Board Guidance/Adviser Compliance: The SEC Proposes Oversight of Investment Adviser Practices

August 11, 2008

The Securities and Exchange Commission (“SEC”) recently published proposed guidance (the “Guidance”) to boards of directors of registered investment companies to assist them in overseeing the trading practices of investment advisers, focusing on the advisers’ best execution obligations and the use of soft dollars.  [1] Whether an investment adviser manages registered investment company assets or not, the oversight responsibility the SEC expects mutual fund boards to exercise is illustrative of the review processes all investment advisers will be expected to employ when examiners from the SEC’s Office of Compliance Inspections and Examinations conduct investment adviser examinations.  As such, the SEC’s views are set forth below.

The Guidance noted that several factors go into the evaluation of an adviser’s best execution obligation, including the minimization of transaction costs.  Both explicit costs (such as brokerage commissions, dealer markups/downs and taxes paid) and implicit costs (such as bid/ask spreads, the impact of executing a trade on prices and missed trading opportunities) are to be considered.  The SEC noted that the implicit costs of a trade may, in fact, exceed its explicit costs and that implicit costs can themselves be influenced by several factors, including anonymity, the trading intermediary’s willingness to commit capital to facilitate the trade, and the speed and price of execution, as well as the quality and usefulness of any research obtained by the investment adviser.  An adviser’s use of alternative trading systems, such as “dark pools, [2] ” advanced mathematical models and algorithmic trading systems and crossing networks, is an additional factor to be evaluated.  Accordingly, the Guidance often uses the term “trading intermediary” rather than broker-dealer.  In any event, every investment adviser is expected to determine for itself what processes it should employ in selecting trading intermediaries, but an adviser must “periodically and systematically” evaluate the performance of the broker-dealers that it engages to execute securities transactions.

In light of the foregoing, the Guidance advises mutual fund directors to obtain information from their investment advisers that will permit a proper evaluation of the adviser’s trading practices.  With respect to best execution obligations, this information generally should include at least the following:

• the identities of all broker-dealers employed by the adviser,
• the commission rates or spreads paid,
• total commissions and the value of securities executed by each broker-dealer during a measurement period, and
• the fund’s portfolio turnover rates.

Boards should also consider, among other things, the following:

• the adviser’s process for making trading decisions,
• the factors involved in selecting trading markets,
• the factors involved in selecting broker-dealers,
• how the adviser defines best execution and evaluates execution quality,
• how the adviser evaluates the impact of alternative trading systems on best execution,
• how commission rates are negotiated, including whether comparative data is used,
• how transactions costs are measured,
• how the quality of “execution-only” trades is measured against other trades, such as those with soft dollar components,
• how the adviser’s trading performance is measured,
• how the adviser’s traders’ performance is measured,
• how each broker-dealer’s performance is measured and how problems are addressed, and
• with respect to international trading, how trades are conducted and monitored.

The Guidance noted that some firms use third-party vendors to employ transaction cost analyses based on comparative industry data to assist in the best execution evaluation, while acknowledging that there are no commonly accepted standards as to how to measure price impact.  The Guidance also asked for comments from the industry regarding these issues.

The object of these reviews is, of course, to make sure that the adviser conducts its trading in the best interests of the fund and whether the adviser’s policies and procedures are “reasonably designed, adequate, and being effectively implemented to prevent violations of the Federal securities laws.” As such, any investment adviser can incorporate the SEC’s guidance into its own trading practices review policies and procedures.

With respect, specifically, to the use of soft dollars generated by trading on behalf of a mutual fund, an adviser is required to determine that the use of soft dollars falls within the safe harbor provided by section 28(e) of the Securities Exchange Act of 1934, as amended (“Section 28(e)”).  In particular, the product or service obtained must be eligible research or brokerage and provide lawful and appropriate assistance in the performance of the adviser’s investment decision-making responsibilities and the adviser must in good faith determine that the amount of commissions paid is reasonable in light of the value of what was provided.  The Guidance nevertheless advises that mutual fund directors evaluate the adviser’s use of soft dollars to determine whether or not the adviser is acting in the best interest of the fund.  In order to do so, directors are advised to examine the procedures the adviser uses to address potential conflicts of interest.  To avoid concerns that a broker-dealer may be selected for reasons other than the quality of execution (including the provision of soft dollar benefits), some large advisers use a process referred to as a “broker vote” or “broker tolls.” This process involves the assessment of the value of the research and services different broker-dealers provide to determine which broker-dealers should continue to be employed.

To assist a mutual fund’s board in conducting its evaluation, the Guidance suggests that the directors obtain information regarding how the adviser:

• determines how much research should be obtained and by what means,
• determines the amount of hard dollars and soft dollars to be spent,
• elects between proprietary research and third-party research arrangements,
• selects the types of research products and services to be obtained and how they will benefit the fund,
• determines how commission recapture programs and expense reimbursement programs will be employed,
• establishes a soft dollar research budget, and
• allocates soft dollars among broker-dealers.

In addition, consideration should be given to the following factors, among others:

• whether any alternative trading venues produce soft dollar credits and to what extent,
• how the adviser determines that soft dollars usage is within the Section 28(e) safe harbor described above,
• the ratio between the adviser’s soft dollars and total commission budgets,
• the allocation of soft dollar products and services among the adviser’s clients,
• the adviser’s brokerage policies in general and the commission rates paid by other clients, especially those that do not include a soft dollar component,
• the extent, if any, to which soft dollar arrangements benefit clients that do not generally pay brokerage commissions, such as fixed-income funds,
• the process for assessing the value of the products or services purchased with soft dollars,
• the process used to evaluate the portion of a mixed use product or service that can be paid for under section 28(e), and
• the extent to which the adviser uses client commission arrangements and their effect on the adviser’s broker-dealer selection process. 

Again, the SEC requested comment on the information boards should receive to facilitate their review of an adviser’s use of soft dollars with the goal of facilitating a fund board’s ability to determine the best use or uses to which the fund’s commission dollars can be put.

Advisers who do not provide their services to mutual funds should not ignore or feel exempt from the Guidance.  While the Guidance may appear limited to fund board oversight of adviser practices, the Guidance is cautionary for all investment advisers.  In proposing disclosure oversight that fund directors should practice, the Guidance reflects expectations for disclosure that all investment advisers owe their clients.  As a practical matter, from an adviser’s perspective, much of the disclosure and maintenance requirements the Guidance addresses are already expected of all advisers.  For example, Part II to Form ADV already obligates disclosure to clients; an adviser’s practices and policies regarding conflicts of interest and appropriate management of these conflicts are already subjects of disclosure to clients.  But the Guidance suggests that Form ADV is inadequate in application, as it is provided only to clients and has insufficient detail.  Therefore, changes proposed in the Guidance may be read as potentially applicable to all advisers, even those without fund clients.  Additionally, the Guidance proposes not only that disclosure of this information be expanded, but also that disclosure stop not with directors; i.e., that disclosure be made available to fund participants. It is not a reach to expect this expansive disclosure to fund investors eventually to be mirrored for an adviser’s clients. 

In addition, while the Guidance is directed at addressing the needs of mutual fund boards to stay knowledgeable and act proactively where investment adviser trading practices are concerned, the Guidance clearly focuses attention on the fiduciary obligations that investment advisers owe their clients.  Consequently, all advisers—even those who do not advise mutual funds—should be alert to how they exercise and monitor their performance with respect to their best execution obligation and compliance with Section 28(e).  Hence, all advisers should consider how ably they comply with these obligations and how readily they could respond to a disclosure request that might result from the Guidance.

[1] Commission Guidance Regarding the Duties and Responsibilities of Investment Company Boards of Directors with Respect to Investment Adviser Portfolio Trading Practices, SEC Release Nos. 34- 58264; IC-28345; IA-2763 File No. S7-22-08, July 30, 2008.

[2] The Guidance describes dark pools as “markets that do not display quotes, but rather execute trades internally without displaying liquidity to other participants. A number of markets combine non-displayed liquidity with display of quotes. A substantial portion of the trading volume of these markets may result from interaction of orders with their non-displayed liquidity.” The Guidance further noted that it was recently reported that “although dark pools currently make up seven to ten percent of equities’ share volume in the U.S., that percentage is steadily increasing” while cautioning that dark pools can “raise challenges to funds in certain situations.”

For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.