Best Execution Standard

Art by Tim Bower

Registered broker/dealers (B/Ds) and investment advisers have long been required to comply with a “best execution” standard when making trades for their clients. That obligation is now one of the conditions a financial institution and financial professional must meet to take advantage of the Department of Labor (DOL)’s Prohibited Transaction Exemption (PTE) 2020-02. The failure to meet the standard will result in the loss of exemptive relief. Therefore, firms should be looking at their current best execution policies and procedures and how those should be coordinated with their PTE 2020-022 compliance efforts.

The fiduciary standards in Section 203 of the Investment Advisers Act of 1940, according to the Securities and Exchange Commission (SEC), establish a best execution requirement. Advisers must select broker/dealers through which trades on behalf of clients will be executed in a manner that helps ensure that the client’s total costs or proceeds in each transaction are the most favorable under the circumstances.

Further, Financial Industry Regulatory Authority (FINRA) Rule 5310 imposes a best execution standard on registered broker/dealers. Brokers must use reasonable diligence to determine the best market through which a trade should occur and to establish that this transaction is made at a price as favorable as possible under the prevailing market conditions. The Municipal Securities Rulemaking Board (MSRB) also imposes a best execution standard—on trades involving municipal securities.

Now, firms need to consider that a condition of PTE 2020-02 is that the representative and firm: 1) do not receive more than reasonable compensation, and 2) do “seek to obtain the best execution of the investment transaction reasonable under the circumstances.” Notably, these two requirements are distinct. The first addresses how much the firm and representative get paid, while the second addresses the cost to the client of executing the trades.

The DOL clarifies in the preamble to PTE 2020-02 that the representative and the firm meet this best execution condition if they meet the applicable SEC, FINRA and MSRB best execution requirements. This should be good news to firms, because they already should have policies and procedures in place to promote compliance with those applicable standards. Thus, if the firm and its representatives comply with these policies and procedures, and thus with applicable best execution standards, they should meet the PTE 2020-02 condition.

However, the reality is that not all firms have sufficient policies and procedures in this regard. Additionally, not all representatives follow otherwise sufficient policies and procedures. These facts are well-known to compliance officers responsible for verifying ongoing compliance and to the SEC and FINRA, which investigate these practices. In such circumstances, the firms most often improve their policies, procedures and compliance activities to better ensure compliance in future trades. Trades may be adjusted but certainly not in every case.

On the other hand, if a firm or representative relies on PTE 2020-02, a prohibited transaction has likely occurred by reason of that entity failing to comply with one of the exemption’s conditions. In that case, something needs to be done to address the prohibited transaction. Indeed, PTE 2020-02 provides a self-correction mechanism that would require, among other things, some sort of remedial action—e.g., making the client whole for any investment losses, and self-reporting the violation to the DOL. PTE 2020-02 does not provide for a de minimis or materiality threshold here.

If a firm and its representatives intend to rely on PTE 2020-02, they should think about the effectiveness of their current best execution policies and procedures and whether those in fact meet applicable SEC, FINRA and MSRB requirements. They should also consider how they will remedy violations of these policies and procedures, particularly in light of the PTE’s self-correction requirements. This situation is a clear example of where the securities compliance and Employee Retirement Income Security Act (ERISA) compliance worlds collide, particularly as the DOL moves to take a more active role in regulating the activities of advisers and broker/dealers.

David Kaleda is a principal in the fiduciary responsibility practice group at Groom Law Group, Chartered, in Washington, D.C.