Best Execution Tips, FINRA Impostors, Changes in Liquidity Disclosures for Funds: Regulatory Update for August 2018

by Hardin Compliance Consulting LLC

For Investment Advisers:  SEC Actions

 OCIE Issues Risk Alert on Best Execution: The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a risk alert to provide investment advisers with information about the most common deficiencies found in best execution programs.  The winners are:

  1.  Failure to provide proof of the evaluation of broker-dealers responsible for executing client transactions. Advisers, including those that trade in fixed income, should perform a best execution review routinely (e.g., quarterly), and maintain documentation such as a memo or meeting minutes that includes their conclusions on the quality of execution.  Many advisers establish a brokerage or best execution committee for this purpose, but a less formal quarterly meeting with participants from trading, portfolio management, compliance, and other stakeholders may also be appropriate depending on the adviser’s business.  We recommend using a standard agenda for the meeting, including:  review of the performance of approved brokers, an analysis of commissions and other qualitative and quantitative factors considered,  proposed additions and deletions to any approved broker list, review of any soft dollar payments and any new soft dollar requests and a review of commission payments.  For retail advisers that primarily use mutual funds, best execution boils down to making sure that the investor gets the least expensive share class. Check out our blog post for more details on how retail investment advisers can meet their best execution obligations.
  2. Failure to consider materially relevant factors during a best execution review. Advisers should select the quantitative and qualitative factors are important to their business and then ensure that these factors are used to evaluate a broker-dealer’s services.  These typically include execution capability, financial responsibility and responsiveness.  As part of the review, advisers should consider creating a scorecard for their broker-dealers and periodically rating these factors.  Traders and portfolio managers should provide input on the quality of services provided.
  3. Failure to compare quality and costs of services provided by other brokers. Retail investment advisers that establish a relationship with one (or more) a broker-dealer(s) to provide execution and custody services should document their due diligence efforts.  The documentation could include a memo comparing the quality and costs of broker-dealers considered, including a discussion of the deciding factors.  The SEC also expects to see more than a cursory review of broker-dealer policies and procedures.  Finally, advisers should revisit this selection every couple of years to ensure that their clients are still receiving quality service at competitive prices.
  4. Failure to disclose best execution practices. The SEC found that many advisers did not explain to clients that certain types of accounts may trade the same securities after other client accounts and the potential impact that might have on execution prices.  For example, a firm that trades its discretionary accounts before directed or non-discretionary accounts should disclose this practice in the Form ADV Part 2A.
  5. Failure to disclose soft dollar arrangements. Advisers using soft dollars should disclose the types of products and services being obtained more specifically.  For example, the disclosure should specify that if the adviser is getting analyses and reports concerning issuers, industries, securities, economic factors and trends.  Soft dollars might also be used to compensate broker-dealers to arrange meetings with security analysts, government representatives and company and industry representatives, for attendance at research conferences, reports of third-party market strategists, earnings information (including estimates), surveys and custom research reports.  Advisers also need to disclose that some clients bear more of the cost of soft dollar arrangements than others (if true).    Failure to allocate the cost of a mixed-use product or service, or provide evidence of the allocation. Advisers should maintain written documentation on how much a “mixed use” service was paid for by the firm (“hard dollars”), and how much is paid for with soft dollars.  The process for allocation should be a good faith effort to make a reasonable allocation, consistently applied.  Depending on the nature of the product or service and its actual use by the adviser, factors could include:  the amount of time the service is used for eligible purposes (to assist in the investment process) versus non-eligible purposes, how the firm uses the products or services, or the number of employees using the research for investment purposes as compared to non-investment purposes (e.g., marketing).
  6. Weak policies and procedures. The final winner should come as no surprise to anyone, since violations of the Compliance Program Rule (Rule 206-4(7)) seem to show up in every exam letter or administrative proceedings these days.  Advisers should (1) have policies and procedures on best execution, (2) follow those policies and procedures, and (3) keep written documentation of the results. For investment advisers that recommend mutual funds to their clients, best execution policies and procedures should include a review of mutual fund share class selection (check out our blog post).

All advisers are encouraged to review their own best execution policies and procedures related to the common findings outlined above to identify any gaps and to promote a strong compliance program.

California Issues its Own GDPR: On the heels of the GDPR in Europe, California passed a new comprehensive consumer privacy law, California Consumer Privacy Act 2018, for California residents effective January 1, 2020.  Consumers will gain more control over their personal information which includes the right to request disclosure of information the company collects, sells or shares; the right to request deletion of their information; the right to opt out of their information being shared; and the right not to be discriminated against because of choices based on personal information.  Also, the definition of personal information has been greatly expanded to encompass anything that can identify a California resident.   The law covers for-profit entities that exceed $25 million in gross revenues; that buy, sell or share personal information of 50,000 consumers or more; or derive more than 50% of their annual revenue from selling consumer information.  Between Europe and California, it stands to reason companies will probably make comprehensive changes to their systems to meet these obligations impacting consumers. For more details, check out these summaries on the new California data privacy law, one from Pillsbury available here, and another from the Harvard Business Review available here.

SEC’s Pause in ALJ Actions Continues:  The SEC continues its halt on proceedings before its administrative law judges for an additional 30 days to August 22, 2018.   The SEC issued the original order after the U.S. Supreme Court held that the process for hiring SEC’s administrative law judges (“ALJs”) was unconstitutional in its 7-2 decision on June 21, 2018, in Raymond J. Lucia vs. Securities and Exchange Commission.

For Mutual Funds:  SEC Actions

 SEC Changes Disclosure Requirements for Liquidity Information.  The SEC recently adopted various amendments to Form N-PORT as it continues to digest industry feedback on implementing the October 2016 Investment Companies Liquidity Risk Management Programs Rule. First, funds will now be required to disclose information about the operations and effectiveness of their liquidity risk management programs (LRMP) in shareholder reports. This new narrative replaces the original requirement that funds report on Form N-PORT the aggregate percent of a fund’s portfolio in each of the four defined liquidity buckets.  Additionally, the narrative should describe any material liquidity happenings during the reporting period and how the manager addressed them. The SEC offers examples in its adopting release, including the occurrence of and response to any significant withdrawals.  The SEC also amended Form N-PORT to permit advisers to split a holding among more than one liquidity bucket in certain situations, such as a fund with multiple sub-advisers with different liquidity assessments.  Finally, funds will be required to disclose cash and cash equivalent positions on Form N-PORT quarterly.  The SEC noted this disclosure will be beneficial given that funds will no longer need to report the aggregate percent allocated to each liquidity bucket as described above.

 In its adopting release, the SEC highlighted its extensive outreach to identify potential issues associated with the effective implementation of the Investment Companies Liquidity Risk Management Programs rule.  While amendments may bring challenges as firms invest in operations, technology and human resources to prepare for these new disclosures, the SEC is demonstrating that it is listening to the comments received from the industry.

 Important Dates: Large entities have a compliance date of June 1, 2019, with the first filing date of July 30, 2019.  The compliance date for small entities is March 1, 2020, with the first filing date of April 30, 2020.  Contributed by Cari A. Hopfensperger, Compliance Consultant

Division of Investment Management provides web pages on fund disclosures.  On July 6, 2018, the SEC’s Division of Investment Management’s Disclosure Review and Accounting Office (DRAO) launched a new “Disclosure” section on its website. The section contains three separate web pages. “Fund Disclosures at a Glance” includes an explanation of DRAO’s role, disclosure principles, and risk-based framework.  The second page, Accounting and Disclosure Information, includes a collection of web resources on common disclosure topics designed primarily for practitioners and other interested readers.  The third page, Disclosure Reference Material, includes resources such as the Plain English Handbook and common fund disclosure forms. Interwoven across all three pages, “Disclosure News” highlights developments in the world of fund disclosure. Overall, this new resource has elements targeted to the general public as well as practitioners.  If leveraged by both parties, access to this information should contribute to better-crafted disclosures that are also better understood by shareholders.  Contributed by Cari A. Hopfensperger, Compliance Consultant

For Broker-Dealers:  FINRA Actions

FINRA Members: Beware of Regulatory Imposters: In its Information Notice dated July 13, 2018, FINRA warns firms about individuals posing as FINRA employees to obtain confidential information for malicious purposes.  Firms have reported receiving phone calls and emails, purportedly from FINRA, requesting sensitive information for no apparent regulatory reason.  Be suspicious of information requests from overseas telephone numbers, foreign email domains, and emails that do not end with  Broker-dealers should contact their FINRA Regulatory Coordinator if they have any concerns regarding the validity of a request for information.   Contributed by Rochelle A. Truzzi, Senior Compliance Consultant

FINRA is Requesting Information Regarding Participation in Activities Related to Digital Assets: FINRA is encouraging firms to promptly notify their Regulatory Coordinator in writing if the firm, or any of its associated persons or affiliates, engages or plans to engage in activities related to digital assets.  Regulatory Notice 18-20 provides a non-exhaustive list of the types of activities that interest FINRA.  FINRA is not interested in information related to passive investments and activities of associated persons that are subject to FINRA Rule 3210 (Accounts at Other Broker-Dealers & Financial Institutions).  FINRA wants to learn how firms deal with notifications from associated persons regarding their participation in outside activities and private securities transactions related to digital assets through July 31, 2019.  These voluntary disclosures to the Regulatory Coordinator do not replace other regulatory filing obligations, such as Form CMA for material changes in business operations and Form ATS for material changes to the types of securities traded on a platform.  Firms that previously provided this information in response to a direct request from FINRA, on the 2018 Risk Control Assessment Survey, or by submitting a continuing membership application (CMA), do not need to provide additional notice unless that information has changed.

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Hardin Compliance Consulting LLC

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