Dual Registrant Settles SEC Charges for Overcharging Wrap Accounts
Commentary by Steven Lofchie
A dually registered investment adviser and broker-dealer was penalized for failing to adequately and periodically review wrap fee accounts to identify instances of "reverse churning."
According to the Order, the SEC found that the firm failed to respond to red flags raised in certain instances where wrap fee accounts should have been converted to brokerage accounts. The firm's internal controls had identified multiple accounts that entered into less than four trades over a two-year period which, according to the firm's compliance manual, should have been converted to brokerage accounts after flagging the low trading volume. This lack of response resulted in clients paying over $484,000 in excess fees. In addition to failing to respond to red flags, the firm also failed to conduct reviews at specific intervals to determine if a wrap fee account was still in the best interest of the account holder.
As a result, the SEC determined that the adviser violated Sections 206(2) and (4) of the Advisers Act ("Prohibited transactions by investment advisers"), as well as Rule 206(4)-7 thereunder ("Compliance procedures and practices").
To settle the charges, the adviser agreed to (i) cease and desist, (ii) accept a censure and (iii) pay a civil monetary penalty totaling $899,513, which includes a $200,000 monetary penalty, a $484,645 disgorgement and $90,944 in prejudgment interest.
Commentary
The investment adviser was essentially dead in the water as far as the finding of a compliance violation goes because it failed to follow its own procedures.
Leaving that aside, the question of whether wrap fee accounts are worthwhile for clients is more complicated than how many times the client trades. As the enforcement action notes, the services of a broker-dealer and an investment adviser are somewhat different: The adviser has the task of monitoring the client's account on an ongoing basis, while the broker-dealer does not. Further, under Regulation Best Interest, a broker-dealer that makes a recommendation to a client is subject to more substantial obligations to have the client's information than was the case under the FINRA "suitability rule." Accordingly, the amount a broker-dealer may charge for the execution of recommended trades may mean it is simply not worthwhile for broker-dealers to recommend trades to clients that pay only for execution and not for advice or account monitoring.
In light of the above, advisory firms offering wrap fee accounts should carefully review their compliance manuals to ensure their promises match their actions in terms of moving clients off the wrap fees. They should also be mindful that they take account of the value of any account monitoring they provide in determining whether the client should be a brokerage-only client or if it is better served by being a wrap fee client.
Finally, advisers must be sure that they carefully explain their services and fees so that clients can determine whether they think it worthwhile to pay for account monitoring services.