I. Introduction

On December 14, 2022, the Securities and Exchange Commission (the SEC or Commission) proposed Regulation Best Execution (Proposed Reg Best Ex),1 which would establish through Commission rules a federal best execution regulatory framework for brokers, dealers, government securities brokers, government securities dealers and municipal securities dealers. As proposed, Proposed Reg Best Ex consists of three rules: (1) Rule 1100, which sets forth "the best execution standard"; (2) Rule 1101, which requires policies and procedures; and (3) Rule 1102, which requires an annual report.

This alert discusses the requirements of Proposed Reg Best Ex and the significant impact the proposal may have on the industry, if adopted. Proposed Reg Best Ex goes beyond the existing best execution regulatory regime set forth by the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB).2 The implementation of Proposed Reg Best Ex exactly as proposed could lead to complexities in areas that do not align with existing FINRA and MSRB best execution rules, and create substantial regulatory uncertainty for (not to mention burden on) broker-dealers subject to the various rules. At the same time, certain aspects of Proposed Reg Best Ex are highly complex and trend toward micromanagement of broker-dealers' decision-making processes and best judgment for where and how to execute their customers' orders. Moreover, Proposed Reg Best Ex would require broker-dealers that engage in what the SEC refers to as "conflicted transactions" to have even more robust procedures specific to those transactions. While the proposal asserts that these additional requirements would help mitigate the potential for incentives to negatively impact a broker-dealer's best execution determinations, it is not clear what the SEC's expectation is for broker-dealers and execution-related outcomes under this "better than normal best execution" standard. In various places throughout the proposing release, the Commission highlighted its belief that Proposed Reg Best Ex would enhance investor protection by facilitating the Commission's and self-regulatory organization's (SRO) examination and enforcement capabilities.3 Comments on Proposed Reg Best Ex are due on March 31, 2023.

II. The Best Execution Standard – Rule 1100

Proposed Rule 1100 would require broker-dealers 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.4

The proposed best execution standard would apply broadly to any transaction for or with a customer or a customer of another broker-dealer, with very limited exceptions. The exceptions include when (1) the broker-dealer is quoting a price for a security where another broker-dealer routes a customer order for execution against that quote; (2) an institutional customer, exercising independent judgment, executes its order against the broker-dealer's quotation; or (3) the broker-dealer receives an unsolicited instruction from a customer to route its order to a particular market for execution and the broker-dealer processes that customer's order promptly and in accordance with the terms of the order.5 These exclusions are consistent with preexisting exclusions from SRO best execution rules.

III. Best Execution Policies and Procedures – Rule 1101

Like the current FINRA and MSRB best execution rules, proposed Rule 1101 requires a broker-dealer to establish and maintain written policies and procedures reasonably designed to comply with the proposed standard.6 Yet the requirements in the proposed rule, which we set forth below, go well beyond current SRO rules and frequently prescribe specific assessments a broker-dealer must make in order to comply with its obligation with unprecedented granularity, both with regard to substance and, in some cases, the sequencing of considerations. There is a concern that this level of granularity effectively substitutes the judgment of SEC staff for the judgment of the industry professionals responsible for the broker-dealer's compliance with this highly technical rule.7 There is also a concern that the prescriptive nature of the rule proposal would hinder broker-dealers from adjusting their policies and procedures in accordance with the unique facts and circumstances presented by different markets as they evolve.

A. Framework for Compliance with the Best Execution Standard

Under proposed Rule 1101(a), these procedures must address how the broker-dealer will (1) comply with the best execution standard and (2) determine the best market for the customer order that it receives.8 In particular, such policies and procedures must show how the broker-dealer will:

  • obtain and assess reasonably accessible information, including information about price, volume and execution quality, concerning the markets trading the relevant securities;
  • identify markets that may be reasonably likely to provide the most favorable prices for customer orders (material potential liquidity sources); and
  • incorporate material potential liquidity sources into its order handling practices and ensure that it can efficiently access each such material potential liquidity source.9

The Commission provides the following examples of liquidity sources for National Market System (NMS) stocks, over-the-counter (OTC) equity markets, options markets, and corporate and municipal bond markets and government securities markets.

  • NMS Stocks: Material potential liquidity sources could include exchanges, alternative trading systems (ATSs) and broker-dealers, including market makers and wholesalers.10 The Commission notes that it could also include trading protocols and auction mechanisms operated by these entities, such as those that provide price improvement opportunities and wholesaler price improvement guarantees.11 Sources of reasonably accessible information for NMS stock include (1) publicly available quotation data, (2) consolidated trade information, (3) exchange proprietary data feeds, (4) odd lot market data, and (5) execution quality and order routing information contained in reports made pursuant to Rules 605 and 606 of Regulation NMS.12
  • OTC Equities: Broker-dealers could consider ATSs, wholesalers and other OTC market makers as potential material liquidity sources.13 A broker-dealer could also consider obtaining data from ATSs and OTC market makers as a source for reasonably accessible information, in addition to the data publicly available through the FINRA OTC Reporting Facility.14
  • Options: Material potential liquidity sources could include the options exchanges and the range of trading protocols and auction mechanisms made available by them. This may include: (1) quotes from market makers resting on exchange limit order books, (2) price movement auctions, (3) liquidity resting between the best bid and offer that may be available on exchange limit order books, and (4) floor trading facilities that may provide a broker-dealer with the opportunity to seek competitive prices from floor participants for larger or complex options orders.15 The Commission adds that a broker-dealer would also need to consider whether other broker-dealers may represent material potential liquidity sources for its customers' options orders.
  • Corporate, Municipal and Government Bonds: Material potential liquidity sources could include ATS and non-ATS electronic trading systems, RFQ systems and other auction mechanisms, interdealer brokers and other broker-dealers willing to be a counterparty upon request, and a broker-dealer's own principal trading desk.16 In obtaining reasonable sources of information, a broker-dealer could obtain data from: (1) ATSs and other trading platforms, such as RFQ systems, interdealer brokers, and dealers that handle and execute customer orders; (2) trade data in the corporate bond and municipal bond markets made publicly available through FINRA's Trade Reporting and Compliance Engine (TRACE) and the MSRB's Real-time Transaction Reporting System (RTRS); and (3) price aggregator services or evaluated pricing services.17

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1 Regulation Best Execution, Securities Exchange Act of 1934 Release No. 96496 (Dec. 14, 2022); 88 Fed. Reg. 5440 (Jan. 27, 2023) ("Proposed Reg Best Ex"), https://www.govinfo.gov/content/pkg/FR2023-01-27/pdf/2022-27644.pdf.

2 See Proposed Reg Best Ex at 5441 (the Commission noting that "while FINRA and the MSRB have established best execution rules . . . and generally require broker-dealers to have procedures for compliance with relevant laws and rules, the Commission believes it is appropriate to propose its own comprehensive and detailed best execution requirements."). It is possible that FINRA and MSRB would amend or possibly revoke their rules if and when the Proposed Reg Best Ex is adopted, but the SEC rulemaking does not mandate that outcome.

3 Id. at 5523–24.

4 Id. at 5451.

5 The SEC notes that the exemptions distinguish between a broker-dealer that is acting solely as the buyer or seller of securities and one that is accepting order flow from another broker-dealer. Id. at 5451–52.

6 Id.

7 Commissioner Hester M. Peirce, "Is This the Best Execution We Can Get?" (Dec. 14, 2022), https://www.sec.gov/news/statement/peirce-best-execution-20221214.

8 Proposed Reg Best Ex at 5454–55.

9 The proposed rule highlights the importance of market information to the broker-dealer's best execution analysis and that execution quality is a relevant factor to that analysis. In discussing execution quality, the Commission makes several observations. First, the Commission states that broker-dealers should consider including competition levels of a market as an element of its best execution policies and procedures. Second, in their policies and procedures, broker-dealers should address how they would assess the features of options price improvement auctions, how those features might affect the level of competition and the execution quality offered by the auctions, and whether those features would allow an auction to provide the most favorable prices under prevailing market conditions. Third, in considering request for quote (RFQ) systems as material potential liquidity sources for corporate and municipal bonds, the broker-dealer's policies and procedures could assess the filtering practices that may be applied by the RFQ system operator and the impact that those practices may have on the execution quality of those markets. Id. at 5454–56.

10 Id. at 5457. 11 Id. 12 Id.

13 Id.

14 Id.

15 Id.

16 Id.

17 Id

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