Bates Research | 08-04-21
SEC Focuses on Wrap Fee Programs, Fixed Income Principal and Cross Trading Compliance Deficiencies in New Alerts
Back in 2019, the SEC’s former Office of Compliance Inspections and Examinations (“OCIE”) issued a priorities report which focused, in significant measure, on investment adviser obligations to retail investors related to (i) disclosures, (ii) conflicts of interest, and (iii) portfolio management and trading. (See Bates post.) That report noted that the OCIE would pay particular attention to investment advisers that participate in wrap fee programs—the practice of charging investors a consolidated fee that includes both investment advisory services and transaction execution. (These issues were also identified as SEC national priorities in 2017 and 2018.)
In September 2019, the OCIE issued a risk alert on another compliance concern: principal trading and agency cross transactions by investment advisers. In that alert, the OCIE discussed the fiduciary obligations of advisers with respect to a “principal trade” (a security to be purchased from or sold to a client from an adviser’s account), an “agency cross transaction” (where the advisor serves both the client and the other party), or a “cross transaction” (where “an adviser effects a trade between two or more of its advisory clients’ accounts, but does not charge a fee for effecting the transaction.”)
On July 21, 2021, the renamed Division of Examination (“Division”) issued new alerts on both these compliance concerns. The alerts were based on the latest observations of compliance deficiencies drawn from extensive examinations. The Division stated that the new alerts should be considered alongside these earlier priorities and observations. Here we review the Division’s recent findings and guidance.
The Division engaged in wrap fee program review because of the growth in investment assets under such programs, and to see if firms were responding to previous observations of deficiencies with respect to conflicts and disclosure practices.
This time, the Division observed that investment firms:
- failed to effectively monitor trading activity in clients’ accounts (specifically, failing to monitor for "trading-away" from broker-dealers who bundled brokerage services with greater costs in their wrap fee programs);
- failed to conduct adequate assessments or “to have a reasonable basis to believe that the wrap fee programs were in the clients’ best interests;”
- failed to disclose or to consistently disclose conflicts of interest, fees, and expenses, (including financial incentives the advisers or their supervised persons had when making certain recommendations, including recommendations to purchase mutual fund share classes that charge 12b-1 fees to clients. See Bates post);
- failed to have adequate written policies and procedures relating to “key business functions and risk areas,” such as best interest reviews, policies tailored to the advisers’ businesses, best execution, custody, and disclosure delivery;
- failed to implement policies covering review of client accounts and fee billing, best interest reviews, advertising, code of ethics, and “due diligence on third-party portfolio managers recommended to clients;” and
- failed to conduct required annual reviews on the effectiveness of required policies and procedures.
To address these issues, the Division suggested practices to improve compliance on a firm’s wrap fee programs. In particular, the Division highlighted ways to strengthen the adviser’s compliance with their fiduciary obligation to make recommendations in the client’s best interest. While the Division noted that observed best practices should not be taken as a recommendation for all firms in all circumstances, the regulators did suggest (i) performing ongoing reviews to assess whether a recommended wrap fee program is in their best interests of the client, (ii) engaging clients—early and often—to evaluate their financial situations, risk tolerances, and investment objectives, and (iii) to communicate with clients frequently “to prepare and educate” them when making a recommendation to convert from “non-wrap fee accounts to participating in wrap fee programs.”
Further, the Division recommended more attention to disclosure of conflicts of interest. The Division noted firms that disclosed conflicts on transactions executed within wrap fee programs, as well as disclosing charges or expenses for a host of activities that the client might incur that are not included in the wrap fee program (e.g., those imposed by mutual funds, wire transfer fees, options trading fees, and transfer taxes, among others).
Finally, the Division recommended strengthening policies and procedures on periodic reviews, automated systems and internal controls to ensure that investment recommendations are suitable and in the best interest of clients, and that firm’s compliance programs include monitoring and validating that the advisers sought best execution for clients’ transactions.
Fixed Income Principal and Cross Trades
The OCIE’s 2019 risk alert on fixed income principal and cross trading reminded investment advisers of their duty to “disclose facts necessary to alert the client to the adviser's potential conflicts of interest in a principal trade or agency cross transaction,” and to ensure that a client’s consent to a principal trade or agency cross transaction is informed” (emphasis added). The Division’s July 21, 2021, alert (which was the product of extensive examinations) was specifically intended to supplement the OCIE 2019 publication.
In this latest alert, the Division noted that nearly two-thirds of the examined advisers received staff-issued deficiency letters, the “vast majority” of which were related to compliance program issues, conflicts of interest and disclosures.
Specifically, the Division observed that investment firms:
- failed to have written compliance procedures to validate (a) that principal trades and cross trades were completed “in a manner consistent with the advisers’ disclosures to clients,” and (b) that appropriate consent was received from, and disclosure provided to clients prior to completing the transactions;
- failed to have policies and procedures that included standards (or guidance on how to use those standards) to ensure compliance with, for example, the advisor’s best interest obligations;
- failed to test the implementation of their written compliance policies and procedures (e.g., by applying analytics to trade blotters to catch unreported principal trades and or cross trades;
- failed to identify, mitigate, disclose or address conflicts of interest by the advisers; and
- failed to provide material disclosures on adviser ADF Form filings.
To address these issues, the Division identified practices to improve compliance on principal trades and cross trades. Generally, the Division urged advisers to “adopt and enforce” policies and procedures that would cover applicable requirements, set standards and supervisory policies, and put in place controls and testing to ensure that they were being followed.
The Division also observed effective practices that placed “conditions, qualifications, or restrictions” on the execution of principal and cross trades, in order to promote adherence to adviser’s “fiduciary obligation, legal requirements, clients’ mandates, compliance policies and procedures, and/or disclosures.”
Further, the Division touted firms that provided clients with robust disclosure of material facts on principal and cross trades. In particular, the Division noted firms that provided fulsome disclosure on conflicts of interest and even associated conflicts of interest by including “a description of the nature and significance of the advisers’ conflicts of interest relative to the impacted client.” The Division cited numerous avenues used to provide such disclosure including Form ADV, advisory agreements, written communications to clients, and private fund offering documents.
Wrap fee programs and principal and cross trading concerns have been an examination priority for several years. The latest observations suggest firms have not responded adequately to earlier Division alerts. Tightening up compliance policies and procedures, amending disclosures and testing that any changes made actually work, particularly in light of the regulator’s focus on best interest compliance, is in order. Experience with the Share Class Selection Disclosure initiative showed that SEC enforcement has ways to make firms pay attention. Bates will continue to keep you apprised.
How Bates Helps:
The Bates Regulatory and Internal Investigations team has supported clients in evaluating exposure to many of the issues highlighted by the SEC above, including fees incurred from trading away in a wrap program (and the disclosure of such fees), fee hypotheticals to evaluate what account type meets the client’s best interest, and detailed blotter analytics to catch unreported principal or cross trades. Our team has also provided support in instances surrounding the miscalculation of account fees based upon the agreements in place with various clients, in addition to numerous reverse churning matters not highlighted above. In both an Examination and Enforcement context, Bates can provide quantitative support in resolving the matter with the regulator and, where necessary, calculating appropriate client restitution.
Bates Compliance provides tailored compliance consulting solutions to financial services clients. Our compliance team includes senior compliance staff and former regulators, who test policies, procedures, supervisory and compliance processes, against industry standards, recommending changes and best practices to enhance compliance and supervisory systems, and to assist in the remediation of regulatory findings.