SEC Sues Investment Advisory Firm for Failure to Disclose Conflicts of Interest in its Wrap Fee Program

If your firm offers a wrap fee program to clients or recommends that clients participate in a wrap program, now is an opportune time to review your fee disclosures and billing practices and best execution protocols. In July 2021, the U.S. Securities and Exchange Commission (SEC) published a risk alert focused on wrap fee programs, which outlines the associated conflicts and disclosure practices observed by the SEC during previous examinations.

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In the alert, the SEC said its Division of Examinations (“EXAMS Division”) conducted more than 100 reviews of advisory firms engaged in wrap programs either as sponsors, portfolio managers, and/or third-party users. The SEC said its ongoing interest in wrap program compliance is partly a result of continued growth of investor assets participating in such programs.

Read our recently issued Risk Management Tip “SEC Strengthens Focus on Wrap Fee Programs”.

The EXAMS Division found that many of the examined firms had significant compliance deficiencies in their wrap programs. Among the most noteworthy failures were not having an adequate basis for determining a wrap program was in a client’s best interest and a lack of having developed policies and procedures for recommending wrap programs. The SEC also found inadequate disclosure of conflicts regarding financial incentives an adviser and/or its representatives had when making recommendations.

 

A Recent Enforcement Example

On September 23, 2021, the SEC filed a lawsuit against a Kansas City-based advisory firm and its President for failure to disclose conflicts of interest to clients pertaining to the firm’s wrap fee program and violating the firm’s best execution obligation. The complaint alleges, among other things, that the advisory firm had selected more expensive mutual fund share classes for its clients because the advisory firm did not have to pay any transaction fees that they are obligated to pay under their wrap program.

Specifically, the SEC alleged that the firm’s clients in their wrap program paid the advisory firm an inclusive annual advisory fee that covered not only investment advice, but also the transaction costs of any securities trades made based on that advice. According to the SEC complaint, the advisory firm had entered into an agreement with an unaffiliated third-party broker wherein the advisory firm agreed to invest at least 60% of its clients’ assets in mutual fund class shares that paid a 12b-1 fee and in exchange the firm would not be charged a transaction fee for clients’ investments in mutual funds and equities. The agreement also allegedly stipulated that the advisory firm had to pay a $25 transaction fee whenever their wrap program clients purchased or sold mutual fund share classes that did not pay a 12b-1 fee.

As a result, the lawsuit said the Kansas City-based advisory firm and its President - through his majority ownership interest in and profit participation from the firm - benefited whenever a wrap client’s trades incurred no or lower transaction costs because the firm retained a larger share of the client’s fee. Additionally, the SEC said the advisory firm had violated its best execution obligation as a fiduciary, since the wrap clients were invested in mutual fund class shares that had a higher expense ratio.

  

Next Steps for Compliance

Over the last few years, a lack of adequate disclosure regarding conflicts of interest has become a strong focus for the SEC, along with advisory firms’ best execution practices surrounding mutual fund trading This case is a good example of the SEC’s position on these areas and should prompt Chief Compliance Officers to take time to review their firm’s processes to ensure that each investment made is in a client’s best interest, that conflicts are addressed and disclosed, and confirm that disclosures made are detailed and adequate.

Consider having a regulatory mock audit performed by a third-party firm. The team at Core Compliance & Legal Services, LLC, can work with you and your firm to find and fix any compliance deficiencies before the SEC does. Contact us to schedule a consultation.