On July 21, 2021, the SEC’s Division of Examinations (“Division”) published a Risk Alert that discussed the deficiencies found most frequently by examiners during its Wrap Fee Initiative examinations. The Division shared this information to encourage Registered Investment Advisors (“RIAs”) that recommend wrap fee programs to consider and adopt policies and procedures to address the risks, conflicts of interest, and challenges that go hand-in-hand with those recommendations. The Risk Alert is available here.
Background on wrap fee programs and the Wrap Fee Initiative
Wrap fee programs are known by different names such as:
- Asset allocation programs;
- Asset management programs;
- Investment management programs;
- Uniform managed accounts; and
- Separately managed accounts.
Advisory clients who participate in wrap fee programs typically pay a consolidated fee to sponsors, which covers certain investment advisory services and most execution costs. The wrap fee owed is usually a percentage of the client’s account value and is not based upon the number of transactions executed. Although wrap fee programs are designed to offer clients certainty related to advisory and execution costs for implementing, maintaining, and changing their investment strategies, they may also put investors at risk and create conflicts of interest for RIAs.
In addition to the conflicts of interest and disclosure practices observed during prior examinations, the Division’s Wrap Fee Initiative was precipitated by the continued growth of investor assets in these programs and the SEC’s evaluation of market-wide risks. The Initiative was not unexpected, since wrap fee programs were highlighted in the Division’s annual examination priorities in 2017, 2018, and 2019. Wrap fee programs are likely to impact investors who are saving for retirement.
The findings and observations in the Risk Alert were based on over 100 examinations of advisors associated with wrap fee programs. These examinations included advisors serving as portfolio managers in, or sponsors of, wrap fee programs. Examiners also scrutinized advisors that advised their clients’ accounts through one or more unaffiliated third-party wrap fee programs. Generally, Wrap Fee Initiative examinations focused on:
- Consistency with fiduciary duty obligations;
- The adequacy of disclosures provided by the advisors examined; and
- The effectiveness of the examined advisors’ compliance programs.
Observations derived from the Wrap Fee Initiative examinations
Not surprisingly, the Division’s Risk Alert concluded that many of the advisors examined could improve their compliance programs. The most frequently-cited deficiencies related to:
- Compliance and oversight, including policies and procedures regarding the tracking and monitoring of the wrap fee programs; and
- Disclosures of conflicts of interest, fees, and expenses.
In certain instances, examiners questioned whether it was appropriate for the advisor to recommend a wrap fee program, especially when clients had no or low trading volume in their accounts. Examiners’ observations can be broken down into three categories.
- Fiduciary duty and recommendations not made in clients’ best interests
Suitability is one very important element of an investment advisor’s fiduciary duty. As a fiduciary, advisors must have reasonable grounds to believe that their recommendations are suitable for the client. Examiners observed issues with advisors’ recommendations that clients participate in wrap fee programs, both initially and on an ongoing basis. Advisors did not always monitor their clients’ trading activity, or their monitoring efforts were ineffective.
Certain advisors failed to meet their duty of care obligation. They were not vigilant regarding trading-away from the broker-dealers providing bundled brokerage services to the recommended wrap fee programs. They also did not monitor the costs resulting from trading-away practices.
Many of the examined advisors did not have a reasonable basis for a belief that the wrap fee programs recommended were in clients’ best interests. Examiners observed instances where the examined advisors routinely recommended that their clients participate in wrap fee programs without conducting any evaluation of whether those recommendations were in their best interests.
- Potentially misleading or omitted disclosures
Examiners observed that many advisors omitted or provided inadequate disclosures, particularly those that described conflicts of interest, fees, and expenses. Examiners identified disclosure issues in RIAs’ Form ADV, Part 2A and sponsors’ Part 2A Appendix 1, the wrap fee program brochure. Examiners also observed issues in advisory agreements and other account documents.
Examiners found that RIAs did not provide full disclosure regarding costs that were not included in the wrap fee, such as fixed income mark ups and trading-away charges. In some instances, advisory contracts stipulated that the client would pay brokerage commissions, even though the wrap fee program brochures expressly stated that this would not occur.
RIAs’ disclosures often omitted or inadequately described the financial incentives the examined advisors and their supervised persons received when recommending a wrap fee program. Examiners discovered that certain advisors did not disclose that accounts with low trading volumes, high cash balances, or significant fixed income weightings could have received similar services at a lower cost outside of a wrap fee program. RIAs did not always disclose that wrap fee accounts incur extra costs when trades are executed by a non-designated broker-dealer.
Examiners frequently observed that advisors had weak or ineffective compliance policies and procedures governing their wrap fee programs. In some cases, advisors did not comply with their own policies and procedures. Certain advisors did not conduct initial and/or ongoing “best interest” reviews when recommending wrap fee accounts to clients.
In some instances, advisors followed internal guidelines or informal practices for key operational areas but did not memorialize these practices in written compliance policies and procedures. At some RIAs, there were informal practices for conducting a best execution analysis of wrap fee accounts. There was no formal process applicable to the selection of separate portfolio managers to advise clients’ wrap fee accounts.
In some cases, RIAs’ policies and procedures touched on certain key risk areas but did not fully address the applicable risks. For example, policies and procedures were deficient regarding the review of trading activity in wrap fee accounts. They were also inadequate regarding how to determine the suitability of wrap fee accounts for clients.
Examiners observed that several RIAs inconsistently enforced, or failed to implement, their policies and procedures. RIAs did not always conduct due diligence on third-party portfolio managers they recommended to clients, although the advisors made statements to the contrary. They did not review client accounts and fees in the manner prescribed in their policies and procedures. Certain firms did not perform annual reviews or performed them inadequately.
Best practices related to wrap fee programs
Although the Risk Alert recognized that there is no one-size-fits-all approach to compliance, the Division did offer numerous examples of policies and practices that may help RIAs to improve compliance.
- Fiduciary duty and recommendations made in clients’ best interests
The Risk Alert encouraged RIAs to conduct reviews of wrap fee programs – both initially and periodically thereafter – to evaluate whether recommendations were in the best interests of clients. Advisors should obtain information directly from clients, using interviews, discussions, and/or questionnaires. After conducting initial best interest reviews regarding recommendations to participate in wrap fee programs, advisors should periodically remind clients to report any changes in their personal situations, risk tolerance, and investment objectives.
As they communicate with clients, advisors should prepare and educate clients when recommending a change from non-wrap fee accounts to wrap fee programs. It is a best practice to provide clients with specific information about investing through wrap fee program accounts, including fees, expenses, and other costs.
The Risk Alert stressed that advisors should disclose if they receive compensation or incentives, such as soft dollars or forgivable loans, from sponsors or portfolio managers for investing clients’ assets through wrap fee programs. Among other disclosures, advisors should disclose that clients may incur more costs by participating in the wrap fee program than if they received similar services provided in other types of accounts.
Advisors should clearly disclose if certain services or expenses are not included in the wrap fee, such as additional charges for options trading and fees and expenses imposed by mutual funds or ETFs.
With regard to RIAs’ compliance programs, the Risk Alert highlighted the need for written policies and procedures that articulate the factors to be used when determining whether investment recommendations made to clients participating in wrap fee programs are in their best interests.
The Risk Alert recommended that compliance policies and procedures define what is meant by infrequently-traded accounts. Policies and procedures would then compel review of infrequently-traded accounts to evaluate whether the wrap fee programs remain in the clients’ best interests. If those wrap fee arrangements are no longer in their clients’ best interests, the wrap fee-related advisory agreement should be terminated.
The one hundred examinations in the Wrap Fee Initiative did not end well for some of the RIAs examined. In response to examiners’ observations, certain advisors “elected” to amend their disclosures, revise compliance policies and procedures, conduct suitability reviews of wrap fee clients, and/or change other practices. When examiners find fault with an RIA’s compliance program, it is almost always a good idea for the firm to take note of their specific concerns and to act immediately to correct their wrap fee program shortfalls.
Any RIA that is associated with a wrap fee program should heed examiners’ observations. They should consider improving their supervisory, compliance, and/or other risk management systems based on the guidance in the Risk Alert. It is also a good idea for these RIAs to make any changes that are appropriate to address or strengthen their compliance program.
Risk Alerts allow advisors to learn from the compliance mistakes committed by other firms. Advisors whose business models involve wrap fee programs should take note of the Division’s observations and put their own compliance program under observation.