By Anne Sherry, J.D.
In a pair of risk alerts, the SEC’s Division of Examinations cautioned investment advisers about compliance issues that it observed in connection with fixed-income principal and cross trades and wrap-fee programs. The documents highlight deficiencies and other staff recommendations, particularly with regard to compliance programs, disclosures, and conflicts of interests, that advisers may wish to address in their policies and procedures.
Fixed-income principal and cross trades. The Division published the risk alert on fixed-income principal and cross trades as a follow-up to its September 2019 alert on this topic. The update follows an examination initiative focusing on SEC-registered investment advisers that engaged in cross trades or principal trades (or both) involving fixed-income securities. The alert defines a principal trade as involving a security sold to or bought from the adviser’s own account, an agency cross trade when the adviser arranges a trade between a client and a non-client, and a cross trade when the adviser effects a trade between multiple clients’ accounts.
As part of its FIX Initiative, Division staff conducted over 20 examinations of advisers that collectively managed $2 trillion in assets for over two million client accounts. Nearly two-thirds of the advisers received deficiency letters as a result, the vast majority of which related to compliance programs, conflicts of interest, and disclosures.
The staff found that policies and procedures were inconsistent with the advisers’ practices, disclosures, and/or regulatory requirements and sometimes lacked certain considerations or guidance. Many advisers did not effectively test the implementation of their written policies and procedures, so that even firms that prohibited principal and cross trades were unaware that such trades had occurred. Division staff also uncovered conflicts of interest that were not identified, mitigated, disclosed, or otherwise addressed by the advisers. Examined advisers omitted relevant information about cross-trading activities and failed to disclose conflicts.
The risk alert also identifies some of the practices that appeared to be effective in improving compliance. This includes policies and procedures that incorporate all applicable legal and regulatory requirements, define covered activities, set standards, provide for supervision, and establish controls. With regard to the disclosure deficiencies, the report suggests that advisers provide full and fair disclosure of all material facts and do so in multiple documents (Forms ADV, Part 2A; advisory agreements; separate written communications; and/or private fund offering documents).
Wrap fee programs. In a separate alert, the Division focused on wrap fee programs due to the growth of assets in these programs and the conflicts and disclosure issues staff discovered in over 100 examinations. The exams included both advisers that served as portfolio managers in, or sponsors of, wrap fee programs and those that advised client accounts through third-party programs. Division staff found room for improvement in many of the advisers’ compliance programs, particularly with respect to compliance, oversight, and disclosures.
In particular, Division staff cited issues with advisers’ recommendations that clients participate in wrap fee programs. The most common duty-of-care issue was a failure to monitor for "trading away" and the associated costs; due to fees, some clients would have been better off in non-wrap-fee accounts. In other cases, advisers did not have a reasonable basis to believe the programs were in clients’ best interests.
Advisers also had inconsistent disclosures across various documents, such as advisory agreements indicating that clients would pay brokerage commissions while the wrap-fee program brochures expressly stated clients would not pay such fees. Staff found that advisers omitted disclosing or inadequately described conflicts of interest.
The staff also observed that advisers omitted compliance policies and procedures entirely or their policies and procedures were inadequate. Where policies and procedures were in place, some advisers did not implement or enforce them consistently, while some did not perform adequate annual reviews (if any).
Best practices for wrap-fee programs involve both initial and periodic reviews to assess whether the programs are in clients’ best interest, using information directly obtained from clients, the risk alert states. Advisers should periodically remind clients to report any changes to their situations and objectives, and should otherwise communicate with clients to prepare and educate them when recommending wrap fee accounts.
The risk alert also recommends clear disclosures regarding conflicts of interests and spelling out what additional services and expenses are not included in the wrap fee. Compliance programs should include written policies and procedures and should be monitored for best execution.