SEC Risk Alert: Wrap Fee Programs

SEC Risk Alert: Wrap Fee Programs

01 November 2021

Main Contributor: Katie Mogan, IACCP® Vice President, Senior Compliance Consultant

Introduction

On July 21, 2021, the SEC released a Risk Alert focusing on examinations of wrap sponsors and wrap advisors. After examining over 100 advisors associated with wrap programs, the SEC found compliance concerns and identified areas where advisors needed to make improvements. The focus of the exams included advisors’ fiduciary duty to the wrap program/sponsors, disclosures to wrap-fee clients, and advisors’ compliance programs. This risk alert noted some examples of best practices, which we will review alongside SCS’s suggestions.

Let’s start by defining key terms.

Wrap Fee is a fee designed to cover all the expenses of trading and managing an advisory account including investment advisory, trading, custodial, and sometimes other fees. The term “wrap” derives from the idea that the fees are wrapped into one fee the client pays.

Wrap accounts are the advisory accounts that participate in the wrap program or strategy.

Wrap sponsors are the custodians or investment advisors who recommend a wrap program to an advisory client. The wrap sponsor provides the access to the portfolio managers and their investment products.

Wrap programs are offered through investment advisors who have agreements in place with wrap sponsors to offer specific strategies or models to underlying investors. The wrap program has a portfolio manager and a wrap sponsor.

Portfolio Manager to a Wrap Program is the advisor who creates the strategy and trades the wrap accounts to that specific strategy.

Fiduciary Duty

Wrap sponsors and portfolio managers to wrap programs have a fiduciary duty to put clients’ best interests before their own, which includes making recommendations based on the suitability of an investment for a client, not based on the fees an advisor will collect as a result of the recommendation. Reviewing a client’s suitability and financial situation in a meaningful way (and documenting that review) is part of this obligation. Disclosure and the mitigation of conflicts both play a role in your fiduciary duty as well.  If an advisor financially benefits from a relationship or trading scenario that costs the wrap account an additional fee, this fact and material details should be disclosed.

Fiduciary Duty and Recommendations Not Made in Clients’ Best Interest

The SEC found wrap sponsors and portfolio managers failed to uphold their fiduciary duties in several ways, including:

  • Advisors did not monitor trading activity in clients’ accounts
  • Advisors did not have a reasonable basis to believe a wrap program was in their clients’ best interest

The SEC found wrap sponsors failed to monitor the trading activity of portfolio managers to wrap programs. The lack of oversight caused clients to incur additional fees like step out fees (trading away from the sponsor or custodian of record). The failure compounds when the wrap account pays the additional fees and there is no review of appropriateness or of the additional costs in light of the bundled wrap fee clients are paying. Typically, wrap accounts should not incur additional charges because the wrap fee is intended to cover all trading costs. The lack of or insufficient trade monitoring also caused the sponsors to miss low volume trading, which in turn caused those wrap accounts’ total trading fees to be higher per trade than an account trading more frequently.

The SEC found conflicts of interest with regards to the appropriateness of wrap fee programs for clients. Advisers in the exams were frequently recommending wrap fee programs to their clients without conducting suitability reviews to understand if the wrap program was in the client’s best interest initially and throughout the advisory relationship. A conflict exists because the advisers (both the wrap sponsor and portfolio manager to the wrap program) earn fees from clients in the program and would potentially lose those fees if they made a recommendation to the client to leave the wrap program.

SCS Suggests:

You must evidence you are meeting your fiduciary obligation and making choices in the clients’ best interest. This can be done in various ways, but we always suggest documenting your reviews. For example:

  • Conduct regular reviews of the wrap programs. Key topics to focus on include:
    • Trading volume – low trading volume means higher per trade costs on clients
    • Additional fees – trading/commissions costs, soft dollars, mutual fund/ETF 12b-1 fees
    • Turnover

Review these data points in conjunction with the fees a client is paying and the disclosures the client received (see next section!) with regards to these activities. Reviews can be documented during a best execution meeting, or a separate wrap suitability review.

  • Conduct suitability reviews at the beginning of the relationship, and at least annually thereafter.
    • Add a note in the quarterly letters to clients instructing them to touch base with the advisor if financial conditions change. This is a great way to remind clients that their changes impact your advice.
    • Document reviews via your CRM, in a memo to the client file, or in a follow-up email.

How often you review these topics depends on the level of risk and impact to your business. The larger the impact to your business and the higher the risk, the more often you should consider reviewing these topics.

Disclosures

With conflicts, fees, and expenses appearing on the SEC’s Exam Priorities List for several years running, this focus comes as no surprise. Conflicts of interest exist for all advisors and if an advisor cannot mitigate a risk or conflict, they are expected to properly disclose the conflict(s). In addition, if a conflict exists, you must have policies and procedures established to mitigate the conflict.

The SEC found advisors had inadequate or inconsistent disclosures when it came to their participation in wrap fee programs including disclosures around conflicts of interest, fees, and expenses. For example:

  • Advisors had inconsistent language in disclosures or contradictory language across multiple disclosure documents
    • The SEC pointed out that advisors’ disclosure documents, ADV Part 2A and the Part 2A Appendix 1, or the wrap fee brochure, were not in sync and contradicted one another.
  • Advisors omitted or inaccurately described conflicts of interest

Fees and Expenses: The SEC found brochures did not provide full or accurate disclosures around additional fees not included in the wrap fee like fixed income mark-ups and trade away fees, or one document indicated clients would pay commissions when another brochure stated they would not and disclosing rebates or house-hold fee discounts that were not applied.

Conflicts of interest:  The SEC found advisors failed to disclose incentives gained from recommending certain high-paying investments, client trades, or failed to disclose that low-volume trading, high cash balances or significant fixed-income weightings could benefit from lower cost services outside a wrap fee program.

SCS Suggests:

Review your disclosure documents together and ensure they are “telling the same story”. Review sections that refer to fees and conflicts to ensure the same details are discussed and the language is consistent. Look specifically at your wrap program relationship and how it produces money for your firm and make certain those aspects are fully disclosed.  Review fees clients incur (trade away fees, commissions, 12b-1 fees, and other mutual/ETF fees) and confirm there are clear explanations of those fees in your disclosure documents. If you have multiple disclosure documents or programs to track, we suggest a list in excel to monitor the important disclosure areas and documents included, so you don’t omit an important fact or document.

The SEC gave some helpful disclosure examples to help you get started.

  • Disclose compensation received from wrap fee program sponsors for investing client assets, such as:
    • Soft dollars
    • Forgivable loans
    • Technology
    • Research/meeting access
  • Disclose if you have financial incentives (penalties) to keep infrequently-traded wrap accounts as opposed to transitioning the account to non-wrap.
  • Disclose if there are additional ticket charges incurred when you trade that might cause you to trade less in order to avoid such fees.
  • Disclose that clients can receive the same services for less with you/elsewhere.

Keep your disclosures clear and concise and review them at least annually when you make your annual ADV amendment.

Compliance Programs

The Compliance Rule requires registered advisers to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and the rules thereunder, and to review at least annually the adequacy and effectiveness of those policies and procedures. Your policies should be specific to your firm’s unique business model, risks, and conflicts. If your advisory activities include wrap programs in some way, your policies and procedure and annual review testing should include some review of that activity.

In their exams, the SEC found advisors did not have policies and procedures or the policies were inadequate to address their wrap business. Examples of issues the SEC found include:

  • A lack of or inadequate compliance policies and procedures specific to the advisors wrap business
  • Inconsistently implemented or enforced policies and procedures
  • Failure to perform annual reviews or inadequate annual reviews

SCS Suggests:

If you work with wrap programs, this risk alert is a good starting point to review your compliance program and disclosures. Your policies and procedures and annual review should be tailored to your wrap business and include documented reviews. Reviews can include meeting minutes, analysis of trade data, random reviews of client notes for suitability, and training your staff on policies and procedures. The documentation is just as important as the process. The SEC recommendations included:

  • Policies and procedures should include specific items to be reviewed when reviewing suitability of a client for a wrap program.
  • Develop monitoring processes, such as best execution, to ensure analysis is performed and applied to the wrap portion of the advisor’s business.
  • Review data of portfolio managers to ensure they have accurate knowledge of an activity like trading away.
  • Define topics in policies and procedures such as
    • Excessive trading
    • Infrequent trading
    • High cash
    • Low cash
    • Excessive fees

Conclusion

As an advisor, if you are associated with wrap programs, a critical component of your compliance program is to review current practices around those wrap programs to ensure you have consistent and robust policies and disclosures to mitigate and address the potential conflicts that exist. We recommend you start by gaining a complete understanding of the wrap programs and the fees associated.  Schedule testing and reviews, review disclosures for consistency, and where necessary update your policies to address the controls put in place.