Due Diligence of Broker-Dealers Often Overlooked by Investment Advisers

July 03, 2012

Reading time : 4 minutes

Due diligence needs to be an important component for any investment adviser compliance program.  As we discussed earlier, due diligence should not be limited to recommending investments, but must also be employed when recommending or using third party service providers.  In our opinion, one of the most important, if not the most important, outside service provider decisions made by investment advisers are the selection of a recommended broker/dealer.  In fact, many investment advisers require clients to use a particular broker/dealer.  However, far too many investment advisers fail to perform adequate due diligence on this important selection.  We hear from many investment advisers that they fully understand broker/dealer best execution reviews are expected, but are not completed because of reasons such as (1) the broker/dealer they work with is large and reputable, (2) the investment adviser only selects mutual funds so best execution doesn’t matter or (3) the differences between broker/dealers are so slight that due diligence is unnecessary.  Because of these reasons and others such as time and cost constraints, broker/dealer best execution reviews and due diligence is a matter often neglected by investment advisers.

Regardless of how valid the reasons not to conduct broker/dealer due diligence may be, the fact is outside service provider due diligence and broker/dealer best execution are issues regulators take seriously and remain a focus during routine examinations.  Investment advisers need to implement a system to conduct due diligence reviews of any third party hired to work on behalf of the firm, including broker-dealers.  Investment advisers cannot simply rely on information provided by the broker-dealer. Before using or recommending a broker-dealer to clients, an investment adviser must conduct an independent due diligence investigation to ensure, among other things, clients receive best execution of transactions.

At a minimum, we recommend investment advisers conduct a background check of the broker/dealer via the Financial Industry Regulatory Authority (“FINRA”) Broker Check, review publicly available information about the broker/dealer available on the internet, review the range and quality of services available, and review the reliability in executing trades and keeping records. While there are no set rules as to what an investment adviser must do to satisfy due diligence obligations, the presence of any “red flags” must alert it to the need for further inquiry.  As a fiduciary, providing a thorough investigation of broker/dealers used or recommended to clients is necessary for investment advisers.

Investment advisers also have the duty to investigate and obtain best execution of client transactions. The U.S. Securities and Exchange Commission (“SEC”) has communicated that best execution is not necessarily determined by the lowest possible transaction cost. Investment advisers must systematically and periodically evaluate the best execution practices of their broker/dealers to ensure that services meet their standards. Some of the criteria an investment adviser should consider are:

  • Trading expertise;
  • Execution capabilities;
  • Access to underwritten offerings and secondary markets;
  • Reliability in executing trades and keeping records;
  • The number of primary markets that will be checked; and
  • Timeliness of trade execution

Investment advisers should conduct a due diligence review of broker/dealers and best-execution before approving a broker/dealer and going forward at least annually if not more frequently. To demonstrate its due diligence an investment adviser should retain records documenting both the process and results of its investigation.

To learn more about performing due diligence on broker-dealers and best execution of client transactions sign up for RIA Compliance Consultants’ upcoming webinar “Conducting Service Provider Compliance Due Diligence Reviews.”  The webinar will be held on July 12, 2012, at 12 p.m. CDT.  RIA Compliance Consultants can assist you with establishing policies and procedures for your broker/dealer due diligence review or performing your review.  If you are an existing client of RIA Compliance Consultants interested in discussing how we can assist your investment adviser, please contact your consultant. If you are a new client that would like to speak with us regarding the services we can provide, please contact us to schedule a time to speak with one of our consultants.

Posted by Bryan Hill
Labels: Best Execution, Compliance Program, Compliance Training, Due Diligence, SEC