Based on the definition employed by Supreme Court Justice Potter Stewart in 1964, best execution is the opposite of hard-core pornography: no one seems to know it when they see it. Despite this (at best) fuzzy standard, FINRA and the SEC still require all broker-dealers to obtain best execution for their customers when they place orders for execution.  Because the historic guidance on obtaining best execution is all over the place, and therefore of limited utility, FINRA celebrated the Holiday season by releasing Regulatory Notice 15-46, about best execution, subtitled “Guidance on Best Execution Obligations in Equity, Options and Fixed Income Markets,” to try to clear things up.

There are some fairly interesting things buried in this Notice.

First, as an initial observation, it is worth noting that, like 99% of its Regulatory Notices, FINRA characterizes 15-46 as a “reminder” of guidance supposedly issued previously. Sometimes that’s true, but, other times, as discussed below, it is a much more dubious proposition.  FINRA is legally prohibited from creating new obligations or standards in Regulatory Notices (or through Enforcement actions); that can only come out of the rule-making process.  Nevertheless, it often seems that so-called “reminders” are, in fact, brand new propositions.

Second, harkening back to some earlier blog posts about FINRA’s increasingly frequent willingness to blur the lines between broker-dealers and investment advisors, and, more specifically, the suitability standard which governs the former and the fiduciary standard which governs the latter, FINRA states at the outset of 15-46 that “a broker-dealer’s obligation to obtain best execution of a customer’s order in any security is based, in part, on the common law agency duty of loyalty, which obligates an agent to act exclusively in the principal’s best interest.” This use of the phrase “best interest” – essentially a synonym for “fiduciary duty” – clearly reveals that, at least to some degree, FINRA is already holding broker-dealers to a higher standard than the law presently requires.[1]  It is bad enough when a customer’s lawyer makes that fallacious argument in the context of an arbitration, but it is downright regrettable when the principal regulator cannot get it right.

The most noteworthy takeaway from 15-46 concerns a firm’s obligation to conduct a “regular and rigorous” review of its best execution. Historically, that has meant a periodic review – perhaps monthly or quarterly – conducted on a look-back basis, to determine that the prices obtained in executions are both quantitatively and qualitatively appropriate.[2]  The reason the review is done retrospectively is that there may not be time to do it upon receipt of an order, since orders have to be executed “fully and promptly,” and searching for the “best” venue for order execution can take some time.

Notwithstanding this, FINRA has now concluded that “given developments in order routing technology, order-by-order review of execution quality is increasingly possible for a range of orders in all equity securities and standardized options.”  The Notice goes on to say: “A firm that chooses not to conduct an order-by-order review for some orders must have procedures in place to ensure that it periodically conducts a regular and rigorous review of execution quality for those orders.”  Finally, FINRA admonishes that “[f]irms choosing to conduct a regular and rigorous review must conduct the reviews, at a minimum, on a quarterly basis; however, Supplementary Material .09 to Rule 5310 notes that firms should consider, based on the firm’s business, whether more frequent reviews are needed.”

Remember I said Regulatory Notices are supposed to be “reminders?” This is anything but that.

But, FINRA goes well beyond merely establishing a new minimum frequency for a regular and rigorous review; it actually dictates circumstances when a real-time, order-by-order review must be undertaken, rather than a look-back review:

Although FINRA has noted that a regular and rigorous review can satisfy a firm’s best execution obligation for firms that route orders and for firms that internalize orders, a firm’s ability to rely on a regular and rigorous review applies only to the firm’s initial determination whether to route an order and those orders ultimately routed outside of the firm. Any orders a firm determines to execute by internalizing would be subject to an order-by-order analysis of execution quality. Thus, while Supplementary Material .09 to Rule 5310 allows a firm to use a regular and rigorous review of execution quality, this standard only applies to a firm’s initial determination whether to route an order and to its review of orders routed outside of the firm. Orders that a firm determines to execute internally are subject to an order-by-order best execution analysis.

Notably, but not surprisingly, no attribution is supplied for this guidance, which, of course, suggests that it is brand new.

Finally, much of the remainder of the Notice is devoted to obtaining best execution for fixed income securities. Here are the key points:

• FINRA recognizes that the market for fixed income securities differs from the market for equity securities and options and also can vary significantly depending on the specific fixed income product.
•  Given this significant variation in trading characteristics across fixed income securities, the best execution rule uses a “facts and circumstances” analysis by requiring that a firm use reasonable diligence to ascertain the best market for the security and to buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.
• FINRA recognizes that orders may be handled and executed differently in the fixed income market than in the market for equity securities and options. Given such differences firms may determine that their review of execution quality for fixed income securities may be less frequent than that of equity securities or options.

I don’t find these concepts alarming, but, what is concerning is that FINRA’s conclusion that obtaining best execution in fixed income securities is a “facts and circumstances” analysis. In reality, obtaining best execution for any security is a “facts and circumstances” endeavor, that requires “reasonable diligence.”  I am just not sure why FINRA has seemingly applied these concepts only to fixed income securities.

The bottom line, I suppose, is that with best execution, as with everything else, BDs need to be prepared to be second-guessed by FINRA examiners who employ standards of conduct that FINRA conjures up to suit its whims, rather than articulating in a manner that facilitates compliance.

[1] Curiously, however, in the same paragraph, FINRA also observes that when a broker-dealer acts as agent on behalf of a customer in a transaction, the BD is merely “under a duty to exercise reasonable care to obtain the most advantageous terms for the customer.”  There is a vast difference between a “reasonable care” standard and a “best interests” standard; it is unfortunate that FINRA is so loose with its verbiage.

[2] Interestingly, “best” execution does not necessarily mean the cheapest price, given that qualitative concerns also must be addressed.