Wrap Fee Programs and “Trading Away”
On September 8th the Securities and Exchange Commission (SEC) announced that two investment advisory firms had agreed to pay penalties in the amounts of $600,000 and $250,000 and commit to certain disclosure and compliance undertakings for failing to have established policies and procedures designed to determine the amount of commissions their clients were being charged when wrap fee program sub-advisers “traded away”.
Wrap fee programs, sub-advisers and trading away
A wrap fee program is an advisory program under which a specified fee is charged for both investment advice and for the execution of related transactions. Sponsors of wrap fee programs are required to prepare and deliver a “wrap fee program brochure” (Form ADV Part 2A, Appendix 1) to clients and prospective clients. There is an assumption that a sub-adviser to wrap fee program will use the broker-dealer(s) identified within the wrap fee program to execute transactions. These are typically the broker-dealers affiliated with the investment adviser firm that is sponsoring the wrap fee program. However, sub-advisers to the wrap fee program often have the ability to use a broker-dealer outside of the wrap fee program – this practice is known as “trading away”. When trading away occurs, a client can incur additional charges that could impact that client’s decision to use the wrap fee program and a financial adviser’s ability to conduct initial and ongoing suitability reviews.
Wrap fee programs have been a focus of regulatory concern. In 2014, the SEC added wrap fee programs to its examination priorities stating that its staff would “assess whether advisers [that sponsor wrap fee programs] are fulfilling their fiduciary and contractual obligations to clients.” The SEC noted that it would review investment adviser processes “for monitoring wrap fee programs recommended to advisory clients, related conflicts of interest, best execution, trading away from the sponsor, and disclosures.”
SEC takes action
Last month, the SEC charged the investment advisory firms of Robert W. Baird & Co. (Baird) and Raymond James & Associates (RJA) with failure to establish policies and procedures necessary to determine the amount of commissions their clients were being charged when sub-advisers to their wrap fee programs traded away. The SEC found that this deficiency prevented the firms from providing financial advisers, and therefore clients, with the full scope of charges associated with the traded away transactions. Furthermore, while both Baird and RJA had access to information relating to these additional charges, neither firm was using the data to conduct a cost analysis for their clients. As such, neither firm could accurately make initial nor ongoing suitability analysis for clients within the respective wrap fee programs.
The SEC further found that additional costs incurred were not explicitly made known to clients when sub-advisers used a broker-dealer other than the associated broker-dealer of RJA or Baird. Instead, transaction costs associated with sub-advisers having traded away were embedded in the price of the security as reported on periodic client account statements.
Corrective action required
In addition to the fines imposed by the SEC, Baird and RJA were required to make several significant changes to the handling of their respective wrap fee programs. Baird was required to update and expand its wrap fee program disclosures and add disclosures to its client agreements regarding the trading away practices of sub-advisers in wrap fee programs. Baird also created, updated and delivered annual disclosure statements that are now made available on its website regarding the trading away practice.
RJA created a publicly available website that discloses the trading away practices of its sub-advisers with information identifying the impact trading away can have on sub-adviser performance. RJA now identifies for clients on their periodic statements any transaction that was traded away and discloses that a commission may have been charged by the executing broker-dealer and directs the client to the website. RJA has also undertaken to establish policies and procedures designed to ensure that its financial advisers receive adequate information concerning trading away practices and commission costs and to conduct related training regarding the use of this information for determining whether a particular sub-adviser would be, or continues to be, suitable for a particular advisory client.
Wrap fee program compliance
Investment advisers that choose to sponsor wrap fee programs should dedicate the time and effort to thoroughly review the practices of their sub-advisers. If sub-advisers are trading away the practice and its impact should be clearly disclosed to clients in the sponsoring firm’s wrap fee program brochure and in client agreements. A well-structured compliance program allows investment adviser firms and their associated financial advisers to conduct comprehensive examinations as to the suitability of a wrap fee program for each client on a case-by-case basis.
Michael Rasmussen is a Compliance Associate at NCS Regulatory Compliance and can be reached by calling 561-330-3878 or by e-mailing him at mrasmussen@ncsregcomp.com.