Smart RIA

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On July 11, 2018, the Office of Compliance Inspections and Examinations (OCIE) released a risk alert dealing with the most frequent best execution deficiencies identified during investment adviser exams. The risk alert can help Registered Investment Advisers (RIAs) improve their best execution policies and procedures and avoid potential problems during their own examinations.

The duty to seek best execution is an important component of an RIA’s fiduciary obligation. Investment advisers must attempt to obtain the best qualitative execution for the managed account. An RIA’s obligation is not necessarily to get the lowest price but to obtain the best qualitative execution.

Six problem areas uncovered by OCIE examiners

OCIE’s risk alert listed six areas where RIAs were deficient in relation to best execution:

Not performing reviews of best execution

Examiners found that RIAs were unable to prove they periodically and systematically evaluated their broker-dealer’s execution performance. Even if these RIAs had performed a review, they lacked books and records to document their efforts.

Not considering relevant factors during their reviews of best execution

Some of the RIAs examined failed to consider all of the relevant factors impacting best execution. They neglected to evaluate broker-dealers’ execution capability, financial responsibility, whether they were responsive to adviser requests, and other important factors. Their evaluation process did not always take the opinions of the firm’s traders and portfolio managers into consideration.

Not comparing broker-dealers

The risk alert found that some RIAs relied on a single broker-dealer without shopping around. The firms did not analyze competing broker-dealers’ execution performance initially and/or on an ongoing basis. Some of the RIAs only conducted superficial reviews of their broker-dealer’s policies and prices or only looked at a brief summary without thoroughly investigating other firms.

Disclosure deficiencies regarding best execution

Examiners learned that some RIAs did not fully disclose their best execution practices. Some failed to disclose that they occasionally trade the same securities after other client accounts, and this practice potentially impacts execution prices. Even if full disclosure occurred, firms did not always adhere to those practices.

Soft dollar issues related to disclosure and mixed-use allocations

Examiners discovered that RIAs were not making fair and full disclosure of their soft dollar arrangements. They did not disclose that some clients were bearing more of the soft dollar costs than others. RIAs must disclose on Part 2A of Form ADV whether the firm uses soft dollars to service all client accounts or only those that paid for the benefits. Firms must also disclose whether they allocate soft dollar benefits proportionately.

Investment advisers did not provide adequate or accurate disclosure of soft dollar payments, which did not qualify as eligible brokerage and research services under the Section 28(e) safe harbor. In accordance with Section 28(e) of the Securities Exchange Act of 1934, investment advisers may pay more than the lowest commission rate in soft dollar arrangements without violating their fiduciary duty. They must, however, meet certain conditions.

Other soft dollar issues arose from RIAs failing to properly administer mixed-use allocations. They did not retain proper documentation to support their rationale for their mixed-use allocations.

Inadequate policies and procedures

Examinations determined that some RIAs established inadequate policies and procedures regarding best execution. Furthermore, they sometimes failed to follow those procedures. For example, RIAs failed to seek comparisons from competing broker-dealers to test for pricing and execution quality. RIAs also did not adhere to procedures requiring that they continue to monitor their broker-dealers for the purpose of evaluating best execution.

Take-aways from OCIE’s risk alert

OCIE’s risk alert can help RIAs to avoid making similar mistakes related to best execution. If necessary, they should amend their best execution and soft dollar disclosures. They should also revise and enhance their policies and procedures in these areas. As is the case with all policies and procedures, RIAs must take steps to ensure that advisory personnel are following them to the letter.

The risk alert can be downloaded at this link.

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Ara Jabrayan is the Managing Member of RIA Compliance Group, LLC, and on the Advisory Board for SmartRIA. His specialties include SEC and state RIA registrations, ongoing compliance assistance, mock exams, and the development of compliance programs. Follow him on LinkedInFacebook, or check out his Blog.

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