On July 11, 2018, the staff in the Office of Compliance Inspections and Examinations (the “Staff“) of the U.S. Securities and Exchange Commission (the “SEC“) issued a risk alert (the “Risk Alert”) describing many of the most common best execution-related deficiencies cited by the Staff in recent examinations of investment advisers. In addition, on July 10, 2018, the SEC announced settlements with investment advisers whom the SEC alleged had committed violations of the SEC’s pay-to-play and advertising regulations. This client alert briefly summarizes the Risk Alert and the settlements, and offers some practical guidance for private fund managers.
By way of background, investment advisers (registered and unregistered) have a fiduciary duty to seek “best execution” of client securities transactions, taking into consideration the circumstances of the particular transaction and considering the full range and quality of a broker-dealer’s services. The Staff has indicated that to fulfill this duty advisers should periodically and systematically evaluate the execution quality of broker-dealers executing their clients’ transactions.
Below are the best execution-related deficiencies highlighted by the Staff in the Risk Alert:
- Not performing best execution reviews. Advisers did not periodically and systematically conduct a best execution review when selecting broker-dealers or were unable to demonstrate, through documentation or otherwise, that they performed such a review.
- Not considering materially relevant factors during best execution reviews. As part of their best execution reviews, advisers did not consider the full range and quality of a broker-dealer’s services, and did not solicit and review input from the adviser’s traders and portfolio managers.
- Not seeking comparisons from other broker-dealers. Advisers used particular broker-dealers without seeking out or considering the quality and costs of services available from other broker-dealers, including some that utilized only one broker-dealer for all clients without shopping around.
- Not fully disclosing best execution practices and soft dollar arrangements. Advisers did not adequately disclose their best execution practices to clients, and did not follow best execution procedures that were disclosed to clients. Advisers also did not fully disclose their soft dollar arrangements in Form ADV, including those products and services obtained with soft dollars that did not qualify as eligible brokerage and research services under Section 28(e) of the Securities Exchange Act of 1934, as amended.
- Not properly administering mixed use allocations. Advisers did not make a reasonable allocation of mixed-use product or service costs based on actual use or did not furnish support, through documentation or otherwise, of the basis for mixed use allocations.
- Weaknesses relating to best execution policies and procedures. Advisers had inadequate – and, in some cases, no – compliance policies and procedures or internal controls regarding best execution, including advisers that failed to monitor broker dealer execution performance and advisers with generic policies that did not reflect the adviser’s actual business practices. Advisers also did not follow their policies and procedures regarding best execution.
According to the Risk Alert, the advisers who were examined took a range of actions, including amending their disclosures regarding best execution or soft dollar arrangements, revising their compliance policies and procedures, or otherwise changing their practices regarding best execution or soft dollar arrangements.
There are a number of takeaways from the Risk Alert for private fund managers. For example, managers should ensure that their reviews of best execution and soft dollar practices are thoughtful and comprehensive, and that adequate documentation of those reviews is maintained. Client disclosures should be accurate and complete, and include any applicable conflicts of interest and risks regarding the manager’s best execution and soft dollar practices. Managers should review their current policies and procedures and disclosure documents regarding best execution and soft dollars to ensure that they are being followed. Managers who in particular have policies and procedures that are “off-the-shelf” or that have not been reviewed in some time should evaluate whether those policies and procedures require updating to sufficiently reflect actual business practices. Furthermore, fund managers who utilize a single or small number of brokers should be especially careful in conducting and documenting their best execution reviews.
On July 10, 2018, the SEC announced settlements with three registered investment advisers regarding alleged violations of Rule 206(4)-5 (the “Pay-to-Play Rule“) under the Investment Advisers Act of 1940, as amended (“Advisers Act“). Among other things, the Pay-to-Play Rule generally prohibits investment advisers from providing investment advisory services for compensation to a government client (or to an investment vehicle in which a government entity invests) for two years after the adviser or its covered associates make a campaign contribution to certain elected officials or candidates for state or local office who can influence the selection of investment advisers to manage government client assets, including public pension fund assets. The Pay-to-Play Rule applies to registered and unregistered investment advisers (including exempt reporting advisers and foreign private advisers).
The alleged violations involved some political contributions made almost 6 years ago and, in some cases, the violative contributions were returned. The settlements included fines ranging from $100,000 to $500,000, plus censure and an order to cease and desist from future violations. The regulatory assets under management of the advisers ranged from approximately $1.7 billion to $110 billion.
These actions reflect that Pay-to-Play Rule compliance remains a hot button item for the SEC, and serve as a reminder to private fund managers of all sizes about the importance of implementing and administering robust policies and procedures regarding political contributions, as well as refreshing the training of relevant employees regarding compliance with the Pay-to-Play Rule. Private fund managers should evaluate their current practices and policies and procedures regarding political contributions to determine whether any potential gaps in compliance exist that should be addressed.
On July 10, 2018, the SEC announced settlements with two registered investment advisers, two investment adviser representatives and a marketing consulting regarding alleged violations of Section 206(4) of the Advisers Act and Rule 206(4)-1(a)(1) under the Advisers Act (collectively, the “Advertising Rule“). Among other things, the Advertising Rule prohibits any SEC-registered investment adviser from using any “advertisement” which refers to any testimonial concerning the investment adviser.
The alleged violations involved publishing client testimonials about the advisers and the investment advice and services that they provide in the form of internet advertisements and videos on various popular social media websites and the advisers’ own websites. The settlements included fines ranging from $10,000 to $35,000, plus censure and an order to cease and desist from future violations. The regulatory assets under management of the advisers ranged from approximately $112 million to $900 million.
Advertising, including the use of testimonials, continues to be a key focus area for SEC examinations and enforcement. Fund managers should be wary not to fall into the same traps regarding their social media and online activities as the advisers in these actions, and should evaluate their current advertising policies and procedures and marketing practices to ensure that they are tailored to actual practices and compliant with the Advertising Rule and related SEC guidance.
 Securities and Exchange Commission, Office of Compliance Inspections and Examinations, Risk Alert: Compliance Issues Related to Best Execution by Investment Advisers (Jul. 11, 2018), available here. The Risk Alert reflects issues identified in deficiency letters from over 1,500 adviser examinations by the Staff.
 See In the Matter of Encap Investments L.P., available here; Sofinnova Ventures, Inc., available here; and Oaktree Capital Management, L.P., available here.
 Just last year, the SEC announced that 10 investment advisory firms agreed to pay penalties ranging from $35,000 to $100,000 to settle charges that they violated the Pay-to-Play Rule (see the SEC press release available here).
 See In the Matter of Romano Brothers & Company, available here; In the Matter of HBA Advisors, LLC, and Jaime Enrique Biel, available here; In the Matter of Brian S. Eyster, available here; In the Matter of William M. Greenfield, available here; and In the Matter of Leonard S. Schwartz, available here.
 See Securities and Exchange Commission, Office of Compliance Inspections and Examinations, Risk Alert: The Most Frequent Advertising Rule Compliance Issues Identified in OCIE Examinations of Investment Advisers (Sep. 14, 2017), available here.
 See the Division of Investment Management’s prior guidance for investment advisers regarding advertising via social media, entitled Division of Investment Management Guidance Update: Guidance on the Testimonial Rule and Social Media (Mar. 2014), available here.