Best execution for investment advisers

An investment adviser that is responsible for choosing the broker-dealers that execute client trades has a duty to seek best execution: to execute each client's transactions so that the client's total cost or proceeds are the most favorable under the circumstances. The duty is part of the duty of care an adviser owes as a fiduciary under Section 206 of the Advisers Act. No rule sets out a formula for meeting it. The standard comes from Commission interpretations, and the evidence that a firm meets it is the record of how it chose and reviewed its brokers.

This guide covers where the duty comes from, what a periodic and systematic review looks like, soft dollars and Section 28(e), directed brokerage, trade aggregation and allocation, disclosure in Form ADV Part 2A Item 12, and the records that hold it together. The fiduciary duty guide places best execution within the wider duty of care.

Where the duty comes from

The Commission set out its current view in the Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release IA-5248, dated June 5, 2019. It says that an adviser's duty of care includes "a duty to seek best execution of a client's transactions where the adviser has the responsibility to select broker-dealers to execute client trades (typically in the case of discretionary accounts)." It continues:

• the adviser must seek to obtain execution such that the client's total cost or proceeds in each transaction are the most favorable under the circumstances
• the goal is maximizing value for the client under the particular circumstances at the time of the transaction, and maximizing value "encompasses more than just minimizing cost"
• the adviser should consider "the full range and quality of a broker's services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness" to the adviser
• the "determinative factor" is not the lowest possible commission cost "but whether the transaction represents the best qualitative execution"
• the adviser should "periodically and systematically" evaluate the execution it is receiving for clients

Those phrases come from the Commission's 1986 interpretive release on Section 28(e), Exchange Act Release 23170, which IA-5248 quotes. The 2019 release also noted that advisers may use an affiliated broker, but that the conflict must be fully and fairly disclosed and the client must give informed consent.

Best execution is also a compliance program topic. When the Commission adopted Rule 206(4)-7 in 2003, it said an adviser's policies should address, where relevant, trading practices "including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services ('soft dollar arrangements'), and allocates aggregated trades among clients." The Division of Examinations named advisers "seeking best execution with the goal of maximizing value for their clients" in its fiscal year 2026 priorities, and its fiscal year 2027 priorities list trading among the compliance program areas examiners review.

When the duty applies

The duty attaches where the adviser has responsibility for selecting the broker. That is clearest in discretionary accounts where the adviser places trades with brokers of its choosing. It is less obvious, but still relevant, for the many advisers that recommend a single custodian and execute through it: the choice of that firm, and the decision to keep using it, is a broker selection decision, and Item 12 asks about the factors behind "selecting or recommending" broker-dealers. Where a client directs the adviser to use a particular broker, the duty narrows, and the disclosure obligations described below take over.

What a periodic and systematic review looks like

The Commission has not prescribed a method, and IA-5248 declined commenters' requests to do so. The Division's July 2018 Risk Alert on best execution, drawn from adviser exam findings, describes what examiners expect by describing what was missing. Building a review around those findings gives a defensible process.

Who does it

Firms of any size can run a review. Larger firms usually use a best execution or brokerage committee that includes compliance, trading and portfolio management, meets on a set schedule (often quarterly) and keeps minutes. A smaller firm can do the same work with one or two people on a calendar, provided the work is written down. The 2018 Risk Alert criticized reviews that did not solicit input from the firm's traders and portfolio managers, so whoever runs it should hear from the people who place and receive the trades.

What it covers

A review should consider both quantitative and qualitative factors:

• Price and cost. Commissions, markups and markdowns, spreads, and where the data allows, execution prices compared with a benchmark such as volume-weighted average price or the arrival price. Include the costs clients actually bear, such as ticket charges, clearing and other brokerage fees. A 2017 settled order cited in the 2018 alert (Advisers Act Release 4730) involved an adviser that left introducing, clearing and execution costs out of its best execution analysis.
• Execution quality. Speed, likelihood of execution, handling of large or illiquid orders, and errors.
• Qualitative factors. The 2018 alert criticized reviews that ignored them: execution capability, financial responsibility, responsiveness to the adviser, and the value of any research.
• Comparisons. The alert also criticized advisers that used a single broker-dealer for all clients without seeking comparisons from competing broker-dealers, initially or on an ongoing basis, or relied on a broker's own summary of its services. Gather quotes or data from alternatives at least periodically, even if the firm stays where it is.
• Each asset class you trade. Equities, fixed income, options and funds behave differently. The alert criticized policies that did not reflect the types of securities the adviser actually traded.

What it produces

The output is a written record: the data reviewed, the brokers compared, the conclusions, and any action taken, such as moving flow, renegotiating rates or adding a broker to an approved list. If your brochure says you review trades to make sure prices fall within an acceptable range, the record should show that you did. The 2018 alert describes advisers whose brochures said exactly that while no review took place.

Soft dollars and Section 28(e)

"Soft dollars" means using client brokerage commissions to obtain research or other products and services from a broker-dealer or a third party. It creates a conflict: the adviser receives something of value, paid for with client money, and may be tempted to choose brokers for what they provide the adviser rather than for execution quality.

The safe harbor

Section 28(e) of the Securities Exchange Act provides a safe harbor. A person exercising investment discretion over an account is not deemed to have acted unlawfully or breached a fiduciary duty solely because the account paid a commission higher than another broker would have charged, if the person "determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided," viewed in terms of either that transaction or the person's overall responsibilities to the accounts over which it has discretion.

The Commission's 2006 guidance (Exchange Act Release 54165) describes a three-step analysis:

1. Eligibility. Is the product or service eligible research under Section 28(e)(3)(A) or (B), or eligible brokerage under Section 28(e)(3)(C)? Research must reflect the expression of reasoning or knowledge, so products with inherently tangible attributes, such as telephone lines or office furniture, are not research, and operational overhead, including travel and meals for meetings, does not qualify. Brokerage begins when the adviser communicates with the broker to transmit an order and ends when funds or securities are delivered or credited to the account.
2. Lawful and appropriate assistance. Does the product actually help the adviser in its investment decision-making? For a mixed-use item, such as a data service also used for marketing, the adviser must make a reasonable allocation of its cost according to use, and pay for the non-research part itself.
3. Good faith determination. Has the adviser determined in good faith that the commissions paid are reasonable in relation to the value of what was received?

The safe harbor covers commissions on agency transactions and fees on certain riskless principal transactions. The 2006 release states that it does not cover principal trades generally, fixed income trades not executed on an agency basis, or other instruments traded net with no explicit commission.

Operating outside the safe harbor is not automatically unlawful, but the adviser then relies entirely on disclosure and consent to address the conflict, and Form ADV requires more detailed disclosure of benefits that fall outside it.

Common soft dollar findings

The 2018 Risk Alert listed soft dollar findings alongside the best execution ones: inadequate disclosure of soft dollar arrangements, not disclosing that some clients may bear more of the cost than others, inadequate disclosure of products that did not qualify under Section 28(e), mixed-use allocations that were not reasonable or not documented, and soft dollar expenses not allocated as the firm's own policy required.

Directed brokerage

Directed brokerage comes in two forms, and Item 12.A.3 of Part 2A treats them differently.

• The adviser requires or recommends it. If you routinely recommend, request or require that clients direct you to use a specified broker, describe the practice, explain that not all advisers require it, describe any affiliation or economic relationship with that broker and the conflict it creates, and explain that directing brokerage may mean you cannot achieve most favorable execution and may cost clients more money.
• The client chooses it. If you permit clients to direct brokerage, describe your practice and, where applicable, explain that you may be unable to achieve most favorable execution and that it may cost the client more, for example because their orders cannot be aggregated with others or they receive less favorable prices.

Keep the client's direction in writing, and consider where directed accounts sit in your trade rotation, since the 2018 alert found advisers that did not disclose that some accounts trade the same securities after others, and the effect that can have on price.

Trade aggregation and allocation

Aggregating (or "blocking") orders for several clients can reduce costs and give each participant the same price. It also creates allocation conflicts, especially where the adviser, its staff, or accounts paying higher fees participate alongside other clients.

The staff's 1995 no-action letter to SMC Capital remains the reference point most firms use. The adviser's representations included full disclosure of its aggregation policy, aggregating only when consistent with best execution and each client's agreement, favoring no client over another, giving each participant the average price for the day with transaction costs shared pro rata, preparing a written allocation statement before placing the order, allocating partial fills pro rata, and requiring a written explanation, approved by compliance, for any departure from the planned allocation.

IA-5248 adds that an adviser need not have pro rata allocation policies, or any particular method, but must eliminate or fully and fairly disclose the conflicts in its allocation practices so that clients can give informed consent. Item 12.B of Part 2A asks whether and under what conditions you aggregate orders, and if you do not aggregate when you could, to explain why and describe the cost to clients of not aggregating. The allocation policy template covers the procedures.

Disclosure in Form ADV Part 2A, Item 12

Item 12 is where best execution practices are disclosed. It asks you to:

• 12.A: describe the factors you consider in selecting or recommending broker-dealers and in determining the reasonableness of their compensation
• 12.A.1, research and other soft dollar benefits: disclose your practices and the conflicts, including both proprietary and third-party research; explain that you benefit because you do not have to produce or pay for the research; disclose the incentive to choose brokers for the benefits rather than for most favorable execution; disclose whether you may "pay up"; say whether soft dollar benefits serve all accounts or only those that generated them; describe the types of products and services acquired in the last fiscal year, with more detail for anything outside Section 28(e); and explain the procedures used to direct transactions in return for those benefits
• 12.A.2, brokerage for client referrals: disclose any practice of considering referrals when choosing brokers, the incentive it creates, and the procedures used
• 12.A.3, directed brokerage, as described above
• 12.B, aggregation, as described above

The instructions say that merely disclosing that you obtain "various research reports and products" is not specific enough. Part 1A Item 8.G also asks about soft dollar benefits, so the two parts of the form should agree. The Form ADV Part 2 guide covers the rest of the brochure, and the General Instructions' warning against saying you "may" have a conflict you actually have applies here as much as anywhere.

Documentation

Under Rule 204-2, an adviser keeps a memorandum of each order showing, among other things, the broker through which it was executed (paragraph (a)(3)), and written communications relating to the placing or execution of orders (paragraph (a)(7)(iii)). Beyond those required records, the documents that show a working best execution program are:

• the written best execution, soft dollar and allocation policies
• review or committee minutes, with the data and comparisons considered
• the approved broker list and the reasons for each addition and removal
• soft dollar budgets, the eligibility analysis for each product, and mixed-use allocation workpapers
• allocation statements for aggregated orders, and approvals of any departure
• written client directions for directed brokerage accounts
• trade error records and how each was resolved

Common questions

Is best execution the same as the lowest commission?

No. The Commission's position, repeated in IA-5248, is that the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution, considering the full range and quality of the broker's services.

How often should an adviser review best execution?

No rule sets a frequency. The Commission says reviews should be periodic and systematic, and many firms review quarterly, with an annual deeper review. Whatever the frequency, follow it, and keep a record of each review.

Do advisers that use a single custodian need a best execution review?

Yes, if the adviser selects or recommends that custodian for execution. The 2018 Risk Alert specifically criticized advisers that used a single broker-dealer for all clients without seeking comparisons, initially or on an ongoing basis.

Are soft dollars allowed?

Yes, within limits. Section 28(e) protects paying more than the lowest commission for eligible brokerage and research services, if the adviser determines in good faith that the commission is reasonable in relation to their value. All soft dollar arrangements must be disclosed in Item 12, with more detail for anything outside the safe harbor.

What should a best execution committee document?

Who attended, the data reviewed for each broker and asset class, the comparisons with alternatives, the qualitative assessments, any soft dollar and allocation issues, the conclusions, and the follow-up actions with owners and dates.

Put the review on a schedule

The trading and best execution template sets out the policy, the review and the soft dollar analysis, and the allocation policy template covers aggregation. Luna's ADV brochure review reads the brokerage and trading topics in your Part 2A alongside firms like yours, and the compliance calendar reminds the person who owns the best execution review before each one is due.