As the SEC does annually, earlier this year, it published its National Examination Program Priorities for 2018. The SEC included in its statement of priorities its review of wrap fee programs, when an investor is charged a single bundled (wrapped) fee based on a percentage of assets for investment advisory and brokerage services, as opposed to being charged an investment advisory fee and then separate transactional fees as may be required based on the trading in the account. The SEC posited that it would review whether advisers are acting in a manner consistent with their fiduciary duty and whether they are meeting their contractual obligations to clients, including whether the recommendations to invest in a wrap fee program and to continue in the program were reasonable, the disclosure of conflicts in compliance with applicable regulatory requirements, and whether advisers were obtaining best execution and disclosing costs associated with executing trades through another broker-dealer. The SEC‘s underlying concern with wrap fee programs is that an adviser may be placing a client in a fee-based account for no reason other than to collect the fee where the adviser is actually providing very little actual advice and there is no trading activity.
The SEC’s exam priority letter, however, isn’t the first time that the SEC has been focused on wrap fees. Articles regarding the SEC “cracking down” on wrap fee abuses date back several years. In fact, the SEC’s Investor Bulletin: Investment Adviser Sponsored Wrap Fee Programs details several enforcement actions brought by the SEC for violations of the Investment Advisers Act of 1940 (“Advisers Act”) in connection with wrap fee programs.
As an investment adviser waiting for the SEC to inquire about your wrap fee program, what should you do? Consider these questions for your wrap fee program (modified from the aforementioned Investor Bulletin):
1- What services are included in the wrap fee program? Why does the wrap fee program make sense for your particular client(s) as opposed to another account type? Will the account in question be actively traded or will the account pursue a buy and hold strategy?
2- Who else will be involved in making investment decisions or providing services to the client’s account? Will the client have any direct contact with that third party? Is the third party affiliated with the adviser or independent?
3- How often will the adviser review whether the wrap fee program still makes sense for the specific client? What factors will the adviser assess?
4- What fees and expenses are included in the wrap fee? For example, will the wrap fee include all of the client’s trade execution costs?
5- Other than the wrap fee, what other fees and expenses will the client pay? Will these include fees and expenses to other managers/service providers associated with the wrap fee program? What is the likely frequency with which the client will incur those fees and expenses?
6- How can the client change or cancel the wrap fee program contract if the client no longer wishes to participate in the wrap fee program?
To the extent an adviser determines a wrap fee program is best for its client, document the initial assessment for why that’s the case, and monitor and document why that remains the case during the relationship. Also ensure that your wrap fee brochure meets its disclosure requirements under Advisers Act Rule 204-3, including fully and clearly disclosing costs to the client both inside and outside of the wrap fee program.