Experts believe that the U.S. Securities and Exchange Commission’s industrywide sweep of disclosures is likely to lead to enhanced scrutiny and enforcement proceedings.
Counsel and investment advisers can prepare for SEC Enforcement Division investigations and Office of Compliance Inspections and Examinations inspections by: testing wrap fee compliance controls; analyzing quantitative assertions made in disclosures; calculating the relative cost of wrap fees versus traditional fee arrangements; and monitoring accounts in wrap fee programs.
Has your investment adviser offered a “wrap fee” to roll all of your individual transaction fees into a single charge? While this may seem convenient in practice, there is increasing scrutiny around potential abuse related to wrap fee programs.
In January, the SEC listed wrap fee programs among its 2014 priorities. The SEC made good on its stated commitment this summer, when the Office of Compliance Inspections and Examinations issued a letter to certain investment advisers, requesting 21 detailed items on wrap fee programs.
Wrap fee programs protect clients from churning. But, abuse can occur when only few transactions are being executed and the overall fixed fee cannot be justified — especially, when it amounts to more than the individual commissions based on trading activity.
WHAT IS A WRAP FEE?
A wrap fee covers advisory, trading and custodial services. Fixed as a percentage of assets under management, wrap fees typically range from 1.25 percent to 3 percent of assets under management, and are paid by customers in lieu of individual fees and commissions based on trading activity.
Firms with wrap fee programs, among other requirements, must provide a detailed disclosure of the program to clients, as well as ongoing monitoring of the accounts. Rule 204-3(d) of the Advisers Act requires firms to prepare and provide to clients a brochure that explains the wrap fee program. Additionally, Financial Industry Regulatory Authority rules require firms to develop and implement a system to monitor accounts to determine whether the wrap fee program remains appropriate for clients.
As part of its focus on wrap fees, including both the disclosures and the firm’s ongoing monitoring of the accounts, the SEC explained that “the staff will assess whether [investment] advisers are fulfilling their fiduciary and contractual obligations to clients and will review the processes in place for monitoring wrap fee programs recommended to advisory clients, related conflicts of interest, best execution, trading away from the sponsor, and disclosures.” The letter issued to a number of investment advisers as part of the wrap fee sweep requests, among others:
- A copy of each wrap fee program’s disclosure brochure furnished to clients;
- A list of all marketing materials used to promote wrap fee programs;
- Compliance policies specific to monitoring for wrap accounts with high cash balances or low level of trading; and
- Any analyses to identify wrap accounts with low levels of trading or high cash balances.
The SEC’s analytics program can identify inadequate monitoring of wrap fee accounts. In an October 2013 speech to the National Society of Compliance Program, SEC Chairwoman Mary Jo White explained that the SEC’s Risk Analysis Examination initiative, which has analyzed more than 400 million transactions as part of a single examination, was able to use quantitative analytics to identify inadequate supervision of reverse churning.
REVERSE CHURNING AND THE ROLE OF FORENSIC TESTING AND DATA ANALYTICS
Forensic testing and data analytics can be useful tools when preparing for an SEC examination or defending an enforcement proceeding. Specifically, these tools are useful to:
- Test the effectiveness of compliance controls around wrap fee programs, including decisions to accept new accounts and monitor existing accounts. An independent review — whether conducted by internal audit/compliance or an independent third party — is essential to demonstrating an effective compliance program.
- Test and analyze quantitative assertions made in disclosures, including the wrap fee program brochure. Proactive assessment will help firms prepare for SEC scrutiny.
- Develop forensic data analytics tools to monitor accounts in wrap fee programs and identify potential reverse churning. This allows firms to proactively address potential issues using tools similar to the SEC’s own analytics program.
- Calculate the relative cost of wrap fees versus traditional fee arrangements for existing and new accounts. Those accounts that generate substantially higher fees under wrap fee programs are likely to be subject to a higher degree of regulatory scrutiny.
THE WRAP UP: WHAT YOU CAN DO
With attention to wrap fee programs on the rise, the SEC seems committed to sending a strong message to investment advisers that protecting clients is paramount. This emphasis is likely to result in an increase in enforcement activity, placing investment advisers and their counsel in a position to defend actions related to these programs.
Employing forensic auditing and data analytics tools early on can help to detect potential abuse of wrap fee programs, remediate issues before they become larger problems and demonstrate a firm’s commitment to compliance.
—By Jonny Frank and Tristan Cecala, StoneTurn Group
Jonny Frank is a partner in the New York office of consulting firm StoneTurn Group. He brings more than 30 years of public, private and education sector experience in preventing, investigating and remediating fraud and misconduct. Frank began his career as a federal prosecutor and later founded and led the global fraud risks and controls practice at a Big Four firm.He has taught Fraud Management, Criminal Investigations and International Criminal Law courses at the Yale School of Management, Fordham University and Brooklyn Law School.
Tristan Cecala, a Senior Consultant with StoneTurn Group in Boston, has more than five years of experience in providing forensic accounting and dispute consulting services. He has assisted clients on a variety of complex business matters, including breach of contract claims, post-acquisition disputes, regulatory issues within the financial services industry and shareholder disputes. He has also provided support to counsel on corporate investigations involving fraud and embezzlement, potential False Claims Act violations and various other types of financial statement manipulation.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 See DOJ and SEC, A Resource Guide to the US Foreign Corruptions Act 54 (2012)(“FCPA Resource Guide”);
United States Sentencing Commission, Guidelines Manual §8B2.1, commentary 6 (2011)(“USSG”).
All Content © 2003-2014, Portfolio Media, Inc.