The Securities and Exchange Commission's attempt to ferret out conflicts of interest at registered investment advisers has zeroed in on potential misuse of popular flat-fee wrap accounts.
The SEC made the vehicles
an examination priority this year and is following through with vigor, according to Patrick J. Burns, an attorney who specializes in investment advisory compliance.
“They seem to be spending an inordinate amount of time on wrap fee programs,” Mr. Burns said. “It seems to have been built into the general exams over the last couple of months. It's definitely going to hit firms by surprise that that level of focus is being placed on just one issue.”
Clients pay an annual or quarterly fee for wrap products that manage a portfolio of investments, rather than paying individual commissions for trades. For advisers who charge fees based on assets under management, these money management charges for wrap products often are additional — either billed to the client separately or through a higher adviser AUM fee to cover them.
The assets in such arrangements totaled $3.5 trillion in 2013, a 25% increase from 2012, according to Cerulli Associates Inc. The market includes separately managed accounts, mutual fund advisory programs, exchange-traded-fund advisory programs, unified managed accounts and two types of brokerage-based managed accounts.
“The market is growing tremendously,” said Tom O'Shea, associate director at Cerulli. “The SEC needs to understand this space.”
Wrap programs are supposed to protect a client from superfluous account activity, or churning. But the opposite problem — reverse churning — can occur if there's little trading in the account.
“If the activity doesn't justify the additional fee, then you've got a problem,” said Steve Thomas, chief compliance officer and chief operating officer at Wealth Financial Advisory Services.
The SEC's scrutiny of these products was highlighted Aug. 13 with a victory in a court case that revolved in part around an adviser's improperly placing his clients into wrap programs. In a Boston federal court, the jury decided in the SEC's favor against Benjamin Lee Grant, an investment adviser who the agency argued improperly induced his clients to follow him when he left the broker-dealer Wedbush Morgan Securities in 2005 to set up his own investment advisory firm, Sage Advisory Group.
The court will determine damages in the case later.
The SEC's
complaint, filed in September 2010, said Mr. Grant encouraged his clients to move with him to Sage by telling them they would save money on fees. He said they would pay a 2% wrap fee to Sage, which included advisory and management fees as well as transaction costs, instead of the 1% fee plus trading commissions they were charged at Wedbush.
The SEC claimed Mr. Grant failed to tell his clients that brokerage costs would be significantly lower at the discount broker Sage used, Charles Schwab & Co., compared with the money manager Wedbush employed, First Wilshire Securities Management Inc. The agency said the savings lined Mr. Grant's pockets, as his compensation climbed from less than $500,000 in 2004-05 to more than $1 million in 2006-07.
“In short, even though he styled himself as an investment adviser, Mr. Grant did little more than sit back and wait for the clients' wrap fee payments to roll in,” the SEC complaint states.
“This case sends an important message to investment advisers that they must put the needs of their clients before their own,” Andrew Ceresney, director of the SEC Division of Enforcement, said in a statement.
Wrap programs work for some of adviser Matthew Tuttle's clients because he is frequently changing their asset lineups.
“I'm not a buy-and-hold guy,” said Mr. Tuttle, chief executive of Tuttle Tactical Management. “I don't want to have to worry about all sorts of commissions and things.”
As an RIA, he supports the SEC's review of wrap programs.
“I'm glad the SEC is cracking down on this,” Mr. Tuttle said. “You have to look at what's best for the clients.”
An adviser who avoids wraps also backs the SEC's efforts.
“I am not a fan [of wrap accounts],” said Kevin Starkey, president of FTN Capital Management. “It's a gray area. It is a license to collect fees without actively trading. It is important that clients get what they pay for.”
The “information request list” on wrap accounts the SEC sends to advisers who are being examined includes 21 questions. In addition to general information, the SEC is seeking details on disclosure, account activity and transaction fees, including best execution.
The SEC's focus on wrap accounts dovetails with its scrutiny of dually registered firms, said Amy Lynch, president of FrontLine Compliance. If a financial firm has both an RIA and broker-dealer operation, it can move clients between the two.
“The SEC is interested in seeing the different roles that these firms are playing and how they're being compensated in these roles,” Ms. Lynch said. “The key with [wrap] programs is to make sure their disclosures are very tight. You want to show the client how their money is being utilized.”
The SEC declined to comment on the wrap program examinations. Earlier this year in
an interview with InvestmentNews, Jane Jarcho, national associate director of the SEC examination program, said firms must show they are monitoring their wrap accounts.
But wrap programs present a big challenge, said Todd Cipperman, managing principal of Cipperman Compliance Services.
“There's no compliance infrastructure helping make that [initial] decision on whether a client goes to the B-D or RIA” in a dually registered firm, Mr. Cipperman said. That underscores “the idea of building a culture of compliance throughout the entire firm, including at the point of sale.”
