procedures or internal controls regarding best execution.

SCS Suggests

  • Create a policy around best execution. For example, “a best execution committee comprised of [identify the employees/roles] meets [number of times per year] to discuss broker-dealer relationships, and [responsible party] documents the meeting minutes, including quantitative and qualitative aspects of each broker’s services.”
  • Follow your policies and update them if you change your procedures. For example, if your policy states that you meet quarterly, meet quarterly, or change your policies to reflect a different practice.
  • Document your attendees.
  • Implement a repeatable process for your meetings. Some third-party vendors provide trade commission analysis (“TCA”) which compares VWAP and commissions across different brokers.   Some brokers also provide commission reports, for example, Fidelity, Schwab and TD Ameritrade have trade execution quality analysis (also referred to as a venue analysis) that is provided through their institutional platform upon request.
  • Alternatively, block trades could be reviewed for same execution price and commissions with outliers explained via meeting minutes.
  • As with all policies and procedures, it’s important to have a policy that you can follow and can document the process. If you create a policy and it does not work, amend the policy and document the change.

 

Best execution cannot be described as a one-size-fits-all process which contributes to the confusion around it.  Start small and simple by creating a procedure that is repeatable and document the process.

If you have additional or firm-specific questions around best execution…  Contact us!  We are here to help!