SEC Risk Alert on Use of Wrap Fee Accounts by Investment Advisers

On July 21, 2021, the Division of Examinations (the “Division”) of the U.S. Securities and Exchange Commission (“SEC”) released a Risk Alert about its assessment of investment adviser firms associated with wrap fee programs. The SEC identified multiple areas where the investment advisers examined were deficient in their policies, procedures, and practices related to wrap fee programs, and further noted a range of industry practices that investment advisers might consider adopting to meet their fiduciary duty when recommending and managing wrap fee programs.

Common Deficiencies Related to Wrap Fee Programs

Failure to Meet Fiduciary Duty

 

• Advisers did not monitor the trading activity in clients’ accounts or their monitoring activities were ineffective. The SEC identified instances where investment adviser firms or their supervised persons recommended wrap fee programs but subsequently (and sometimes regularly) incurred trading away fees in client accounts, in addition to the bundled wrap fee. The SEC also noted instances where an investment adviser recommended or managed a wrap fee account despite minimal transactions occurring in the account, causing the client to pay a higher total fee than the client would have incurred in a non-wrap account.
• Advisers did not have a reasonable basis to believe that the wrap fee programs were in the clients’ best interests. Investment advisers must make an individual determination, both initially and on an ongoing basis, whether a wrap fee program is in the client’s best interest. The SEC regularly observed investment advisers that failed to assess whether a wrap fee was in a client’s best interest at the time the recommendation was made or on an ongoing basis. The SEC noted that performing a review only of a sample of accounts or systematically excluding certain types of accounts from the ongoing review was insufficient.

Inadequate Disclosures

 

• Inconsistent/incorrect disclosures in related documents. The SEC noted multiple instances where an investment adviser’s documents (e.g., Form ADV Part 1, Part 2, Wrap Fee Brochure, client agreements, etc.) provided inconsistent or inaccurate disclosures, or where disclosed discounts or rebates were not actually applied to accounts.
• Omitted or inadequate disclosures regarding conflicts of interest. The SEC noted that disclosures “often” failed to adequately describe the financial incentives presented to the investment adviser and/or its representatives regarding wrap fee accounts. Among these omitted conflicts were the incentive to make fewer trades to reduce the trading fees paid by the adviser/representative, the incentive to recommend higher cost mutual fund share classes to reduce the adviser’s costs or increase their revenue via 12b-1 fees, and the incentive to not recommend a client move from a wrap fee account to a non-wrap account due to the fees the investment adviser or representative would incur. The SEC also observed certain investment advisers failed to disclose that a wrap fee program might be more expensive than other options for clients with low trading volumes, high cash balances, or large fixed income weightings.

Compliance Programs

 

• Omitted compliance policies and procedures. The SEC observed many cases where investment advisers had no compliance policies and procedures relating to wrap fee programs, despite recommending and managing such programs for their clients. In other cases, investment advisers purported to follow informal practices or guidelines, but had not memorialized such practices or documented the outcome of any such informal reviews.
• Inadequate compliance policies and procedures. In some cases, the SEC found investment adviser firms with present but inadequate policies and procedures related to their wrap fee programs. The SEC noted that robust compliance policies and procedures should be up-to-date, tailored to the firm, and address all risks associated with wrap fee programs.
• Inconsistent or absent implementation of compliance policies and procedures. Some of the investment advisers examined did not implement or enforce the policies and procedures they had adopted.
• Inadequate annual compliance review. The SEC observed some investment adviser firms that failed to conduct an annual compliance review or did so inadequately.

Industry Best Practices

Although the SEC noted that every investment adviser firm must take a tailored approach to creating its compliance policies and procedures based on the firm’s unique risks and business practices, the Risk Alert details a variety of successful compliance policies and procedures that the SEC observed during its examinations of wrap fee programs. Investment adviser firms should consider the following factors when implementing and maintaining their compliance policies and procedures regarding wrap fee programs.

Fiduciary Duty

 

• Does the investment adviser firm 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)?
• Does the investment adviser firm periodically remind clients 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?
• Does the investment adviser firm and/or its representative communicate with clients – in-person or telephonically, as appropriate – to prepare and educate clients when recommending to convert their accounts from non-wrap fee accounts to participating in wrap fee programs?

Disclosures

 

Does the investment adviser firm provide clients with disclosures regarding the advisers’ conflicts of interest related to transactions executed within the wrap fee programs? Common conflicts include the following:

• The adviser receives compensation or incentives from wrap fee program sponsors or portfolio managers for investing client assets through the wrap fee programs (e.g., soft dollars, forgivable loans, technology, or other services provided).
• The adviser has financial incentives to not migrate infrequently traded wrap fee accounts to brokerage or non-wrap advised accounts.
• The adviser or its supervised persons have incentives to not trade in clients’ accounts because they may be responsible for paying ticket charges or other costs.
• Clients may incur more costs by participating in the wrap fee program than if they received similar services provided in other types of accounts.
• Clients would pay share class charges – such as 12b-1 fees – when lower cost alternative classes of the same fund may be available, and that such fees would be paid to the adviser’s supervised persons.
• Does the investment adviser provide clear disclosures, when recommending wrap fee programs to clients, about whether certain services or expenses are not included in the wrap fee?

Compliance Programs

 

• Do the 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?
• Does the compliance program monitor and validate that the advisers sought best execution for clients’ transactions?
• Do the compliance policies and procedures define what the adviser that recommend wrap fee programs to clients considers to be “infrequently” traded accounts and compliance programs review such accounts to determine whether the wrap fee programs remain in the clients’ best interests?
• RIA Compliance Consultants recommends that investment adviser firms that recommend or manage wrap fee programs closely review this Risk Alert and work to implement any needed improvements to the firm’s compliance program.

Contact Us

If your investment adviser firm is an existing client of RIA Compliance Consultants and has questions about this Risk Alert or wrap fee programs, we encourage you to speak with your compliance consultant. Or, if you are not an existing client of RIA Compliance Consultants, click here to set up an introductory call with our Business Development Team

Related Posts

FAQ – Wrap-Fee Programs and ADV Part 2A Appendix 1 Wrap Fee Disclosure Brochures

SEC Requires RIAs to Complete Risk Assessment as Part of Annual Compliance Review – December 2, 2020

SEC Enforcement Action Against an Investment Adviser Over Limiting Wrap to NTF Funds – August 31, 2020

SEC Risk Alert – Supervising IARs and Conflicts of Interest Deficiencies – July 31, 2019

SEC Risk Alert – Frequent Advisory Fee and Expense Compliance Issues – April 13, 2018

SEC Focuses On Wrap Fee Disclosures and “Trade Away” Costs – September 13, 2016

SEC Risk Alert For Investment Advisers – Share Class Initiative – August 09, 2016

Sample Forms

Suitability – Wrap vs. Non-Wrap Account – Client Acknowledgement

WSP/CoE Section Update – Account Type Suitability (Commission vs. Fee)

WSP/CoE Section Update – Wrap v. Non-Wrap Account

WSP/CoE Section Update – Account Type Suitability (Wrap v. Non-Wrap Fee Account)

Disclosure

The information contained in this blog post is general in nature intended for educational purposes only and is not intended to be a comprehensive analysis of this topic. It is not intended to constitute compliance consulting advice or apply to any particular investment adviser firm’s specific situation. For more information, please see our Disclosures webpage.

 

 

Posted by Tyler Bolden
Labels: Examination, Risk Alert, SEC, SEC Inspection, Wrap Fee
Tagged: Examination, Risk Alert, SEC, SEC Inspection, Wrap Fee