The Securities and Exchange Commission recently brought two enforcement actions1 that highlight the SEC’s focus on the investment adviser fiduciary duties, particularly as applied to recommendations that clients open or remain in certain types of accounts. The cases also reflect the SEC’s continued movement toward emphasizing the duty of care and a client’s best interest when describing an adviser’s fiduciary duties. In these enforcement actions, which the SEC brought in August and September of this year, the SEC alleged that the wrap program sponsors violated the Investment Advisers Act of 1940, either by: failing to review the continued suitability of wrap accounts for certain clients; or failing to take reasonable steps after reviews identified wrap accounts that were no longer in certain clients’ best interests. As discussed in more detail below, both advisers were charged with: non-scienter-based violations of the antifraud provisions of the Advisers Act; and failing to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act.2
These orders follow the SEC’s release of: a bulletin in March 2022 (Staff Bulletin) in which the Staff expressed its views concerning the standards of conduct for broker-dealers and investment advisers when recommending account types to retail investors;3 and the Division of Examination’s 2022 priorities report (Examination Priorities), which identified the assessment of account types as a priority.4
Together, these actions illustrate that the SEC is focusing on how advisers assess and monitor the types of accounts in which their clients participate. The SEC also continues to call out the duty of care, including providing advice in a client’s best interest, as a distinct element of an adviser’s fiduciary duties. This emphasis suggests a desire to look beyond disclosures when assessing compliance with an adviser’s fiduciary duties. At the same time, the SEC’s enforcement orders show that clear disclosures, and implementing practices consistent with those disclosures, continue to be essential to demonstrating compliance with the Advisers Act.
Recent Regulatory Background
In March 2022, the SEC Staff issued guidance in a Staff Bulletin highlighting the standard of conduct for broker-dealers and investment advisers when making account type recommendations to retail investors. The Staff Bulletin reflects the staff’s views and largely draws from statements that the SEC made in its 2019 interpretation of advisers’ fiduciary duties (Fiduciary Interpretation) and in the adopting release for Regulation Best Interest.5 The Staff Bulletin states that the staff aimed to “assist firms and their financial professionals with considering reasonably available alternatives and cost, addressing conflicts of interest, and adopting and implementing reasonably designed policies and procedures when making account recommendations.” As in the Fiduciary Interpretation, the Staff Bulletin stated that an adviser’s duty of care encompasses three components: (1) the duty to provide advice that is in a client’s best interest (which includes suitability obligations); (2) the duty to seek best execution; and (3) the duty to provide advice and monitoring over the course of the adviser-client relationship.
Also in March 2022, the staff of the SEC’s Division of Examinations issued its Examination Priorities. The Division included scrutinizing compliance with the fiduciary duty among its five “Significant Focus Areas.” The Division also stated that it would pay particular attention to the adviser’s duty of care in connection with wrap fee programs.6 While the standards of conduct received mention in previous years, this year’s priorities suggested greater emphasis in this area.
Enforcement Cases
KAI
Kovack Advisors, Inc. (KAI), a registered investment adviser, offered a wrap fee program to its clients from at least 2015 through August 2018. According to the SEC order, the adviser disclosed in its brochures and certain of its client account agreements that it would review its advisory accounts on a periodic basis in order to monitor whether wrap accounts remained suitable for its clients.7 Additionally, the adviser’s compliance policies and procedures required the adviser to conduct reviews of client accounts, including for “volume of trading.”
According to the KAI Order, following an examination by the SEC’s Division of Examinations that began in 2017, the adviser conducted account reviews for the first time in almost two years. The SEC also found that the adviser did not monitor such accounts “consistent with its representations to wrap clients” and “did not have policies and procedures in place reasonably designed to determine” when to convert inactive accounts. The SEC alleged that this resulted in certain clients remaining in the wrap fee program despite low volume of trading in the accounts.8
Waddell
Waddell & Reed, Inc. (Waddell), a dually registered adviser and broker-dealer, maintained a wrap fee investment advisory program from at least January 2015 through July 2021. According to the SEC order, Waddell maintained certain written compliance policies and procedures for financial advisors (Compliance Policy) to monitor whether its wrap fee program remained suitable for advisory clients.
As described in the Waddell Order, the Compliance Policy provided that accounts enrolled in Waddell’s wrap fee program must maintain “an appropriate level of … activity,” and that an account with less than four trades over the most recent eight quarters “will be terminated and the account will be converted to a traditional brokerage … account.” The firm also had policies and procedures that required compliance and supervisory personnel to: review the wrap program accounts; flag accounts with lower trading activity; and create reports on the same. However, the SEC found that the program “lacked reasonable coordination, oversight and a method of confirming” that accounts with lower levels of trading activity were “addressed appropriately.” Although Waddell conducted such reviews and transitioned some accounts out of the wrap fee program, the SEC found that Waddell did not always follow up. The order indicates that Waddell did not, in each case, contact the account’s financial advisor and coordinate with operations to transition accounts out of the wrap fee program in accordance with the firm’s policies. According to the SEC, the failure to transition those accounts resulted in clients paying $484,645 in wrap fees during the relevant period.
Conclusion
While the SEC issued the KAI and the Waddell Orders addressing similar conduct in successive months, their vocabulary in these orders differs, in potentially significant ways. Both orders highlight the SEC’s emphasis on advice that is in a client’s “best interest,” but only the Waddell Order uses the term “duty of care.” In addition, while both orders focus on periodic reviews of account type recommendations, the Waddell order contains additional exposition concerning an adviser’s obligation, in general, to provide advice and monitoring over the course of the adviser-client relationship.9 These differences may be explained by the relevant period of the conduct: KAI terminated its wrap fee program before the SEC issued the Fiduciary Interpretation, while Waddell’s program continued until 2021. If this is the case, the juxtaposition demonstrates the SEC’s growing emphasis on the duty of care and suggests a desire, ultimately, to reduce the SEC’s need to point to false or misleading disclosures when enforcing an adviser’s fiduciary duties.
The orders also underline the SEC’s previously announced focus on account recommendations. Advisers should expect that SEC examiners may ask whether they periodically reassess the suitability of account type recommendations and how they follow through when an account type may no longer fit a client’s needs. The SEC’s orders indicate that an adviser’s policies and procedures with regard to monitoring client accounts should be robust and that an adviser will need to act consistently with those policies, and related disclosures, to demonstrate compliance with the Advisers Act.
Footnotes
1) In the Matter of Kovack Advisors, Inc., SEC Order, SEC Rel. No. IA-6098 (Aug. 26, 2022) (KAI Order); In the Matter of Waddell & Reed, LLC, SEC Order, SEC. Rel. Nos. 34-95828 and IA-6136 (Sept. 19, 2022) (Waddell Order).
2) The SEC explained in the interpretive release that an adviser’s fiduciary duties are made enforceable by the antifraud provisions of the Advisers Act. Commission Interpretation Regarding Standard of Conduct for Investment Advisers, SEC Interpretation, SEC Rel. No. IA-5248 at 7 (effective July 12, 2019) (Fiduciary Interpretation). For further information on the standards of conduct releases, please refer to Dechert Newsflash, SEC Adopts Enhanced Standard of Conduct for Broker-Dealers and Clarifies Fiduciary Duties of Investment Advisers.
3) Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Account Recommendations for Retail Investors (Mar. 30, 2022) (Staff Bulletin). For further information on the Staff Bulletin and its contents, please refer to Dechert OnPoint, SEC Publishes Staff Bulletin on the Standards of Conduct for Broker-Dealers and Investment Advisers Making Account Recommendations to Retail Investors.
4) 2022 Examination Priorities, SEC Division of Examination (Mar. 30, 2022) (Examination Priorities).
5) Regulation Best Interest: The Broker-Dealer Standard of Conduct, SEC Final Rule, SEC Rel No. No. 34-86031 (effective Sept. 10, 1991).
6) Examination Priorities at 14 (the “Significant Focus Area” in the 2022 Examination Priorities Report is titled: “Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS”).
7) According to the KAI Order, KAI stated that such reviews would be “on at least a semi-annual basis” in its 2015 and 2016 brochures. In 2017 and 2018, KAI’s brochures stated that the reviews would be periodic.
8) The SEC also found that KAI charged brokerage fees to certain wrap account clients in addition to the wrap fee without appropriate disclosure.
9) As described in the Fiduciary Interpretation, among the fiduciary duties that an adviser owes to its clients is to provide advice regarding selecting an account type in the client’s best interest. The SEC asserted in the Waddell Order that, “[a] wrap fee account may not be in the best interest of a client with minimal or no trading activity as compared to a non-wrap fee or brokerage account, where the client would otherwise pay trading costs (commissions) as incurred but lower overall fees than in a wrap account."
