For the last several years, the Securities and Exchange Commission (“SEC”) has continually provided guidance and direction with regards to advisers’ fiduciary duty in making recommendations for wrap fee programs. From exam priorities to an investor bulletin, the writing has been on the wall indicating the position the SEC is taking on this issue with the growth of investor assets into such programs. The conflicts of interest and disclosure practices have come under increased scrutiny during examinations in recent years leading to enforcement actions. Conflicts related to costs paid by the adviser and whether the program remains in the best interest of the client remain at the top of their priority list. In this Risk Management Update, we discuss the SEC’s Division of Examinations’ (“EXAMS”) recently issued Risk Alert on this subject and provide compliance tips.
What was the SEC’s Focus?
Through their Wrap Fee Exam Initiative, EXAMS focused on advisers associated with wrap fee programs from two perspectives: (i) those that serves as portfolio managers in, or that sponsor wrap fee programs; and (ii) those that advised clients’ accounts through unaffiliated third-party wrap fee programs.
The focus centered around the following thoughts:
- Whether or not the adviser maintained consistency with their fiduciary duty and obligations, both initially and on an ongoing basis;
- Adequacy of advisers’ disclosures and if there was consistency of material disclosures between client agreements, solicitors’ arrangements, and wrap fee brochures; and
- Effectiveness of the advisers’ compliance programs, including attention to the processes for determining whether wrap fee accounts were in the best interest of its clients.
The Division determined the most frequent errors related to 1) compliance programs and oversight, including tracking and monitoring of wrap programs, initial and ongoing fiduciary duty of determining best interest; and 2) adviser disclosures, including conflicts of interest, fees and expenses.
The staff made observations across all components of their examinations as noted above. Where they found advisers to be deficient were in practices related to disclosure of conflicts of interest, trading practices as well as initial and ongoing assessments of client best interest. Below is a summary.
Recommendation Not in the Client’s Best Interest
The first observation of note is that recommendations to invest in a wrap account were not consistent with the client’s best interest and the fiduciary obligation of the adviser. Of significance was the fact that advisers did not monitor trading activity in a client’s wrap account. Issues such as trading away, was an example where clients may have been charged fees over and above fees typically bundled in wrap programs. The staff also noted that purportedly advisers were providing ongoing monitoring services. The advisers failed to document their analysis and recommendation to remain in a wrap account, therefore the client continued to stay invested in the program whereby they likely paid more in fees than they would have had they been placed in a non-wrap account.
Additionally, examined advisers did not have a reasonable basis to believe that the wrap program remained in the clients’ best interest. Observations included lack of documentation around the initial recommendation of the wrap program, the analysis that ensued, and ultimately the factors that were identified that culminated in the recommendation. Further, the documentation of an ongoing recommendation to remain in the program was non-existent. On the other hand, the assessments conducted by some advisers were inadequate, often excluding legacy and transferred accounts.
Misleading or Omitted Disclosures
Examined advisers lacked consistency across relevant documents such as client agreement, firm disclosure brochures and wrap fee documents and brochures. For example:
- Firm brochures did not provide adequate disclosure regarding fees paid by wrap clients that were not included in the wrap fee, such as clients paying an advisory fee as well as fees to participate in a wrap program, mark ups, and trade-away fees.
- Advisory agreements indicating clients will pay brokerage commissions, but the wrap program brochures stated that clients will not pay such fees.
- House-holding fee discounts and other rebates, such as 12b-1 fees, were not applied, resulting in overbilling.
Advisers examined also failed to disclose or inadequately disclosed financial incentives their supervised persons had upon making certain recommendations to their clients to participate in wrap programs. Examples included:
- Supervised persons made account and investment recommendations to clients that resulted in clients paying higher fees while avoiding transactions costs the supervised person would normally incur.
This became problematic when a supervised person that was responsible for paying ticket charges, but recommended clients purchase mutual fund share classes that charged 12b-1 fees, that were likely more expensive; and not recommending that clients exit a wrap account because the supervised person would be responsible for certain expenses and transaction fees related to such transfers.
- Investment recommendations to participate in a wrap program when the accounts had high cash balances, minimal trading activity or significant allocations to fixed income and that alternatively, the client could receive similar services at a lower cost outside of the wrap program.
Compliance Program Failures
Frequently, the staff found examined advisers had weak or ineffective policies and procedures relating to their wrap programs. More often than not, advisers did not comply with what procedures they did have in place. Identified failures included:
- Advisers failed to adopt and implement or had inadequate written policies and procedures for identified risk areas, including, but not limited to initial and ongoing assessments of whether or not the wrap account was in the client’s best interest.
- Advisers had not fully implemented or enforced their own compliance policies and procedures. Policies not followed were best interest, advertising, code of ethics, billing and even ensuring documents were current.
- Advisers failed to conduct annual compliance reviews or lacked sufficient documentation evidencing tests performed.
Best Practices to Remain Compliant
All in all, EXAM’s Risk Alert is the blueprint for what firms should and shouldn’t do. It is an outline for how to develop compliance programs consistent with the SEC’s expectations. Below are some additional risk management steps to also consider:
- Conduct and document best interest reviews, both initially and periodically thereafter, to assess whether the wrap program is, and continues to be in the best interest of the client.
- Periodically contact clients to determine if there have been any changes to their personal circumstances, whether it is financial, tolerance for risk, or investment objectives. Also, sending regular reminders to clients, such as a brief note in a account statement, or periodic emails, provides a reminder to clients of their responsibility to inform the firm of any updates to such information.
- When recommending a wrap program to clients, in addition to providing required disclosures brochures, be sure to discuss in detail the services they will receive, all the fees associated with the program that the client will pay, and the applicable conflicts and risks to prepare and educate clients about such programs.
- Develop written compliance policies and procedures that include, among other things, elements such as factors to consider when recommending a wrap program, asset allocation, selection of managers, and how those recommendations are in the client’s best interest.
- Ensure that the compliance policies address and define what constitutes an infrequently traded account and the types of reviews that are needed to address ongoing suitability of a wrap account.
Wrap fee programs are not one-size-fits-all and each need to be assessed based and facts and circumstances. Assessing appropriateness of this type of program against others that are available, and then remaining vigilant as to client best interest on an ongoing basis is paramount. As the SEC’s scrutiny continues surrounding what is in a client’s best interest and the focus on wrap programs continues to intensify, one thing is for certain, the industry has been put on notice as to where the next phase of enforcement actions is headed.
If you need help with compliance related to wrap programs, Core Compliance can help. Our consultants have extensive knowledge and experience in advising firms on how to develop and maintain a robust compliance program, as well as identifying and drafting disclosure of conflicts surrounding wrap fee programs. For assistance, please contact us at (619) 278-0020, or visit us at www.corecls.com.
Author: Core Compliance; Editor: Tina Mitchell, Managing Director, Consultation Services, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer and/or tax professional.