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Advisers Failing Best Execution Compliance Obligations

The SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert listing the most common deficiencies cited in recent examinations of advisers’ best execution obligations.  Reviewing over 1,500 exams, the OCIE staff highlighted advisers’ failures to (i) conduct any best execution reviews, (ii) consider qualitative factors (e.g. execution capability, responsiveness), and (iii) utilize multiple brokers or to compare execution quality against other brokers.  The OCIE staff also witnessed widespread failures to fully disclose best execution practices such as client preferences and soft dollar arrangements.  The staff reports that many advisers either had inadequate policies and procedures or failed to follow them.  The staff encourages advisers “to reflect upon their own practices, policies, and procedures in these areas and to promote improvements in adviser compliance programs.”

OUR TAKE:  In its recent fiduciary interpretation release, the SEC specifically identified best execution as core to an adviser’s fiduciary obligation.  As a core obligation, it concerns OCIE that they have identified pervasive compliance failures during examinations.  Ensuring a best execution review should be part of every compliance testing program.


Adviser Failed Best Execution When Recommending 12b-1 Fund Class


An investment adviser agreed to pay over $2 Million in disgorgement, interest and penalties for failing to buy the least expensive share class of recommended mutual funds.  The SEC maintains that the respondent, an investment adviser representative of a large advisory firm, recommended Class A shares that carried a 12b-1 fee instead of lower-expense institutional shares.  The adviser received a portion of the 12b-1 fees from the clearing firm as revenue sharing.  The SEC did not absolve the adviser even though he received approval for the practice after consulting his firm’s management.  The SEC asserts that the adviser violated his obligation to seek best execution for securities transactions.

OUR TAKE: The SEC requires advisers to recommend the lowest-expense share class available, which requires more diligence by advisers before making recommendations.  It is also noteworthy that the SEC uses an expansive interpretation of an adviser’s best execution obligations, which historically has centered on brokerage commissions.


Wrap Sponsor Fined for Failing to Monitor Trading Away Practices

The SEC fined and censured a wrap fee sponsor for failing to provide sufficient trading away information to financial advisers and their clients.  The wrap program’s third-party sub-advisers had full discretion to direct trades to any broker, but a program client would only be charged additional fees and commissions if a sub-adviser chose a broker other than the respondent’s affiliate.  According to the SEC, the sponsor discovered that many of the sub-advisers placed a majority of trades with third-party brokers.  The SEC faults the program sponsor for failing “to inform its clients when they have incurred these additional trading away costs or provide its clients with the amount of the additional trading away costs.”  As a result neither the clients nor their financial advisers could assess suitability or best execution.  The SEC found that the wrap sponsor violated the compliance rule (206(4)-7) for failing to implement reasonable policies and procedures to monitor brokerage practices and costs.

OUR TAKE: The SEC will scrutinize wrap programs and other sub-advisory relationships to ensure proper supervision and full transparency to clients.  It is noteworthy that the SEC is concerned that the clients didn’t have sufficient information to make an assessment about execution quality and suitability, but the SEC did the not allege the clients failed to receive best execution.


Executing Broker to Pay $22.6 Million for Misrepresenting Order Filling Process

hidden ball

A large executing broker agreed to pay $22.6 Million to settle charges that it misled broker-dealers clients about the mechanism for filling orders.  The SEC charges that the executing broker claimed that it would deliver best price but, instead, used two algorithms that capitalized on price discrepancies that often benefited the respondent.  An SEC official warned, “We are focused on the execution of retail orders and encourage investors to ask brokers, and brokers to ask internalizers, how they are determining best prices for retail orders.”

OUR TAKE: This case looks like a disconnect between the front office and the back office.  It appears that the folks talking to clients did not understand how the firm actually filled orders.  “Don’t let the facts ruin a good story” is a recipe for an enforcement action.