Seeking Best Execution: Understanding The SEC’s Expectations For Advisors To Deliver Best Outcomes For Clients

An investment adviser is a fiduciary. As a fiduciary, an investment adviser owes a duty of care and loyalty to its clients. The duty of care obligates an investment adviser to seek best execution of client securities transactions.

Easy, right?

If only. Neither the Investment Advisers Act of 1940 nor any of the rules promulgated thereunder contain a single reference to the term "best execution". Nor do the General Instructions to Form ADV  or Form ADV Part 2. To decipher the SEC's expectations with respect to best execution, an adviser must traverse a path through the fiduciary of care and loyalty, borne from a Supreme Court case dating back to 1963, an SEC interpretive release from 1986, an SEC Risk Alert from 2018, an SEC interpretation regarding an adviser's standard of conduct from 2019, and (of course) various enforcement actions over the years.

Best execution is even more of an enigma for advisers that manage client accounts through a single executing broker-dealer that also serves as the qualified custodian of the assets maintained in client accounts (what we'll simply refer to herein as a "custodial broker-dealer"). Advisers that otherwise limit the number of custodial broker-dealers through which they execute trades to those directed by clients face a similar quandary. And given that most blue-chip custodial broker-dealers have effectively eliminated trading commissions for US equities and certain other products, comparing the actual execution costs among such firms may seem like performative quibbling rather than substantive analyses.

What follows is an attempt to unpack an adviser's fiduciary duty to seek best execution of client securities transactions, and what substantive actions can be taken to comply with SEC expectations in this regard.

A Fiduciary Duty

Investment Adviser Regulation 101 can be summarized as follows:

All advisers are fiduciaries that owe a duty of care and loyalty to their clients.

This fundamental tenet is the spring from which all laws and regulations applicable to advisers flows, and traces its roots to the seminal 1963 SEC v. Capital Gains Research Bureau, Inc. Supreme Court case that first read-in an adviser's fiduciary duty to the anti-fraud section of the Advisers Act. In a nutshell, the duty of care is what underlies an adviser's obligation to act with prudence and reasonableness, while the duty of loyalty is what underlies an adviser's obligation not to subrogate clients' interests to the adviser's own interests. This duty cannot be waived, but "follows the contours of the relationship between the adviser and its client, and the adviser and its client may shape that relationship by agreement."

Readers can go deeper on what I've referred to as the "fiduciary funnel" in this prior article.

As near as I can tell, the concept of best execution was first introduced as a component of the fiduciary duty of care in 1967 (Delaware Management Co., 43 SEC 392) and again one year later (Kidder, Peabody & Co. Inc., 43 S.E.C. 911, 915). Henceforth, advisers have been explicitly expected to seek best execution of the transactions they execute in client accounts.

The 1986 SEC Interpretive Release

It wasn't until 1986 that the SEC unofficially set forth a framework for satisfying the fiduciary duty to seek best execution of securities transactions in client accounts, and did so in an interpretive release in which the predominant topic was soft dollars: Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters (the "Interpretive Release"). The topic of best execution was one of the "related matters" and accounts for just 143 words in the entire Interpretive Release.

However, a subset of those 143 words has since become one of the most oft-cited sources of truth for the SEC's expectations for best execution:

The money manager must:

execute securities transactions for clients in such a manner that the client's total cost or proceeds in each transaction is the most favorable under the circumstances.

A money manager should consider the full range and quality of a broker's services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the money merger [sic]. The Commission wishes to remind money managers that the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account. In this connection, money managers should periodically and systematically evaluate the execution performance of broker-dealers executing their transactions. (emphasis added)

There is a lot to unpack here, but the key phrases are excerpted and elaborated upon below.

The Full Range And Quality Of A Broker's Services

As a threshold matter, the Interpretive Release makes it clear that an adviser's best execution analysis shouldn't consider just a single factor or a limited number of factors, but should instead zoom out to appreciate the totality of services that the custodial broker-dealer can bring to the table. Nor should an adviser's best execution analysis be limited to purely quantitative factors like execution speed or price. Qualitative factors should be given just as much attention in the overall kaleidoscope of considerations.

For example, a custodial broker-dealer's instantaneous execution speed and rock-bottom commissions may very justifiably be outweighed by the frequency of trade errors it commits, a terrible online user interface, or a lack of overall capabilities as compared to competitors. On the other hand, a custodial broker-dealer that offers a wide range of services with impeccable quality but that is 3 times the cost of a comparable custodial broker-dealer may not be worth the added expense borne by clients.

Value Of Research

The fact that a custodial broker-dealer makes research available to an adviser (regarding investment products, strategies, micro- or macroeconomic trends, the general market environment, etc.) should also be taken into account, as should the usefulness or "value" of such research. The thinking is that an adviser could ostensibly utilize such research to elevate its investment management prowess, educate its personnel, and generally bring such enhanced knowledge to bear in the products and strategies it implements into client accounts.

Does this mean that an adviser must use the research made available by a custodial broker-dealer? No. But if a custodial broker-dealer's research is used by an adviser, such adviser should consider its quality and usefulness in facilitating "lawful and appropriate assistance to the money manager in the carrying out of his responsibilities".

Execution Capability

Execution capability generally refers to the types of investment products or strategies that a custodial broker-dealer can handle in an accurate and timely fashion. An adviser whose strategy is dependent on the fulfillment of complex derivative transactions would naturally want to seek a custodial broker-dealer that can accommodate such transactions with ease.

If a custodial broker-dealer cannot handle the execution or clearance of certain transactions directly, perhaps it has established a "trade away" or "step-out" relationship with one or more other independent brokers that can (whereby the original custodial broker-dealer is relegated to simply settle the trade away transactions in the client's account and maintaining the safekeeping of the assets under its custody).

Such trade away or step-out transactions may result in additional transaction costs to be borne by clients, so it's important to understand whether an adviser's product or strategy choices will necessitate the use of a trade away relationship and what such incremental costs will be.

Commission Rate

Historically, commission rate was perhaps the most straightforward factor in an adviser's best execution analysis due its quantitative nature and the ability to undertake an apples-to-apples comparison of the fee or commission that was applied on a per trade basis. Over the years, however, custodial broker-dealers have found increasingly 'creative' ways to charge for their services. The evolution of asset-based pricing, platform fees, account activity fees, account type fees, paper statement fees, PITA fees (just checking to see if you're still paying attention), etc. now make the cost analysis a bit more multi-dimensional than a pure 'commission rate' comparison.

However, it is perfectly reasonable for an adviser to focus on a custodial broker-dealer's fees and costs as applied to the types of accounts, transactions, and products that the adviser manages for clients. An adviser that does not invest in mutual funds for its clients may justifiably underweight mutual fund trade costs in its best execution analysis. An adviser that frequently trades in foreign stocks may justifiably overweight foreign stock trade costs in its best execution analysis. The point is that an adviser need not concern itself equally with every conceivable line item fee and cost that a custodial broker-dealer might charge if none of its clients will conceivably incur such fee or cost.

And again, there is no obligation to simply choose the cheapest custodial broker-dealer; cheap execution does not always equal best execution.

Financial Responsibility

Incorporating a custodial broker-dealer's financial responsibility into a best execution analysis is a somewhat bizarre concept, as it implies that there are financially irresponsible custodial broker-dealers that advisers may engage to execute client transactions. Perhaps for this reason, the Securities and Exchange Act of 1934 requires broker-dealers to publish certain financial statements on a periodic basis that should help advisers assess financial responsibility. For example, a sample of such financial statements for Schwab, Fidelity, and Altruist have been linked here for reference.

Advisers are not expected to be spontaneously imbued with the skills of a forensic accountant when reviewing such financial statements, but they should at least get a sense of whether the custodial broker-dealer's financial statements clearly signal a path to financial ruin or an unsustainable business model. Advisers are also encouraged to consider independent analyst research and media reports to the extent they suggest dwindling assets, spiraling pricing pressure, mounting debt, or overall financial instability.

Responsiveness

While execution responsiveness to an online equity order is fairly straightforward and quantitative (in the sense that most blue-chip custodial broker-dealers facilitate such orders in a seamless fashion through their online order entry systems with near instantaneous execution), a custodial broker-dealer service team's responsiveness to an adviser's service requests can be a bit more qualitative. For example, some questions to consider when assessing the responsiveness of service teams are listed below:

• How long is an adviser on hold before connecting with a human being from a custodial broker-dealer's service team?
• How long does a custodial broker-dealer service team take to respond to service requests submitted online or via email?
• How many different custodial broker-dealer service team members does the adviser have to interact with before finding someone who can actually help with the nature of the adviser's inquiry?
• Even if a custodial broker-dealer's service team is highly responsive, are the responses actually accurate, clear, and helpful in addressing the adviser's inquiry?

Advisers may want to consider maintaining a running log of custodial broker-dealer service requests and other interactions to track responsiveness to such requests and interactions over the course of the year, both to uncover upward or downward trends and also to provide a high level snapshot against which to compare other custodial broker-dealers.

Among Other Things

The inclusion of the phrase "among other things" in the Interpretive Release simply means that advisers should not feel limited to solely consider the factors set forth therein, but should instead consider all factors they deem relevant in fulfilling their fiduciary duty to seek best execution.

Periodic And Systematic Evaluation Of Execution Performance

The SEC's expectation of "periodic and systematic evaluation" can more or less be reframed as "initial and ongoing due diligence" of the custodial broker-dealer(s) that are utilized for client securities transactions. In other words, an adviser should perform initial due diligence on any new custodial broker-dealer to be used for client securities transactions, and then periodic ongoing due diligence of said custodial broker-dealer thereafter. The SEC does not prescribe any particular frequency of such evaluations, as they will naturally vary based on the investment products and strategies utilized in client accounts. Most advisers undertake a best execution analysis annually, at least from what I've anecdotally observed.

Embedded within the expectation of periodic and systematic evaluation, however, is the implied obligation to periodically and systematically consider alternatives to the custodial broker-dealers currently utilized for client transactions. Rather than assuming that an adviser's current custodial broker-dealer(s) still provide the best qualitative and quantitative execution for client accounts year after year, an adviser should periodically assess the same best execution factors above with respect to comparable custodial broker-dealers.

This does not mean that an adviser has to suffer through a wholesale custodial broker-dealer change simply because a competitor now offers mutual fund trades that are 10% less than the current incumbent. Instead, the adviser should assess all relevant factors and ask: "Can I continue to fulfill my fiduciary duty to seek best execution by utilizing ABC custodial broker-dealer for client securities transactions given my evaluation of XYZ custodial broker-dealer?".

The conclusion is perhaps based more on art than science, but the factors set forth in the Interpretive Release should at least provide a decision-making framework.

The 2018 SEC Risk Alert

The SEC's Division of Examinations typically publishes a handful of Risk Alerts each year "to remind firms of their obligations under the federal securities laws and help them improve their systems, policies, and procedures." Though Risk Alerts are not rules, regulations, or statements of the SEC and instead simply reflect the views of the staff of the Division of Examinations, they are often a treasure trove of information and provide insight into common issues unearthed during the course of registrant examinations.

The 2018 Risk Alert entitled Compliance Issues Related to Best Execution by Investment Advisers (the "Risk Alert") is no exception.

After summarizing the Interpretive Release and best execution factors described above, the Risk Alert goes on to call out the most common deficiencies that SEC exam staff have encountered over the course of adviser examinations:

• Not performing best- execution reviews (i.e., no demonstrable evidence that the adviser had periodically and systematically evaluated the execution performance of broker-dealers used to execute client transactions).
• Not considering materially relevant factors during best execution reviews (i.e., not considering the "full range and quality of a broker-dealer's services," including execution capability, financial responsibility, and responsiveness to the adviser). In addition, the Risk Alert also notes that – particularly for larger firms – best execution reviews were conducted in a compliance vacuum without input from traders and portfolio managers.
• Not seeking comparisons from other broker-dealers (i.e., not periodically evaluating comparable alternative custodial broker-dealers against the current custodial broker-dealer utilized for all clients). The Risk Alert also cites pure "cursory" reviews that did not provide any substantive value.
• Not fully disclosing best execution practices (i.e., not following the Form ADV Part 2A instructions regarding disclosure of directed brokerage arrangements and order aggregation practices, or otherwise not adhering to the trade review practices described in Form ADV Part 2A).
• Not disclosing soft dollar arrangements (i.e., failing to give clients the opportunity to provide their informed consent to an arrangement whereby commissions are paid to a broker-dealer not only for execution, but also for additional services, namely research). Note: Soft dollar arrangements are inexorably intertwined with best execution, but that's a topic for another day.
• Inadequate policies and procedures relating to best execution (i.e., written best execution policies and procedures either did not exist, did not reflect actual best execution practices, were insufficient, or were not appropriately tailored to the type of securities traded by the adviser).
• Not following best execution policies and procedures (i.e., even if such best execution policies and procedures were adequate, they were not followed).

As should now be apparent, the Risk Alert essentially tracks the components of the Interpretive Release and thus reinforces the SEC exam staff's contemporaneous expectation that – though nearly 40 years old – the expectations set forth in the Interpretive Release should still be respected.

The 2019 SEC Interpretation Regarding An Adviser's Standard Of Conduct

As further evidence of the Interpretive Release's precedence, the 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers (the "Commission Interpretation") cites back to the same 143 words as the 2018 Risk Alert after providing the following conceptual summary:

In meeting [the best execution] obligation, an adviser must seek to obtain the execution of transactions for each of its clients such that the client's total cost or proceeds in each transaction are the most favorable under the circumstances. An adviser fulfills this duty by seeking to obtain the execution of securities transactions on behalf of a client with the goal of maximizing value for the client under the particular circumstances occurring at the time of the transaction. Maximizing value encompasses more than just minimizing cost.

In quoting the Interpretive Release, the Commission Interpretation underscores that an adviser's duty of care in seeking best execution necessitates consideration of the "full range and quality of a broker's services," the "value of research," "execution capability," "commission rate," "financial responsibility," and "responsiveness," as well as the "periodic and systematic" evaluation of execution.

Sound familiar?

A Wrinkle For Directed Brokerage Arrangements?

By this point, I think we've established that the Interpretive Release still carries the day insofar as SEC expectations of an adviser's best execution obligation. However, there are a few sentences from both the Risk Alert and the Commission Interpretation that suggest that not all advisers are subject to the same best execution obligations – or that some advisers may not have a fiduciary duty to seek best execution of client securities transactions at all:

• Risk Alert: "As a fiduciary, when an adviser has the responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek to obtain 'best execution' of client transactions, taking into consideration the circumstances of the particular transaction."
• Commission Interpretation: "An investment adviser's duty of care includes a duty to seek best execution of a client's transactions where the adviser has the responsibility to select broker-dealers to execute client trades (typically in the case of discretionary accounts)."

I've intentionally emphasized "when an adviser has the responsibility to select broker-dealers and execute client trades" and "where the adviser has the responsibility to select broker-dealers to execute client trades" as they represent important qualifiers that condition the application of the duty to seek best execution. Said another way, such qualifiers suggest that an adviser that has not accepted the responsibility to select custodial broker-dealers on behalf of the client is not under an obligation to seek the best execution of client transactions.

In the simplest application of a client-directed brokerage arrangement, this makes logical sense. If a client voluntarily directs an adviser to execute trades on behalf of the client at a particular broker of the client's choosing, the adviser literally cannot seek out alternative executing brokers without disregarding the client's instructions and creating an entirely different fiduciary duty issue for itself. It is the client, in a purely directed brokerage relationship, who assumes the responsibility of determining whether the client-directed broker provides the best execution of the desired transaction pursuant to whatever factors the client deems relevant.

Indeed, the Form ADV Part 2 Instructions require specific disclosure to be made about directed brokerage arrangements in Item 12.A.3.b. that reflect the implicit transfer of best execution responsibility from the adviser to the client: "If you permit a client to direct brokerage, describe your practice. If applicable, explain that you may be unable to achieve most favorable execution of client transactions. Explain that directing brokerage may cost clients more money. For example, in a directed brokerage account, the client may pay higher brokerage commissions because you may not be able to aggregate orders to reduce transaction costs, or the client may receive less favorable prices." Though the client may have assumed best execution responsibility in what I'll refer to as a "permitted" directed brokerage arrangement, the adviser must still disclose the downside possibilities of such an arrangement to the client (namely, less favorable execution and/or higher costs).

On the other hand, not all directed brokerage arrangements are created equal. What if an adviser recommends, requests, or requires that a client direct the adviser to use a particular custodial broker-dealer? The Form ADV Part 2 Instructions specifically address this scenario in Item 12.A.3.a: "If you routinely recommend, request or require that a client direct you to execute transactions through a specified broker-dealer, describe your practice or policy. Explain that not all advisers require their clients to direct brokerage. If you and the broker-dealer are affiliates or have another economic relationship that creates a material conflict of interest, describe the relationship and discuss the conflicts of interest it presents. Explain that by directing brokerage you may be unable to achieve most favorable execution of client transactions, and that this practice may cost clients more money." Again, advisers are required to disclose the potential downside of what I'll refer to as a "recommend/request/require" directed brokerage arrangement.

Importantly, there is a key difference between permitted directed brokerage arrangements and recommend/request/require directed brokerage arrangements: Permitted directed brokerage arrangements cause the client to assume best execution responsibility, whereas recommend/request/require directed brokerage arrangements do not. By recommending, requesting, or requiring that clients use a custodial broker-dealer (likely one with which the adviser has an established relationship pursuant to some form of service agreement and online platform access), the adviser cannot absolve itself of its fiduciary duty to seek best execution through such custodial broker-dealer even if the client ultimately directs the adviser to use the custodial broker-dealer recommended, requested, or required to be used by the adviser.

Additional clarity regarding the SEC's expectation with respect to directed brokerage arrangements is provided in the following excerpt from the Final Rule Adopting Amendments to Part 2 of Form ADV, Release No. IA-3060:

Item 12 requires an adviser that permits clients to direct brokerage to describe its practices in this area. Item 12 also requires that such an adviser explain that it may be unable to obtain the most favorable execution of client transactions if the client directs brokerage and that directing brokerage may be more costly for clients. If, however, an adviser routinely recommends, requests or requires clients to direct brokerage, Item 12 also requires the adviser to describe this practice in its brochure, to disclose that not all advisers require directed brokerage, and to describe any relationship with a broker-dealer to which the brokerage may be directed that creates a material conflict of interest. An adviser may omit disclosure regarding its inability to obtain best execution if directed brokerage arrangements are only conducted subject to the adviser's ability to obtain best execution.

Mutual Fund Share Class Selection

I would be remiss if I did not at least mention the SEC Division of Enforcement's extension of best execution principles to advisers' mutual fund share class selection, as evidenced by the string of enforcement actions that resulted from the SEC's iterative Share Class Initiative that originated in 2016. Though ostensibly focused on undisclosed conflicts of interest and associated compensation earned by advisers from mutual fund companies through the purchase of certain higher cost mutual funds, such enforcement actions also cited such adviser's failure to seek best execution – a breach of the fiduciary duty of care. The SEC's contention is that an adviser that recommends a higher-cost mutual fund share class, which results in additional compensation for the adviser when the client was eligible for a lower cost share class within the same mutual fund, has de facto failed to satisfy its duty to seek best execution of the attendant transaction.

Notwithstanding the debatable application of best execution to mutual fund share class selection in and of itself (given the historical application of best execution solely to broker selection), what has raised my eyebrows even further is – in my anecdotal experience – the SEC exam staff's assertion of a best execution failure to an adviser's mutual fund share class selection that did not result in any compensation to the adviser and thus presented no associated conflict of interest. All else being equal, it appears that there is a de facto best execution obligation for an adviser to select the lowest cost share class a client is eligible for within a mutual fund that offers multiple share classes.

For this reason, I recommend that advisers periodically scrub the roster of mutual funds they may purchase for their clients to confirm that no lower-cost share class alternatives are available. I also recommend that advisers periodically scrub existing mutual fund holdings within client accounts to confirm that clients are not eligible for a tax-free conversion to a lower cost share class within the same mutual fund.

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At least for most likely readers of this article, gone are the days of advisers doling out orders to Bud Fox at Jackson Steinem & Co. for positions in Anacott Steel and Bluestar Airlines. In its place, 'advicers' have largely transitioned to establishing a single or small handful of relationships with blue-chip custodial broker-dealers that they recommend, request, or require their clients to utilize for the execution of transactions.

By remaining mindful of both the quantitative and qualitative factors that the SEC expects to be considered when initially and periodically evaluating such custodial broker-dealers, advisers can ensure they not only fulfill their fiduciary duty to seek the best execution on behalf of their clients but also continue delivering the best possible outcomes!