Compliance Solutions for Investment Advisers

FAQs — Trade Errors

 

What is a trade error?

A trade error is an error in the placement, execution or settlement of an advisory client’s trade.

What are some examples of trade errors?

Examples of common trade errors include:

  • Buying the wrong security.
  • Selling the wrong security out of a client’s account.
  • Buying or selling the wrong amount of a security.
  • Selling a security rather than buying a security (and vice versa).
  • Buying or selling a prohibited security.
  • Having insufficient funds to cover the purchase of a security.
  • Buying a security that violates a specific account restriction.
  • Failing to buy a security as directed by a client.
  • Allocating a blocked trade incorrectly.
  • Making a discretionary trade in a non-discretionary account.
  • Executing a limit order at market price.
  • Buying a security that is not in line with an account’s investment objectives.

What are some examples of trading mishaps that are not considered errors?

The following should not be considered trade errors:

  • An incorrect trade that is caught and broken before settlement as long as there is no negative economic impact to the client.
  • Errors committed by a broker, custodian or other unaffiliated third party.

Is an investment adviser required to implement trade error policies and procedures?

While there is no statutory requirement, it would be prudent for an adviser to have written trade error correction policies and procedures.

What should an investment adviser’s trade correction policies and procedures cover?

When developing trade correction policies and procedures, an adviser should ask the following questions:

  • When a trade error is discovered, who within the firm will be alerted?
  • Who will handle the resolution of the trade error (e.g., the compliance department, the trading desk or client services)?
  • Will clients be notified that a trade error has occurred in their account?
  • What is the criteria for notifying clients  (e.g., if the trade error is above a de minimis level, if the trade error results in client harm)?
  • When will clients be notified (e.g., prior to resolution)?
  • How will clients be notified (e.g., in writing or orally)?
  • How will errors be corrected (e.g., will the advisory firm use an error account)?
  • What is the mechanism for reimbursing a client for a loss?
  • How should a loss from a trade error be calculated?
  • Will the advisory firm’s E & O insurance carrier be informed and who will make this decision?
  • Will penalties be imposed against the individual that made the trade error?
  • What types of transactional and forensic testing will the advisory firm employ to determine if trade errors are being caught and handled in accordance with the firm’s fiduciary duty?

What is an investment adviser’s responsibility to the client when a trade error occurs?

The industry standard is that a client should never suffer a loss resulting from a trade error.

How should an investment adviser calculate the loss suffered by the client?

There is no standard method for calculating client losses. Some methods for calculating loss include:

  • The decline in value of the position while held in the client’s account.
  • Commissions, ticket charges and other transactional expenses.
  • Any opportunity costs (e.g., had the money been invested properly what gains would the client have experienced).

Should an investment adviser maintain a trade error log?

Yes.  An adviser should maintain a record of all trade errors including the transaction date, security involved, account and broker-dealer involved and a summary of the trade error and disposition (including the conditions of any financial settlement with the client).

What types of records will the SEC request during or prior to an examination?

The Staff of the SEC may request some or all the following documents and information pertaining to trade errors:

  • A copy of the advisory firm’s policies and procedures with respect to trade errors.
  • A list of trade errors that occurred in any advisory client, proprietary account or private investment fund during the examination period featuring the transaction date, the security, the account and broker-dealer involved and a summary of the error and its ultimate disposition, including the conditions of any financial settlement.

What are some compliance tests an investment adviser can conduct to determine whether the adviser’s policies and procedures adequately address trade errors and reflect the firm’s actual practices?

Tests an adviser can run include:

  • Determining whether the advisory firm’s internal controls ensure that that trade errors are consistent with regulatory requirements, best practices, firm policies and disclosures.
  • Reviewing trade errors over the course of one year to determine if a pattern exists and if trading procedures need to be changed as a result.
  • Reviewing patterns of trade errors to assess broker quality.
  • Inspecting cash journals for any non-recurring or special payments to determine whether there have been any inappropriate or undisclosed cash adjustments for trade errors.
  • Reviewing all trade confirmations to ensure that trade errors are caught and corrected as soon as possible.
  • Checking records supporting trade error corrections to ensure that they are consistent with procedures and do not violate applicable SEC guidelines (e.g., brokers absorbing the cost of adviser trade errors in exchange for soft dollars).
  • Aggregating trade error information over time to determine the overall error rate and error rates for each account.
  • Selecting accounts in which trade errors have occurred for a sample period and review the entries to ensure that errors have been corrected promptly.
  • Identifying any concentrations of trade errors by a single broker-dealer and follow-up on any efforts to get the broker to reduce its error rate and to ensure that there are no undisclosed conflicts of interest.
  • Substantiating that your firm obtains all information related to trade errors in a timely, accurate, and complete manner.

 

Important Information

The information contained in this Frequently Asked Questions is only a summary and is not intended to be a comprehensive analysis of the rules and regulations applicable to registered investment advisers. It is not intended to constitute legal or compliance consulting advice or apply to any one investment adviser’s particular situation. For more information, please see our Terms of Use.

line