Board Oversight of Best Execution. James R. Burns April 13, 2016

Transcription

1 Board Oversight of Best Execution James R. Burns April 13, 2016

2 Agenda I. Overview II. Best Execution Obligations of Investment Advisers and Broker-Dealers III. A Director s Oversight Obligation IV. Recent Developments V. Questions 2

3 I. Overview 3

4 The Mutual Fund Director s Role The SEC and its staff maintain that mutual fund directors play a critical role in overseeing the funds operations and protecting the interests of their shareholders an obligation to: act as a watchdog over the actions of a fund s investment adviser (managing inherent conflicts of interest in a fund structure) oversee the activities of other fund service providers while delegating day-to-day operational responsibilities For best execution, this requires a thorough understanding of the regulatory obligations facing the service providers involved in executing trades: the investment adviser and the broker-dealer 4

5 Two Standards for Best Execution The SEC and its staff have indicated that best execution obligations are subject to different standards depending on whether a firm is an adviser or broker-dealer: An investment adviser s best execution duty focuses on the total transaction cost of a client s order, including consideration of the commission that the brokerdealer charges A broker-dealer s best execution duty largely focuses on the price at which a client s order is executed, without consideration of the commission that the broker-dealer charges 5

6 Best Execution Overview: Investment Advisers An Adviser s obligation to seek best execution is derived from the general anti-fraud provisions of the Investment Advisers Act The U.S. Supreme Court recognized a fiduciary duty in Section 206 The Courts and the SEC determined that such fiduciary duties include the duty to seek best execution Courts and the Securities and Exchange Commission (the SEC ) have interpreted Section 206 to mean that an adviser has certain fiduciary duties including the duty to seek best execution. This means: 6

7 Best Execution Overview: Investment Advisers, cont. An adviser must execute securities transactions for clients in a manner that the client s total cost or proceeds in each transaction is the most favorable under the circumstances. SEC Policy Statement on Future Structure of Securities Markets, Exchange Act Release No (May 9, 1972). Most favorable terms reasonably available While transaction cost is important, it is not the most important factor. 7

8 Best Execution Overview: Broker-Dealers Generally broker-dealers are required to seek the most favorable terms for a customer order that are reasonably available under the circumstances The SEC has stated that additional factors, other than price and speed, may help determine whether best execution was achieved (1) the size of the order (2) the trading characteristics of the security involved (3) the availability of accurate information affecting choices as to the most favorable market center for execution and the availability of technological aids to process such information (4) the cost and difficulty associated with achieving an execution in a particular market center 8

9 I. Best Execution Obligations II. of Investment Advisers and Broker-Dealers 9

10 Client s Total Cost or Proceeds The SEC has taken the position that, in fulfilling its duty of best execution, an adviser 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. See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Securities Exchange Act Release No (Apr. 23, 1986) ( Soft Dollar Release ) < Two key component parts to the client s total cost or proceeds: (1) the transaction compensation paid to the broker-dealer executing the transaction (2) the market price paid or received in connection with the transaction 10

11 Relevant Circumstances Relevant circumstances in the context of best execution include: the full range and quality of a broker s services in placing brokerage [such as] the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the money manager. Soft Dollar Release. The SEC has emphasized that the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account. Soft Dollar Release. 11

12 Quantitative and Qualitative Factors Advisers must analyze the full range and quality of a broker's services in placing brokerage, including both quantitative and qualitative factors: Quantitative Considerations Commission rates Cost/price Qualitative Considerations Broker s ability to handle complex trades Ability to borrow securities for short sales Knowledge of and access to market participants Value of each broker s research Execution capability Financial stability and responsibility Reputation and knowledge within the industry Advisers must periodically and systematically evaluate the execution performance of broker-dealers executing their transactions 12

13 Reasonable Diligence and Current Market Conditions A broker-dealer must use reasonable diligence to ascertain the best interdealer market for a security, and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions The factors to be used when applying reasonable diligence in this area are: The character of the market for the security (e.g., the price, volatility, relative liquidity, and pressure on available communications) The size and type of transaction The number of markets checked Accessibility of the quotation The terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member 13

14 A Broker-Dealer s Internal Review of Best Execution Firms also have the obligation, as articulated by both the SEC and FINRA, to regularly and rigorously review, as opposed to review on an order-by-order basis, the execution quality likely to be obtained from different markets or market makers for a security The SEC has acknowledged that it may be impractical for broker-dealers that handle large volume orders to evaluate best execution on an order-byorder basis. See Exchange Act Release No A (Sept. 6, 1996) < Automated routing or execution of customer orders is not inherently inconsistent with best execution 14

15 Internal Review, cont. Factors for a broker-dealer to consider when conducting a regular and rigorous review under Rule 5310, include: (1) price improvement opportunities (2) differences in price disimprovement (3) the likelihood of execution of limit orders (4) the speed of execution (5) the size of execution (6) transaction costs (7) customer needs and expectations (8) the existence of internalization or payment for order flow arrangements. should be considered when conducting a regular and rigorous review, as required. 15

16 Best Execution Obligations: Broker-Dealers FINRA Regulatory Notice (Nov. 20, 2015) providing guidance on best execution < [G]iven developments in order routing technology, order-by-order review of execution quality is increasingly possible for a range of orders in all equity securities and standardized options. The regular and rigorous standard of review only applies to a firm s initial determination whether to route an order and to its review of orders routed outside the firm. Orders that a firm determines to execute internally are subject to an order-by-order best execution analysis. These statements appear to be the basis for the new guidance requiring an order-by-order review of larger-sized orders that are externally routed and internally executed orders 16

17 Best Execution Obligations: Broker-Dealers Municipal Securities Rulemaking Board ( MSRB ) Rule G-18 (Effective March 21, 2016) < Requires dealers, in any transaction for or with a customer or a customer of another dealer, to use reasonable diligence to ascertain the best market for the subject security and to buy or sell in that market so that the resultant price to the customer is as favorable as possible under prevailing market conditions Applies to any transaction in a municipal security for or with a customer or a customer of another dealer, without any exception for orders that are routed to another dealer Section (a) includes a non-exhaustive list of factors that dealers must consider when exercising this diligence, which includes: the character of the market for the security (e.g., price, volatility, and relative liquidity), the size and type of transaction, the number of markets checked, the information reviewed to determine the current market for the subject security or similar securities, the accessibility of quotations, and the terms and conditions of the customer s inquiry or order, including any bids or offers, that result in the transaction, as communicated to the dealer 17

18 Director Guidance 18

19 Director Guidance As various brokerage practices come under increasing fire, boards of registered funds should evaluate the extent to which their investment adviser has resolved the following fundamental questions: Should we measure best execution on a per trade basis, or over a certain time period? Does the fund excessively use one or a small group of brokers? Should the focus of the best execution review be on execution date or overall account performance? What circumstances suggest the use of an ECN or a full service broker-dealer? Should a consultant be retained to assist in the best execution analysis? For fund boards, has all potentially relevant documentation regarding the adviser s execution process been requested? Have we adequately disclosed our brokerage practices? 19

20 Questions to Ask of an Adviser When assessing an investment adviser s best execution process during the course of a routine inspection of the adviser s operations, the SEC staff typically asks seven questions: How is the process organized? Who participates in the process? What types of information does the adviser use? What criteria does the adviser use to select its brokers and to evaluate its executions? What documentation is prepared to reflect the decision process? What disclosure does the adviser make regarding its execution practices and policies? Does the process include regular review? Alison Sahoo, Seven Key Questions the SEC Asks about Best Execution, Ignites.com, (May 29, 2001) ( Seven Key Questions ) < A mutual fund board can follow their lead and ask these same questions 20

21 Preferred Answers Generally, the answers to those questions should include: The adviser should have an organized process for making execution determinations The adviser should ensure that all users of broker-dealer services within the advisory organization participate in the process The adviser should evaluate the cost of the brokerage services against its quality based on the services the adviser receives from the broker The adviser should document the decision process The adviser should disclose its execution practices and policies The adviser should establish a process for regular review Seven Key Questions 21

22 SEC Guidance re: Portfolio Trading In July of 2008, the SEC issued a release proposing guidance to fund boards of directors concerning their responsibilities to oversee the adviser s satisfaction of its best execution obligations... See Commission Guidance Regarding the Duties and Responsibilities of Investment Company Boards of Directors with Respect to Investment Adviser Portfolio Trading Practices, Securities Exchange Act Release No (July 30, 2008) < Although never officially adopted, the SEC noted that the guidance did not impose any new or additional requirements on fund directors It is often considered the SEC s gold standard for a fund director s oversight responsibilities relating to best execution 22

23 Portfolio Trading Guidance, cont. The SEC indicated that mutual fund directors should: Be aware of transaction costs incurred by the fund, making sure that the payment of such costs is in the best interest of the fund and its shareholders Maintain familiarity with the adviser s trading practices to the extent necessary to satisfy itself that the adviser is acting in the best interest of the fund Consider if the adviser s decision on whether to use alternative trading practices benefits the fund. Should demand all information necessary from the adviser to make an informed decision with respect to all of the above prescriptions, including: The identification of broker-dealers utilized by the adviser Commission rates or spreads paid Total brokerage commissions allocated to each broker-dealer The fund s portfolio turnover rates 23

24 Portfolio Trading Guidance, cont. The SEC also indicated that a board should discuss with the adviser: The process by which trading decisions are made The means by which the adviser evaluates best execution The process by which commission rates are negotiated How a determination of execution-only trade quality is made The process by which trader performance is evaluated If sub-advisers are used, how they are monitored The means and regularity with which the adviser transacts with affiliates The monitoring process for international trades The process by which fixed-income instruments are traded How trade execution quality is evaluated with respect to instruments traded on a principal basis 24

25 Director Guidance: Additional Considerations Mutual fund directors responsibilities are not bounded at trading and conflicts of interest Directors must ensure that they stay informed about every aspect of an adviser s interaction with the fund and use of brokerage commissions, including: The adviser s processes for self-policing, both with respect to soft dollar use (e.g. determination of what constitutes research) and generally The terms of the contract between the adviser and the fund, especially including compensation The adviser s accounting procedures, including its classification process for soft dollar expenditures, if any 25

26 Director Guidance: Best Practices Third party review of transactions The SEC s proposed 2008 guidance did not require that directors retain a third party vendor to perform a review of an adviser s transaction costs However, advisers are increasingly turning to outside consultants to evaluate best execution procedures Board reporting Commission cost How does the adviser determine its soft dollar research budget? How does it allocate soft dollar commissions? Soft dollar use and value How are soft dollar products and services allocated among the advisers clients? Adviser representation in 15(c) process re: best execution Brokerage Committee Depending on the size of the adviser, directors should consider appointing a brokerage committee that specializes in overseeing issues related to best execution 26

27 Director Guidance: Best Practices Soft Dollar Committee, voting on research providers Separation of trading and portfolio management functions Recordkeeping Document the steps that the adviser takes to achieve best execution Directors should require larger advisers to provide more detailed records on their brokerage selections than smaller firms The more resources an adviser has, the better equipped the SEC presumes it to be to evaluate its trades Disclosure of policies Disclose to clients the procedures governing how the adviser selects brokerage services on behalf of investment clients Disclose to clients any potential conflicts of interest 27

28 Recent Developments 28

29 Recent Developments: SEC Enforcement Actions Manarin Investment Counsel, Ltd., Advisers Act Release No (Oct. 2, 2013) < The SEC alleged that an adviser and broker-dealer failed to obtain best execution for three investment funds managed by the adviser (including a mutual fund) by purchasing higher cost mutual fund shares, even though cheaper shares in the same mutual funds were available A.R. Schmeidler & Co., Inc., Advisers Act Release No. 3637(July 31, 2013) < The SEC alleged that a dually-registered investment adviser and broker-dealer failed to seek best execution in breach of its fiduciary duty, and allegedly failed to implement policies and procedures reasonably designed to prevent its purported best execution violations Goelzer Investment Management, Inc., Advisers Act Release No (July 31, 2013) < The SEC alleged that a dually registered investment adviser and broker-dealer inappropriately directed trades through itself as a broker-dealer without disclosing on its Form ADV that it did not consider or analyze other unaffiliated broker-dealers 29

30 Recent Developments: SEC Enforcement Actions (cont d) In the Matter of Northern Lights Compliance Services, LLC, et al, Investment Company Act Release No (May 2, 2013) < pdf> The SEC alleged that certain mutual fund trustees misrepresented to shareholders the extent of information they relied on, and diligence they performed, when evaluating investment advisory contracts up for renewal J. Kenneth Alderman, CPA, et al., Investment Company Act Release No (Dec. 10, 2012) < The SEC alleged that former members of the boards of directors overseeing five mutual funds violated their asset pricing oversight responsibilities under the Federal Securities laws Tilden Louck & Woodnorth, LLC, LaSalle St. Securities, LLC, and Ralph B. Louck, Advisers Act Release No (Oct. 29, 2012) < The SEC alleged that an adviser obtained undisclosed compensation and violated its best execution obligations by charging increased commissions on trades executed through its affiliated broker-dealer 30

31 Recent Developments: Regulatory Guidance November 2015 FINRA Publishes FINRA Regulatory Notice providing guidance on best execution (See Best Execution Obligations: Broker-Dealers, slide 16) November 2015 MSRB published implementation guidance to accompany MSRB Rule G-18, the first best execution rule established for transactions in municipal securities (See Best Execution Obligations: Broker-Dealers, slide 17) 31

32 Questions? 32