United States: Wrap Fee Programs In SEC's Crosshairs: Program Participants On Notice

Since 2014, wrap fee programs have been highlighted as an annual exam priority by the SEC's National Exam Program. Over the last three months, those priorities appear to have picked up some tailwind, with the SEC announcing three separate enforcement actions and simultaneous settlements against wrap fee program participants. Two of those actions involved program sponsors—Robert W. Baird & Co., Inc. and Raymond James & Associates, Inc.—while the other action involved a third-party manager to multiple programs—RiverFront Investment Group, LLC.1 The actions against Baird and Raymond James focused on the adequacy of each sponsor's compliance policies and procedures related to the oversight and disclosure of certain trading practices of third-party managers (or "sub-advisers") on their wrap fee platforms, while the action against RiverFront focused on the sub-adviser's disclosure to investors about its trading practices.

Wrap Fee Programs and Trading Practices

Investors who participate in wrap fee programs pay the advisory firm that sponsors the program a single "wrap fee" that generally is a set percentage of the investor's assets held in its program account, although the amount of the wrap fee is often negotiable. A wrap fee usually covers all the services that are provided to the investor's account by the sponsoring firm, including investment advisory, asset allocation and, importantly in this context, brokerage services. By charging a single fee for all of the account services, wrap fee programs are designed to provide some degree of cost certainty to investors.

Sponsors often select multiple sub-advisers for their platforms, from which investors can choose to allocate their assets or select a model portfolio. Most wrap fee programs contemplate that sub-advisers will use a sponsor-designated broker-dealer (often the sponsor itself) to execute the sub-adviser's trades on behalf of investors. When trades are executed through the designated broker-dealer, those transaction costs are included in the wrap fee that each investor pays. However, if a sub-adviser chooses not to direct the execution of a particular trade through the designated broker-dealer, the investor generally is charged for any transaction costs outside of the wrap fee. This practice is referred to as "trading away" and these types of trades are commonly called "trade aways."

SEC Enforcement Actions

The SEC's enforcement actions against Robert W. Baird & Co., Inc. and Raymond James & Associates, Inc. focused on each sponsor's alleged failure to adopt adequate compliance policies and procedures with respect to the trading away practices of sub-advisers on their wrap fee platforms. In each instance, the SEC alleged that the sponsor failed to collect, or was delinquent in collecting, information from sub-advisers about their trading away costs or about the frequency with which they traded away, and then failed to properly disclose that information to financial advisers and investors in their programs. The SEC found that each sponsor was aware that certain sub-advisers traded away a significant amount—at times over 90%—of their trades from a designated broker-dealer. However, because those costs were embedded in security prices provided as part of monthly client account statements and not otherwise readily distinguishable from the wrap fee, they were not fully disclosed to investors and their financial advisers. As a result, financial advisers who recommend a wrap fee program to their advisory clients were not in a position to determine whether a particular sub-adviser was suitable for a client—both initially and on an ongoing basis—and advisory clients lacked sufficient information to assess the complete costs of the program, determine which sub-advisers to select or meaningfully negotiate wrap fees with a sponsor.

As a result, the SEC alleged that these sponsors violated Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder, due to a failure to adopt sufficient compliance policies and procedures around the collection and disclosure of information concerning the trading away practices of sub-advisers on their platforms. Without admitting or denying the SEC's charges, the sponsors consented to the SEC's findings, agreed to pay civil penalties of $250,000 and $600,000 and undertook certain remediation efforts. The lesser penalty paid by Baird may reflect the fact that the sponsor already had undertaken certain efforts over the last three years to identify and disclose the frequency of, and costs associated with, the trading away practices of the sub-advisers on its platform.

The SEC's enforcement action against RiverFront Investment Group, LLC did not focus on the adequacy of the sub-adviser's compliance program, rather it focused on the sufficiency of the sub-adviser's disclosures to investors concerning its trading away practices. At the time the sub-adviser began managing assets through wrap fee programs, its Form ADV stated that the sub-adviser was permitted to trade away in an effort to obtain best execution for investors, but that it would generally execute trades through the sponsor (or sponsor-designated broker-dealers) (emphasis added). Over time, the sub-adviser substantially increased the amount of transactions executed away from the sponsor and, at times, nearly 100% of the trades executed on an investment strategy-level basis (i.e., across all client accounts) were traded away. During this period, according to the SEC, disclosure changes to the sub-adviser's Form ADV were late-coming and insufficient to alert investors to the sub-adviser's trading practices and the increased costs borne by clients as a result.

Without admitting or denying the SEC's alleged violations of Sections 204(a) and 207 of the Investment Advisers Act of 1940 and Rule 204-1(a) thereunder, RiverFront consented to the SEC's findings and agreed to pay a $300,000 civil penalty. The sub-adviser also agreed to disclose, on an investment strategy basis, the volume of trades by market value traded away and the associated transaction costs passed on to investors outside of their wrap fees. This disclosure will be available on the sub-adviser's website, updated quarterly and also accessible through the sub-adviser's Form ADV.

Implications for Wrap Fee Program Participants

This spate of SEC enforcement actions serves to remind program participants of their fiduciary duties to investors (who are clients of both the sponsor and sub-adviser). Unless a client consents to the direction of all brokerage to the program sponsor, sub-advisers have a duty to seek best execution. Trades with the sponsor-designated broker-dealer should be considered "commission-free" (as those brokerage services are included in the wrap fee pricing) and trading away justified only if the other broker is expected to improve execution by a sufficient amount to justify the additional commission or fee. Sponsors have a duty to supervise the activities of sub-advisers on their platform, including their best execution practices, and both sponsors and sub-advisers have an obligation to provide advisory services consistent with the disclosure they have made to their clients.

Unlike the vast majority of enforcement actions the SEC brings each year against investment advisers, these wrap fee program participants did not appear to have undisclosed conflicts of interest with their clients (e.g., failing to disclose that the brokers receiving commissions or fees were affiliates of a participant). Thus, there does not appear to be a breach by a program participant of its duty of loyalty underlying the alleged violations. Instead, the SEC's actions appear to involve alleged violations of the participants' duty of care—the duty of an adviser to use reasonable care, skill and diligence on behalf of its client as would a prudent person under similar circumstances.

In light of these recent SEC settlements, wrap fee program sponsors and sub-advisers would be well-advised to review their compliance policies and procedures and disclosure documents governing trading away practices.

In particular, these settlements highlight the need for sponsors to have specific policies and procedures in place to monitor the trading practices of program sub-advisers to determine whether they conform to the disclosure provided to clients. Although these enforcement actions involve trading away from the sponsor, there may also be circumstances when sub-advisers have valid reasons for trading away from a single broker-dealer, including avoiding principal trades or seeking to satisfy best execution obligations. In those instances, both sponsors and sub-advisers should consider appropriate actions in light of the wrap account client's best interests, and review their client disclosures accordingly. As part of any compliance program, sponsors should be reviewing those policies and procedures no less frequently than annually. In addition, wrap fee program sponsors should consider an appropriate means of disseminating information to financial advisers and their advisory clients about trading away practices, the costs of such practices and the impact, if any, on the sub-adviser's performance as a result. That information could be posted on a sponsor's website or provided in client communications, such as monthly account statements or in a separate periodic communication that would direct clients and their financial advisers to the information on the sponsor's website. Finally, as part of their compliance programs, sponsors should assess whether they have sufficient training for their financial advisers about trading away practices, and their associated costs, in order to assist financial advisers to assess which sub-advisers are suitable for their clients.

Sub-advisers on wrap fee platforms should review their Form ADV disclosures (both in Part 2A and in any required wrap fee program brochure) in light of these settlements. In evaluating whether current disclosures should be updated, sub-advisers should consider whether any disclosure amendments are material and should be summarized in Item 2 of Form ADV Part 2A (Material Changes) and then ensure that all clients—not just new clients—receive an updated brochure. Sub-advisers also should assess how best to satisfy their duty to seek best execution for investors in wrap accounts—which may result in increased costs to those clients—in light of their public disclosures and SEC guidance.

Footnote

1. The SEC orders announcing the institution and simultaneous settlement of the administrative proceedings are available at: https://www.sec.gov/litigation/admin/2016/ia-4526.pdf (Robert W. Baird & Co., Inc.); https://www.sec.gov/litigation/admin/2016/ia-4525.pdf (Raymond James & Associates, Inc.); and https://www.sec.gov/litigation/admin/2016/ia-4453.pdf (RiverFront Investment Group, LLC).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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