On July 21, 2021, the U.S. Securities and Exchange Commission (“SEC”) Division of Examinations issued a new risk alert discussing the findings from recent examinations of more than 100 investment advisers registered with the SEC associated with wrap fee programs. Wrap fee programs can be called by several different names, such as: asset allocation programs, asset management programs, investment management programs, mini-accounts, uniform managed accounts, and separately managed accounts Advisory clients who participate in wrap fee programs generally pay the programs’ sponsors a consolidated fee that includes investment advisory services and the execution of transactions. The wrap fee is generally based on a percentage of the value of the client’s account in the wrap fee program (the “wrap fee account”), rather than upon the transactions in the client’s account. Wrap fee programs may offer clients certainty concerning advisory and execution costs for implementing, maintaining, and changing their investment strategies. However, these programs may also create conflicts of interest for advisers and risks to investors – such as incentives for advisers trading less frequently than may be in the client’s best interest, engaging in transactions that reduce costs to the adviser but increase expenses borne by the client, or mis-billing by failing to incorporate certain covered transactions costs into the wrap fee – to the extent that advisers or their supervised persons have incentives to lower their internal costs.
The SEC stated their decision to focus on wrap fee programs is due to the persistent growth of investor assets in wrap fee programs and the observed conflicts and disclosure practices. As part of this focus, the SEC conducted over 100 examinations of advisers associated with wrap fee programs from two perspectives, including advisers that: served as portfolio managers in, or sponsors of, wrap fee programs; and advised their clients’ accounts through one or more unaffiliated third-party wrap fee programs.
The SEC’s Focus of Examinations Pertaining to Wrap Fee Programs
The examinations focused on the following areas: consistency with fiduciary duty obligations; the adequacy of the examined advisers’ disclosures; and the effectiveness of the examined advisers’ compliance programs.
Consistency with fiduciary duty obligations
Section 206 of the Investment Advisers Act of 1940 (“Advisers Act”) imposes a fiduciary duty on advisers (see, e.g., Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Advisers Act Rel. No. 5248 (Jun. 5, 2019) (the “Fiduciary Interp.”)). As fiduciaries, investment advisers owe their clients a duty of care, which includes a duty to provide investment advice to a client that is in the best interest of the client, including a duty to provide advice that is suitable for a client. In order to provide such advice, an adviser must have a reasonable understanding of the client’s objectives. Further, an adviser’s duty to monitor extends to all personalized advice it provides to the client, including, for example, in an ongoing relationship, an evaluation of whether a client’s fee wrap account continues to be in the client’s best interest. In providing advice about account type, an adviser should consider all types of accounts offered by the adviser and acknowledge to a client when the account types the adviser offers are not in the client’s best interest.
The staff reviewed whether the examined advisers had fulfilled their fiduciary duty by having a reasonable basis to believe that the wrap fee programs were in the best interests of participating clients – both initially and on an on-going basis – and whether the advisers had documented such assessments. The staff also reviewed for the imposition of undisclosed transaction charges (e.g., charges associated with undisclosed trade-away practices) and for the extent of account trading activity (e.g., little-to no trading activity in accounts for extended periods of time).
The adequacy of the examined advisers’ disclosures
Advisers must eliminate or make full and fair disclosure of all conflicts of interest that might cause them – consciously or unconsciously – to render advice which is not disinterested such that a client can provide informed consent to the conflict (see id). Each wrap fee sponsor generally must deliver a Form ADV Part 2A Appendix 1 wrap fee program brochure to its wrap fee clients (Advisers Act Rule 204-3(d)). Advisers that are not sponsors and that recommend wrap fee programs as investments are required to provide their own Part 2A brochure to clients. Portfolio managers providing management services for wrap fee programs that they do not sponsor are generally required to provide their Part 2A brochure to clients invested in their wrap fee program portfolio (see Instructions for Part 2A of Form ADV: Preparing Your Firm Brochure (“Form ADV Instructions,” Instruction 11).
The staff assessed whether the examined advisers provided full and fair disclosures of all material facts to their clients participating in the wrap fee programs, particularly regarding the fees, expenses, conflicts of interest, and entities involved in the programs. The staff also reviewed whether the agreements between the examined advisers and the wrap fee program sponsors, portfolio managers, any solicitors referring clients to the wrap fee program, and other service providers sufficiently disclosed which parties would be fulfilling certain core responsibilities for the participating wrap fee clients’ accounts.
The effectiveness of the examined advisers’ compliance programs
Advisers Act Rule 206(4)-7 (the “Compliance Rule”) requires SEC-registered advisers to adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Advisers Act and rules thereunder by advisers and their supervised persons. In addition, advisers are required to conduct annual reviews of their policies and procedures to assess their adequacy and effectiveness. See also, generally, Final Rule: Compliance Programs of Investment Companies and Investment Advisers, Advisers Act Release No. 2204 (December 17, 2003) (“Adopting Release”).
The staff assessed the effectiveness of the examined advisers’ compliance policies and procedures and other processes, particularly those for determining whether the wrap fee programs and accounts were in the best interests of their clients.
The SEC’s Observations of the Examinations Pertaining to Wrap Fee Programs
The SEC staff observed common deficient practices in the areas of advice to clients about participation in wrap fee programs and monitoring the clients’ wrap fee accounts, disclosures, and compliance policies and procedures.
Fiduciary Duty and Recommendations Not Made in Clients’ Best Interests
The SEC staff often observed issues with the examined advisers’ recommendations for clients to participate in wrap fee programs. These issues related to both the advisers’ trading practices and their assessments that the wrap fee programs were initially, and on an on-going basis, in the best interests of their clients. For example:
- 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. In these instances, the advisers were purportedly providing on-going monitoring services and continued to recommend the wrap fee programs to clients but did not consider that the clients may have incurred transaction costs in addition to paying the bundled wrap fees. Infrequent trading in wrap fee accounts was also identified at several examined advisers, raising concerns that clients whose wrap fee accounts are managed by portfolio managers with low trading activity are paying higher total fees and costs than they would in non-wrap fee accounts.
- 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). In other instances, the examined advisers: (1) conducted initial reviews, but did not continue to consider whether the programs remained in the clients best interests, and did not obtain or maintain information from clients to assist in periodically reassessing whether the wrap fee programs remained in the clients’ best interests; or (2) conducted on-going assessments, but such reviews were inadequate, including instances of reviews comprising a very small sample of accounts or systematically excluding certain accounts (e.g., transferred accounts, legacy accounts, or both).
Potentially Misleading or Omitted Disclosures
The SEC staff observed that many of the examined advisers had omitted or provided inadequate disclosures, particularly disclosures regarding conflicts of interest, fees, and expenses. Examples of these disclosure issues are as follows:
- 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, such as:
- The firm brochure did not provide full disclosures regarding fees that were not included in the wrap fee (e.g., fixed income mark ups and trade-away fees that were discussed in the wrap fee program agreements, and information related to clients paying both an advisory fee and fees to participate in the wrap fee program).
- Advisory agreements indicated that clients will pay brokerage commissions, but the wrap fee program brochures expressly stated that clients will not pay such fees.
- Disclosed house-holding discounts and other rebates (e.g., rebating 12b-1 fees on clients’ fee billing statements) were not applied, resulting in clients being overbilled.
- 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. Examples of poor or omitted disclosures include conflicts regarding:
- Supervised persons, who would incur transaction costs when executing certain investments, they recommended to clients, made investment and account recommendations that resulted in clients paying higher fees while avoiding transaction costs the supervised persons would incur. This included supervised persons that were: (1) responsible for paying any ticket charges, but recommended clients purchase mutual fund share classes that charged 12b-1 fees (and were likely more expensive for clients) that did not incur ticket charges; and (2) not recommending that clients move from wrap fee accounts to non-wrap accounts because the supervised persons would be required to pay certain expenses and transaction fees with such account transfers.
- Certain investment recommendations that resulted in clients paying higher expenses because they were participating in the wrap fee programs. For example, the advisers recommending wrap fee programs to their clients did not disclose that accounts with low trading volumes, high cash balances, or significant fixed income weightings may be able to receive similar services at a lower cost outside of a wrap fee program. Similarly, such advisers did not disclose that wrap fee accounts that incurred transaction-based costs for transactions excluded from the bundled fee, such as trading away fees, may collectively be paying higher fees.
The SEC staff frequently observed that the examined advisers had weak or ineffective compliance policies and procedures relating to their wrap fee programs. Also, in some instances, advisers did not comply with their own policies and procedures, and a few advisers did not comply with the annual review and other provisions of the Compliance Rule. The staff’s observations are regarding compliance programs are as follows:
- 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 on-going best interest reviews when recommending wrap fee accounts to clients. In some instances, the wrap fee advisers had no compliance policies or procedures that addressed the risk applicable to recommending and managing client participation in wrap fee programs, despite providing advisory services to such programs. Lastly, some of the examined advisers followed internal guidelines or informal practices for key operational areas, but had not memorialized these practices in written compliance policies and procedures. Examples of areas where advisers had informal practices included: (1) conducting best interest reviews of client accounts; (2) conducting best execution analysis for wrap fee accounts (when appropriate); and (3) selecting separate portfolio managers to advise portions of clients’ wrap fee accounts.
- 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. In some cases, the advisers’ policies and procedures included inaccurate information about the firm, or the policies were not tailored to the advisers’ businesses. In other cases, the policies and procedures touched on certain key risk areas, but did not fully address the applicable risks, such as in the areas of: (1) reviewing the trading activity in wrap fee accounts for trading-away practices; (2) determining suitability of wrap fee accounts versus other types of advisory or, if applicable, brokerage accounts; (3) conducting best execution analysis; (4) identifying accounts over which the firms maintained custody; and (5) delivering disclosure documents.
- 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. Examples of such practices included instances where advisers were not: (1) conducting due diligence on third-party portfolio managers they recommended to clients, despite statements otherwise, (2) reviewing client accounts and fee billing as outlined in the policies; and (3) implementing policies, as stated, related to best interest reviews, advertising, code of ethics, and ensuring disclosure documents were current.
- Advisers did not perform required annual reviews or performed the reviews inadequately. A few of the examined advisers did not conduct annual compliance reviews. Several others conducted annual reviews, but the reviews were inadequate due to: (1) the limited testing or validation that took place; (2) their failures to review the effectiveness of the advisers’ policies and procedures, particularly in the areas of client fees and best interest, thus failing to identify compliance issues that occurred in these areas; or (3) their inability to demonstrate that they performed an annual review (primarily due to maintaining minimal documentation regarding the reviews and tests performed).
The following are best practices for investment advisers to ensure their wrap fee programs are meeting regulatory requirements and expectations. Investment advisers should review these key takeaways and, where gaps are identified, implement changes to their wrap fee programs to address these areas:
- Conduct initial and periodic reviews of wrap fee programs to assess whether they are in a client’s best interest, using information obtained directly from clients.
- Conduct periodic client reviews with clients to remind them to report changes to their personal situations, financial standing, and investment objectives. Make sure to document any changes/updates
- Communicate with clients in person or virtually to prepare and educate them when recommending conversions to wrap fee accounts.
- Provide clients with full and fair disclosures about the fees and expenses being charged.
- Provide full and fair disclosures regarding any potential conflict of interest related to transactions executed within the wrap fee programs.
- Ensure that all required disclosures are being provided to clients.
- Include factors to be used when making a best interest determination.
- Monitor and validate that the advisers sought best execution for clients’ transactions.
- Define what the advisers consider to be “infrequently” traded accounts in a wrap fee program.
- Ensure that the policies and procedures pertaining to wrap fee programs are adequate to comply with all applicable rules and regulations.
- Ensure that the policies and procedures regarding wrap fee programs are properly implemented and enforced.
Who should you talk to if you have further questions?
If you would like to discuss the SEC expectations discussed in this Legal Insights or need someone to conduct a review of your compliance program to ensure that its in compliance with all applicable rules and regulations, please contact the following:
|Robert Moreiro, Partnerfirstname.lastname@example.org|
About the Author
Robert Moreiro is a Partner with the Financial Services practice at Practus LLP. Robert has close to 20 years of considerable experience in financial services, advising registered investment advisers and broker-dealers regarding regulatory and compliance issues. With a deep understanding of the federal securities laws, Robert provides registered investment advisers, broker-dealers, and other financial institutions comprehensive and diverse services relating to all aspects of the federal securities laws, FINRA rules, and BSA/AML and OFAC regulations.
Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.