May 12, 2015

CCO Series (2015) - Best Execution

As an investment advisor, the duty to seek best execution arises from the core fiduciary duty and the related duties of loyalty and care for your clients. In seeking best execution for your clients, the advisor's duty focuses on your firm’s obligation to seek the best available trade execution when exercising discretion to trade on behalf of your clients. While the concept can be subjective it is an important element of the fiduciary duty owed to clients since the costs of trading have a material impact on portfolio performance, especially over years of management.

Best Execution In a Nutshell

Regulations state that as fiduciaries, registered investment advisors owe their clients a duty to seek and obtain “best execution” on securities transactions, under the circumstances of the particular transaction.

It is important to note that this does not necessarily mean “lowest trading fee” or “most favorable execution price” but rather, the best qualitative execution quality that is available to the advisor at that time.

While commission rates are certainly a component of determining best execution, the explicit “cost to trade” is just one of several factors to consider. Advisors may also consider the full range and quality of a broker’s services, including:

  • Value of research
  • Execution capability (e.g. minimizing market impact, liquidity, order size)
  • Financial responsibility or solvency (e.g financial strength of broker-dealer)
  • Responsiveness of the broker-dealer
  • Availability of price improvement
  • Cost effectiveness, including related clearing and settlement impacts

Below we describe some specific guidelines you should follow based on your firm’s specific circumstances.

Discretion to Select Brokers vs. Recommending Brokers

If your firm has brokerage discretion (see Item 8.C.3 on your Form ADV Part 1, and Item 12 of your Form ADV Part 2A) this means that, on a trade by trade basis, your clients have given you the ability to determine which broker-dealer will execute each transaction. In this case, you will be expected to demonstrate the rationale behind broker selection for each trade, relying on factors such as those listed above.

If your firm does not have brokerage discretion but rather you recommend brokers to your clients (See Item 8.D on Form ADV Part 1), then your client is formally selecting the broker-dealer to be used for their trades, which is typically noted in the client advisory agreement. They are doing so based on your recommendation, usually because your firm has a preexisting relationship with a recommended custodian that executes and clears your client trades, based on your prior best execution diligence. In this case, your compliance duties are lighter than a situation where you have brokerage discretion, and firms are obligated to monitor and assess this broker-dealer/custodial relationship on a periodic basis, and confirm that your factors supporting the recommendation continue to remain valid.

Single vs. Multiple Brokerage Relationships?

Regardless of whether your firm uses one or multiple broker-dealers, you are required to “periodically and systematically” evaluate the quality of execution services received from each.

In either case, you are expected to monitor and review formally, at least annually, the arrangement(s) in place with your broker-dealer(s) to confirm that the total transaction costs paid continue to be competitive when compared to other alternatives available to your firm. A key point here is that the formal diligence on your best execution compliance is geared towards what is best for your client and supports your assertion that you are upholding your fiduciary duty to your clients by ensuring they receive best execution as a client of your firm.

A common misperception is that if you utilize just one broker-dealer (and your firm simply recommends that broker-dealer) then there is no evaluation or due diligence requirements. However, this is not the case, because that broker-dealer could be providing inadequate execution for your clients.

Through the Regulator's Eyes

Since the concept and determination of best execution is in many ways a qualitative one, it may be helpful to view it more as a process. Regulators need to evaluate your firm to ensure it has a process of continuously assessing the overall execution services provided to your clients, after considering the facts and circumstances that prevail, such as discretion, strategy and due diligence.

A common examination request from regulators is for a copy of trade blotters for a specific period of time that identifies the executing broker, as well as any documents created in the evaluation of brokerage arrangements and best execution.

The latter can be satisfied by providing the regulator with a copy of your Annual CCO report, which should include a section on vendor due diligence and best execution assessment.

Regulators expect your firm to be able to answer questions such as:

  1. Is our current line-up of broker-dealers the best available?
  2. Are there alternatives to this line-up that could provide our clients with a better deal?
  3. What factors are considered when evaluating a particular broker-dealer for your clients?
  4. How frequently do you perform diligence on broker-dealers and could you provide me the historical diligence documents?

CCO Best Practices for Best Execution

  • Review the “Brokerage Practices” section of your compliance manual to confirm that the policies and procedures laid out here are being followed.
  • Review the brokerage-related disclosures in your ADV Part 1 and 2A for consistency with your compliance manual and current brokerage activities.
  • Review execution performance of brokers on an ongoing basis, paying particular attention to commission rates paid and quality of execution and settlement (i.e quality execution prices, low error rate on order management and trade settlement).
  • For any brokers you recommend to clients, perform a review of your relationship of each broker at least annually, to assess the full range and quality of the services your firm receives based on best execution factors (i.e. value of research, execution quality, commission rates, financial responsibility and responsiveness) to ensure the recommended brokers would provide best execution for your clients.
  • If you have brokerage discretion, implement a process of periodically reviewing your trade blotter to monitor broker usage at the firm- and client-level, as well as by security type.
  • Document your brokerage review process in your Annual CCO Report and related assessments.
  • Review your investment advisory agreements to confirm that they are consistent with your brokerage discretion disclosures and brokerage practices.

The AdvisorAssist CCO Series is a collection of blog posts that cover each of the elements of your RIA's compliance program.  Each post will provide an overview of one compliance topic, including our insights on how regulators view each topic as well as some practical steps to help Chief Compliance Officers address this topic. As always, we would welcome your comments and thoughts.

Michael Conlon


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