The continued growth of investor assets participating in wrap fee programs has prompted regulators to maintain a sharp focus on the programs as part of an ongoing assessment of market-wide risks and matters of importance to retail investors saving for retirement.
The U.S. Securities and Exchange Commission (SEC) has issued key findings by its Division of Examinations (the Division) from the more than 100 investigations it conducted into wrap fee programs from 2017-2019.
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. Whatever the name, the primary focus of the program is to “wrap” most investment advisory, brokerage, and/or custodial fees together into one.
A Recent Case
In an enforcement action that mirrored its findings, the Division levied fines and penalties of more than $1 million against Northwest Advisors, Inc., (NWA) on August 24, 2021, for several alleged violations and compliance deficiencies over a four-year period.
Most notably, NWA purchased, recommended, or held for certain advisory clients’ mutual fund share classes that charged 12b-1 instead of lower-cost share classes of the same funds that were available to the clients and did not charge 12b-1 fees. As a result, the advisory clients paid excess fees on their investments and NWA avoided paying transaction fees for trades placed in those clients’ accounts.
During its examination of NWA, the Division uncovered numerous failures in all three of its focus areas for such exams.
- Consistency with fiduciary duty obligations. NWA had not fulfilled its fiduciary duty by having a reasonable basis to believe that the wrap fee programs reflected best execution and were in the best interests of participating clients – both initially and on an ongoing basis – and whether NWA had documented such assessments. The Division’s review also found NWA did not disclose transaction charges and the extent of account trading activity.
- The adequacy of the examined advisers’ disclosures. NWA did not provide full and fair disclosure of all material facts to their wrap-fee clients. particularly regarding the fees, expenses, conflicts of interest, and entities involved in the programs.
- The effectiveness of the examined advisers’ compliance programs. In its complaint, the Division cited NWA’s failure to adopt and implement written policies and procedures reasonably designed to prevent in connection with the disclosure of conflicts of interest presented by its mutual fund share class selection practices, or in connection with making recommendations of mutual fund share classes that were in the best interests of its advisory clients. In 2017, NWA amended its policies and procedures regarding mutual fund share class selection practices and disclosure of conflicts of interest, but the firm continued its practice of investing clients into higher-cost share classes when lower-cost share classes of the same fund were available and did not disclose this practice or the related conflict of interest.
NWA is no longer an active investment adviser.
In its exams of wrap fee programs, the Division frequently observed that the examined advisers had weak or ineffective compliance policies and procedures regarding their wrap fee programs. 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.
To assist advisers with compliance of wrap fee programs, the SEC recommends the following:
- 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.
- 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, financial standing or needs, and investment objectives.
- Communicate with clients – in-person or telephonically, as appropriate – to prepare and educate them when recommending converting 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 that 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.
- Compliance programs monitor and validate that the advisers sought best execution for client transactions.
- Compliance policies and procedures 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.
Additional can be found in this SEC Risk Alert on wrap fee programs.
A Final Word
Firms that offer wrap fee accounts should be prepared for ongoing scrutiny. With that in mind, the experienced and specialized team at Core Compliance & Legal Services can conduct a review of your policies and procedures and note any deficiencies before regulators do. For more information, contact us at 619.278.0020 or at www.corecls.com.