Wrap It Up! SEC Settles Wrap Fee Case

July 21, 2016

Wrap fees became all the rage for those arguing that there had to be a better way to invest than via the old broker-dealer model, which relied upon transaction-based commissions. With a wrap fee, in theory, investors pay a percentage of their assets under management ("AUM") instead of commissions on each trade, and all your investing is covered under what looks like a flat fee. The thing about using the phrase "in theory," is that it tends to underscore that "in reality" everything doesn't run according to plan.

The SEC OIP

A recent Securities and Exchange Commission ("SEC") enforcement action alleges that investment advisory firm RiverFront Investment Group LLC, which was a registered investment adviser ("RIA") with the SEC since 2008, marketed a wrap fee program to its clients but also charged its clients for additional transaction costs. The SEC asserted that RiverFront's Forms ADV did not sufficiently disclosed the additional costs and, as such, were rendered materially misleading by said omissions. In anticipation of the institution of administrative and cease-and-desist proceedings by the SEC but without admitting or denying the findings, Respondent RiverFront submitted an Offer of Settlement, which the federal regulator accepted.

As set forth in the Order Instituting Proceedings (the "OIP"), Respondent RiverFront was found to have willfully violated Sections 207 and 204 of the Investment Advisers Act of 1940 and Rule 204-1(a); and was Censured and agreed to pay a $300,000 penalty. In accordance with the terms of the settlement, on a quarterly basis, RiverFront will post on its website the volume of trades by market value executed away from sponsors and the associated transaction costs passed onto clients. In the Matter of Riverfront Investment Group LLC, Respondent (OIP; Admin. Proc. File 3-17343 / July 14, 2016).

As explained in the "Summary" portion of the OIP [Ed: Footnote omitted]:

1. This matter arises from materially misleading disclosures made by RiverFront in its Forms ADV concerning the frequency that it traded in a manner that resulted in additional, insufficiently disclosed transaction costs to advisory clients in wrap fee programs that were not covered by the annual wrap fee. In wrap fee programs, clients pay an annual fee which is intended to cover the cost of several services "wrapped" together, such as custody, trade execution, portfolio management, and back office services. Wrap fee programs are typically created by a sponsoring firm. Sponsors provide a portion of the program's services. They also may select multiple third party managers for their platforms, from which clients can choose. These third-party managers, often called subadvisers, have discretion over the clients' investment decisions in the programs.

2. Most wrap fee programs contemplate that subadvisers will use a sponsor-designated broker-dealer (often the sponsor itself) to execute the subadviser's trades on behalf of clients. As such, the transaction costs of the trades executed through the designated broker-dealer are included in the wrap fee that each client pays.

3. RiverFront, a registered investment adviser, serves as a subadviser to clients in various wrap fee programs created by a number of different sponsors. As a subadviser, RiverFront creates investment strategies for those wrap fee programs and executes those strategies on behalf of the clients that select RiverFront to manage their accounts, from amongst the subadviser choices available to a client on any particular platform. In this role, RiverFront has sole discretion over whether to send trades to the designated broker-dealer for execution, in which case the transaction charges are covered by the wrap fee, or to send the trades to another broker-dealer in which case the client typically pays additional transaction costs charged by that broker-dealer. The practice of sending trades to a non-designated broker-dealer is referred to as "trading away" and these trades are frequently called "trade aways." The extent to which a subadviser trades away from the designated broker-dealer is relevant to a client selecting a wrap fee program because it entails additional costs to the client and could influence the client's evaluation of the reasonableness of the wrap fee, which is often negotiable.

4. RiverFront first began serving as a subadviser to advisory clients in wrap fee programs in mid-2008. At that time, RiverFront disclosed that it may trade away in an effort to obtain best execution on behalf of its clients, but that it would "generally" execute trades through the designated broker-dealers, which it did. However, beginning in late 2009, RiverFront substantially increased the amount it was trading away. RiverFront claims that trading away resulted in improved execution prices. However, by trading away, RiverFront caused its clients to pay millions of dollars' worth of transaction costs that were not covered by the annual wrap fee, This matter arises from materially misleading disclosures made by RiverFront in its Forms ADV concerning the frequency that it traded in a manner that resulted in additional, insufficiently disclosed transaction costs to advisory clients in wrap fee programs that were not covered by the annual wrap fee. In wrap fee programs, clients pay an annual fee which is intended to cover the cost of several services "wrapped" together, such as custody, trade execution, portfolio management, and back office services. Wrap fee programs are typically created by a sponsoring rendering its existing disclosures inaccurate. By failing to make timely and accurate disclosures to its clients about this change to its trading practices, RiverFront violated Sections 207 and 204(a) of the Advisers Act and Rule 204-1(a) thereunder.

Essentially, from mid-2008 until March 2009, RiverFront had directed almost all wrap trades to designated broker-dealers for exectuion and, as such, the bulk of transaction costs were covered under the Wrap Fee. By second quarter 2009, RiverFront increased its so-called "trading away" and over the next several quarters, Riverfront traded away about 100% of the trades it utilized to implement its client portfolio strategies. The apparent exception to this migration was that client-initiated trades were still routed to the designated broker-dealers. As noted in the OIP:

12. By the beginning of 2010, RiverFront was trading away a majority of its overall
wrap trading by market value and share volume. As shown in the chart below, RiverFront traded away approximately 74% of the market value of its overall wrap fee program trading in 2010 and approximately 82% in 2011. In terms of the percentage of shares, rather than market value, those percentages were approximately 68% and 73% of all wrap trading for those two years.

Unwrapped

One quirk in the OIP is that RiverFront did not appear to financially benefit merely from trading away; however, the lack of benefit to the firm did not result in the lack of detriment to its customers. As noted in the OIP:

13. RiverFront did not profit by trading away, and it claims to have obtained improved execution prices by doing so. However, when RiverFront traded away, any applicable transaction costs charged by the executing broker-dealer were passed through to clients on a per-share basis. Therefore, its clients paid millions of dollars' worth of transaction costs charged by non-designated broker-dealers that were not covered by the wrap fee.

Dis-ADV-antaged

As an RIA, RiverFront filed Form ADV, Parts 1 and 2, which the firm was required to amend annually (within 90 days of fiscal year end) or "promptly" in order to disclose a material change. As explained in the OIP:

17. RiverFront filed Forms ADV on September 2, 2008 and March 31, 2009, prior to
engaging in significant trading away. In the brochure portion of these filings, RiverFront disclosed to its clients that it might trade away in an effort to obtain best execution, and that in such instances clients may pay transaction costs not covered by the annual wrap fee. However, RiverFront also stated that (i) it would typically trade through the sponsor-designated broker-dealers, (ii) clients would not be charged a commission on those trades, (iii) a portion of the wrap fee was considered to be in lieu of brokerage commissions, and (iv) RiverFront therefore generally directed trades to
the designated broker-dealer "in order to enjoy the greatest cost benefits of the wrap fee program."

18. RiverFront significantly increased its trading away activity during 2009 and early
2010. Consequently, trading away began to constitute a majority of wrap trading by volume, whether measured in terms of market value or shares, during this time period. However, RiverFront did not update its Form ADV as required in light of this material change. RiverFront Made Materially Misleading Statements in Its March 31, 2010 and August 31, 2010 Forms ADV

19. On March 31 and August 31, 2010, RiverFront filed its next two Forms ADV,
including amended brochures. In those brochures, RiverFront made identical disclosures regarding trade execution in wrap fee programs that it had in its prior Forms ADV. Specifically, RiverFront repeated that wrap trading would "generally" or "customarily" be done through the sponsor designated broker-dealers "in order to enjoy the greatest cost benefits of the wrap fee program." RiverFront also reiterated that wrap fee program trades "are generally effected without commissions."

20. By the time RiverFront repeated these disclosures in its March 31, 2010 Form
ADV, it was trading away the majority of its wrap trading. By market value, RiverFront traded away approximately 57% of the total wrap trades that quarter and approximately 61% by shares. In the next quarter, those percentages were approximately 73% and 54%, respectively.

21. By the third quarter of 2010, the quarter in which RiverFront filed the August 31,
2010 Form ADV which continued to include identical language regarding the trade away practice, RiverFront sent approximately 82% of the market value of wrap trades to non-designated broker dealers, representing approximately 78% of shares traded.

Remedial Acts

In settling this case, the SEC asserted that RiverFront had "willfully" violated Sections 207 and 204(a) of the Advisers Act. In considering the sanctions to be imposed upon the firm, the SEC noted the following in the OIP:

RiverFront's Remedial Efforts

29. In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Respondent and cooperation afforded the Commission staff.

Undertakings

30. Respondent has undertaken to disclose, on a quarterly basis, on its public website, the volume of trades by market value executed away from sponsor firms and the associated transaction costs charged by non-designated broker-dealers and passed onto clients. Respondent will provide this information on an investment strategy by investment strategy basis. The location of this data will be referenced by its URL in all of Respondent's future Forms ADV and Respondent's client agreements. In determining whether to accept the Offer, the Commission has considered this undertaking.

Bill Singer's Comment

Compliments to the SEC for publishing a concise and informative OIP replete with sufficient content and context to make the document both intelligible and educational. The sanctions do not seem excessive or punitive but, to the contrary, reasonable under the attendant circumstances and well suited to best address the conduct at issue. I urge all serious industry participants to invest the time to read this regulatory release.

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Wrap It Up! SEC Settles Wrap Fee Case

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