Key Takeaways
- Best execution requires seeking the most favorable terms reasonably available.
- Applies to both investment advisers (fiduciary duty) and broker-dealers.
- Factors include price, speed, likelihood of execution, and total cost.
- Soft dollar arrangements must provide research benefits to clients.
- Section 28(e) provides safe harbor for soft dollars used for research.
- Directed brokerage may impact best execution obligations.
- Regular review of execution quality is required.
- Trade allocation must be fair among all client accounts.
Best Execution
Best execution is the obligation to seek the most favorable terms reasonably available when executing client transactions.
Definition and Scope
What is Best Execution?
Best execution means executing client orders at the most favorable terms reasonably available under the circumstances.
Who is Subject to Best Execution?
| Entity | Standard |
|---|---|
| Investment Advisers | Fiduciary duty component |
| Broker-Dealers | FINRA Rule 5310 |
| Dual Registrants | Both standards apply |
Factors in Best Execution
Key Considerations
| Factor | Description |
|---|---|
| Price | Best available price for the security |
| Speed | Timeliness of execution |
| Size | Ability to execute the full order |
| Likelihood | Probability of execution |
| Total cost | All-in cost including commissions |
| Settlement | Certainty of settlement |
Market Conditions
Consider prevailing market conditions:
- Current bid/ask spread
- Market volatility
- Liquidity of the security
- Size of the order relative to volume
Execution Quality Review
Regular and Rigorous Review
Advisers must conduct regular and rigorous evaluation of execution quality:
| Review Element | Frequency |
|---|---|
| Broker comparison | At least annually |
| Execution quality analysis | Quarterly recommended |
| Commission rate review | Annually |
| Service evaluation | Ongoing |
Documentation Requirements
| Document | Purpose |
|---|---|
| Broker selection criteria | How brokers are chosen |
| Execution reports | Analysis of execution quality |
| Commission schedules | Fee arrangements |
| Review findings | Results of periodic evaluations |
Soft Dollar Arrangements
Definition
Soft dollars are arrangements where advisory clients pay more than the lowest available commission in exchange for research or other services.
Section 28(e) Safe Harbor
The safe harbor protects advisers who use commissions to pay for:
| Eligible | Not Eligible |
|---|---|
| Research reports | Office rent |
| Financial databases | General office equipment |
| Analytical software | Travel expenses |
| Portfolio analysis tools | Salesperson salaries |
| Market data | Advertising |
| Execution services | Legal services |
Three-Part Test
For Section 28(e) protection:
- Eligible product or service - Must be research or brokerage
- Lawful and appropriate assistance - Helps in investment decision-making
- Good faith determination - Commission is reasonable relative to value
Disclosure Requirements
Soft dollar arrangements must be disclosed in:
- Form ADV Part 2A (Brochure)
- Description of services received
- Conflicts of interest involved
Directed Brokerage
Client-Directed Brokerage
When clients direct which broker to use:
| Consideration | Implication |
|---|---|
| Best execution | May not achieve best execution |
| Disclosure | Must disclose potential impact |
| Documentation | Client direction must be in writing |
| Responsibility | Adviser not responsible for execution quality |
Adviser-Directed Brokerage
When advisers select brokers:
- Best execution obligation fully applies
- Must periodically evaluate alternatives
- Document selection rationale
Trade Allocation
Fair Allocation Policy
When aggregating orders, allocation must be:
| Principle | Application |
|---|---|
| Fair | No favoritism among accounts |
| Equitable | All accounts share proportionally |
| Consistent | Applied uniformly over time |
| Documented | Allocation policy in writing |
Allocation Methods
| Method | Description |
|---|---|
| Pro-rata | Based on account size or order size |
| Rotational | Accounts take turns receiving first fills |
| Random | Computer-generated random allocation |
| Bundled | All accounts receive same average price |
IPO Allocation
Special considerations for IPOs:
- Must have written allocation policy
- Cannot favor certain accounts
- Performance-based fees don't get priority
- New accounts don't automatically get IPOs
Trade Aggregation
When Aggregation is Appropriate
Aggregating client orders may be appropriate when:
- Multiple clients need similar trades
- Aggregation benefits all participants
- Written policies permit aggregation
- Fair allocation is ensured
Benefits of Aggregation
| Benefit | Description |
|---|---|
| Better prices | Larger orders may get better execution |
| Lower costs | Reduced per-share commissions |
| Fair treatment | All clients share same price |
| Efficient execution | Reduces market impact |
Exam Tip: Best execution considers price, speed, size, likelihood, and TOTAL COST. Soft dollars are protected under Section 28(e) for RESEARCH and BROKERAGE only. Trade allocation must be FAIR and EQUITABLE among all accounts.
Best execution requires an adviser to seek:
Under Section 28(e), an investment adviser may use soft dollars to pay for:
When aggregating trades for multiple client accounts, the adviser must:
A client directs the adviser to use a specific broker. The adviser:
15.3 Account Management and Supervision
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