1.1 Timely and Best Execution

It should be established that once an operator has agreed to effect a transaction on behalf of a CIS, the transaction was executed as soon as was reasonably practicable and was executed on terms that were the best available, taking into account the market, the kind and size of the transaction concerned and the characteristics of the executing broker.

The specific risk is that the CIS does not receive the best terms at the time of dealing. This may be because an operator has misdirected business because of an inducement, because the transaction has been executed through an in house market maker or because the operator's procedures are generally ineffective.

Supervision should seek to establish how an operator satisfies itself that its business is conducted at best execution. This may involve having procedures in place requiring a fund manager to print out a computer screen which demonstrates that when a transaction was executed, it was done at the best price available. Procedures may also require consideration to be given to the rates available from different brokers. Supervision should also seek to confirm that procedures are followed in practice.

1.2 Timely and Fair Allocation

Supervision should seek to establish that an operator has a policy in place which determines how transactions should be allocated and that, in practice, that policy has been followed and all customers treated fairly. Supervision should seek to confirm that when an operator has placed an order on behalf of more that one customer, which may include a CIS, a record was made promptly of the intended basis of allocation of a particular transaction and that, in practice, that basis was followed or any exceptions noted and explained. This is particularly important if the operator proposes to deal on behalf of itself as well as a number of customers. Reference should be made to an operator's own procedures to ensure that in-house allocation policies have been complied with.

The risks to a CIS are that an allocation of a transaction may be delayed until subsequent price movements are known, thereby facilitating an allocation which favors another customer over the CIS. In addition there may have been an unfair allocation of placing or underwriting opportunities which favour one customer over another.

1.3 Churning

Supervision should seek to ensure that the CIS operator has procedures in place to guard against trading of the CIS portfolio which is excessive in light of the CIS stated objectives.

It should be established whether an operator has dealt too frequently on behalf of a CIS, to the detriment of the CIS, taking into account the investment objectives of the fund.

There are a number of reasons why churning may be to the detriment of a CIS. Excessive turnover may result in a CIS incurring charges which are unreasonable and which should not be paid.

1.4 Cash Commission Rebates

Supervision should seek to ensure that an operator does not benefit from unauthorized rebates of brokerage commission from transactions made on behalf of a CIS. The practice of rebate commissions presents a number of possible conflicts of interest. The CIS portfolio may be churned in order to generate more income for the operator. In addition, such income may lead to a lack of transparency in the fees being received by the operator from the CIS.

In markets where brokerage rebates are commonly paid (as a result of fixed commission structures or otherwise), supervision should seek to ensure that such rebates are, unless explicitly authorized by and disclosed in the CISdocumentation, credited to the CIS rather than retained by the operator.

1.5 Soft Commission Arrangements

Operators may enter into soft commission arrangements with counterparties whereby they agree to pay for services for the operator in return for broking business which will generate an understood or agreed level of commission. Services may typically include computer facilities, research material and safe custody. A soft commission arrangement is an inducement and, unless it is property controlled, may result in a detriment to the interest of a CIS.

There are a number of risks associated with soft commission agreements. If an operator is obliged to use a particular counterparty to execute transactions on behalf of a CIS, it is possible best execution may not be achieved. A CIS's portfolio may be churned in order to generate sufficient business to meet the understood or agreed level of commission. In addition, it is possible that a service may be provided to an operator under a soft commission agreement which does not benefit a CIS but only the operator itself.

Supervision should seek to confirm that the services which are subject to a soft commission agreement are for the benefit of a CIS, have been disclosed to investors, and that transactions carried out are done in accordance with best execution standards.

1.6 Inducements

Supervision should ensure that an operator (or its agents) does not offer or accept any inducement which is likely to significantly conflict with the duties owed by the operator to its customers. The risk is that a CIS is disadvantaged by paying higher costs, receiving worse dealing terms or undertaking unsuitable transactions due to obligations owed to a party with whom an inducement has been received or given. Supervision should establish the adequacy of procedures within the operator to ensure that any inducements that are received or given that might give rise to a conflict of interest are limited and properly disclosed.

Footnote:

4 Potential conflicts of interest are also set out in Supervision Principle 2 concerning transactions with connected persons.