On July 11, 2018, the Securities and Exchange Commission’s (“Commission”) Office of Compliance Inspections and Examinations (“OCIE”) published a risk alert describing common deficiencies that OCIE staff observed in recent examinations regarding advisers’ compliance with their obligation under the Investment Advisers Act of 1940 (the “Advisers Act”) to seek “best execution” of client transactions. This obligation is a specific component of advisers’ general fiduciary duties owed to clients and requires an adviser to execute transactions so that “the client’s total cost of proceeds in each transaction is the most favorable under the circumstances.” Though what constitutes “best execution” lacks a uniform definition, the staff continues to maintain the well-settled principle that an analysis of whether a broker-dealer provides best execution should be qualitative based on the nature of the broker-dealer’s services, and that the lowest price does not necessarily equate to best execution. The risk alert nonetheless clarifies and reiterates particular practices that the staff considers inconsistent with an adviser’s best execution obligation.
These practices generally fall into three categories: first, deficiencies in conducting diligence of broker-dealers and their execution practices; second, flaws in policies and procedures; and third, failure to disclose practices that may impact the execution quality of orders entered on behalf of advised clients.
First, the staff expects advisers to conduct diligence of broker-dealers selected to execute transactions on behalf of their clients—both initially and on an ongoing basis. In particular, the staff expects advisers to compare the services of different broker-dealers and to solicit outside feedback, rather than relying solely on information provided by the broker-dealer. The staff also expects advisers to continuously and systematically monitor a broker-dealer’s performance and to document its analysis. The staff highlighted that, in conducting these reviews, an adviser should consider the broker-dealer’s execution capability, financial condition, and responsiveness to the adviser.
Second, the staff observed that policies and procedures sometimes did not take into account advisers’ current business practices (e.g., trading in securities not reflected in the adviser’s policies and procedures), suggesting that advisers should periodically update their policies and procedures to ensure they remain appropriately tailored. In addition, the staff observed that advisers did not consistently follow their own policies and procedures regarding whether to retain a broker-dealer, for example, by not conducting a comparative review, even though their own internal policies required them to do so.
Third, Staff observed deficiencies in advisers’ disclosures of execution practices. Examples highlighted by the staff include whether certain clients’ transactions are executed ahead of others’ even when purchasing or selling the same security and soft dollar arrangements—not only the mere use of them, but more specifically, whether certain clients bear greater costs and to what degree an adviser may use commissions to pay for research from broker-dealers. The staff appears particularly concerned about deficiencies in disclosure of these arrangements and, as a substantive matter, whether costs associated with soft dollar benefits that have “mixed uses” (both research and non-research) are passed on (and disclosed) to advisory clients who do not receive as great a share of the benefits as the adviser, could be inconsistent with the adviser’s fiduciary duty.
Consistent with the Commission’s overall approach to the relationship between advisers and their clients, OCIE appears focused on requiring that advisers establish, maintain, and follow appropriate policies and procedures and on the adequacy of disclosures to clients, rather than on prohibitions of particular practices. However, the alert’s focus on soft dollar arrangements reinforces that an adviser should expect significant scrutiny not only of the substantive nature of any soft dollar arrangements, but also of the adequacy of disclosures, which OCIE has stated will remain a focus of exams at least for the remainder of this year. Moreover, though the risk alert details several other practices that the OCIE staff considers problematic, the alert is consistent with the Commission’s and staff’s previously stated views about the substantive requirements of an adviser’s best execution obligation. Nevertheless, OCIE expects advisers to document compliance with these standards in their own internal policies and diligently adhere to and update those policies. In addition, inadequate policies and procedures may form the basis of claim that an adviser is in violation of SEC Rule 206(4)-7, relating to compliance procedures and practices, which requires that advisers both establish and review no less than annually procedures designed to prevent violations of the Advisers Act and the rules thereunder.
 OCIE 2018 National Exam Program Examination Priorities, https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2018.pdf (p. 10).