Megan Aldworth
Associate Editor
Loyola University Chicago School of Law, JD 2023
On December 14, 2022, the U.S. Securities and Exchange Commission (SEC) announced a proposal for Regulation Best Execution (Reg BE). The regulation would broadly affect those buying and selling securities in a wide array of markets. Reg BE would generally require broker-dealers to implement a range of policies and procedures to ensure heightened due diligence compliance measures that consider several factors. Notably, Reg BE would place enhanced scrutiny on transactions involving conflicts of interests with retail investors. If a conflict of interest for the broker-dealer is present in a transaction, Reg BE would trigger requirements related to additional policies and procedures and documentation requirements.
Major Reg BE proponents and critics
Reg BE has both proponents and skeptics. Some fear that while its end goals are commendable, the pathway to them may not be the best course of regulation. Chairman of the SEC, Gary Gensler, released a statement on the proposal saying, “I am pleased to support this proposal because, if adopted, it would help ensure that brokers have policies and procedures in place to uphold one of their most important obligations: to seek best execution when trading securities, whether equities, fixed income, options, crypto security tokens, or other securities.”
The proposal passed with three commissioners in favor and two dissenting. One of the dissenters, Hester M. Peirce, acknowledged the importance of a best-execution regulation at the Commission level, but asserted that this proposal draws “sweeping conclusions about execution quality” in markets. Ms. Pierce further regards the proposal as being a “handy checklist for SEC examiners and enforcement attorneys” but not a body of law that “fosters brokers’ exercise of judgment to achieve what is best for customers… invit[ing] a culture of check-the-box compliance that does little to improve execution quality.”
Existing FINRA and MSRB best execution rules
Although Reg BE proposal considers a wealth of new requirements on broker-dealers regarding execution requirements, best execution rules are already implemented under the Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB) rules. The National Association of Securities Dealers (NASD), predecessor to FINRA, had its own best execution rule which was remodeled in FINRA Rule 5310. Rule 5310 requires broker-dealers to use reasonable due diligence to find the market that best suits the security such that the executed price is as favorable to the customer as can be, considering the prevailing market conditions. The rule lists factors that should be considered during a due diligence analysis including (a) the character of the market for the security, (b) the volume and type of transaction, (c) the number of markets considered, (d) the accessibility of a price quote, and (e) the terms and conditions of the order communicated to the broker-dealer and associated persons that lead to a transaction. The MSRB has its own best execution rule, Rule G-18, implemented for municipal security transactions, which mirrors FINRA Rule 5310, but adds an extra factor that the dealer must review information that was used to determine the market for the security or similar securities.
How this proposal expands the scope of existing best execution rules
Reg BE proposal will not affect the FINRA or MSRB best execution rules, such that broker-dealers must comply with the existing rules and Reg BE if implemented. While Reg BE proposal is similar in many respects, it is different in others. Reg BE broadens the scope of best execution rules to cover customer transactions where a broker-dealer receives the order and utilizes a wholesaler broker-dealer to execute the transaction, requiring both the introducing broker and the wholesaler broker to implement reasonable due diligence standards for best execution. More specifically, Reg BE proposal requires a more detailed analysis of factors in due diligence assessments to be implemented in policies and procedures of broker-dealers, gives a narrower exception for introducing brokers enhancing qualification requirements, and imposes heightened documentation and policy and procedure requirements for transactions involving conflicts of interest.
The proposal and the intention behind its implementation
The SEC’s Reg BE proposal takes best execution requirements to an unprecedented level, the proposal itself is over four hundred pages long and reflects a long standing desire by Chairman Ginsler for the SEC to implement its own rules regarding best execution. One of Ginsler’s main drivers in pushing for this proposal, was that FINRA’s best execution rule has not seen updates since 2014 and that business models and exchanges have since changed, including the addition of equities that trade in off-exchange “dark venues” that are less transparent. In his view, the SEC’s adoption of Reg BE would require reasonable due diligence standards in best execution in transaction on these off-exchange networks.
How this adds regulatory pressures on broker-dealers
While there seems to be a strong need for more transparency in transactions, especially those involving conflict of interest between an introducing broker and a wholesaler broker, the Reg BE proposal is overly broad and puts additional regulatory pressures on broker-dealers. Reg BE, as written, puts hefty duties on brokers and broker-dealers to analyze a variety of criteria before executing a transaction, criteria that will put additional burdens on the relationship between a broker and a client and potentially create transactions that may be “best” in the context of Reg BE, but not best in terms of reality. For instance, performing the considered due diligence analysis and adding new policies and procedures may be a resource-intensive and time-consuming task for firms. This would especially impact firms without access to new technologies that streamline this due diligence process or give more transparency in transactions. The nature of the broker-customer relationship hinges on the broker’s ability to execute a trade with its unimpeded best judgment and discretion, however this proposal begs the question of where the line is between a broker’s discretion and the SECs hefty expectations.