General Background on the Duty of Best Execution
Best execution of customer orders is a key investor protection requirement. The SEC has explained that “[a] broker-dealer’s duty of best execution derives from common law agency principles and fiduciary obligations, and is incorporated both in SRO rules and, through judicial and Commission decisions, in the antifraud provisions of the federal securities laws. This duty of best execution requires a broker-dealer to seek the most favorable terms reasonably available under the circumstances for a customer’s transaction.”
FINRA has codified the duty of best execution in its rules—specifically, Rule 5310 (Best Execution and Interpositioning). Rule 5310 provides that, "[i]n any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions."
Among the factors that will be considered in determining whether a firm has used “reasonable diligence” are:
the character of the market for the security (e.g., price, volatility, relative liquidity, pressure on available communications);
the size and type of the transaction;
the number of markets checked;
accessibility of the quotation; and
the terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member.
In the context of small-size retail customer orders, the SEC and FINRA have noted the ready accessibility of prices better than the prevailing best quote (the “national best bid and offer,” or the “NBBO”), and SEC rules require information about the frequency and magnitude of price improvement relative to the NBBO to be included in monthly public reports. While the SEC and FINRA have recognized that best execution is not concerned solely with price, price is undoubtedly a key concern for most retail customers. As discussed further below, compliance with Rule 5310 requires member firms to regularly evaluate the availability of reliable, superior prices and to assure that order flow is directed to markets providing the most beneficial terms for customer orders. Accordingly, member firms’ best execution procedures must be reasonably designed to identify the best prices and obtain best execution for customer orders under prevailing market conditions.
Rule 5310 applies whether member firms act as agent or execute transactions on a principal basis,5 and it covers transactions for or with a customer or a customer of another broker-dealer. As FINRA has explained, this means that best execution obligations apply to member firms that receive customer orders from another member firm for purposes of order handling and execution, including wholesale market makers, in addition to member firms that receive orders directly from customers. A member firm cannot transfer its best execution obligations to another person or firm, although other firms may also acquire best execution obligations where they receive customer order flow for handling and execution. Accordingly, when a firm receives customer orders from a routing firm for purposes of order handling and execution, FINRA has explained that both the routing firm and the receiving firm have best execution obligations.
Specific Guidance on Best Execution and Payment for Order Flow
Payment for order flow is defined broadly by the SEC and generally encompasses “a wide variety of cash or in-kind compensation structures that a broker may receive for directing its customers’ orders to a particular broker-dealer or trading venue.” Given its broad definition, payment for order flow may refer to, among other things, arrangements where retail brokerage firms receive cash payments from wholesale market makers in exchange for customer order flow, as well as transaction fee rebates, credits, or discounts provided by exchanges. Payment for order flow is one form of economic inducement that has the potential to influence the way a member firm handles customer orders. The opportunity to trade as principal and internalize a firm’s own customer orders is another form of economic inducement that the SEC has noted could similarly influence customer order handling.
Longstanding SEC guidance generally holds that “a broker-dealer does not violate its best execution obligation solely because it receives payment for order flow or trades as principal with customer orders.” However, the SEC also has stated that payment for order flow may “raise concerns about whether a firm is meeting its obligation of best execution to its customer.” And ultimately, the SEC has stated that “a broker-dealer must not allow a payment or an inducement for order flow to interfere with its efforts to obtain best execution.”
These same principles have been incorporated into FINRA’s best execution rule. Specifically, Rule 5310 requires member firms to assure that they direct customer orders to markets that provide the most beneficial terms for such orders.15 To support this overarching objective, Rule 5310 requires member firms to compare any material differences in execution quality their customers will receive at competing markets—including markets they may have existing routing arrangements with, as well as those they do not.
FINRA has provided member firms with detailed guidance on the execution quality review standards imposed by Rule 5310, including most recently in Regulatory Notice 15-46. As discussed more fully in Regulatory Notice 15-46, order-by-order review of execution quality is increasingly possible for a range of orders in equity securities and standardized options, and it is required for any orders that a member firm determines to execute internally. Where member firms may choose not to perform an order-by-order review, they must have procedures in place to ensure that they periodically conduct regular and rigorous execution quality reviews on a security-by-security, type-of-order basis.
Under Rule 5310, when conducting their reviews of execution quality, member firms should consider:
price improvement opportunities (i.e., the difference between the execution price and the best quotes prevailing at the time the order is received by the market);
differences in price disimprovement (i.e., situations in which a customer receives a worse price at execution than the best quotes prevailing at the time the order is received by the market);
(3) the likelihood of execution of limit orders;
the speed of execution;
the size of execution;
transaction costs;
customer needs and expectations; and
the existence of internalization or payment for order flow arrangements.
FINRA discussed these and additional execution quality review factors in Regulatory Notice 15-46, including areas of particular focus where inducements such as payment for order flow arrangements or internalization exist. For example, the possibility of obtaining price improvement is a heightened consideration when a member firm receives payment for order flow. In other words, it is especially important under these circumstances to determine that customers are receiving the best price and execution quality opportunities notwithstanding the payment for order flow. As FINRA has reminded member firms, when a firm is routing order flow for automated execution, or internally executing such order flow on an automated basis, the SEC has indicated that simply obtaining the best bid or best offer may not satisfy a firm’s best execution obligation, particularly with respect to small orders. In addition, FINRA cautioned that member firms would not satisfy their duty of best execution if they do not compare the execution quality they receive under their existing order routing and execution arrangements (including the internalization of order flow) to the quality of the executions they could obtain from competing markets.
Importantly, inducements such as payment for order flow and internalization may not be taken into account in analyzing market quality. Accordingly, for member firms that receive payment for order flow, FINRA has stated that such firms should carefully evaluate the impact of the practice on execution quality. Similarly, firms that provide payment for order flow for the opportunity to internalize customer orders cannot allow such payments to interfere with their best execution obligations. In other words, order routing firms and firms receiving customer orders from other firms for handling and execution must regularly evaluate whether reliable, superior prices are readily accessible for the customer orders they handle, and these firms may not negotiate the terms of order routing arrangements for those customer orders in a manner that reduces the price improvement opportunities that otherwise would be available to those customer orders absent payment for order flow. Such a practice would not be consistent with the requirement that member firms assure that order flow is directed to markets providing the most beneficial terms for their customers’ orders. It also would not satisfy a member firm’s obligation to use reasonable diligence to ascertain the best market for a 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. Ultimately, as FINRA has noted, the existence of an order routing, handling and execution arrangement between firms in no way alters either firms’ best execution obligation to analyze and review the execution quality of the orders routed pursuant to the arrangement.
Finally, FINRA notes that member firms are not relieved of their best execution obligations because of related disclosure requirements. Several SEC rules require disclosure of payment for order flow practices. Exchange Act Rule 10b-10 generally requires that broker-dealers indicate on customer confirmation statements when payment for order flow has been received on a transaction, and also that the source and nature of the compensation received in connection with the particular transaction will be furnished upon the customer’s written request. In addition, Rule 606 of Regulation NMS generally requires broker-dealers to post on their website quarterly public reports that identify the top ten venues to which they route orders for execution and to discuss material aspects of payment for order flow arrangements. When the SEC amended Rule 606 in 2018 to require, among other things, new aggregate payment for order flow disclosures in broker-dealer’s quarterly public reports, the SEC noted that “the amended rule requires disclosure of the details of any arrangement between a broker-dealer and a Specified Venue where the level of execution quality is negotiated for an increase or decrease in payment for order flow.” Rule 607 of Regulation NMS further requires broker-dealers to disclose upon opening a new customer account and on an annual basis thereafter policies relating to payment for order flow and order routing.
These disclosures provide customers and the public with important information, and member firms must provide them as required. However, FINRA notes that the SEC did not intend for order routing and execution disclosures to alter the legal duties that apply to a broker-dealer’s duty of best execution, and FINRA has stated that disclosure will not absolve a firm of potential best execution violations.
Full online Notice is available here.
Full Notice in PDF format is available here.