RIA Compliance and Practice Management Blog

Wrap Fee Programs Remain a Hot RIA Compliance Area of Regulatory Focus

Posted by RIA in a Box

Aug 23, 2014 11:10:00 AM

Registered investment adviser (RIA) wrap fee programs are once again in the headlines this week as both Melanie Waddell of ThinkAdvisor and Mark Schoeff of InvestmentNews have some great coverage of the SEC's victory in a recent federal case on August 13 against a Massachussetts-based investment adviser in which the SEC successfully argued that the investment adviser misled clients when placing them into a wrap fee program. 

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As RIA compliance consultants, we often find that wrap fee programs are a common point of confusion for RIA firms. Often, many investment advisory firms do not realize that they are indeed sponsoring a wrap free program. Rule 204-3(g)(4) defines a wrap free program as: 

a program under which any client is charged a specified fee or fees not based directly upon transactions in a client's account for investment advisory services (which may include portfolio management or advice concerning the selection of other investment advisers) and execution of client transactions.

In other words, a wrap fee program is generally when an RIA firm "wraps" the advisory fees and commissions that would be charged to a client into a single, all-inclusive fee. For example, instead of an RIA firm charging a client a 1.00% advisory fee and brokerage commissions being charged directly to the client in addition to the advisory fee, a "wrapped fee" would include all brokerage commissions as the RIA firm would pay all brokerage commissions on behalf of the client and charge the client a flat fee of perhaps 1.25%.

When an RIA firm sponsors a wrap fee program, it is also required to provide a wrap free brochure to clients as defined by Rule 204-3(f)(1) which states: 

an investment adviser...that is compensated under a wrap fee program for sponsoring, organizing, or administering the program, or for selecting, or providing advice to clients regarding the selection of, other investment advisers in the program, shall, in lieu of the written disclosure statement required by paragraph (a) of this section and in accordance with the other provisions of this section, furnish each client and prospective client of the wrap fee program with a written disclosure statement containing at least the information required by Schedule H of Form ADV. 

Thus, it is critical that any investment advisory firm which is sponsoring a wrap fee program ensure that it is providing the appropriate wrap fee brochure to clients in order to ensure full and proper disclosure of the details of the wrap fee program.

ThinkAdvisor recently published a sample SEC exam information request list focusing on wrap free programs. The SEC's sample request list focuses on three key RIA compliance areas related to wrap free programs:

  1. Disclosures: Copies of client advisory contracts, copies of any other relevant contracts (between the RIA firm and sponsor, the investment manager, etc.), the Form ADV Part 2, the wrap free program's disclosure brochure, and marketing materials.
  2. Inactive Accounts: Areas of focus include accounts with low levels of trading or high cash balances.
  3. Transaction Fees: Areas of interest include best execution, trading away, and what other fees may or may not be included as part of the client's wrap free program.

SEC and state regulators have long publicly stated that wrap fee programs can create a significant conflict of interest for an investment adviser and may not always be in the best interests of the client. While at times a properly designed wrap fee program may protect a client from excessive brokerage commissions, commonly referred to as churning, the opposite scenario referred to as reverse churning may also occur when there is very little trading activity in the client's account(s). As such, there may be times when the client would benefit significantly by not being placed into a more expensive wrap free program and instead paid brokerage commissions separately.

As RIA compliance consultants, we continue to see an increasing number of new and existing investment advisory firms looking to sponsor wrap free programs. While wrap free programs can at times be appropriate for investment advisory clients, we strongly encourage all investment advisers to be very cautious and disciplined when it comes to the implementation of wrap free programs. Not only does sponsoring a wrap free program require additional compliance procedures and disclosure documents, but it may also not be appropriate for clients. It's likely this investment adviser compliance area will continue to receive more regulatory focus as the number of wrap free programs continues to grow across the RIA industry.

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Topics: RIA Compliance

RIA in a Box LLC is not a law firm, investment advisory firm, or CPA firm. RIA in a Box LLC does not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.

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