SEC's Recent Communications on "Best Execution"

January 18, 2000

The Securities and Exchange Commission (the "SEC") has recently focused its attention on whether financial advisers are ensuring that their clients are receiving best execution of their transactions. Best execution issues have surfaced as on line trading has mushroomed and as a result of the SEC's 1998 "sweep" examination of soft dollar practices, both within and beyond the scope of the safe harbor provided by Section 28(e) of the Securities Exchange Act of 1934¹ . Whether the safe harbor is available or not, the investment advisor still owes a fiduciary duty to its clients to obtain the best execution of client transactions.

The "sweep" exam heightened the SEC's awareness of the variety of rates that are now available to customers. This awareness caused the SEC to question whether, given the variety of rates available, investment advisers were still adhering to the requirement that they obtain best execution for their client. Best execution encompasses a number of factors starting with the price of the execution and the opportunity for price movement. Other factors are speed and the likelihood of execution. The SEC emphasizes that the quality of execution must be viewed from the customers' perspective, not the firm's.

The SEC began a sweep examination of best execution practices in 1999. No report of that examination has been made public, but in a recent address to the Securities Industry Association, SEC Chairman Arthur Levitt disclosed a number of troubling preliminary findings. He noted, for example, that some firms appear to be allowing payments for order flow or other inducements to affect their placement practices, possibly at the expense of quality executions. Although this is not the time for rulemaking regarding order execution, said Chairman Levitt, investors would benefit from more information.

In addition, the SEC is stressing that financial advisers need to have, and to consistently follow, a method to ensure that their clients are getting best execution of their transactions. Whatever method a financial advisor chooses to put in place, it should evaluate several factors including:

the price of the execution,
the opportunity for price movement,
the speed of the execution, and o the certainty of execution.

According to Lori Richards, Director of the SEC's Office of Compliance, Inspections and Examinations, an investment adviser's evaluation method needs to be reviewed on at least a quarterly basis to make sure that the analysis remains fluid enough to permit clients to get the best prices on their execution. It is anticipated that the changeover from pricing in increments of 1/16 to decimal pricing later this year will serve as a catalyst for quote competition and to further narrow spreads on some securities. Best execution practices may also need to be reviewed after the changeover.

It can be anticipated that SEC examinations will seek to determine that firms have in place an evaluation method that looks at all the necessary factors for best execution, and that the process is implemented on a regular basis. Additional information regarding the results of the SEC's best execution sweep examination also can be expected in the not too distant future.

NOTES:

Under Section 28(e) investment advisers are expressly permitted to use "soft dollars" to pay more than the lowest available commission to a broker dealer in return for research and brokerage services.

If you would like further information about best execution practices or to discuss other issues relating to hedge funds and their investment managers, contact Howard A. Neuman at (212) 818-9200.