Best Execution Issues for Registered Investment Advisers
By David Mullé, Partner, Seward & Kissel LLP
In recent years the Securities and Exchange Commission has brought a number of enforcement actions against investment advisers alleging that the advisers did not comply with their best execution obligations.This article examines some of those enforcement actions and the implications they may have for investment advisers.
What is Best Execution?
An investment adviser owes a fiduciary duty to its clients to achieve best execution when placing trades.Although best execution is not defined in the U.S. federal securities laws and industry participants do not use a uniform definition, the SEC has described best execution as a duty to execute transactions for a client so that the client’s costs or proceeds in each transaction are the most favorable under the circumstances. Because of the lack of a clear definition, the SEC sometimes seems to be adopting, with respect to its enforcement actions for failure to achieve best execution, the jurisprudential view of Justice Potter Stewart, who said, regarding a movie which had been banned because it had been deemed to be obscene, “I know it when I see it, and the motion picture involved in this case is not that.”
Best Execution Analysis
A complete best execution analysis involves both quantitative and qualitative analysis. On the quantitative side, an investment adviser should consider, among other factors, price and commission rates. On the qualitative side, investment advisers should also examine the broker’s ability to handle complex trades, ability to borrow securities for short sales, knowledge of and access to market participants, ability to commit capital and its financial stability, reputation and overall knowledge of the market. Investment advisers should also consider the broker’s research capabilities and the brokerage services that the broker provides.
In 2011, the SEC brought an action against Pegasus Investment Management LLC (“PIM”) for, among other things, not adequately discharging its obligation of best execution. PIM entered into an agreement with a broker whereby PIM was paid a portion of the trading commissions that a private fund advised by PIM paid to the broker. In addition to alleging that the payment to PIM constituted fraud because PIM was receiving benefits that were generated by the use of fund assets, the SEC also alleged that the receipt of the rebate made it difficult or impossible for PIM to satisfy its best execution obligation.The SEC alleged that PIM could not have avoided taking into account the payment it received from the broker every time the fund traded when the investment adviser was choosing which broker to execute the fund’s trades.
In order to ensure that an investment adviser is fulfilling its best execution obligations by considering the appropriate quantitative and qualitative factors, it is necessary to adopt policies and procedures that state the factors the investment adviser will use when choosing brokers.As a recent enforcement action shows, in addition to adopting the policies, it is also important to follow the policies.
In 2013, the SEC brought an action against Goelzer Investment Management (“GIM”), an entity that was dually-registered as an investment adviser and a broker dealer. The SEC highlighted the discrepancy between GIMs statements regarding its best execution policies and its actual practices.Notably, GIM stated that it “considered a list of factors and conducted comparative brokerage firm commission rate analysis” in its Form ADV.However, GIM was unable to provide any evidence that the analysis was in fact conducted.GIM paid a $500,000 fine as part of the settlement.There is additional discussion regarding the GIM settlement below.
Best Execution Reviews
The investment adviser should conduct reviews to evaluate whether it is obtaining best execution for its clients and whether its policies and procedures are being followed. The ultimate goal of the review is to determine whether the totality of the services received by the investment adviser and its clients were adequate in light of the commissions paid.As part of the review process, advisers should examine their existing best execution policies to ensure that they adequately protect the interests of their clients and are appropriate for their businesses.
An investment adviser should choose a review process that fits their organization but for many advisers the process begins with the traders submitting evaluations of the brokers.The investment adviser can then compare the results of the evaluations to the amount of trading activity carried out with each broker. If there is a disparity between the broker evaluations and the order flow, further inquiry would be warranted.The best execution review should also include an examination of any potential conflicts.This includes monitoring gifts that brokers send to the staff of the investment adviser as well as monitoring any personal or familial relationships between a staff member of the investment adviser and employees of the broker.
In most instances, the best execution review should be done by a committee.Depending on the structure of the investment adviser, the ideal composition of the committee will vary.But in general the committee should include representatives from the compliance staff, the trading staff and the portfolio management staff.
Finally, as part of the best execution review the investment adviser should also confirm that the disclosures made to clients in the investment adviser’s Form ADV, fund offering documents and client contracts all accurately describe the trading activities of the investment adviser.
Conflict of Interest Issues in Best Execution
Conflicts of interest have been a point of emphasis for SEC examinations of investment advisers, especially with regard to advisers that are both broker-dealers and investment advisers and provide brokerage services to advisory clients.Advisers must be careful in these instances to act in a transparent manner and make accurate representations. These types of conflicts create exposure for both firms and their employees. The GIM action discussed above also illustrates the conflict of interest issues that may arise in the best execution context.
According to the SEC, GIM inappropriately directed advisory client trades through itself as broker-dealer without considering other options for executing the trades, such as utilizing unaffiliated broker-dealers. These acts allegedly were in direct contrast to statements in GIM’s Form ADV that indicated GIM would conduct comparative analysis of other brokerage firm commission rates prior to recommending itself as broker for its clients. In addition, GIM allegedly misrepresented to its clients that using GIM as a broker would result in lower commission costs as a result of aggregating the client’s trades. According to the SEC, GIM’s chief executive officer and chief compliance officer was responsible for the false information contained in the Form ADV that established policies and procedures for the firm to conduct best-execution reviews.
On the same day that the GIM enforcement action was announced, the SEC also announced another enforcement action relating to best execution.A.R. Schmeidler & Co. (“ARS”), an investment adviser that is also registered as a broker-dealer, agreed to settle best execution violations for more than $1 million in disgorgement and penalties. ARS served as broker-dealer for its clients and had an agreement with a clearing firm to split the flat-rate commission ARS charged.When that agreement was subsequently renegotiated and ARS began receiving a greater share of the commission amount, it did not notify its clients and it also did not undertake an analysis to ensure it was providing best execution to its clients. It should also be noted that similarly to GIM, ARS also did not follow its written policies regarding the best execution review.
Both the GIM and ARS enforcement actions demonstrate the need for advisers to fully evaluate any potential conflicts of interest that may exist in connection with their execution decisions. Once the potential conflicts are identified an adviser must then create policies to mitigate the conflicts.Finally, those policies must be followed.
David Mullé is a partner in Seward & Kissel’s Investment Management Group. Mr. Mullé may be reached at (212)574-1452 or email@example.com.
Seward & Kissel LLP, founded in 1890, is a leading U.S. law firm with an international reputation for excellence. The Firm’s practice primarily focuses on corporate, litigation and restructuring/bankruptcy work for clients seeking legal expertise in the financial services, corporate finance and capital markets areas. The Firm is particularly well known for its representation of major commercial banks, investment banking firms, investment advisers and related investment funds (including mutual funds and hedge funds), master servicers, servicers, investors, distressed trade brokers, liquidity providers, hedge fund administrators, broker-dealers, institutional investors and transportation companies (particularly in the shipping area).