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SEC Cautions Advisers on Wrap-Fee Accounts

Financial advisers are being urged to increase monitoring of wrap-fee accounts to improve compliance and oversight.

The SEC recently warned investment advisers to step up their monitoring of wrap-fee accounts and think twice before recommending such accounts to clients.

Why the warning?

Well, the SEC recently conducted over 100 examinations of advisers associated with wrap fee programs from two perspectives, including advisers that: 1) served as portfolio managers in, or sponsors of, wrap-fee programs (“wrap-fee advisers”); and 2) advised their clients’ accounts through one or more unaffiliated third-party wrap-fee programs (“wrap-fee initiative”).

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And what the SEC found is this: Many of the examined advisers’ compliance programs could be improved. According to the SEC’s Risk Alert, Observations from Examinations of Investment Advisers Managing Client Accounts That Participate In Wrap Fee Programs, the most frequently cited deficiencies were related to:

  • compliance and oversight, including policies and procedures regarding the tracking and monitoring of the wrap fee programs; and
  • disclosures, including disclosures regarding conflicts, fees, and expenses.

Specifically, the SEC found:

  • Advisers did not monitor the trading activity in clients’ accounts or their monitoring activities were ineffective. The most common duty-of-care issue was the examined advisers’ failure to monitor for “trading-away” from the broker-dealers providing bundled brokerage services to the wrap-fee programs and the associated costs of such trading-away practices.
  • Advisers did not have a reasonable basis to believe that the wrap-fee programs were in the clients’ best interests. The staff observed instances where the examined advisers routinely recommended that their clients participate in wrap-fee programs without conducting any assessments as to whether programs were in the best interests of clients (initially, on-going, or both).
  • Advisers had inconsistent disclosures regarding the same topic in various documents. The staff identified disclosure issues when reviewing for consistency across the examined advisers’ Part 2A of Form ADV (the firm brochure), sponsors’ Part 2A Appendix 1 of Form ADV (the wrap-fee program brochure), advisory agreements, and other account documents and agreements for wrap fee clients.
  • Advisers omitted disclosures or inadequately described conflicts of interest. The disclosures often omitted or inadequately described the financial incentives the examined advisers, and their supervised persons had to make certain recommendations.
  • Advisers omitted compliance policies and procedures. In many cases, the examined advisers did not adopt and implement written compliance policies and procedures for key business functions and risk areas, including conducting initial and/or ongoing best interest reviews when recommending wrap fee accounts to clients.
  • Advisers had inadequate policies and procedures. The staff observed compliance programs that were deficient because the examined advisers had inadequate policies and procedures for key areas.
  • Advisers inconsistently implemented or enforced, or failed to implement, their policies and procedures. Several of the examined advisers had not fully implemented or enforced their compliance policies and procedures.
  • Advisers did not perform required annual reviews or performed the reviews inadequately.

“The SEC Division of Examination’s recent risk alert on wrap-fee programs reinforces what we have been seeing first-hand through SEC exams,” said Bryan Hill, president of RIA Compliance Consultants. “This is definitely an exam focus and priority. SEC examiners are challenging firms on justification of recommending/using wrap programs.”

Given the findings in the SEC’s report, what advice do experts have for advisers associated with wrap-fee programs?

“We have been dissuading our investment adviser clients from having a wrap-fee program for a number of years,” said Daniel Bernstein, chief regulatory counsel for MarketCounsel. “Not because there is anything inherently wrong with them, but because the SEC has been focused on wrap programs for a number of years.”

Bernstein also noted that most investment adviser custodians do not charge commissions for anything but mutual funds, so there’s less reason to have a wrap program.

Others agree. “With qualified custodians like Charles Schwab  (SCHW)  and TD Ameritrade  (AMTD)  going to commission-free trades, it appears that the wrap programs on those platforms become harder to justify when an investment adviser firm is not lowering its management fee,” said Hill.

According to Bernstein, the SEC is concerned that wrap programs give investment advisers an incentive to trade less frequently (reverse churning), purchase products with little or no transaction costs that come with higher holding costs (such as no transaction fee funds), and conduct transactions away from brokers covered by the wrap-fee programs (trading away). “All of these conflicts of interest involve the investment adviser avoiding costs to the investment adviser at the expense of the client,” he said.

One primary issue that the SEC found, according to Bernstein, is that investment advisers aren’t monitoring client accounts to ensure that the wrap program is in that client’s best interest. “So the firm needs to analyze the specific number of transactions to determine if they’d be better off paying separately for transactions,” he said.

Chris DiTata, vice president and general counsel at RIA in a Box, said investment advisers need to be aware of their duty — and it is an ongoing duty — to act in the best interest of the client when utilizing a wrap-fee program. 

“Clients with infrequent transactions may not be well-suited for wrap fee programs and, even for clients where a wrap fee program is appropriate, advisers need to regularly document their monitoring of trading activities and make updated disclosures regarding the program,” DiTata said. Read: SEC Releases Investment Adviser Risk Alert on Wrap Fee Programs.

Another issue is that investment advisers aren’t clearly disclosing what fees are covered and what aren’t, said Bernstein. “For example, if a client is charged for certain types of holdings like alternative investments, that must be disclosed,” he said.

Bottom line for Bernstein: “Our reaction is that this is nothing new. The SEC has been focusing on these same conflicts for years. What we can, however, take out of the Risk Alert is that this continues to be a focus.”

Also, considering the SEC publications on this topic, Bernstein said it will be harder for investment advisers to say they didn’t know about the issue, and errors can result in more difficult examinations or enforcement.

For its part, the SEC is encouraging advisers that recommend wrap-fee programs to consider and adopt policies and procedures to address those risks, conflicts, and challenges. The following are examples of the policies and practices to adopt:

  • Conduct reviews of wrap-fee programs – both initially and periodically thereafter – to assess whether the programs recommended to clients are in the best interests of clients, using information obtained directly from clients (e.g., through interviews, discussions, and/or questionnaires).
  • Periodically remind clients, after conducting initial best interest reviews associated with the recommendation to participate in wrap fee programs, to report any changes to their personal situations, or financial standing or needs, and investment objectives that might impact the clients’ risk tolerances, investment allocations, and/or recommended investments.
  • Communicate with clients — in-person or by telephone, as appropriate — to prepare and educate clients when recommending to convert their accounts from non-wrap-fee accounts to participating in wrap-fee programs.
  • Provide clients with disclosures regarding the advisers’ conflicts of interest related to transactions executed within the wrap fee-programs.
  • Provide clear disclosures, when recommending wrap-fee programs to clients, about whether certain services or expenses are not included in the wrap fee.
  • Written compliance policies and procedures include factors to be used when assessing whether investment recommendations made to clients participating in wrap-fee programs, including asset allocations and selection of managers, are in the clients’ best interests.
  • Monitor and validate that the advisers sought best execution for clients’ transactions.
  • Define what the advisers that recommend wrap-fee programs to clients consider to be “infrequently” traded accounts and compliance programs review such accounts to determine whether the wrap-fee programs remain in the clients’ best interests.

The SEC’s recommendations are well worth adopting, according to Hill. “It appears that some investment adviser firms have lax policies and procedures related to wrap programs,” he said. "When considering whether to offer a wrap-fee program, we believe many firms aren’t giving enough weight to the compliance issues and regulatory scrutiny.”

Hill also believes that it’s very difficult for an investment adviser firm to offer both wrap-fee and non-wrap-fee programs and meet its regulatory obligations. “Firms that offer both need to have reasonable policies and procedures designed to ensure every recommendation/decision to go with the wrap-fee option is in the client’s best interest, which could be hard to prove under certain circumstances,” he said.